UNIT 1: CONCEPTS IN RISK AND INSURANCE

Content
1.0 Aims and Objectives
1.1 Introduction
1.2 Meaning of Risk
1.3 Risk and Uncertainty
1.4 Risk, Peril and Hazard
1.5 Chance of Loss Distinguished from Risk
1.6 Classification of Risk
1.6.1 Objective and Subjective Risk
1.6.2 Financial and Non-Financial Risk
1.6.3 Pure and Speculative Risks
1.6.4 Static and Dynamic Risks
1.6.5 Fundamental and Particular Risks
1.7 Risk Related to Business Activities
1.8 Burden of Risk on the Society
1.9 Summary
1.10 Answer to Check Your Progress Exercise

1.0 AIMS AND OBJECTIVES

Dear student, in this section, you will learn about the fundamental concepts in risk and insurance and
the classifications of risk based on various criteria.
After studying this unit, you should be able to:

▪ summarize why the study of risk management is important;

▪ outline the ideas incorporated in the meaning of risk;
▪ classify risk according to various criteria; and
▪ describe the extent of risk in various areas (for example: at work, crime, road accidents, fire).

1.1 INTRODUCTION

In your earlier courses, you have discussed some important concepts in business. Business, which
refers to all those activities there are connected with production or purchase of goods and services with
the object of selling them at profit, has some essential characteristics and one of these is the fact that it
involves an element of risk and uncertainty. Because the adverse effects of risk have affected mankind
since the beginning of time, individuals groups and societies have developed various methods for
managing risk. Since no one knows the future exactly, every one is a risk manager not by choice, but
by sheer necessity. The purpose of this course is then to examine how businesses and families might
effectively mange a major class of exposures to loss through a process called risk management, which
is the identification, measurement, and treatment of exposures to potential accidental losses.

1.2 THE MEANING OF RISK

Dear student, the starting point for any reading material on risk and insurance must be the concept of
risk itself and our understanding of it. What exactly is meant by the word risk? The word is certainly
used frequently in everyday conversation and seems to be well understood by those using it.
What is your understanding when the term ‘risk’ is mentioned? Do you have any idea? Please write
your response in the space provided below.
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Dear student, there is no single definition of risk. Many writers have produced a number of definitions
of risk. These are usually accompanied by lengthy arguments to support the particular view they put
forward. Economists, behavioral scientists, risk theorists, statisticians, and actuaries each have their
own concept of risk. Some of these definitions are forwarded for your consideration.
A. Risk is potential variation in outcomes. When risk is present, outcomes cannot be forecasted with
certainty. William, Smith and Young
B. Risk is the variation in outcomes that could accrue over a specified period in a given situation.
William’s and Heins
C. Risk is the condition in which there is a possibility of adverse deviant from desired outcome that is
expected or hoped for. Vaughen Wiliams and Heins did not focus only on the negative side as
variation could be both positive and negative. The emphasis is then on both negative and positive
feelings of risk. But Vaughen focuses on the negative felling of risk.

Dear student, could you identify the defining elements of the concept of risk? Please itemize them
down, in your own words, in the space provided below.
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However, looking at the definitions, there does seem to emerge some kind of common thread running
through each of them.

Firstly, there is the underlying idea of uncertainty, what we have referred to as doubt about the future.

Secondly, there is the implication that there are differing levels or degrees of risk. The use of words
such as possibility and unpredictability, do seem to indicate some measure of variability in the effect of
this doubt.

Thirdly, there is the idea of a result having been brought about by a cause or causes. This does seem to
tie in nicely with the working definition we used earlier of uncertainty about the outcome in a given
situation.

The value of having a single definition is questionable because it is likely to be limited in its ability to
capture the comprehensive flavor of risk. It is more valuable to dissect the idea of risk and consider its
component parts.
Dear student, in the forthcoming discussions, we will look at the common concepts in risk
management. In doing this, we may be able to move towards a more comprehensive and practical
understanding of the meaning and nature of risk than would be the case if we stuck rigidly to one or
two definitions.

1.3 RISK AND UNCERTAINTY

We have used the word uncertainty several times already. In our first attempt at a working definition of
risk, we said that it was uncertainty about the outcome in a given situation. Uncertainty is at the very
core of the concept of risk itself, but are we clear what we mean by it when we use the word?

We could take rather the philosophical view and say that uncertainty is, like beauty, in the eye of the
beholder. We could go a step further than this and say that there is no real uncertainty in the natural
order of things in our world. This point is worth exploring a little further as part of our consideration of
the nature of risk.

An argument can be put which says that there is no uncertainty, that it does not exist in the natural
order of things. You may well respond to this by saying that there are a number of outcomes which are
uncertain. For example: a risk of a rain, the possibility of being made redundant, the risk of having an
accident. There is surely uncertainty surrounding all of these events - or is there?

We may say that there is a risk of rain, a risk of being made redundant or a risk of being in an accident.
We use the phrase almost suggesting that the event may or may not happen. The fact is that the event
will or will not occur, there is no doubt about that. What we are really expressing is the fact that we
have some doubt as to whether the event will occur or not. We have imperfect information about the
future, and this imperfection in our knowledge is what leads to the doubt and hence to the uncertainty
which we express.

This rather places the idea of uncertainty, and consequently risk, with the individual and supports the
view that uncertainty is in the eye of the beholder.

Consider a child playing in the middle of a busy road; a workman using a machine while being
unaware that it is faulty and dangerous; pedestrians unaware that a wall running alongside a pavement
is in a dangerous condition and about to collapse. In each of these situations there is an element of risk.
However, uncertainty will only be created when the individuals recognize the existence of the risks.
The child may escape free of injury, the machine may hold out until the workman has finished using it
and the wall may not collapse and injure passers by. Alternatively, there could be serious injury in each
case.

The people involved in each of these examples are unaware of the risk, but it does not mean that there
is no risk. Most people would agree that risk is present, even if it is not recognized by the people who
could be affected. We conclude that risk can exist in the abstract; it is not dependent on being
recognized as existing by those who may be most directly involved. Risk is linked more to the event
itself, rather than to any personal perception of the existence of uncertainty. Unlike risk, uncertainty
dependent on being recognized.

To bring this philosophical discussion to some conclusion, we could say that the concept of uncertainty
implies doubt about the future based on a lack of knowledge, or imperfection in knowledge. Risk
exists regardless of whether this doubt has been recognized by those who may be most directly
involved.

The reason for looking at uncertainty was that it formed one of the components of the concept of risk.
Going back to the broader idea of risk, and using our understanding of uncertainty, we could say that
the basis of risk is lack of knowledge, regardless of whether the state of lack of knowledge is
recognized. If we always knew what was going to happen there would be no risk. We would know for
certain if our house was to burn down this year, if we were to have an accident, if the burglars were to
select our house, if our car was to be stolen, and so on. We do not have this knowledge and hence
operate in an uncertain or risky environment.

We can therefore say that risk exists outside the individual, it may be recognized as existing but this is
not a pre-requisite. In this sense, it is objective and not dependent on any one individual. In chapter
two we will see that people very often do place their own subjective assessments on the existence and
level of risk in given situations.
1.4 RISK, PERIL AND HAZARD

We often use the word risk to mean both the event, which will give rise to some loss and the factors
which may influence the outcome of a loss. When we think about cause, we must be clear that there
are at least these two aspects to it. We can see this if we think of a house on a riverbank and the risk of
flood. The risk of flood does not really make sense, what we mean is the risk of flood damage. Flood is
the cause of the loss and the fact that one of the houses was right on the bank of the river influences the
outcome.

Flood is the peril and the proximity of the house to the river is the hazard. The peril is the prime cause;
it is what will give rise to the loss. Often it is beyond the control of anyone who may be involved. In
this way we can say that storm, fire, theft, motor accident and explosion are all perils.

Factors, which may influence the outcome are referred to as hazards. Hazards refer to the conditions
that create or increase the chance of loss. These hazards are not themselves the cause of the loss, but
they can increase or decrease the effect should a peril operate. In fact, hazards would facilitate the
occurrence of perils. The consideration of hazard is important when an insurance company is deciding
whether or not it should insure some risk and what premium to charge.

There are four major types of hazards:

▪ Physical hazards
▪ Moral hazard
▪ Morale hazard
▪ Legal hazard

Physical hazard is a physical condition that increases the likelihood of loss. It relates to the physical
characteristics of the item or the property exposed to the risk, such as the nature of construction of a
building, the nature of the road (e.g. Icy, rough roads that increase the likelihood of an auto accident,
etc) loose security protection at a shop or factory, or the proximity of houses to a riverbank.
Moral hazard is dishonesty or character defects in an individual that increases the frequency or
severity of loss. It is related with the human aspects which may influence the outcome. This usually
refers to the attitude of the insured person. Examples of moral hazard include taking an accident to
collect from an insurer, submitting a fraudulent claim, inflating the amount of the claim, and
intentionally burning unsold merchandise that is insured.

Morale hazard refers to the carelessness or indifference to a loss because of the existence of an
insurance. Some insureds are careless or indifferent to a loss because they have insurance. Examples of
morale hazard include leaving car keys in an unlocked car, which increases the chance of theft; leaving
a door unlocked that allows a burglar to enter, etc….

Legal hazard refers to characteristics of the legal system or regulatory environment that increase the
frequency or severity of losses. Examples include adverse jury verdicts or large damage awards in
liability lawsuits, statutes that require insurers to include coverage for certain benefits in health
insurance plans, such as coverage for alcoholism; and restrict the ability of insurers to withdraw from
the state because of poor underwriting results.

1.5 CHANCE OF LOSS DISTINGUISHED FROM RISK

Chance of loss is closely related to the concept of risk. Chance of loss is defined as the probability that
an event will occur. Chance of loss should not be confused with objective risk. Chance of loss is the
probability that an event will occur. Objective risk is the relative variation of actual loss from the
expected loss. The chance of loss may be for two different groups, but objective risk may be quite
different. For example, assume that a fire insurer has 10,000 homes insured in Addis Ababa and
10,000 homes in Mekelle and that the chance of loss in each city is 1 per cent. Thus, on average, 100
homes should burn annually in each city. However, if the annual variation in losses ranges from 75 to
125 in Addis Ababa, but only from 90 to 110 in Mekelle, objective risk is greater in Addis Ababa even
the chance of loss in both cities is the same.

1.6 THE CLASSIFICATION OF RISK

We turn our attention now to the classes into which risk can be placed. This is different from
scrutinizing the actual idea of risk; we are now looking at the whole concept of risk and grouping
together similar classes of risk. Of the many classes, we will look at five.

1.6.1 Objective and Subjective Risk

Some authors make a careful distinction between objective risk and subjective risk. We shall briefly
discuss the distinction between the two in the forthcoming paragraphs.

Objective risk – is defined as the relative variation of the actual loss from expected loss. For example,
assume that a fire insurer has 10,000 houses insured over a long period and, on average, 1 percent, or
100 houses burn each year. However, it would be rare for exactly 100 houses to burn each year. In
some years as few as 90 houses may burn, while in other years, as many as 110 houses may burn.
Thus, there is a variation of 10 houses from the expected number of 100, or a variation of 10 percent.
This relative variation of actual loss from expected loss is known as objective risk.

Objective risk declines as the number of exposures increases. More specifically, objective risk varies
inversely with the square root of the number of cases under observation. In our previous example,
10,000 houses were insured, and objective risk was 10/100, or 10 per cent. Now assume that 1 million
houses are insured. The expected number of houses that will burn is now 10,000, but the variation of
actual loss from expected loss is only 100. Objective risk now is 100/10,000, or 1 per cent. Thus, as the
square root of the number of houses increased from 100 in the first example to 1000 in the second
example (ten times), objective risk; declined to one-tenth of its former level. (this is discussed in detail
in the next chapter)

Objective risk can be statistically measured by some measure of dispersion, such as the standard
deviation or the coefficient of variation. Since objective risk can be measured, it is an extremely useful
concept for an insurer or a corporate risk manager. As the number of exposures increases, an insurer
can predict its future loss experience more accurately because it can rely on the law of large numbers.
The law of large numbers states that as the number of exposure units increases, the more closely will
the actual loss experience approach the probable loss experience. For example as the number of homes
under observation increases, the greater is the degree of accuracy in predicting the proportion of homes
that will burn.

Subjective risk – is defined as uncertainty based on a person’s mental condition or state of mind. For
example, an individual is drinking heavily in a bar and attempts to derive home. The driver may be
uncertain whether he or she will arrive home safely without being arrested by the police for drunk
driving. This mental uncertainty is called subjective risk. Often subjective risk is expressed in terms of
the degree of belief.

The impact of subjective risk varies depending on the individual. Two persons in the same situation
may have a different perception of risk, and their conduct may be altered accordingly. If an individual
experiences great mental uncertainty concerning the occurrence of a loss, that person’s conduct may be
affected. High subjective risk often results in less conservative conduct, while low subjective risk may
result in less conservative conduct. A driver may have been previously arrested for drunk driving and
is aware that he or she has consumed too much alcohol. The driver may then compensate for mental
uncertainty by getting someone else to drive him or her home or by taking a cab. Another driver in the
same situation may perceive the risk of arrested as slight. The second driver may drive in more
careless and reckless manner; a low subjective risk results in less conservative driving behavior.

1.6.2 Financial and Non-Financial Risk

We have already said that risk implies a situation where there is uncertainty about the outcome. A
financial risk is one where the outcome can be measured in monetary terms. This is easy to see in the
case of material damage to property, theft of property or lost business profit following a fire. In cases
of personal injury, it can also be possible to measure financial loss in terms of a court award of
damages, or as a result of negotiation between lawyers and insurers. In any of these cases, the outcome
of the risky situation can be measured financially.

There are other situations where this kind of measurement is not possible. Take the case of the choice
of a new car, or the selection of an item from a restaurant menu. These could be taken as risky
situations, not because the outcome will cause financial loss, but because the outcome could be
uncomfortable or disliked in some other way. We could even go as far as to say that the great social
decisions of life are examples of non-financial risks: the selection of a career, the choice of a marriage
partner, having children. There may or may not be financial implications, but in the main the outcome
is not measurable financially but by other, more human, criteria.

In the world of business we are primarily concerned with risks which have a financially measurable
outcome.

1.6.3 Pure and Speculative Risks

This classification also concerns the outcome. It distinguishes between those situations where there is
only the possibility of loss and those where a gain may also result.

Pure risks involve two possible outcomes a loss or, at best, no loss. The outcome can only be
unfavorable to us, or leave us in the same position as we enjoyed before the event occurred. The risk of
a motor accident, fire at a factory, theft of goods from a store, or injury at work are all pure risks with
no element of gain. It is a loss or no loss that can result from such risks.

The major types of pure risks that are associated with great financial and economic insecurity include
personal risks, property risks, and liability risks.

Personal risk is chiefly concerned with death and the time of its occurrence. And apart from death,
there is incapacity through accident, injury, illness or old age – loss of earning power.

Property risk refers to losses associated with ownership of property such as destruction of property by
fire, lightening, windstorm, flood and other forces of nature. Property risk leads to direct loss and
consequential loss. For example, when the New York twin towers were destroyed, the direct loss is the
building itself and the consequential loss is the benefit generated from it including the rent income.

Losses to property may be classified as either direct loss or indirect loss. Each of this group is
discussed below.

• Direct loss – a direct loss is defined as a financial loss that results from the physical damage,
destruction, or theft of the property. For example, assume that you own a restaurant, and the
building is insured by a property insurance policy. If the building is damaged by a fire, the physical
damage to the property is known as a direct loss. In other words, property suffers a direct loss
when the property itself is directly damaged or destroyed or disappears because of contact with a
physical or social peril.

• Indirect or consequential loss – an indirect loss is a financial loss that results indirectly from the
occurrence of a direct physical damage, destruction, or theft. Thus, in addition to the physical
damage loss, the restaurant would lose profits for several months while it is being rebuilt. The loss
of profits would be a consequential loss. Other examples of consequential loss would be the loss of
 the use of the building, the loss of rents, and the loss of a market.

Extra expenses are another type of indirect, or consequential loss. For example, suppose you own a
newspaper, bank, or dairy. If a loss occurs, you must continue to operate regardless of cost;
otherwise, you will lose customers to your competitors. It may be necessary to set up a temporary
operation at some alternative location, and substantial extra expenses would then be incurred.

Property refers to a bundle of rights that form part of the tangible physical assets, but which
independently possess certain economic value. The exposures that result from these interests may be
property including net income or liability exposures. Only the direct and indirect property loss
exposures are considered below.

Liability Risk
Liability risk is the possibility of loss arising from intentional or unintentional damage made to other
persons or to their property. One would be legally obliged to pay for the damages he inflicted upon
other persons or their property. A court of law may order you to pay substantial damages to the person
you have injured.

Liability risks are of great importance for several reasons. First, there is no maximum upper limit with
respect to the amount of the loss. You can be sued for any amount. In contrast, if you own a property,
there is a maximum limit on the loss. For example, if your automobile has an actual cash value of Br.
10,000, the maximum physical damage loss is Br. 10,000. But if you are negligent and cause and
accident that results in serious bodily injury to the other driver, you can be sued for any amount – Br.
50,000, Br. 500,000, or Br.1 million or more – by the person you have injured.

Second, although the experience is painful, you can afford to lose your present financial assets, but you
can never afford to lose your future income and assets. Assume that you are sued and are required by
130the court to pay a substantial judgment to the person you have injured. If you do not carry liability
Insufficient number of homogeneous
insurance or are underinsured, your future and assets can be attached to satisfy the judgment. If you
exposure units to predict future losses
declare bankruptcy to avoid payment of the judgment, your ability to obtain credit will be severely
impaired.
Fewer persons purchasing the
insurance
Finally, legal defense costs can be enormous. If you are sued and have no liability insurance, the cost
of hiring an attorney to defend you and represent you in a court of law can be staggering.
Substantial increase in premium

Speculative Risk` The alternative to pure risks is speculative risk, where there are two possible
Substantial increase of moral Hazard
outcomes – gain or loss. Speculative risk is defined as a situation in which either profit or loss is
possible. Investing money in shares is a good example. The investment may result in a loss or possibly
a break-even
Paymentposition, but the reason
for of intentional lossesit was made was the prospect of gain. People are more adverse to
pure risks as compared to speculative risks. In speculative risk situation, people may deliberately
create the risk when they realize that the favorable outcome is, indeed, so promising.

Dear student, it is important to distinguish between pure and speculative risks for three reasons. First,
private insurers generally insure only pure risks. With some exceptions, speculative risks are not
considered insurable and other techniques for coping with risk must be used. (one exception is that
some insurers will insure institutional portfolio investments and municipal bonds against loss.)

Second, the law of large numbers can be applied more easily to pure risks than to speculative risks.
The law of large numbers is important since it enables insurers to predict losses in advance. In contrast,
it is generally more difficult to apply the law of large numbers to speculative risks in order to predict
future loss experience.

Finally, society may benefit from a speculative risk even though a loss occurs, but it is harmed if a
pure risk is present and a loss occurs. For example, a firm may develop a new technological process
for producing computers more cheaply and, as a result, may force a competitor into bankruptcy,
society benefits since the computers are produced more efficiently and at a lower cost. However,
society will not benefit when most pure risks occur, as for example, if a flood occurs or an earthquake
devastates an area.

The reason for stressing the difference between pure and speculative risks is to highlight the fact that
pure risks are normally insurable while speculative risks are not normally insurable. It is difficult to be
dogmatic about this, as practice is changing and the division between pure and speculative is becoming
more blurred as time passes. Take the case of the credit risk, which we listed under the heading of
speculative risks. The goods have been sold on credit in the hope that a gain will result but a form of
credit insurance is available which will meet some of the consequences should the debtor default.

However, insurance is not normally available for those risks where the outcome can be a gain and it is
easy to see why this should be so. Speculative risks are entered into voluntarily, in the hope that there
will be gain. There would be very little incentive to work towards achieving that gain if it was known
that an insurance company would pay up, regardless of the effort expended by the individual. Using
the terminology of hazard, we could say that there would be a very high risk of moral or morale
hazard.

However, we should be clear that the pure risk consequences of speculative risks can be insured
against and that more and more people involved in risk and insurance are being asked to handle
speculative risks.

1.6.4 Static and Dynamic Risks

Dynamic risk originates from changes in the overall economy such as price level changes, changes in
consumer taster, income distribution, technological changes, political changes and the like. They are
less predictable and hence beyond the control of risk managers. Static risks, on the other hand, refer to
those losses that can take place even though there were no changes in the over all economy. They are
losses arising from causes other than changes in the economy. Unlike dynamic risks, they are
predictable and could be controlled to some extent by taking loss prevention measures. Many of the
perils fall under this category.
1.6.5 Fundamental and Particular Risks
The final classification relates to both the cause and effect of risk. Fundamental risks are those, which
arise from causes outside the control of any one individual or even a group of individuals. In addition,
the effect of fundamental risks is felt by large numbers of people. This classification would include
earthquakes, floods, famine, volcanoes and other natural ‘disasters’. However it would not be accurate
to limit fundamental risk to naturally occurring perils. Social change, political intervention and war are
all capable of being interpreted as fundamental risks.

In contrast to this form of risk, which is impersonal in origin and widespread in effect, we have
particular risks. Particular risks are much more personal both in their cause and effect. This would
include many of the risks we have already mentioned such as fire, theft, work related injury and motor
accidents. All of these risks arise from individual causes and affect individuals in their consequences.

What is interesting is the way in which risks can change classification. This does support the view that
risk is a dynamic concept and that our view of it can be modified as time passes. Much of this
movement in classification has been from particular to fundamental.

Unemployment was regarded as a particular risk for much of the early part of this century, there was
almost the implication that being unemployed was the fault of the individual. However, the
technological unemployment of the seventies and eighties has changed that view, and we now talk
about people suffering unemployment. As a consequence of changes in our industrial and commercial
world, the emphasis has moved away from the individual to society as a whole. The evidence of this is
seen in the financial provision made for those who are unemployed, in almost all industrialized
countries.

A similar move has taken place concerning injury in motor accidents, injury at work and injury caused
by faulty products. In each of these cases society has decided that those who are injured should be able
to receive financial compensation. It does this by passing legislation, which ensures either that suitable
insurance is in force, or that those who are injured need not have the burden of proving fault.

In the main, particular risks are insurable while fundamental risks are not, but it is difficult to
generalize as views in the insurance market place change from time to time. We could say that
fundamental risks are normally so uncontrollable, widespread and indiscriminate that it is felt they
should be the responsibility of society as a whole. The geographical factor is often important,
particularly for natural hazards such as flood and earthquake. In many parts of the world these risks
would be regarded as fundamental and not insurable, but in the United Kingdom they are insurable.

Dear student, the discussion up to this point has been intended to give a rounded view of the nature of
the concept of risk itself. It may have seemed rather philosophical at times, but it has been useful to
explore ideas rather than simply accept definitions. We now move on to the much more practical and
objective question of the cost of risk

1.7 RISKS RELATED TO BUSINESS ACTIVITIES

Most risks in business environment are speculative in nature. The finance literature considers five
types of risks that business organizations face in the course of their normal operation. These are:
business risk, financial risk, interest rate risks, purchasing power risks, and market risks. Each of these
are briefly discussed below.
Business Risk - This is the risk associated with the physical operation of the firm. Variations in the
level of sales, costs, profits are likely to occur due to a number of factors inherent in the
economic environment. Business risk is independent of the company’s financial
structure.

Financial Risk - This is associated with debt financing. Borrowing results in the payment of periodic
interest charge and the payment principal upon maturity. There is a risk of default by
the company if operations are not profitable. Other financial risks include;
bankruptcy, stock price decline, insolvency. Bondholders are less exposed to financial
risk than common stockholders because they have a priority claim against the assets
of an insolvent firm. Government securities, however, bear very low risk.

Interest Rate Risk - This is a risk resulting from changes in interest rates. Changes in interest rates
affect the prices of financial securities such as the prices of bonds etc. for interest rate
rise depresses bond prices and vice, versa.

Purchasing Power Risk - This risk arises under inflationary situations (general price rise of goods and
services) leading to a decline in the purchasing power of the asset held. Financial
assets lose purchasing power if increased inflationary tendencies prevail in the
economy.

Market Risk - Market risk is related to stock market. It refers to stock price variability caused
by market forces. It is the result of investors’ reactions to real or psychological
expectations. For example, some forecasts may convince investors that the economy
is heading towards a recession. The market index would decline accordingly. In other
situation investors erroneously overreact to events and affect the market by making
abnormal transactions. The market, in many cases, is also affected by such events as:
presidential elections, trade balances, balance of payment figures, wars, new
inventions, etc...Market risk is also called systematic or non-diversifiable risk. All
investors are subject to this risk. It is the result of the workings of the economy; and
cannot be eliminated through portfolio diversification. However, investors are paid for
this risk.

1.8 BURDEN OF RISK ON SOCIETY

The presence of risk results in certain undesirable social and economic effects. Risk entails three major
burdens on society:

i. The size of an emergency fund must be increased.

ii. Society is deprived of certain goods and services.
iii. Worry and fear are present.

i. Larger Emergency Fund

It is prudent to set aside funds for emergency purposes. However, in the absence of insurance,
individuals and business firms must increase the size of their emergency funds in order to pay for
unexpected losses. For example, assume you have purchased a Br. 300,000 home and want to have
money for repairs if the home is damaged from fire, hail, windstorm, or some other peril. Without
insurance, you would have to save some big lump-sum annually to build up an adequate fund within a
relatively short period of time. Even then, an early loss could occur, and your emergency fund would
be insufficient to pay the loss. If you are a middle-income wage earner, you would find such saving
difficult. In any event, the higher the amount that must be saved, the more consumption spending must
be reduced, which results in a lower standard of living.

ii. Loss of Certain Goods and Services

A second burden of risk is that society is deprived of certain goods and services. For example, because
of the risk of a liability lawsuit, many corporations have discontinued manufacturing certain products.
Numerous examples can be given. Some 250 companies in the world used to manufacture childhood
vaccines; today, only a few firms manufacture vaccines, due in part to the threat of liability suits. Other
firms have discontinued the manufacture of certain products, including single-engine airplanes,
asbestos products, football helmets, silicon-gel breast implants, and certain birth control devices.

iii. Worry and fear

A final burden of risk is that worry and fear are present. Numerous examples can illustrate the mental
unrest and fear caused by risk. A college student who needs a grade of C in a course in order to
graduate may enter the final examination room with a feeling of apprehension and fear. Parents may be
fearful if a teenage son or daughter departs on a skiing trip during a blinding snowstorm since the risk
of being killed on an icy road is present. Some passengers in a commercial jet may become extremely
nervous and fearful if the jet encounters severe turbulence during the flight.

Check Your Progress Exercise

1. Give any three common elements in the definition of risk.
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2. "Risk is the state of mind". Argue on this.
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3. What are the basic differences between moral and morale hazards?
………………………………………………………………………………………………………
………………………………………………………………………………………………………

4. Identify the risk, peril and hazards of the September 11 incidents of the twin towers in the United
States of America.
………………………………………………………………………………………………………
………………………………………………………………………………………………………
……………………………………………………………………………….
5. Which of the following is not true about risk.
a. It is a potential variation in outcome.
b. Being an inherent element in business it cannot be managed.
c. It has something to do with future uncertainty.
d. All of the above
e. None of the above

1.9 SUMMARY

▪ There is no single definition of risk. Risk has been defined in a number of ways by different authors.
▪ Objective risk is the relative variation of actual loss from expected loss. Subjective risk is uncertainty
based on an individual’s mental condition or state of mind. Chance of loss is defined as the
probability that an event will occur; it is not the same thing as risk.
▪ Peril is defined as the prime cause of the loss. Hazard is any condition that creates or increases the
chance of loss. There are four major types of hazards. Physical hazard is a physical condition
present that increases the likelihood of loss. Moral hazard is dishonesty or character defects in an
individual that increases the likelihood of loss. Morale hazard is carelessness or indifference to a
loss because of the existence of insurance. Legal hazard refers to characteristics of the legal system
or regulatory environment that increase the frequency or severity of losses.
▪ The basic categories of risk include the following:
o Objective and subjective risk
o Pure and speculative risk
o Fundamental and particular risk
o Static and dynamic risk
o Financial and non-financial risk.

▪ A pure risk is a risk where there are only the possibilities of loss or no loss. A speculative risk is a
risk where either profit or loss is possible.
▪ A fundamental risk is a risk that affects the entire economy or large number of persons or groups
within the economy, such as inflation, war, or recession. A particular risk is a risk that affects only
the individual and not the entire community or country.
▪ The following kinds of pure risk can threaten an individual’s financial security:
o Personal risks
o Property risks
o Liability risks
- Personal risks are those risks that directly affect an individual.
- Property risk affects persons who own property.
- A direct loss is a financial loss that results from the physical damage, destruction,
or theft of the property. An indirect, or consequential, loss is a financial loss that
result indirectly from the occurrence of a direct physical damage or theft loss.
Examples of indirect losses are the loss of use of property, loss of profits, loss of
rents, and extra expenses.
- Liability risks are extremely important because there is no maximum upper limit
 on the amount of the loss, and if a person must pay damages, future incomes and
assets can be attached to pay an unsatisfied judgment; substantial legal defense
costs and attorneys fees may also be incurred.

▪ Risk entails three major burdens on society:

- The size of an emergency fund must be increased.
- Society is deprived of needed goods and services.
- Worry and fear are present.

1.10 CHECK YOUR PROGRESS QUESTION

1. Refer to Section 1.2

2. Refer to Section 1.3
3. Refer to Section 1.4
4. Hint: Risk is unexpected losses of exposures (property and person).
Peril is the specific cause for the occurrence of the loss.
Hazard is any condition that facilitates the occurrence of loss from the peril element.
5. B

Unit 2: THE RISK MANAGEMENT PROCESS

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Risk Management Defined
2.3 Objectives of Risk Management
2.4 Possible Contributions of Risk Management
2.5 The Risk Management Process
2.5.1 Risk Identification
[Link] Sources of Risk
[Link] Identification of Exposures
[Link] The Range of Risk Identification Techniques
[Link] Common Features of Risk Identification
2.5.2 Risk Management
[Link] Poisson Distribution
[Link] Binomial Probability Distribution
[Link] Normal Distribution
2.6 Tools of Risk Management
2.6.1 Risk Control Tools
2.6.2 Risk Financing Tools
2.7 Selection of Risk Management Tools: Quantitative Approaches
2.7.1 Expected Utility Model
2.7.2 The Worry Factor Model
2.8 Summary
2.9 Answer to Check Your Progress Exercise

2.0 AIMS AND OBJECTIVES

After studying this unit, you should be able to:

▪ define risk management and briefly explain its purpose.
▪ describe briefly the basic components of risk management.

2.1 INTRODUCTION

We have looked at the nature of risk and the various classifications into which it can be put. The
concept, which develops, is one of risk as an all-pervasive force in the world; a negative feature in life
bringing unfortunate, or unlooked for, outcomes. The various classifications that we have used all tend
to support the view that risk is to be avoided at all costs. It would be valuable to stop here for a
moment and take stock of what this means. Are we to conclude that risk has no beneficial side to it? Is
it solely a negative concept, implying loss and not gain? Has the world gained nothing from the
existence of risk?

2.2 RISK MANAGEMENT DEFINED

Dear student, the following definitions of risk management have been forwarded for your study.
Thoroughly study the definitions and compare their essence.
Definition 1
Risk Management refers to the identification; measurement and treatment of exposure to
potential accidental losses almost always in situations where the only possible out comes are
losses or no change in the status.

Definition 2
Risk Management is a general management function that seeks to assess and address the causes
and effects of uncertainty and risk on an organization. The purpose of risk management is to
enable an organization to progress towards its goals and objectives in the most direct, efficient,
and effective path. It is concerned with all risks.

Definition 3
Risk Management is the executive function of dealing with specified risks facing the business
enterprise. In general, the risk manager deals with pure, not speculative risk.

What are the specific duties of a risk manager? Could you get any hint from the above definitions?
Please write down your response in the space provided below.

The risk manager has certain specific duties. These include:

1. To recognize exposures to loss; the risk manager must, first of all, be aware of the possibility of
each type of loss. This is a fundamental duty that must precede all other functions.
2. To estimate the frequency and size of loss; to estimate the probability of loss from various
sources.
3. To decide the best and most economical method of handling the risk of loss, whether it be by
assumption, avoidance, self-insurance, reduction of hazards, transfer, commercial insurance, or
some combination of these methods.
4. To administer the programs of risk management, including the tracks of constant revaluation of
the programs, record keeping and the like.

2.3 OBJECTIVES OF RISK MANAGEMENT

Risk management has several important objectives that can be classified into two categories: pre-loss
objectives and post-loss objectives.
Pre-loss objectives. A firm or organization has several risk management objectives prior to the
occurrence of a loss. The most important include economy, the reduction of anxiety, and meeting
externally imposed obligations.

The first goal means that the firm should prepare for potential losses in the most economical way
possible. This involves an analysis of safety program expenses, insurance premiums, and the costs
associated with the different techniques for handling losses.

The second objective, the reduction of anxiety, is more complicated. Certain loss exposures can cause
greater worry and fear for the risk manager, key executives, and stockholders than other exposures. For
example, the threat of a catastrophic lawsuit from a defective product can cause greater anxiety and
concern than a possible small loss from a minor fire. However, the risk manager wants to minimize the
anxiety and fear associated with all loss exposures.

The third objective is to meet any externally imposed obligations. This means the firm must meet
certain obligations imposed on it by outsiders. For example, government regulations may require a
firm to install safety devices to protect workers from harm. Similarly, a firm’s creditors may require
that property pledged as collateral for a loan must be insured. The risk manager must see that these
externally imposed obligations are met.

Post-loss objectives. The first and most important post-loss objective is survival of the firm. Survival
means that after a loss occurs, the firm can at least resume partial operation within some reasonable
time period if it chooses to do so.

The second post-loss objective is to continue operating. For some firms, the ability to operate after a
severe loss is an extremely important objective. This is particularly true of certain firms, such as public
utility firm, which must continue to provide service. The ability to operate is also important for firms
that may loss customers to competitors if they cannot operate after a loss occurs. This would include
banks, bakeries, dairy farms, and other competitive firms.
Stability of earnings is the third post-loss objective. The firm wants to maintain its earnings per share
after a loss occurs. This objective is closely related to the objective of continued operations. Earning
per share can be maintained if the firm continues to operate. However, here may be substantial costs
involved in achieving this goal ( such as operating at another location), and perfect stability of earnings
may not be attained.

The fourth post-loss objective is continued growth of the firm. A firm may grow by developing new
products and markets or by acquisitions and mergers. The risk manager must consider the impact that
a loss will have on the firm’s ability to grow.

Finally, the goal of social responsibility is to minimize the impact that a loss has on other persons and
on society. A sever loss can adversely affect employees, customers, suppliers, creditors, taxpayers, and
the community in general. For example, a severe loss that requires shutting down a plant in a small
community for an extended period can lead to depressed business conditions and substantial
unemployment in the community.

2.4 POSSIBLE CONTRIBUTIONS OF RISK MANAGEMENT

Because risk management, as defined in this reading material, is concerned with pure risks, it may be
regarded by some as the true “dismal science.” Pure risks can only hurt a firm or family, and the
purpose of risk management is to minimize the hurt at minimum cost. Upon closer investigation,
however, one discovers that the possible contributions of risk management to businesses, families, and
society are highly significant.

To a Business
The possible contributions of risk management to a business can be divided into five major categories.
The contributions that the risk manager will make in a particular case depend upon the objectives set
for this function (see objectives of risk management) and the extent to which these objectives are
achieved.

First, risk management may make the difference between survival and failure. Some losses, such as
large liability suits or the destruction of a firm's manufacturing facilities, may so cripple a firm that
without proper advance preparation for such event the firm must close its doors. Even if risk
management did not contribute to the economic health of businesses in any other way, this one benefit
would make it a critical function of business management.

Second, because profits can be improved by reducing expenses as well as increasing income, risk
management can contribute directly to business profits (or, in the case of nonprofit organizations or
public agencies, to operating efficiency). For example, risk management may lower expenses through
preventing or reducing accidental losses as the result of certain low-cost measures, through transferring
potential serious losses to others at the lowest transfer fee possible, through electing to take a chance
on small losses unless the transfer fee is a bargain, and through preparing the firm to meet most
economically those losses that it has decided to retain.

Third, risk management can contribute indirectly to business profits in at least six ways.

i. If a business has successfully managed its pure risks, the peace of mind and confidence this creates
permits its managers to investigate and assume attractive speculative risks that they might
otherwise seek to avoid. For example, if a firm had to worry about windstorm damage to its
plants and industrial injuries to its employees, it might elect to limit itself to its present markets.
Freed of this worry, it might expand to new markets.

ii. By alerting general managers to the pure-risk aspects of speculative ventures, risk management
'improves the quality of the decisions regarding such ventures. For example, a firm that was
deciding whether to lease or purchase a building might reach the wrong decision if it ignored the
differing economic impacts of accidental physical damage to the building.

iii. Once a decision is made to assume a speculative venture, proper handling of the pure-risk aspects
permits the business to handle the speculative risk more wisely and more efficiently. For
example, a business may develop its product lines more aggressively if it knows that it is
adequately protected against suits by persons who may be harmed accidentally by defective
products.

iv. Risk management can reduce the fluctuations in annual profits and cash flows. Keeping these
fluctuations within bounds aids planning and is a desirable goal in itself. Investors regard more
favorably a stable earnings record than an unstable one.
v. Through advance preparations, risk management can in many cases make it possible to continue
operations following a loss, thus retaining customers or suppliers who might otherwise turn to
competitors.

vi. Creditors, customers, and suppliers, all of whom contribute to company profits, prefer to do
business with a firm that has sound protection against pure risks. Employees also prefer to work
for such firms.

Fourth, the peace of mind made possible by sound management of pure risks may itself be a valuable
noneconomic asset because it improves the physical and mental health of the management and owners.

Fifth, because the risk management plan may also help others, such as employees, who would be
affected by losses to the firm, risk management can also help satisfy the firm’s sense of social
responsibility or desire for a good public image.

To a family
Risk management can provide families with the same five major classes of benefits. For example, by
protecting the family against catastrophic losses, risk management may enable a family to continue a
lifestyle that might otherwise be severely threatened or disrupted. Indeed the continued existence of
the family unit might be at stake. Second, sound risk management may enable the family to reduce its
expenditures for insurance without reducing its protection. Because a family cannot deduct insurance
premiums from its taxable income, a dollar reduction in insurance premiums may be worth more than
an additional dollar of income. Third, if a family has adequate protection against the death or poor
health of the breadwinner, damage to or disappearance of their property, or a liability suit, they may be
willing to assume greater risks in equity investments or career commitments. They may also find it
easier to secure a mortgage or personal loan. Fourth, family members are relieved of some physical
and mental strain. Fifth, families may also gain some satisfaction from a risk management program
that helps others as well as themselves or that improves their image.

To the Society
To the extent that individual businesses and families benefit from risk management, so does the society
of which they are members. Society also benefits from the more efficient use risk management permits
of business and family resources and from the reduction in social costs associated with business and
family financial reverses.
2.5 THE RISK MANAGEMENT PROCESS

Dear student, as you may have noted it in the definitions forwarded to describe risk management, risk
management is the identification, measurement and treatment of property, liability, and personnel pure-
risk exposures. What does the process specifically involve? What are the sequence of activities to be
performed in the risk management process? Do you have any idea?

The process involves five steps. These are:

i. Identifying loss exposures. The loss exposures of the business or family must be identified. Risk
identification is the first and perhaps the most difficult function that the risk manager or
administrator must perform. Failure to identify all the exposures of the firm or family means that
the risk manager will have no opportunity to deal with these unknown exposures intelligently.
ii. Measuring the losses. After risk identification, the next important step is the proper measurement
of the losses associated with these exposures. This measurement includes a determination of (a)
the probability or chance that the losses will occur, (b) the impact the losses would have upon the
financial affairs of the firm or family, should they occur, and (c) the ability to predict the losses
that will actually occur during the budget period. The measurement process is important because
it indicates the exposures that are most serious and consequently most in need of urgent
attention. It also yields information needed in step 3.
iii. Selection of the risk management tools. Once the exposure has been identified and measured, the
various tools of risk management should be considered and a decision made with respect to the
best combination of tools to be used in attacking the problem. These tools include primarily (a)
avoiding the risk, (b) reducing the chance that the loss will occur or reducing its magnitude if it
does occur, (c) transferring the risk to some other party, and (d) retaining or bearing the risk
internally. The third alternative includes, but is not limited to, the purchase of insurance.
Selecting the proper tool or combination of tools requires considering the present financial
position of the firm or family, its overall policy with reference to risk management, and its
specific objectives.
iv. Implementing the decision made. After deciding among the alternative tools of risk treatment, the
risk manager must implement the decision made. If insurance is to be purchased, for example,
establishing proper coverage, obtaining reasonable rates, and selecting the insurer are part of the
implementation process.
v. Evaluating the result. The results of the decisions made and implemented in the first four steps
must be monitored to evaluate the wisdom of those decisions and to determine whether changing
conditions suggest different solutions.

Dear student, this process will be discussed in greater detail in this and the subsequent units.
As is true of management in general, risk management may be described as both an art and a science.
Risk managers must still rely heavily upon nonquantitative techniques that depend upon deduction and
intuitive judgments. Yet certain broad principles of risk management have been developed.
Furthermore, during the recent past, quantitative techniques have become more commonplace and
more sophisticated. These principles and some of the current developments in scientific risk
management will be presented at various points in this reading material. In time these guides to risk
management will be improved and new ones will be created, but sound judgment will continue to play
an important role.

2.5.1 Risk Identification

Dear student, what idea do you have about risk identification? Please write down your response in
your own words in the space provided below.
__________________________________________________________________________________
____________________________________________________________________

Risk identification is the process by which an organization is able to learn areas in which it is exposed
to risk. Identification techniques are designed to develop information on sources of risk, hazards, risk
factors, perils, and exposures to loss. It seems quite logical to inquire in to the sources of
organizational risks at this particular moment. A discussion of the sources is presented below.

[Link] Sources of Risk

Sources of risk are the sources of factors or hazards that may contribute to positive or negative
outcomes. Sources of risk can be classified in several ways. For instance, the following sources of risk
represent one listing:

i. Physical Environment. Clearly, the physical environment is a fundamental source of risk.

Earthquakes, drought, or excessive rainfall can all lead to loss. The ability to fully
understand our environment and the effects we have on it - as well as those it has on us - is
a central aspect of this source of risk. The physical environment may be the source of
opportunity as well, for example, real estate as an investment, agribusiness, and weather as
a contributing factor to tourism.
ii. Social Environment. Changing traditions and values, human behavior, social structures, and
institutions are a second source of risk.
iii. Political Environment. Within a single country, the political environment can be an important
source of risk. A new party can move the nation into a policy direction that might have
dramatic effects on particular organizations (new stringent regulations on toxic waste
disposal). In the international realm, the political environment is even more complex. Not
all nations are democratic in their form of government, and some have very undemocratic
attitudes and policies toward business. Foreign assets might be confiscated by a host
government or tax policies might change dramatically. The political environment also can
promote positive opportunities through fiscal and monetary policy, enforcement of laws,
and the education of the population.
iv. Legal Environment. the expected laws and directives may be issued by the government which
may render risky environment to the businesses operating in the country. In the
international domain, complexity increases because legal standards can vary dramatically
from country to country. The legal environment also produces positive outcomes in the
sense that rights are protected and that the legal system provides a stabilizing influence on
society.
v. Operational Environment. Processes and procedures of an organization generate risk and
uncertainty. A formal procedure for promoting, hiring, or firing employees may generate a
legal liability. The manufacturing process may put employees at risk of physical harm.
Activities of an organization may result in harm to the environment. International
businesses may suffer from risk or uncertainty due to unreliable transportation systems. The
operational environment also provides gains, as it is the ultimate source of the goods and
services by which an organization succeeds or fails.
vi. Economic Environment. Although the economic environment often flows directly from the
political realm, the dramatic expansion of the global marketplace has created an
environment that is greater than any single government. Although a particular government’s
actions may affect international capital markets, control of capital markets is beyond the
reach of a single nation. Inflation, recession, and depression are now elements of
interdependent economic systems. On a local level, interest rates and credit policies can
impose significant risk on an organization.
vii. Cognitive Environment. A risk manager’s ability to understand, see, measure, and assess is
 far from perfect. An important source of risk for organizations is the difference between the
perception of the risk manager and reality. The cognitive environment is a challenging
source of risk to identify and analyze. The analyst must contemplate such questions as
“How do we understand the effect of uncertainty on the organization? and “How do we
know whether a perceived risk is real?” An evaluation of the cognitive environment partly
addresses the distinction between risk and uncertainty as defined in Chapter 1.

[Link] Identification of Exposures

A given peril or hazard can originate in any one of several environments. Fire, for example, could arise
from the physical environment (a lightning strike) or the social environment (arson, civil unrest).
Sources of risk are essentially of no concern to an organization unless that organization is exposed or
vulnerable to the perils that arise from those environments. Therefore, an important aspect of risk
identification is exposure identification. Although in the broadest sense an entire organization is at
exposure to risk, it is useful to develop categories of exposures for analytical purposes. This reading
material considers four categories of risk exposures: physical asset exposures, financial asset
exposures, liability exposures, and human exposures.

i Physical Asset Exposures. Ownership of property gives rise to possible gains or losses to
physical assets and to intangible assets (goodwill, political support, intellectual property),
that arise from these exposures. Property may be damaged, destroyed, lost, or diminished in
value in a number of ways. The inability to use property for a period of time, the so-called
time element loss, is often overlooked by individuals and organizations. Conversely,
property exposures to risk may result in gain or enhancement.
ii Financial Asset Exposures. Ownership of securities such as common stock and mortgages
creates this type of exposure. This exposure can occur either from ownership of the security
or when the organization issues a security held by others. A financial asset conveys rights
that are enumerated in financial terms, such as the right to receive income or the right to
purchase an asset at a specified price. Unlike physical property, loss or gain to a financial
asset can occur without any physical change in the asset itself. Often these gains and losses
occur as a consequence of changing market conditions or changes in the value of the rights
conveyed by the security as perceived by investors.
iii Liability Exposures. Obligations imposed by the legal system create this type of exposure.
Civil and criminal law detail obligations carried by citizens; state and federal legislatures
impose statutory limitations on activities; governmental agencies promulgate administrative
rules and directives that establish standards of care. Legal obligations that differ from
country to country are an increasingly important aspect of this area.

Unlike property exposures to risk, liability exposures do not have an upside. That is, liability
exposures generally can be considered pure risks. It is true that the law establishes rights as
well as obligations, and the enforcement of a right can result in a gain.

iv Human Asset Exposures. Part of the wealth of an organization arises from its investment in
humans: the human resources of the organization. Possible injury or death of managers,
employees, or other significant stakeholders (customers, Secured creditors, stockholders,
suppliers) exemplifies this type of exposure. Human asset exposures also can lead to gains,
as exemplified by improvements in productivity. One might, for example, view a highly
technical piece of machinery as source of loss (worker injury) and gain (increased
productivity). In such a case, the risk management strategy is likely to incorporate elements
that will reduce the potential for loss while maximizing the likelihood of gain (employee
training, for instance). As a final note, loss of human assets does not always imply physical
harm. Economic insecurity is a common type of loss, unemployment and retirement being
excellent examples. Both the physical and economic welfare of human beings are
components of this type of exposure to risk.

[Link] The Range of Risk Identification Techniques

How is risk to be identified? Where would you begin to start the task of identifying risk in a major
factory complex, a shopping center, an airport, a department store chain, a bank? Do you expect that
you would arrive at the premises, assuming always that the actual premises existed and that we were
not concerned with risks at the planning stage, with a clipboard to begin the task? The world of
industry and commerce is far too complex and sophisticated to allow for proper risk identification
simply by a ‘walk round the premises’.

Specific techniques will have to be employed to aid your identification of risk. However, no one
method for risk identification will be appropriate for all forms of risk, or even for similar forms of risk
in different situations. There is a range of techniques available and these techniques can be classified in
a number of ways.

▪ Some are best used on site, while others are ‘desk based’ methods not requiring site visits.
▪ Some will be more appropriate to the development stages of a project, while others are best used
 once the project has been commissioned and is up and running.
▪ There are qualitative techniques which make little or no use of statistical measurement and others
which are highly quantitative in their approach.
▪ Certain techniques are very general in their approach to risk, while others are extremely detailed,
even microscopic, in their approach.
▪ There are techniques, which are very appropriate for post-loss situations, while others are
primarily for use prior to any loss having taken place.

These divisions highlight the variety of techniques, which are available, but in themselves the divisions
have no practical value. What they do underline is the fact that there are different ways in which risk
can be identified and that techniques do exist to match particular needs. As we work our way through
the techniques, we will suggest the advantages and disadvantages of each one and where each one
could be used.

Organizational Charts
We start the list of risk identification techniques with organizational charts. These are intended to
highlight broad areas of risk rather than specific, individual risks such as fire, security or liability. The
organizational chart encourages the risk identifier to take a birds-eye view of the organization: to stand
back and above the day-to-day operation and take stock of the risks which exist. This term ‘risk
identifier’ does need some explanation. In many organizations there will be a risk or insurance
manager employed whose job, in part, will be the identification of risk. Where no risk manager exists,
it may be that the insurance company performs the risk identification function. In other cases, an
insurance broker or consultant may take on the role of identifying risk. The term risk identifier is
intended to refer to anyone who has the task of identifying risk.

Most organizations will have charts of some kind or another. Even if they are only in publicity
material, there will be some starting point for building a suitable organizational chart. It is wise to
involve as many people as possible in the construction of the chart, in order to ensure that it is not
unrealistic or over-simplistic in its make-up.

Physical Inspections
The organizational chart took a very broad view of the risks to which an organization could exposed.
The physical inspection of premises, plant or processes takes a different approach. Everyone
understands what is meant by physical inspection, it is possibly the most common and best understood
of all the techniques available.

The inspection of plant, processes or premises can be a time-consuming job, and the nature of so many
industrial sites is that they are complex. Prior to the actual visit, it is necessary to do some preparation
work so that time is not wasted during the visit itself. This preparatory work would include finding out
exactly what processes were carried out at the premises, the nature of the service or product
manufactured, the nature of the machinery, the physical layout of the premises and the details from the
last physical inspection if there has been one. All of this information will help and may cut down the
time you have to spend on ascertaining basic information during the visit. The visit should be kept for
the identification of risk, not the finding of information, which was available before the visit.

Checklists
Checklists deal with the particular problem of the time-consuming nature of physical inspections. The
basic idea of the checklist is that a pro-forrna is sent to the site for completion by someone there. This
dispenses with the need for a physical inspection and hence cuts the time and cost of identification.

The checklist acts as the source of information about risk. It really takes the place of the personal visit
and so it has to be drawn up very carefully. It is wise, when constructing a checklist for the first time,
to consult as widely as possible in order to ensure that all aspects of risks are taken into account. In
particular, the following points are worth keeping in mind:

▪ The checklist should be simple to understand

▪ The checklist should be free from ambiguity.
▪ The checklist should be short
▪ The checklist should not be threatening

Having given careful thought to the construction of the form, there is one final decision, which has to
be made, and that relates to the style of the checklist. There are various styles in operation, but for
illustration consider the illustration below;

FIRE CHECKLIST
Please read the following list and ensure that all the items are
 satisfactory. Sign the form and return it
to……………………………..
▪ Fire doors
▪ Fire exists
▪ fire alarms
▪ Extinguishers
▪ Stacking of goods
▪ Removal of waste

This is an extract from a checklist which simply lists a number of points. It is related to the fire risk
and the items which are to be checked all relate in some way to fire. The respondent has to make sure
that all the items have been looked at and that he is satisfied that they are in order, before returning the
form.

Flow charts
We move now to a far more detailed form of risk identification than either the organizational chart or
the checklist, and one which is more specific in its identification than the physical inspection.

In many organizations there is some kind of flow. This could take the form of:
▪ Production flow, where raw materials come in at one end of a process and a finished product
emerges at the other end. There was an identifiable flow through the system.
▪ Service flow, where there may not be raw materials but the business may depend on flow of another
form. It could be the flow of people, as in the case of a restaurant or hotel.
▪ Money flow, as in the case of a bank or an insurance company. Money comes in at one end and
various promises are made, the effects of which are seen at some later date.

In each case there are various stages in the flow, and at each stage there are risks which could impede
or halt the flow. Any interruption to the flow will have consequences for revenue and profit. A flow
chart can be used to identify the key stages, and structure the analysis of the risks at each stage.

The Financial Statement Method

The financial statement method was proposed by A.H. Criddle (1962). Although this approach was
intended for private organizations, the concepts of the financial statement approach can be generalized
in public sector organizations as well. By analyzing the balance sheet, operating statements, and
supporting documents, Criddle maintains, the risk manager can identify property, liability, and human
asset exposures of the organization. By coupling these statements with financial forecasts and budgets,
the risk manager can discover future exposures. Financial statements reveal this information because
every organizational transaction ultimately involves either money or property.

Under this method, each account title is studied to determine what potential risks it creates. The results
of the study are reported under the account titles. Criddle argues that this approach is reliable,
objective, based on readily available data, presentable in clear, concise terms, and able to be applied by
either risk managers or professional consultants. Moreover, it translates risk identification into
financial terminology familiar to other managers, accountants, and bankers. Although Criddle does not
suggest that the financial statement method could be used to identify both speculative and pure risks,
many account titles would be expected to include both types.

Interactions with Other Departments

Frequent interactions with other departments provide another source of information on exposures to
risk. These interactions may include oral or written reports from other departments on their own
initiative or in response to a regular reporting system that keeps the risk manager informed of
developments. The importance of such a communications network should not be underestimated.
These departments are constantly creating or becoming aware of exposures that might otherwise
escape the risk manager’s attention. Indeed, the risk manager’s success in risk identification is heavily
dependent on the cooperation of other departments.

Unfortunately, risk managers often hear about new exposures long after they are created. In developing
interactions with other managers and departments, the risk manager must overcome the natural
reluctance of others to reveal unfavorable information. Most managers would not be expected to reveal
activities that create the potential for unfavorable developments. A critical task for a risk manager is to
persuade others that revealing possibly unfavorable information is in their own interest. Incentives for
revealing this type of information can be tied to the organization’s system for allocating the cost of
losses. For example, losses arising from unreported activities could result in a penalty when charged
against a manager’s account. To avoid confusion and possible ill will, the existence of such a penalty
should be clearly communicated to managers at the same time they are asked for information on risk-
creating activities.
Interactions with Outside Suppliers and Professional Organizations
In addition to communicating with other departments, the risk manager normally interacts with
outsiders who provide services to the organization. These outsiders, for example, might include
accountants, lawyers, risk management consultants, actuaries or loss-control specialists. The objective
would be to determine whether the outsiders have identified exposures that otherwise would be
missed. Possibly, the outsiders themselves may create new exposures.

Involvement with professional organizations and use of published material is another valuable source
of information. For example, the annual meeting of the Risk and Insurance Management Society
normally includes sessions focusing on specific problems faced by areas of industry. In addition, a
number of organizations that focus on specialized areas of risk management have been formed in
response to demands of risk managers in these areas.

Contract Analysis
Many of an organization’s exposures to risk arise from contractual relationships with other persons and
organizations. An examination of these contracts may reveal areas of exposures that are not evident
from the organization’s operations and activities. In some cases, contracts may shift responsibility to
other parties.
Statistical Records of Losses
Where available, statistical records of losses can be used to identify sources of risk. These records may
be available from risk management information systems developed by consultants or, in some cases,
the risk manager. These systems allow losses to be analyzed according to cause, location, amount, and
other issues of interest.

Statistical records allow the risk manager to assess trends in the organization’s loss experience and to
compare the organization’s loss experience with the experience of others. In addition, these records
enable the risk manager to analyze issues such as the cause, time, and location of the accident, to
identify the injured individual and the supervisor, and any hazards or other special factors affecting the
nature of the accident. Common patterns or frequently appearing sets of circumstances point toward
issues requiring special attention. For example, if ladders appear frequently as a cause of accidents, the
organization’s risk manager is well advised to investigate ladders and their use and possibly set up a
training program on safe practices.

When a significant amount of data on past losses is available, the risk manager may use this
information to develop forecasts of loss costs. These forecasts may be developed through trending or
loss development. Forecasts obtained using loss development are extremely useful in budgeting for
programs in which an organization directly pays costs using its own funds (i.e., a self-insurance
program). An organization that uses its own funds to pay the cost of work-related injuries or to provide
health benefits to its own employees has a vital interest in projecting costs of the program.

Incident Reports
A network of information sources can be very useful in identifying possible losses. Ideally, the
information provided through this network should include not only reports of accidents and near
accidents, but also reports of incidents that could have resulted in injury or damage but presumably did
not. Frequently, good fortune and luck allow a person to escape without injury from an incident that
posed a serious threat. Information on these events is useful in preventing injury or damage if the
circumstances are repeated, but only if the risk manager is aware of the potential problem.

A system for reporting of incidents usually includes a form for recording important information. In
addition to date, time, location and identity of parties involved in the incident, the form should request
information that later could prove helpful in preventing similar occurrences or mitigating the injury or
damage if it occurs. In designing the form, a risk manager should recognize that a long period of time
may elapse between the recording of the information and its incorporation into an injury-prevention
program. As an example, some areas of regulation require employers to keep records of employee
exposure to hazardous materials for 30 years beyond the period of employment. The records offer
evidence on the degree of care exercised by the employer, but only to the extent that information is
complete and specific.

Comments appearing earlier in the section entitled “Interactions with other Departments” are
especially applicable to incident-reporting systems. Essentially, a risk manager is asking others to
reveal information that reflects unfavorably on their housekeeping practices. For example, a risk
manager of a hospital who is concerned about the organization’s exposure to medical liability is
requesting hospital employees to report mistakes such as incorrect administration of drugs that might
reflect unfavorably on their own careers and reputation. Earning the trust of employees that the
information will be used fairly removes an obstacle to the manager’s gaining their cooperation in this
effort.
[Link] Common Features of Risk Identification
We have looked at a number of individual techniques and it is now necessary to say something of a
more general nature about the task of risk identification, regardless of the technique selected. We can
do this by commenting on a number of common features of risk identification.

▪ The task of risk identification must be given the proper priority in an organization. It’s an
important function, as many of the risks which are to be identified can put their way into the
very core of the existence of the organization itself.
▪ There is a range of techniques available and no one technique can be used in all situations. As we
have dealt with each technique, we have commented on the relevant uses to which it can be
put. Thought must be given to the nature of each risk and the best technique, or combination of
techniques, selected.
▪ The task of risk identification is a continuing one: the one-off exercise is of little value in many
practical cases. The nature of industry is such that it is constantly changing and it is therefore
essential that risk identification takes place at regular intervals.
▪ Efficient record keeping is an important part of identification of risk. A great deal of valuable
information is obtained at the time of risk identification, and this should be stored carefully for
later use and referral.
▪ Other people, in addition to the risk identifier, should be involved in the process of risk
identification whenever possible. Organizations are complex and no one person will have all
the knowledge which will be required to enable risks to be identified.
▪ The cost of risk identification must be remembered. There is little point in spending Br.10 to
identify risks which in the worst case can only ever cost Br. 1. Identifying risk is important, but
it costs money and this cannot be overlooked.
▪ Finally, a measure of common sense and imagination are valuable attributes to have when flying
to identify risk.

2.5.2 Risk Measurement

Once the risk manager has identified the risks that the firm is facing, his next step would be the
evaluation and measurement of the risks. Risk measurement refers to the measurement of the potential
loss as to its size and the probability of occurrence.

The risk manager, by using available data from past experience, tries to construct a probability
distribution of the number of events and/or the probability distribution of total monetary losses. This
would, indeed, require knowledge of certain statistical techniques and concepts. The probability
distribution of number of events and/or total monetary losses would enable the risk manager to
estimate, among other things, the size of possible monetary losses and the corresponding probabilities
of occurrence.

The following example is considered for illustrative purpose. The data presented below represents the
number of cars operated (similar in type of use) by a firm in each year, the corresponding number of
accidents occurred and the total monetary losses incurred in connection with the accidents.
Number of cars No of Accidents Amount of loss
Year

1 10 1 Birr 2500

2 12 2 4200

3 14 3 4500

4 15 3 6000

5 20 2 6500

6 20 3 6600

7 25 4 6000

8 25 5 8000

9 29 3 7500

10 30 4 10000

SUM 200 30 61800

MEAN 20 3 6180

STA. DEV. 1.15 2115

Probability of Accident = 3/20 =0.15
Monetary loss per accident over 10 years = 6180/3 = 2060

Suppose in year 11 the number of cars owned by the firm increased to 40. The risk manager wants to
construct a probability distribution of accidents on the basis of the data collected above.
[Link] Poisson Distribution
The Poisson probability distribution can be used for the analysis. The only information that is crucial
in constructing a Poisson probability distribution is the expected number of accidents (the mean).
Once the mean is determined the probability of any number of accidents will be easily calculated
using the following formula:

r –M
p (r) = M . e
r!
Where: e = 2.71828
r = number of occurrences
M = Expected number of Accidents = (pn)
STD = Standard Deviation = SQRT (M)
n = number of Exposed Units = 40
SQRT=Square-root
Accordingly,
M = pn = 0.15 * 40 = 6 accidents
STD = SQRT(M) = 2.45

The Poisson probability distribution allows for unlimited number of accidents occurring to the object
under consideration, (car). This means that a particular car can possibly experience more than one
accident. This is normally the case in real life situation.
Using the Poisson process, the following probability distribution is constructed.

Number of Amount Probability Expected number Expected amount

Accident Loss* of accidents of loss**
0 0 0.0025 0 0
1 2060 0.0149 0.0149 30.69
2 4120 0.0445 0.0892 183.26
3 6180 0.0892 0.2676 551.26
4 8240 0.1339 0.5356 1103.34
5 10300 0.1606 0.8030 1654.18
6 12360 0.1606 0.9636 1985.02
7 14420 0.1377 0.9639 1985.63
8 16480 0.1033 0.8264 1702.38
9 18540 0.0688 0.6192 1275.55
10 20600 0.0413 0.4130 850.78
11 22660 0.0225 0.2475 509.85
12 24720 0.0113 0.1356 279.34
13 26780 0.0052 0.0675 139.26
14 28840 0.0022. 0.0308 63.45
15 30900 0.0009 0.0135 27.81
16 32960 0.0003 0.0048 9.89
17 35020 0.0001 0.0017 3.50
18 37080 0.0001 0.0018 3.71
SUM 1.0000 5.9997 12359.39

* Number of accidents multiplied by the loss per accident.

** Amount of loss multiplied by the probability.

Once the probability distribution is developed, it would not be difficult, to determine the probability of
any number of accidents that are likely to occur. Let r represent the number of accidents,

p(r > = 3) = 1 - (.0025+.0149+.0445)

= 0.9381
This is the probability that there would be at least three accidents in the year. Similarly, the probability
that the number of accidents equal or exceed 13 is given by:

p(r > = 13) = .0052+.0022+.0009+.0003+.0001+.0001

 = 0.0088

Accordingly,
p(3 < = r < 13) = 0.9381-0.0088
= 0.9293
This indicates that the risk manager's expectation of accidents is heavily concentrated between 3 and
13 accidents.
The expected annual total monetary loss is Birr 12359.39 as determined on the table above. The
expected dollar loss per accident is obtained by dividing the expected annual total monetary loss by the
expected number of accidents.

Expected Monetary Loss per Accident = 12359.39

6

= 2059.90

The calculation of standard deviation of total monetary loss is presented below. The standard deviation
is 5046,40. From earlier analysis the following measures were obtained:
P = 0.15
n = 40
Expected Number of Accidents = M = np =0 .15*40 = 6
SD of Accidents = SD = SQRT (M) = SQRT(6) = 2.4495
Expected Annual Total Monetary Loss = 12359.9
Standard Deviation of Annual Monetary Loss = SD of accidents x loss per accident
= 2.45 x 2059.90
= 5046.7

Risk Relative to the Mean (Coefficient of Variation) or RM

RM = SD of Loss/expected loss

= 5046.4/12359.9

= 0 . 408

Or

RM = SD of accidents/expected number of accident

= 2.45/6

= 0.408

RM 0.408 indicates the variability of total annual monetary losses from the expected value, (the mean).
The higher the Coefficient of Variation (RM), the higher the risk, meaning variability increases. In this
example total annual monetary losses could deviate 40.8% from the mean in either direction. For
example the range, for 1 standard deviation is Birr 7314 to Birr 17406. On the table above, this range
is approximated by Birr 6180 to Birr 18540. The probability that total annual monetary loss falls in this
range is 0.8542, which is obtained by adding all the probabilities in the range. In terms of number of
accidents, the risk manager expected to observe 3 to 9 accidents about 85.42 percent of the time.
No of Monetary Mean Deviation Deviation Probability DS times probability
accidents loss from mean squared
0 0 12360 -12360 152769600 0.0025 381924
1 2060 12360 -10300 106090000 0.0149 1580741
2 4120 12360 -8240 67897600 0.0446 3028233
3 6180 12360 -6180 38192400 0.0893 3410581
4 8240 12360 -4120 16974400 0.1339 2272872
5 10300 12360 -2060 4243600 0.1603 680249.1
6 12360 12360 0 0 0.1606 0
7 14420 12360 2060 4243600 0.1377 584343.7
8 16480 12360 4120 16974400 0.1033 1753456
 9 18540 12360 6180 38192400 0.0688 2627637
10 20600 12360 8240 67897600 0.0413 2804171
11 22660 12360 10300 106090000 0.0225 2387025
12 24720 12360 12360 152769600 0.0113 1726296
13 26780 12360 14420 207936400 0.0052 1081269
14 28840 12360 16480 271590400 0.0022 597498.9
15 30900 12360 18540 343731600 0.0009 309358.4
16 32960 12360 20600 424360000 0.0003 127308
17 35020 12360 22660 513475600 0.0001 51347.56
18 37080 12360 24720 611078400 0.0001 61107.84
SUM 25465419

Standard deviation = SQRT (25465419) = 5046.4

Risk measures:
Risk relative Mean, (R M) = 5046.4/12359.9 = 0.408

The standard deviation of total annual monetary loss can also be determined as follows:

SD of Accidents x expected monetary loss per Accidents

2.44949 x 2060 = 5046

Risk Relative to the number of Exposure Units or Rn

Rn = SD of accidents/number of items exposed to risk

= 2.24495/40 = 0.061
R n indicates the deviation from the expected outcome as a percentage of the total number of exposure
units. Accordingly, given one standard deviation, the actual accidents could vary from the expected
accidents by about 6.1% of the total number of exposure units. The higher the percentage, the higher
the variability(higher variance), and consequently, the higher the risk.

POSSIBLE DECISIONS
Self-Insurance

1. To keep reserve fund equal to the expected total annual monetary loss

Reserve Fund = Birr 12,360

2. To keep reserve fund equal to the expected value of the loss plus an amount to cover for one
standard deviation of the expected value.

Reserve Fund = 12,360+ 5,046 = Birr 17,406

3. To keep reserve fund equal to the maximum probable loss (ignoring losses with a probability of
occurrence less than 1%)

Reserve Fund -= Birr 24720

RISK AND LOW OF LARGE NUMBERS
Suppose the exposure units are to be increased to 50, (n=50)

Mean Number of Accidents = M = 0 .15*50 = 7.5

SD of Accidents = 3D = SQRT (7.5) = 2.7386

RM = 2.73S6/7.5 = 0.365

Rn = 2.7386/50 = 0.054772
It is possible to simulate this process to see how risk decreases as the number of exposure units
increase. Here is the summary.

n M Sd RM Rn
40 6 2.4495 .408 .06124
50 7.5 2.7386 .365 .05478
100 15 3.8730 .258 .03873
The mean (M) increases proportionately while RM and Rn decrease less than proportionately.

[Link] Binomial Probability Distribution

The Risk Manager may also use the Binomial probability distribution to measure risk. To use the
Binomial distribution the Risk Manager must be familiar with the basic assumptions of the distribution
to avoid misleading results. The first assumption is that the objects are independently exposed to loss.
The other assumption is that each exposed unit suffers only one loss in a year. With this assumption in
mind, the following illustrative example is considered. A fleet of 5 delivery trucks are operated by a
business. If an accident happens to a particular track, it becomes a total loss. New trucks are
purchased at the beginning of every year to make up the lost ones so that the firm always starts the new
fiscal period with a fleet of 5 delivery tracks.
First it is assumed that monetary loss per accident is constant at Birr 5000.

Number of NUMBER OF ACCIDENTS Total Monetary

Year Trucks Loss

1 5 2 Birr 10000
2 5 2 10000
3 5 3 15000
4 5 2 10000
5 5 1 5000
SUM 25 10 50000
MEAN 5 2 10000
SD .707 3162.27

Monetary loss per accident = 10000/2 = 5000

The probability of an accident can be estimated as:

p = 2/5 = .4
With this information as a point of departure it would be possible to construct a binomial probability
distribution for the following variables of interest:

1. Probability distribution of Number of accidents

2. Probability distribution of Total monetary losses

1. PROBABILITY DISTRIBUTION NUMBER OF ACCIDENTS

Under the binomial probability distribution the probability of observing exactly r occurrences is given
by:
r (n-r)
P (r) = n!(P . q )

[n – r]!

Where: p is the probability of accident

q is 1 –p
n is the number of items exposed to risk

Using this formula the following probability distribution is constructed.

Number of Probability Expected No. of

Accidents Accidents
0 0.07776 0
1 0.25920 0.2592
2 0.34560 0.6912
3 0.23040 0.6912
4 0.07680 0.3072
5 0.01024 0.0512
SUM 1.00000 2.0000
The expected number of accidents is 2. The standard deviation can be determined in the usual manner,
which turns out to be 1.095.
The probability that the firm will face some accident is 0.92224, (1-0.07776). This probability is so
high that the risk manager should take appropriate measures to handle the risk.
FORMULA FOR MEAN AND SD OF A BINOMIAL DISTRIBUTION
The mean and the standard deviation of a binomial probability distribution can also be determined
using the following formula;

Mean = M = np
SD = SD = SQRT(npq)

Accordingly,

M = 5*0.4 =2
SD = SQRT(5*0.4*0 .6) = 1.095

RISK MEASURES

Risk Relative to Mean, (coefficient of variation)

RM = 1.095/2 = .5475

Risk relative to the number of exposure units

Rn = 1.095/5 = 0.219

RISK VS LAW OF LARGE NUMBERS

Risk relative to the mean

1/2
RM = (np(l-p))
np

2
RM = np(l-p)

2
RM = np(l-p)

2 2
n P

2
RM = (1-p)
np

2 /2
RM = ((l-p)/np)' RM decreases as n increases

Risk relative to the number of Exposure units

1/2
Rn = (np (1-p)
n
2
R = np(l-p) = p(l-p)

2
n n

1/2
Rn = (p (l-p)/n) Rn decreases as n increases

To illustrate the situation suppose the exposure units are to be increased to 20, (n = 20),

M = np = 20*0.4 = 8

SD = SQRT(np(l-p) ) = SQRT(20*0.4*0.6) =2.19

Then,
 Rm = SD/M = 2.19/8 = 0.27375
Rn = SD/n = 2.19/20 = 0.1095

Increasing the number of exposure units to 100 will give the values for Rm and Rn as shown on the
table below.
M SD RM Rn
n
5 2 1.095 0.54750 0.21900
20 8 2.190 0.23735 0.10950
25 10 2.449 0.2449 0.09796
50 20 3.464 0.1732 0.06928
100 40 4.899 0.12247 0.04899

The risk does not decrease in proportion to the increase in the number of exposure units. Consider also
the following example.

P= 0.4

n1= 25

n2 = 50

1/2
Rn 1 = (n 1 p (1-p)
n1
1/2
Rn 2 = (n 2 p (1-p)
n2
1/2 1/2
Rn 2/ Rn 1 = (n 2 p (1-p) / n 2 = (n 2 p (1-p) n 1
1/2 1/2
(n 1 p (1-p) /n 1 (n 1 p (1-p) n 2

2 2
R n 2/ R n 1 = n 1/n 2
2 2
R n2 = R n 1 (n 1/n 2)
1/2
Rn 2 = R n 1 (n 1/n 2)

Rn 2 = Rn 1

1/2
(n 2/n 1)

OTHER PROPERTIES

n = 5
Mean = np
SD = SQRT(np(1-p))

1. Suppose p = 0
SD = SQRT(5*0*1) = 0

Risk relative to the number of exposure units

Rn = 0/5 = 0

*Risk is zero when p = 0; meaning it is certain that the event will not happen.
2. Suppose p = 0.5
SD = SQRT (5*.5*.5) = 1.118
Rn = 1.118/5 = 0.2236

Relative risk to the number of exposure units reaches its maximum when p = 0.5 (binomial
distribution). Conversely, risk relative to the mean reaches its maximum when p approaches zero.

2. PROBABILITY DISTRIBUTION OF TOTAL MONETARY LOSSES

The binomial probability distribution of total monetary losses is constructed as follows:

Number of Monetary Probability Expected

Accidents Loss Monetary Loss
0 0 0.07776 0
1 5000 0.25920 1296
2 10000 0.34560 3456
3 15000 0.23040 3456
4 20000 0.07680 1536
5 25000 0.01024 256
SUM 1.000 10000

The expected total annual monetary loss is Birr 10000. The standard deviation of total annual
monetary loss is calculated as follows:

SD of number of Accidents x expected monetary loss per accident

1.095 x 5000 = 5475

Risk relative to the mean monetary loss will then become:

RM = 5475/10000 = 0.5475

Risk relative to the maximum possible loss is:

Rn = 5475/25000 = 0.219

The next example reflects a situation where the amount of loss per accident is not constant. Here, the
loss per accident is assumed to be either Birr 5000 or Birr 10000. As a result there will now be two
probability distribution of monetary loss per accident. The following data is collected for the analysis.

Year Number of Number of Amount of Loss*

Trucks Accidents
1 5 2 Birr 10000 each
2 5 2 5000 each
3 5 3 5000 each
4 5 2 10000 each
5 5 1 5000 each
SUM 25 10 70000
Mean 5 2 14000
SD 0.707 6519
* Loss per accident is either Birr 5000 or Birr 10000.

The probability of an accident is estimated to be 0.4 (2/5). The probability distribution of monetary
loss per accident is constructed as follows:

Frequency Relative
Loss per Frequency
Accident
5000 6 0.6
 10000 4 0.4
10 1.0

The probability that an accident will entail a loss of Birr 5000 is 0.6. similarly, the probability that an
accident entails a cost of Br. 10000 is 0.4.

The mean monetary loss per accident is Birr 7000; and the variance of monetary loss per accident is
6000000, 0.6 (5000 – 7000)2 + 0.4 (10000 – 7000) 2. Accordingly, the standard deviation of monetary
loss per accident will be the square root of 6000000, which is 2449.49.

Constructing the Probability Distribution of Total Monetary Losses

The table presented on the next page shows the summary of the construction process.

Loss Amount Probability Expected Loss

0 0.07776 0
5000 0.15552 777.60
10000 0.22810 2281.00
15000 0.21565 3234.75
20000 0.16478 3295.60
25000 0.09370 2342.50
30000 0.04393 1317.90
35000 0.01534 536.90
40000 0.00433 173.20
45000 0.00079 35.55
50000 0.00010 5.00
1.00000 14000.00

Minimum loss = 0
Expected total monetary loss = 14000.00
Maximum possible total loss = 50000.00
Maximum probable total loss(Assuming that losses with
Probability less than 1% are ignored) = 35000.00

The probability that the fire will face some monetary loss is 0.92224 (1 – 0.07776). the probability that
monetary loss equals or exceeds Birr 10000 is 0.76672 , ( 1 – (0.07776 + 0.15552)).

One measure of risk could be to express the expected annual total monetary loss as a percentage of the
maximum possible loss. This is equal to 28% (14000/50000). It could be used as a rough measure of
loss severity. One way of determining the standard deviation of total annual monetary losses. The
expected monetary loss per accident is Birr 7000, (14000/2). Earlier the standard deviation of
monetary loss per accidents was found to be 2449.49. Consequently, the standard deviation of total
annual monetary loss is calculated using the following formula:
Let:
(ENA) = Expected Number of Accidents in a Year
VA = Variance of the Number of Accidents in a Year.
(EMA) = Expected Monetary Loss per Accident
SDM = the Standard Deviation of Monetary Loss per Accident.

SD of Total Annual
Monetary Losses = SQRT ((VA * E (MA) 2 + (SDM) 2 * E (NA))
= SQRT ((1.2) (7000) 2 + (2449.49) 2 (2))
= SQRT (58800000 + 12000000)
= 8414.27

[Link] Normal Distribution

The risk Manager may assume that the number of accidents or total annual monetary losses are
approximately normally distributed. Under such circumstances, he may use the Normal distribution in
measuring the number of accidents or the total annual monetary losses.

If observations are normally distributed, the Risk Manager will have a good insight of the size of
possible losses at much grater ease. This is because the normal distribution can be well explained by
identifying only two parameters, the mean and the standard deviation.

For illustrative purpose let us consider the example under the binomial distribution with a slight
change.
Year Number of Total Monetary
Accidents Loss
1 2 Birr 10000
2 2 10000
3 3 15000
4 2 10000
5 2 10000
SUM 55000
MEAN 11000
SD 2000

The Normal distribution has the following properties:

• 68.27% of the observations fall within the range of one standard deviation of the mean.
• 95.45 % of the observations fall within the range of two standard deviation of the mean.
• 99.73% of the observations fall within the range of three standard deviations of the mean.
The implication of this for the Risk Manager, in the case of monetary losses, is that he would,
construct the following interval estimation about the true mean monetary loss.

The true mean monetary loss is expected to fall in the range of Birr 9000 and Birr 13000 with a
probability of 0.6827.

The true mean monetary loss is expected to fall in the ranges of Birr 7000 and Birr 15000 with a
probability of 0.9545.

The true mean monetary loss is expected to fall in the range of Birr 5000 and Birr 17000 with a
probability of 0.9973.

DETERMINING THE SIZE OF EXPOSURE UNITS

Consider a Binomial probability distribution with p = 0.4 and n = 10.
Expected Number of Accidents = Mean = .4 * 10 = 4
Standard Deviation = SQRT( 10*.4*.6) = 1.55

R
M
= 1.55/4 = 0.3875

Now, suppose the Risk Manager (given p = .4) wants to have R

M
of 20%; and to achieve this level of
variation he wants, to know the number of exposure units, (n).

Mean = np = .4n

SD = SQRT (npq) = SQRT (n*.4*.6) = SQRT (.24n)

1/2 1/2
RM= (.24n) , 0.20 = ( .24n)

.4n .4n

.24n - .0064n2 = 0

n = 37.5

FORMULA

1 2
R
M
= Z (np(1-p)) / , Z = confidence level in number of standard
deviations.
np

1 2
R
M
= Z (np(l-p)) /
2 2 2 2
R M np = Z np(l-p)
2
n = Z p(l-p)
2 2
R M p
 2
n = Z (1-p)
2
R P
M

Risk Relative to the Number of Exposure Units:

Rn = 1.55/10 = 0. 155

Suppose the risk manager wants to have Rn of 10% with a probability of 0.6827. What should
be the number of exposure units to satisfy the requirement?

1/2
0.10 = (np(1-p)
n

1 2
0.10n = (.24n) /

0.01n2 - .24n = 0

n = 24

1/2
When n = 24, SD = (0.4* 0. 6*24) , which is 2.4. Consequently,

Rn = 2.4/24 = .10

1 2
Rn = Z (np(l-p)) /

1 2
Rnn = Z (np(1-p)) /
2 2
Rn n = Z (np(1-p)) , (divide both sides by n)
2
Rn n = Z p(1-p))

n = Z p(1-p))
2
Rn

2.6 TOOLS OF RISK MANAGEMENT

After the risk manager has identified and measured the risks facing the firm, he or she must decide to
handle them. There are two basic approaches. First, the risk manger can use risk control measures to
alter the exposures in such a way as (1) to reduce the firm’s expected property, liability, and personnel
losses, or (2) to make the annual loss experience more predictable. Risk control measures includes
avoidance, loss prevention and reduction measures, separation, combination, & some transfers.

Second, the risk manger can use risk-financing measures to finance the losses that do occur. Funds
may be required to repair or restore damaged property, to settle liability claims, or to replace the
services of disabled or deceased employees or owners. In some, the firm will decide not to restore the
damaged property or replace the disabled or decreased person. Nevertheless, it may also have suffered
a financial loss through a reduction in its assets or its future earning power. The tools in this second
category include those transfers, including the purchase of insurance, that are not considered under
risk control devices and retention, which includes, “self insurance”.
2.6.1 Risk Control Tools
i. Avoidance
One way to control a particular pure risk is to avoid the property, person, or activity with which the
exposure is associated by (1) refusing to assume it even momentarily or (2) an exposure assumed
earlier, most examples of risk avoidance fall in the risk category. To illustrate a firm can avoid a flood
loss by not building a plant in a flood plain. An existing loss exposure may also be abandoned. For
example, a firm that produces a highly toxic product may stop manufacturing that product. Similarly,
an individual can avoid third party liability by not owning a car. Product liability can be avoided by
dropping the product. Leasing avoids the risk originating from property ownership.

The major advantage of avoidance is that the chance of loss is reduced to zero if the loss exposure is
not acquired. In addition, if an existing loss exposure is abandoned, the possibility of loss is either
eliminated or reduced because the activity or product that could produce a loss has been abandoned.

Avoidance, however, has two disadvantages. First, it may not be possible to avoid all losses. For
example, a company cannot avoid the premature death of a key executive. Similarly, a business has to
own vehicles, building, machinery, inventory, etc… Without them operations would become
impossible. Under such circumstances avoidance is impossible. In fact there are circumstances where
avoidance is a viable alternative. For example, it may be better to avoid the construction of a company
near river bank, volcano-prone areas, valleys, etc. because the risk is so great.

The second disadvantage of avoidance is that it may not be practical or feasible to avoid the exposure.
For example, a paint factory can avoid losses arising from the production of paint. However, without
any paint production, the firm will not be in business.

ii. Loss Prevention and Reduction Measures

These measures refer to the safety actions taken by the firm to prevent the occurrence of a loss or
reduce its severity if the loss has already occurred. Prevention measures, in some cases, eliminate the
loss totally although their major effect is to reduce the probability of loss substantially. Loss reduction
measures try to minimize the severity of the loss once the peril happened. For example, auto accidents
can be prevented or reduced by having good roads, better lights and sound traffic regulation and
control, fast first-aid service and control, fast first-aid service and the like. Loss prevention and
Retention measures must be considered before the Risk manager considers the application of any risk
financing measures.
Following are some examples of loss prevention and reduction plans.

Loss Prevention Measures:

▪ Research on fire protection equipment and appliances.
▪ Construction using fire insensitive materials.
▪ Automatic smoke detectors, fire alarms.
▪ Burglar alarms in costly business situation, jewelry, diamonds.
▪ Locational choice, avoiding construction near petrol stations, chemical reservoirs, waste disposal
areas, etc.
▪ Tight quality control to prevent risk of product liability.
▪ Educational programs to the public using available media.
▪ Multiple suppliers, buffer stocks.
▪ Safety measures, adequate lighting, ventilation, special work clothes to prevent industrial
accidents.
▪ Regular inspection of machinery to prevent explosions, breakdowns, etc..
▪ Accounting controls (Internal Control).
▪ Electronic metal detectors to check passengers for arms and explosives in the airline business.
▪ Automatic gates at crossing lines to prevent collisions train and motor vehicles.
▪ Warning posters (NO SMOKING!! DANGER ZONE!!)

Loss Reduction Measures:

▪ Installing automatic sprinklers.
▪ First aid kit
▪ Evacuation of people, CHERNOBYL
▪ Immediate clean-up operations, EXXON – VALDEZ, Alaska oil spill
▪ Fire extinguishers, guards.

Appropriate measures take to prevent accidents bring benefits not only to the firm, but also to the
society as well. For example, a destruction of inventory of a firm, could be a total loss to the firm in
particular. The society also faces a real economic loss because those goods are no more available to
people. Thus, the importance of Loss Prevention and Reduction measures should not be
underestimated by a firm. To design effective LP and R measures, it may be helpful to identify the
causes of accidents.

Some of the causes of accident and the possible Loss Prevention and Reduction measures are indicated
below.

Causes of accidents Loss prevention measures

- Working on dangerous equipment with less care - Safety seminars, inspection at regular times
- Improper use of equipment - Training, safety seminars
- Violating Safety Procedures and Regulations. - Safety seminars, warning, dismissal
- Human error, Negligence - Training, safety seminars
- Use of inappropriate tools - Provide appropriate tools
- Lack of protective clothing - Provide necessary protective clothing
- Use of defective equipment - Regular inspection and maintenance
- Inadequate Knowledge about the job Training
- Working while physically ill - Sick leave, don’t allow to work until recovery
- Mental Disturbance of employee Day-off to the employee

Date should be kept regarding accidents occurred. The causes of these accidents must be investigated.
Pre-designed forms may be employed to report on accidents and their causes. This could allow for the
design of a much better LP and R measures.

LP and R measures entail costs. These costs include expenditures for the acquisition of safety
equipment and services, operating expenses such as salary payments to guards, inspectors, safety
engineers and other employees engaged in safety work. Other costs are also incurred in connection
with safety training and seminars. The risk manager will have to design the LP and R measures in the
most efficient way in order to minimize such costs without reducing the desired safety level.

iii. Separation
Separation of the firm’s exposures to loss instead of concentrating them at one location where they
might all be involved in the same loss is the third risk control tool. For example, instead of placing its
entire inventory in one warehouse the firm may elect to separate this exposure by placing equal parts
of the inventory in ten widely separated warehouse. To the extent that this separation of exposures
reduces the maximum probable loss to one event, it may be regarded as a form of loss reduction.
Emphasis is placed here, however, on the fact that through this separation the firm increases the
number of independent exposure units under its control. Other things being equal, because of the law
of large number, this increase reduces the risk, thus improving the firm’s ability to predict what its loss
experience will be.

iv. Combination/Diversification
Combination is a basic principle of insurance that follows the low of large numbers. Combination
increases the number of exposure units since it is a pooling process. It reduces risk by making loses
more predictable with a higher degree of accuracy. The difference is that unlike separation, which
spreads a specified number of exposure units, combination increases the number of exposure units
under the control of the firm.

In the case of firms, combination results in the pooling of resources of two or more firms. One way a
firm can combine risks is to expand through internal growth. For example, a taxi-cab company may
increase its fleet of automobiles. Combination also occurs when two firms merge or one acquires
another. The new firm has more buildings, more automobiles, and more employees than either of the
original companies. This leads to financial strength, thereby minimizing the adverse effect of the
potential loss. For example, a merger in the same or different lines of business increases the available
resources to meet the probable loss.

Diversification is another risk handling tool, most speculative risk in business can be dealt with
diversification. Businesses diversify their product lines so that a decline in profit of one product could
be compensated by profits form others. For example farmers diversify their products by growing
different crops on their land. Diversification however, has limited use in dealing with pure losses.

VI. Non-insurance Transfer

Transfer, the final tools to be discussed, may be accomplished in two ways. These are:

▪ Transfer of the activity or the property. The property or activity responsible for the risks may
be transferred to some other person or group of persons. For example, a firm that sells one of
its buildings transfers the risks associated with ownership of the building to the new owner. A
contractor who is concerned about possible increase in the cost of labor and materials needed
for the electrical work on a job to which he/she is already committed can transfer the risk by
hiring a subcontractor for this portion of the project.

This type of transfer, which is closely related to avoidance through abandonment, is a risk
control measure because it eliminates a potential loss that may strike the firm. It differs from
avoidance through abandonment in that to transfer a risk the firm must pass it to someone else.

▪ Transfer of the probable loss. The risk, but not the property or activity, may be transferred. For
example, under a lease, the tenant may be able to shift to the landlord any responsibility the
tenant may have for damage to the landlord’s premises caused by the tenant’s negligence. A
 manufacture may be able to force a retailer to assume responsibility for any damage to products
that occurs after the products leave the manufacturer’s premises even if the manufacturer would
otherwise be responsible. A business may be able to convince a customer to give up any rights
the customers might have to give the business for bodily injuries and property damage
sustained because of defects in a product or a service.
2.6.2 Risk Financing Tools
i. Retention
Retention means that the firm retains part or all of the losses that result from a given loss exposure.
Retention can be effectively used in a risk management program when certain conditions exist. First,
no other method of treatment is available. Insurers may be unwilling to write a certain type of
coverage, or the coverage may be too expensive. Noninsurance transfers may not be available. Loss
control can reduce the frequency of loss, but not all losses can be eliminated. In these cases, retention
is a residual method. If the exposure cannot be insured or transferred, then it must be retained.

Second, the worst possible loss is not serious. For example, physical damage losses to automobiles in a
large firm's fleet will not bankrupt the firm if the automobiles are separated by wide distances and are
not likely to be simultaneously damaged.

Finally, losses are highly predictable. Retention can be effectively used for workers' compensation
claims, physical damage losses to automobiles, and shoplifting losses. Based on past experience, the
risk manager can estimate a probable range of frequency and severity of actual losses. If most losses
fall within that range, they can be budgeted out of the firm's income.

ii. Insurance
Commercial insurance can also be used in a risk management program. Insurance can be
advantageously used for the treatment of loss exposures that have a low probability of loss but the
severity of a potential loss is high. If the risk manager decides to use insurance to treat certain loss
exposures, five key areas must be emphasized.
- Selection of insurance coverage’s
- Selection of an insurer
- Negotiation of terms
- Dissemination of information concerning insurance coverage
- Periodic review of the insurance programs
2.7 SELECTION OF RISK MANAGEMENT TOOLS: QUANTITATIVE APPROACHES

This section discusses some quantitative approaches that may be used in selecting risk management
tools. Two models are discussed: Expected Utility Models and The Worry Factor Model.

2.7.1 Expected Utility Model

The expected utility model places emphasis on the risk manager’s attitude towards risk. This means
that the model takes into account differences in risk attitude of risk managers. Risk managers are likely
to assign varying utility points to a given monetary loss. As a result their decisions as to which of the
risk management tools to select for a particular situation is likely to differ. Under this model, therefore,
the risk manager is making a decision on the basis of expected loss of utility.

To illustrate the model, consider the example under binomial distribution where we have a constant
monetary loss per accident, Birr 5000. The probability distribution was as follows:
Number of Monetary Probability
Accidents Loss
0 0 0.07776
1 5000 0.25920
2 10000 0.34560
3 15000 0.23040
4 20000 0.07680
5 25000 0.01024

DERIVATION OF THE UTILITY FUNCTION

1. a. assign an arbitrary utility index of 1 to the maximum possible loss.
U (L max) = U(25000) = 1.00
b. assign an arbitrary utility index of zero to the minimum loss.
U(L min) = U(0) = 0
2. Ask the person how much he would be willing to pay in order to transfer the risk in which he faces a
50 –50 chance of losing the maximum loss (Birr 25000) or nothing. The amount the person is
 willing to pay to transfer the risk will have the following utility value:
U(T 1) = 0.5(1) + 0.5(0) = 0.5 , T = Transfer cost
Suppose the person is willing to pay Birr 13750. The utility value assigned to this transfer cost
will be 0.5
3. Ask the person how much he would be willing to pay in order to transfer the risk in which there is
50 percent chance of losing the transfer cost in (2) above, (Birr 13750) or nothing. The amount he
offers will have a utility value of:
U (T 2) = 0.5 (utility of T 1) + 0.5 (utility of zero)
= 0.5 (0.5) + 0.5 (0)
= 0.25

Suppose that the person is willing to pay transfer cost of Birr 7700. Consequently, the utility
value of Birr 7700 will be 0.25.
4. This procedure is continued until enough information is collected to construct the utility function.
The summary is given below:

Possible Loss Probability Utility Index

25000 0.5 1.00

13750 0.5 0.50
7700 0.5 0.25
4389 0.5 0.125
2400 0.5 0.0625
1300 0.5 0.03125

The next step is to determine the utility index for losses of Birr 5000, 10000, 15000 and 20000 using
linear interpolation.
Linear Interpolation
Given two extreme values, X U and X L, with a corresponding utility index of U (X U) and U (X L), the
utility index for X M, U (X M), will be found using the following formula:

U (X M) = U (X L) + [(X M - X L) ÷ (X U - X L)] [U (X U) - U (X L)]

Example
x U(x)
7700 .25
5000 ?
4389 .125
The utility value of Birr 5000 loss is determined as follows:

XM-XL = 5000 – 4389 = 611

XU-XL = 7700 – 4389 = 3311

U (X U) - U (X L) = 0.25 - 0.125 = 0.125

U (5000) = 0.125 + (611/3311) (0.125) = 0.14807

In the same manner, the utility points for losses of Birr 10000,15000 and 20000 are calculated below.

U (10000) = .25 + (2300/6050) (.25) = 0.34504

U (l5000) = .50 + (1250/11250) (.50) = 0.55556

U (20000) = .50 - (6250/11250) (.50) = 0. 77770

Now it is possible to determine the Expected Utility Loss as shown below:

Possible Utility Probability (2*3) (1*3)

Loss Index Expected Expected
Utility Monetary
 Loss Loss
0 0 0.07776 0 0
5000 0.14807 0.25920 0.03838 1296
10000 0.34504 0.34560 0.11925 3456
15000 0.55556 0.23040 0.12800 3456
20000 0.77778 0.07680 0.05973 1536
25000 1.00000 0.01024 0.01024 256
SUM 1.00000 0.3556 10000

Consequently, if the risk manager does not want to buy an insurance policy (retain the risk), the
expected loss in utility would be 0.3556. He can also find the monetary equivalent for this expected
utility loss. The monetary equivalent is:
X (0.3556) = 7700 + (0.1056/0. 25) (6050) = 10255.52.

This monetary equivalent indicates that if the risk manager is intending to buy insurance, he will be
willing to pay premium up to Birr 10255.52. In this case the risk manager pays more than the expected
monetary loss, which is Birr 10000. He is, therefore, considered as a risk averse. The margin to the
insurer is only 2.56% of the Expected Monetary loss, (255.52/10000). This margin, however, is so
small that an insurance company may not provide protection at this premium level.

PARTIAL RETENTION
Suppose the risk manager considers the following options:

1. Retain losses up to Birr 5000, and purchase insurance to transfer losses exceeding the 5000
limit.
2. Retain losses up to Birr 10000, and purchase insurance to transfer losses exceeding the 10000
limit.
1. Retain up to Birr 5000 Loss
If the risk manager wishes to retain losses up to Birr 5000, the next step will be to determine the
expected loss in utility of absorbing those losses exceeding Birr 5000. This is calculated as follows:

Expected utility Loss = 0.3556 - 0.03838 = 0.31722

Monetary Equivalent: X (0.31722) = 7700 + (0.06722/0.25) (6050)
= Birr 9326.72
Expected Monetary Loss = 10000 - 1296 = Birr 8764

The risk manager is willing to pay up to Birr 9326.72 in premiums to transfer the risk for which the
Expected Monetary is Birr 8704.

2. Retain up to Birr 10000 Loss

Under this option the expected loss in utility of absorbing those losses exceeding Birr 10000 is
calculated below.
Expected Utility Loss = 0.3556 - (0.03838 + 0. 11925)
= 0.19797
Monetary Equivalent:
X(0.19797) = 4389 + (0.07297/0.125) (3311)
= 6321.83
Expected Monetary Loss:
10000 - (1296+3456) = 5248
The risk manager is willing to pay up to Birr 6321.83 in premiums to transfer the risk that has an
expected monetary loss of Birr 5248. Summary of the alternative decisions is given below.

Decisions Expected Monetary Expected Insurer’s

Utility Loss Equivalent of Monetary margin (%)
Utility Loss
No insurance 0.3556 10255.52 10000 2.56
Retain up to 5000 0.31722 9326.72 8704 7.15
Retain up to 10000 0.19737 6321.83 5248 20.46

Other Options
1. Insurance coverage for annual premium payment of Birr 12000.
2. Buy Birr 20000 insurance policy with Birr 5000 deductibles for annual premium payment of Birr
7000.
3. Buy Birr 15000 insurance policy with Birr 10000 deductibles for annual premium payment of 2500.
4. Buy no insurance policy, retain the risk.

1. Complete Coverage, Birr 25000

Under this decision, losses of any amount will be borne by the insurance company. The only loss the
firm incurs is insurance payment, Birr 12000.
The utility point for Birr 12000 payment is determined as follows:

U (12000) = 0.25 + (4300/6050) (0.25) = 0.42769

Potential Loss Utility point Probability Expected Expected
utility loss monetary loss
12000 0.42769 1 0.42769 12000

2. Buy Insurance with Birr 5000 Deductibles

A deductible is a specified amount of the potential loss that the insured agrees to bear under an
insurance contract. Thus, in the event of a loss, the insurer will pay to the insured the amount of loss
less the deductible.
For a 20000-insuranoe policy with Birr 5000 deductibles the potential loss is determined as follows:
Potential Loss = Premium Charge + monetary loss – insurance receipts

Number of Potential loss

Accident

0 7000 + 0– 0 = 7000
1 7000 + 5000 – 0 = 12000
2 7000 + 10000 – 5000 = 12000
3 7000 + 15000 – 10000 = 12000
4 7000 + 20000 – 15000= 12000
5 7000 + 25000 – 20000 = 12000

The expected utility of loss for this decision is determined below.

potential Utility Point Probability Expected Expected
Loss Utility Loss Monetary
Loss
7000 0.2236 0.07776 0.01739 544.32
12000 0.4277 0.92224 0.39444 11066.88
SUM 1.00000 0.41183 11611.20

3. Buy Insurance with Birr 10000 Deductibles

For Birr 15000 insurance with Birr 10000 deductibles, the potential loss is calculated as follows:
Number of Potential loss
Accident

0 2500 + 0 – 0 = 2500
1 2500 + 5000 – 0 = 7500
2 2500 + 10000 – 5000 = 12500
3 2500 + 15000 – 10000 = 12500
4 2500 + 20000 – 15000 = 12500
5 2500 + 25000 – 20000 = 12500

The expected utility loss of this decision is summarized below.

Utility Probability Expected Expected

Point Utility Loss Monetary
Potential Loss
Loss
2500 0. 0583 0.07776 0.0045 194.4
7500 0.2424 0.25920 0.0628 1944.0
12500 0.4483 0.66304 0.2972 8288
SUM 1.00000 0.3645 10426.4
4. Retention
If the risk manager decides to retain the risk, the Expected Utility Loss is 0.3556, and the Expected
Monetary Loss is Birr 10000. Summary of the four alternatives is given below:
Expected Expected
Decision Utility monetary
Loss Loss
1. Complete Coverage, Birr 25000 0.4277 12000.00
2. 20000 Insurance, 5000 deductibles 0.4118 11188.61
3. 15000 Insurance, 10000 deductibles 0.3645 10426.40
4. Retention 0.3556 10000.00

According to the Expected Utility Model, the risk manager selects that alternative which brings the
lowest expected utility loss. In this example, the model suggests for retention of the risk. The model
did not recommend insurance for a number of reasons. Among others is the premium charge which
may not be reasonable to the risk averse manager. Now, let us try to determine the margin to the
insurer. In alternative 1 (complete insurance coverage), the insurer charges premium of Birr 12000.
The Expected Value of Payment the insurer is Birr 10000. His margin is, then, 20% of
expected value of payment. For Alternative 2 and Alternative 3 the calculation is shown below:
Alternative 2 (20000 Insurance with 5000 Deductibles)
No of Accidents Payment by Probability EV of Payment by
Insurer Insurer
0 0 0.07776 0
1 0 0.25920 0
2 5000 0.34560 1728
3 10000 0.23040 2304
4 15000 0.07680 1152
5 20000 0.01024 204.8

Total expected value of payment 5388.8

The same procedure is followed to determine the Expected Value of Payment by the insurer for
Alternative 3. The summary is given below.
Alternative EV of Payment by Premium charge Insurer’s
Insurer Margin (%)
1 10000 12000 20%
2 5388.8 7000 29.9%
3 2073.6 2500 20.6%

2.7.2 The Worry Factor Model

This model tries to assign a monetary value to the mental stress (worry) that may experience because
of the presence of risk. Consequently the monetary value assigned to this worry is treated as part of the
cost of managing the risk.

To apply the worry model the Risk manager will have to follow certain steps.
1. Determine the premium payment for each decision under consideration.
2. Determine the expected value of uncovered monetary loss.
3. Assign a worry value to the expected value of uncovered loss.
4. Determine the total loss for each decision. The total loss can be calculated by summing up the
premium, the expected value of the uncovered loss and the worry value.

What will be the decision rule?

The decision rule for this method is to select an alternative that has the lowest total loss. For
illustrative purpose s the four alternatives discussed under the expected utility model are considered.
Those alternatives are listed below.

Alternatives Premium
1. Complete coverage Br 25000 12000
2. Br 20000 insurance policy with Br 5000 deducted 7000
3. Br 15000 policy with Br 10000 deductibles 2500
4. Retention 0
EXPECTED VALUE OF UNCOVERED LOSS
The total loss would be the sum of the premium, the expected value of uncovered loss (EVUL) and the
worry value. That is,
 TOTAL LOSS = PREMIUM + EVUL + WORRY VALUE

Therefore, the decision rule is to select the alternative that has the lowest total loss. Dear student,
please note that both tangible as well as intangible losses are considered in the worry factor model.
let’s see the computations of total loss under each of the above alternatives.

i. Complete coverage Br. 25000

a. Premium = 12,000
b. EVUL = there is a full coverage
c. Worry value = 0 Þ no mental stress
d. Total loss = 12,000 + 0 + 0 = 12,000

ii. Br. 20,000 insurance policy with Br 500 deductibles

a. Premium = 7000
b. EVUL = 4611.20

Number of (a) (b) c = a –b Probability EVUL

accidents Monetary Insurance Uncovered
loss payment loss
0 0 0 0 0.07776 0
1 5000 0 5000 0.25920 1296
2 10000 5000 5000 0.34560 1728
3 15000 10000 5000 0.23040 1152
4 20000 15000 5000 0.07650 384
5 25000 20000 5000 0.01024 51.20

c. Worry value = 30% of EVUL is 30% (4611.20) = 1383

d. Total loss = 7000 + 4611 + 1383 = 12994

iii. Br 15000 policy with Br 10000 deductibles

a. Premium = 2500
b. EVUL = 7926

No. Of accident Monetary loss Insurance Insurance loss Prob. EVUL

payment
0 0 0 0 0.07776 -
1 5000 0 5000 0.25920 1296
2 10000 0 10000 0.34560 3456
3 15000 5000 10000 0.23040 2304
4 20000 10000 10000 0.07680 768
5 25000 15000 10000 0.01024 102.4

c. Worry value = 50% of EVUL

= 50% X 7926 = Birr. 3963
d. Total loss = 2500 + 7926 + 3963 = Birr. 14389

iv. Retention
a. Premium = 0
b. EVUL = Expected loss = 10000
c. Worry value = 75% X EVUL
= 75% X 10000 = 7500
d. Total loss = premium + EVUL + worry value
= 0 + 10000 + 7500 = 17500
The summary of all the above work may be presented in the following manner.

Decision option Premium EVUL Worry Factor Total loss

1 12000 0 0 12000
2 7000 4611 1383 12994
3 2500 7921 3963 14369
4 0 10000 7500 17500

Decision: Select the full insurance coverage because its total loss is the lowest.

The Expected Utility Model led the risk manager to retain the risk. The Model does not take into
consideration the intangible cost associated with worry. The Worry Method, however, assigns an
arbitrary value to the mental stress of the manager. Consequently, the total loss is bound to increase.
If the objectives were to minimize the expected tangible monetary loss, the following costs would
have been compared; and-retention might have been considered.

Decision Total loss (excluding worry)

1. Complete coverage 12000
2. 20000 with 5000 deductible 11611
3. 15000 with 10000 deductibles 10426
4. Retention 10000

One better approach of estimating the worry value for each alternative could be to determine the
minimum worry value for that alternative by comparing the alternative with the insurance option.
For the above example the following minimum values are established.
1. To select alternative 1 (complete insurance cover) over alternative 2, the minimum
worry value of alternative 2 should be Birr 389, (12000-11611), which is about 8.4%
of EVUL.
2. To select alternative 1 over alternative 3, the minimum worry value of alternative 3
should be Birr 1574, (12000 -10426) which is about 19.9% of EVUL.
3. To select alternative 1 over alternative 4, the minimum worry value of alternative 4
should be Birr 2000, (12000-10000), which is 20% of the EVUL.
The risk manager may consider another approach to determine the worry value. For example, the
Expected Monetary Loss under alternative 4 (retention) is Birr 10000. The EVUL for this alternative
is also Birr 10000. Now, suppose the risk manager is willing to purchase complete insurance cover for
a premium payment of Birr 12000. In doing so, the risk manager is getting rid of the worry associated
with the 10000 EVUL under the retention option. Consequently, the ex—MR payment (Birr 2000) can
be considered as the cost of eliminating the worry by transferring the risk through insurance. Also, it
may be assumed that the risk manager attaches equal degree of worry to each Birr of uncovered loss.
This gives a worry value of 0.20 for each Birr of EVUL, (2000/10000). The analysis under Worry
Method will then becomes as follows:

Decision Premium EVUL Worry Total

Value loss
1. Complete cover 12000 0 0 120
2. 20000 with 5000 deductibles 7000 4611 922.2 125
3. 15000 with 10000 deductibles 2500 7926 1585.2 120
4. Retention 0 10000 2000 1201

Clearly, insurance is preferred to retention although the total cost of the two alternatives is the same.
Regarding alternative 2 and alternative 3, the risk manager will have to bargain with the insurer
concerning the premium payment. To select alternative 2 over alternative 1 (complete insurance
cover) the risk manager will have to demand a reduction in premium of at least Birr 534 (12534 -
12000). Similarly, to sell alternative 3 over alternative 1, the reduction in premium should be at least
Birr 11.2. (12011.2 - 12000).
Models are abstractions of real world situation. Their usefulness in real life situation depend,
among other things on whether or not their assumptions and the variables they incorporate reflect the
prevailing situation in the practical field. The usefulness of the two models discussed above in risk
management should also be approached along these lines.

Check Your Progress Exercise

1. Define the concept of risk management.
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
…………………………………………………………………………….
2. Identify the steps involved in risk management process and explain them in short.
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
…………………………………………………………………………….

3. Given the following binomial probability distribution for the next year.

No of accidents Monetary loss Probability

0 Br. 0 0.40
1 5000 0.25
2 10,000 ?
3 15,000 0.12
4 20,000 0.05
5 30,000 0.03

Based on the above information, determine:

A. The average number of accidents per year
B. The expected monetary loss per year
C. The maximum possible loss
D. The probability that the firm will suffer some loss.

4. Out line and describe briefly the risk control measures.

……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
……………………………………………………………………………
5. Discuss the risk financing tools.
……………………………………………………………………………………………………………
……………………………………………………………………………………………………………
……………………………………………………………………………

2.8 SUMMARY
Risk management is denned as a systematic process for identifying and evaluating pure loss exposures
faced by an organization or individual, and for selecting and administering the most appropriate
techniques for treating such exposures. All pure risks are considered, including those that are
uninsurable.
▪ There are several important differences between risk management and insurance management. First,
risk management places greater emphasis on the identification and analysis of pure loss exposures.
Second, insurance is only one of several methods for handling losses; the risk manager uses a wide
variety of methods to handle losses. Third, risk management provides for the periodic evaluation of
all methods for meeting losses, not just insurance. Finally, risk management requires the
cooperation of other individuals and departments throughout the firm.
▪ Risk management has several important objectives. Preloss objectives include the goals of economy,
reduction of anxiety, and meeting externally imposed obligations. Postloss objectives include
survival of the firm, continued operation, stability of earnings, continued growth, and social
responsibility.
▪ There are four steps in the risk management process. Potential losses must be identified. The
potential losses must then be evaluated in terms of loss frequency and loss severity. An appropriate
method or combination of methods for treating loss exposures must be selected. The risk
management program must be implemented and properly administered.
▪ The major methods for treating loss exposures in a risk management program are avoidance,
retention, noninsurance transfers, loss control, and insurance.
▪ Retention can be used if no other method of treatment is available, the worst possible loss is
notserious, and losses are highly predictable. If retention is used, some method for paying losses
must be sheeted. Losses can be paid out of the firm’s current net income; an unfunded or funded
serve can be established to pay losses; the necessary funds can be borrowed; or a captive insurer
can be formed.
▪ The advantages of retention are that the firm may be able to save money on insurance premiums
there may be a reduction in expenses; loss prevention is encouraged; and cash flow may be
increased. The major disadvantages are the possibility of greater volatility in losses in the short
run, of higher expenses if loss control personnel must be hired, and of possible higher taxes.
▪ There are several advantages of noninsurance transfers. The risk manager may be able to transfer
some uninsurable exposures; noninsurance transfers may cost less than insurance; and the potential
loss may be shifted to someone who is in a better position to exercise loss control. However, there
are several disadvantages. The transfer of a potential loss may fail because the contract language is
 ambiguous; the firm is still responsible for the loss if the party to whom the potential loss is
transferred is unable to pay the loss; and an insurer may not give sufficient premium credit for the
transfers.
▪ Loss control is extremely important in a risk management program. Loss-control activities are
designed to reduce both loss frequency and loss severity.
▪ Commercial insurance can also be used in a risk management program. Use of insurance involves a
selection of insurance coverages, selection of an insurer, negotiation of contract terms with the
insurer, dissemination of information concerning the insurance coverages, and periodic review of
the insurance program.
▪ A risk management program must be properly implemented and administered. This involves
preparation of a risk management policy statement, close cooperation with other individuals and
departments, and periodic review of the entire risk management program.

2.9 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Risk management is the process of identification, measurement; and treatment of pure risks.
2. i) Risk identification: is the process by which a business systematically and continuously identities
property, liability, and personnel exposures as soon as or before they emerge.
ii) Risk measurement: is the process of determining the potential loss as to its size and the
probability of occurrence.
iii) Tools of risk handling: there are various ways of handling risks. Generally, there are two basic
approaches (risk control tool and risk handling tool). Risk control tool is designed to change the
loss exposure itself, the objective is to reduce the frequency or severity of the potential losses.
On the other hand, risk financing tool is a technique designed to provide money to deal with
those losses that occur. For the detail refer unit 3 and 4.
i) Implementation: this is the stage when the actual operation is started. Once the risk-handling
tool is selected, the manager should start to undertake the implementation process.
ii) Controlling (Monitoring): at this stage, the risk manager should evaluate the undertaken
processes to ensure that risk management process is effectively performed. And if
necessary corrective actions should be taken.

3. A. 1.26 Mean
B. 6450 Birr
C. 30,000 Birr
D. 0.6 = 60%
4. Refer to section 2.8.1
5. Refer to section 2.8.2

Chapter III
INSURANCE

3.1DEFINITION OF INSURANCE
The definition of insurance can be made from the following points of view:
⇨ Functional Definition
 ⇨ Contractual Definition
⇨ From an individual point of view
⇨ From the social point of view

Functional Definition
“Insurance is a co-operative device to spread the loss caused by a particular risk over a number of
persons, who are exposed to it and who agree to insure themselves against the risk”.
Thus, from the definition we can derive following features of insurance;
(a) Insurance is a co-operative device to spread the risk.
(b) Insurance is the system to spread the risk over a number of persons who are insured against the
risk.
(c) Insurance is based on the principle to share the loss of each member of the society on the basis
of probability of loss to their risk.
(d) Insurance is a method to provide security against losses to the insured.
Contractual Definition
Insurance contract may be defined as a contract by which one party (the insurer/insurance
company) agrees to pay to the other party (the insured) or his beneficiary, a certain sum upon a given
contingency (the risk) against which insurance is sought.

According to the Commission on Insurance Terminology of the American Risk and Insurance
Association, “Insurance is the pooling of fortuitous losses by transfer of such risks to insurers, who
agree to indemnify insured for such losses, to provide other pecuniary benefits on their occurrence,
or to render services connected with the risk”.
From an individual point of view

Insurance is an economic device whereby the individual substitutes a small certain cost (the premium)
for a large uncertain financial loss (the contingency insured against) that would exist if it were not for
the insurance.

From the social point of view

Insurance is an economic device for reducing and eliminating risk through the process of
combining a sufficient number of homogeneous exposures into a group to make the losses predictable
for the group as a whole
Although this definition may not be acceptable to all insurance scholars, it is useful for analyzing the
common elements of a true insurance plan.

3.2 FUNCTIONS OF INSURANCE

The functions of insurance can be studied into two parts;
1. Primary functions
2. Secondary functions

Primary Functions
i. Insurance provides certainty
Insurance provides certainty of payment at the uncertainty of losses. The uncertainty of loss
can be reduced by better planning and administration. But, the insurance relieves the person from such
difficult task. There are different types of uncertainty in a risk. The risk will occur or not, when will
occur? How much loss will be there? In other words, there are uncertainty of happening of time and
amount of loss. Insurance removes all these uncertainty and the assured is given certainty of payment
of losses.
ii. Insurance provides protection
The main function of the insurance is to provide protection against the probable chances of
loss. The time and amount of loss are uncertain and at the happening of risk, the person will suffer loss
in the absence of insurance. The insurance guarantees the payment of loss and thus protects the insured
from sufferings. The insurance cannot check (or) control the happening of risk but can provide for
losses at the happening of the risk.

iii. Risk Sharing

The risk is uncertain and therefore, the loss arising from the risk is also uncertain. When risk takes
place, the loss is shared by all the persons who are exposed to the risk. The risk sharing in ancient
times was done only at the time of damage or death. But, today, on the basis of Probability of risk, the
share is obtained from each and every insured in the shape of premium without which protection is not
guaranteed by the insurer.
Secondary Functions
i. Prevention of loss
The insurance joins hands with those institutions which are engaged in preventing the losses of the
society because the reduction in loss causes lesser payment to the assured and so more saving is
possible which will assist in reducing the premium. Lesser premium invites more business and more
business cause lesser share to the insured.
Here, the insurance assist financially to health organizations, fire brigade, educational institutions and
other organizations which are engaged in preventing the losses of the masses from death and damage.
ii. It provides capital
The insurance provides capital to the society. The accumulated funds are invested in productive
channels. The dearth of capital of the society is minimized to a greater extent with the help of
investment of insurance. The industry, the business and the individual are benefited by the investment
and loans of the insurers.
iii. It improves efficiency
The insurance eliminates worries and miseries of losses at death and destruction of property. The
carefree person can devote his body and soul together for better achievement. It improves not only his
efficiency, but the efficiencies of the masses are also advanced.
iv. It helps economic progress
The insurance by protecting the society from huge losses of damage, destruction and death,
provides an initiative to work hard for the betterment of the masses. The next factor of economic
progress, the capital, is also immensely provided by the masses.
3.3 BASIC CHARACTERISTICS OF INSURANCE
Insurance has several distinct characteristics. They are:
a. Pooling of losses
b. Payment of fortuitous losses
c. Risk transfer
d. Indemnification

Pooling of losses
The other names for pooling are sharing, spreading or combination. "Pooling is the spreading of
losses incurred by the few over the entire group, so that in the process, average loss is substituted for
actual loss". In addition, pooling involves the grouping of a large number of homogeneous exposure
units so that the law of large numbers can operate to provide a substantially accurate prediction of
future losses.
Homogeneous exposure unit means there is a large number of similar (e.g., houses), but not
necessarily identical exposure units that are exposed to the same perils. Thus pooling implies:
• The sharing of losses by the entire group and
• The prediction of future losses with some accuracy based on the law of large numbers.

a) sharing of loss
The concept of loss sharing can be explained with an example. Assume that there are 10000
houses in Jimma. All the 10000 households agree that if any one of the house is damaged or destroyed
by a fire, the other households will indemnify, or cover, the actual costs of the household who has
suffered a loss. Also assume that each home is valued at 1,00,000 birr, and , on average, one house
burns every year. In the absence of insurance, the maximum loss to each household is 1,00,000 birr, if
the house burns. However, by pooling the loss, it can be spread over the entire group, and if one
household has a total loss, the maximum amount that each household would have to pay only 10 birr
(1,00,000 / 1,000). Thus, the pooling technique results in the substitution of an average loss of 10 birr
for the actual loss of 1,00,000 birr.

b) Prediction of future losses

By pooling the loss experience of a large number of units, an insurer may be able to predict
future losses with some accuracy. From the viewpoint of the insurer if future losses can be predict,
objective risk is reduced. Thus, another characteristic of insurance is risk reduction based on the law of
large numbers.

The law of large numbers states that the greater the number of exposures, the more closely will
the actual results approach the probable results that are expected from an infinite number of exposures.
For example, if you flip a balanced coin into the air, the chance of getting a head is 0.5. If you flip the
coin only 10 times, you may get a head 8 times. Although, the observed probability is 0.8, the true
probability still 0.5. If the coin were flipped 1 million times, however, the actual number of heads
would be approximately 5,00,000. Thus, as the number of random tosses increases, the actual results
approach the expected results.

Payment of fortuitous losses

A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. In
other words, the loss must be accidental. For example, a person may slip on an icy sidewalk and break
his or her leg. The loss would be fortuitous.
Risk Transfer
Risk transfer means that "a pure risk is transferred from the insured to the insurer, who typically is
in a stronger financial position to pay the loss than the insured." Examples: Premature death, Poor
health, Disability, Destruction, Theft of property, etc. With the exception of self-insurance, a true
insurance plan always involves risk transfer.

Indemnification
Indemnification means that the insured is restored to his or her approximate financial position prior to
the occurrence of the loss. Examples of insurance which cover the loss are, Home owners policy,
Automobile liability insurance policy, Disability income policy, etc.

3.4 ELEMENTS OR REQUIREMENTS OF AN INSURABLE RISK

Insurers normally insure only pure risks. However, not all pure risks are insurable. Certain
requirements usually must be fulfilled before a pure risk can be privately insured. From the view point
of the insurer, there are ideally six requirements of an insurable risk.
i. There must be a large number of homogeneous exposure units
ii. The loss must be accidental and unintentional
iii. The loss must be determinable and measurable.
iv. The loss should not the catastrophic
v. The chance of loss must be calculable
vi. The premium must be economically feasible

Large number of Homogeneous Exposure units

The purpose of the first requirement is to enable the insurers to predict losses based on the law of large
numbers. If a sufficiently large number of homogeneous exposure units are present within a class, the
insurer can accurately predict both the average frequency and the average severity of loss.
The items in an insurance pool, or the exposure units, need to be similar so that a fair premium can be
calculated. The fire damage done to brick homes will ordinarily be less than that of suffered by
wooden homes. It would be unfair to combine them is the same insurance pool and charge each
insured the same premium rate based on the combined losses of the pool. If such as attempt were
made, the rate developed would cause the owners of brick home (less susceptible to loss) to pay too
high a premium and the owners of wooden structures (more susceptible to loss) to pay too low a
premium.
Accidental and unintentional loss
This means that if an individual deliberately causes a loss, it should not be paid. If the intentional loss
were paid the effect would be as follows.

The loss should be accidental because the law of large numbers is based on the random occurrence of
events. A curious example of the application of the principle of accidental losses occurs with life
insurance, for which suicide within a year or two of a policy being purchased is considered non
accidental. Insurers do not pay such losses. If a suicide occurs several years in after a policy is in force,
however the loss is considered accidental, or the result of mental illness - a cause as accidental as any
other illness.
Determinable and Measurable loss
Loss must be definite, measurable and of sufficient severity to cause economic hardship. This means
the loss must be definite to cause time place, and amount. Life insurance in most cases meets this
requirement easily. The cause and time of death can be readily determined in most cases. It is difficult
to determine and measure the losses in some cases. E.g. Disability income policy; There are chances of
dishonest claims, taking an illness or injury and collecting the insurance payment.
It is also important that the losses insured against be measurable. The company must determine
whether the insured satisfies the definition of disability as stated in the policy, because sickness and
disability are highly subjective. The basic purpose of this requirement is that the insurers must be able
to determine if the loss is covered under the policy, and if it is covered, how much the company will
pay.

No Catastrophic Loss
This means that ideally a large proportion of exposure units should not incur losses at the same time.
The pooling technique breaks down if most or all of the exposure units in a certain class
simultaneously incur a loss. Examples of catastrophic losses include, flood, hurricanes, earth quakes,
wild fire, tsunami etc. Insurers ideally wish to avoid all catastrophic losses, but still employ two
approaches to handle the this problem.

1. Reinsurance: i.e., Insurance companies are indemnified by re-insurers for catastrophic

losses. It is shifting of part or all of the insurance originally written by one
insurer to another.
2. Dispersing coverage over a large geographical area:
This is a technique to reduce the burden of catastrophic losses by dispersing the
coverage area to different geographic locations.
Calculable Chance of Loss
The insurer must be able to calculate both the average frequency and the average severity of future
losses with some accuracy. This is necessary so that a proper premium can be charged that is sufficient
to pay all claims and expenses and yield a profit during the policy period. Certain catastrophic losses,
however, are difficult to insure because of the chance of loss cannot be accurately estimated.
Economically Feasible Premium
The insured must be able to afford to pay the premium. Premium should be substantially less than the
face value, or amount, of the policy.

APPLICATIONS OF REQUIREMENTS OF INSURANCE

Let us consider the risk of fire to a private dwelling this risk can be privately insured since the
requirements of an insurable risk are generally fulfilled.
The risk of Fire as an insurable Risk
Requirements Does risk of fire qualify as insurable?
1. Large number of Yes. A large number of homogeneous exposure units are present.
homogeneous exposure
units Yes. With the exception of arson, most fire losses are accidental
2. Accidental and and unintentional.
unintentional loss Yes. If there is disagreement over the amount paid, a property
3. Determinable and insurance policy has provisions for resolving disputes.
measurable loss Yes. Although catastrophic fires have occurred, all exposure units
4. No catastrophic loss normally do not burn at the same time.
Yes. Chance of fire can be calculated, and the average severity of a
5. Calculable chance of fire loss can be estimated in advance.
loss Yes. Premium rate per Birr 100 of fire insurance is relatively low.
6. Economically feasible
premium

The risk of unemployment, which generally is not privately insurable

Requirements Does risk of fire qualify as insurable?
1. Large number of Not completely. Exposure units are heterogeneous in nature
homogeneous exposure (professional, skilled, semi skilled, and unskilled workers).
units
2. Accidental and No. A large proportion of unemployment is due to individuals who
unintentional loss voluntarily quit their jobs.
3. Determinable and Not completely. The level of unemployment can be determined,
measurable loss but the measurement of loss is difficult. Some unemployment is
involuntary; however, some unemployment is voluntary.
4. No catastrophic loss No. A severe national recession or depressed local business
conditions could result in a catastrophic loss.
5. Calculable chance of No. The different types of unemployment generally are too
loss irregular to estimate the chance of loss accurately.
6. Economically feasible No. Adverse selection, moral hazard, and the potential for a
premium catastrophic loss could made the premium unattractive.

From the above illustration the risk of unemployment does not completely meet the requirements,
because of the following reasons.
➢ Labor is heterogeneous (professionals, highly skilled, semiskilled, unskilled, blue collar & while
collar workers).
➢ Unemployment rates vary significantly by occupation, age, sex, education, martial status city,
state, etc.
➢ Duration of the unemployment varies widely among different group.
➢ The presence of potential catastrophic loss due to large number of unemployed persons.
➢ Different types of unemployment on an irregular basis

3.4 INSURANCE, GAMBLING& SPECULATION

Insurance and Gambling

Insurance is often confused with gambling. There are two important differences between them.

The insurer and the insured have a common interest in the prevention or non-occurrence of loss and
the insurer in indemnifies the losses incurred by the insured. Whereas gambling transaction never
restores the losses to his or her earlier financial position. A gambler presumably enjoys the risk of
gambling and therefore would be unlikely to pay the premium needed for transferring the risk being
enjoyed.

Insurance and Speculation

Both are similar in that risk is transferred by a contract and no new risk is created. The main difference
between insurance and speculation lies in the type of that each is designed to handle, and in the
resulting differences in contractual arrangements. The main similarity lies in the central purpose
behind each transaction. However there are some important differences exist between them.

Speculation is a transaction under which one party, for a consideration, agrees to assume certain risk.
The risk of adverse price fluctuation is transferred to speculators who believe they can make a profit
because of superior knowledge of market conditions. The risk is transferred, not reduced and
prediction of loss generally is not based on the law of large numbers. A speculator is a transferee of
risk, and the transferor is usually a business person wishing to pass on a price risk to someone who is
more willing and able to bear it. Such a business person then is using the transfer method of handling
the risk.

3.6 BENEFITS OF INSURANCE TO THE SOCIETY

The existence of insurance results in great benefits to society. The major social economic benefits of
insurance include the following.
• Indemnification of losses
• Less worry & fear
• Source of investment fund
• Loss prevention
• Enhancement of credit
Indemnification for loss
The indemnification function contributes greatly to family and business stability and therefore is one
of the most important social & economic benefit is of insurance. The following table lists the benefits
to individuals and families and also to business firms through the indemnification function of
insurance.

To individuals and families To business firms

➢ Permits individuals & families to be restored to ➢ Permits the firm to remain in business even
their former financial position of lei a loss after the loss occurs.
occurs. ➢ Employees of the firm would be able to keep
➢ The families maintain their economic security. their jobs
➢ They are less likely to apply for public ➢ Suppliers continue to receive orders
assistance or welfare. ➢ Customers can still receive the goods &
➢ They are less likely to seek financial assistance services
from relatives & friends.

Less Worry and Fear

Such families who may be exposed to risks the possible worry & fears are reduced.

♦ Persons insured their life in the event of their ⇨ Less worry about financial security of their
premature death. dependents.

♦ Persons insured for long term disability ⇨ Do not worry about the replacement of their
earnings, if a serious illness or accident occurs.
♦ Property owners who are insured ⇨ Enjoy greater peace of mind since they know they
are covered if a loss occurs.

Worry and fear are also reduced after a loss occurs since the insured know that they have insurance
that will pay for the loss.

Source of Investment funds

Insurance provide funds for capital investment and accumulation. Premiums are collected in advance
of the losses and funds not needed to meet the immediate losses can be loaned to business firms. These
investments…..
➢ increases society's stock of capital goods
➢ promote economic growth
➢ promote full employment
➢ reduce cost of borrowings of business firm
Loss prevention
Insurance companies are actively involved in numerous loss prevention programs and also employ a
wide variety of loss prevention personnel. (E.g. Safety Engineers, Specialists in fire prevention,
Occupational Safety and Health, etc.) Some of the loss prevention activities are:
➢ High way safety & reduction of automobile death.
➢ Fire prevention
➢ Reduction of work related disabilities
➢ Prevention of automobile thefts
➢ Prevention and detection of arson losses
➢ Prevention of defective products that could injure the users
➢ Prevention of boiler explosions
➢ Educational programs on loss prevention

The loss prevention activities reduce both direct and indirect, or consequential losses. Society benefits
since both types of losses are reduced.
Enhancement of Credit
Insurance makes a borrower a better credit risk, because its gives greater assurance that the loan will
be repaid.
E.g.
a) Property insurance is obtained while lending for purchase of houses. Property insurance
protects the lender's financial interest if the property is damaged or destroyed.
b) Temporary loan may obtained by insuring inventories of business firms.
c) Insurance on automobile is required to get a loan for purchasing any new automobile
Thus insurance can enhance a person's credit worthiness.

COST OF INSURANCE TO SOCIETY

No institution can operate without certain costs. These are listed below so that one can obtain an
impartial view of the insurance institution as a social device. The major social costs of insurance
include the following:
• Cost of doing business
• Fraudulent claims
• Inflated claims

Cost of doing the business

The main social cost of insurance lies in the use of scarce of economic resources land, labor capital
and organization to operate the business. In financial terms, an expense loading must be added to the
pure premium to cover the expenses incurred by insurance companies. An expense loading is the
amount needed to pay all expenses, including commissions, general administrative expenses, state
premium taxes, acquisition expenses, and an allowance for contingencies and profit. The cost is
justified from the insured's view point as follows:
• Uncertainty concerning the payment of a covered loss is reduced because of insurance.
• The cost of doing business is not necessarily wasteful, because insurers engage in a wide variety
of loss prevention activities.
• The insurance industry provides jobs to millions of workers.

However, because economic resources are used up in providing insurance, a real economic cost is
incurred.

Fraudulent claims
These are the claims made against the losses that one caused intentionally by people in order to collect
on their policies. There always exists moral hazard in all forms of insurance. Arson losses are on the
increase. Fraud and vandalisms are the most common motives for arson. Fraudulent claims are made
against thefts of valuable property, such as diamond ring or fur coat, and ask for reimbursement. These
claims results in higher premiums to all insured. These social costs fall directly on society.

Inflated claims
It is a situation where, the tendency of the insured to exaggerate the extent of damages that result from
purely unintentional loss occurrences. Examples of inflated claims include the following.
a) Attorney for plaintiffs may seek high liability judgments - Liability insurance
b) Physicians may charge above average fees - health insurance
c) Disabled persons may malinger to collect disability income benefits for a longer duration.
These inflated claims must be recognized as an important social cost of insurance. Premiums must be
increased to cover the losses, and disposable income that could be used for the consumption of other
goods or services is thereby reduced.
The social costs of insurance can be viewed as the sacrifice that society must make to obtain the social
benefits of insurance.
3.7. ORGANIZATION OF INSURERS
The organizational framework in which insurance functions are carried out varies considerably
according to the size and scope of operations of the particular company. There are several ways in
which organizational patterns may be classified: by function, by territory, by product line, and through
groups or fleets of companies. Multiple line and all line organization, discussed below, refers to the
corporate structures employed to offer the insurance product.

Functional organization
Insurers frequently set up departments corresponding roughly to the various specialized activities
performed, such as underwriting, production, rate making, accounting, and financial. Each department
has a supervisor or vice-president who is responsible for this function wherever it is performed
throughout the organization. Functional organization is rarely used in a pure form, but is combined
with other patterns.

Territorial Organization
If a Company is operating over a large area, it may divide its operations according to geographical
divisions. Certain operations, such as investment and finance, legal, actuarial, and general accounting,
are often carried out by a central office. Other operations, such as underwriting, claims, rate making,
and production are decentralized in each of the branches. Decentralization is a general practice when
the size of distant markets increases to the point that it is more efficient to make certain decisions at a
local level than to refer everything to a central office. An example of such a decision might be the
underwriting of certain risks where frequent contact with the insured is necessary. Dealing from afar
might be unwieldy, inefficient, and ultimately cause a loss of business.
Product Organization
In some insurance operations, particularly among multiple-line insurers, the problems arising from
differing classes of insurance are so technical and specialized that it is inefficient to have all types of
business handled by the same staff. In these cases, the business may be organized according to product
divisions.
It is common in a life insurance company to find separate divisions handling group life insurance,
group disability insurance, industrial life insurance, and group pensions. Within each group, major
functions such as underwriting, accounting, claims, production, and policyholder service may be
performed, with other functions carried on by the home office.
In property and liability insurance, particularly in multiple line companies, separate divisions are
commonly created for the major types of insurance, such as fire, inland marine, bonding, liability,
automobile, and workers' compensation.
Group Organization
Much insurance in the world is written under the sponsorship of groups, or fleets, of insurers. A fleet is
a group of companies operating under central holding company management. Groups were originally
formed to enable insurers to offer a complete line of coverage because state laws restricted the types of
insurance to be written by a single insurer. This restriction no longer exists because of multiple line
laws, but groups still continue to be important. Group organization permits insurers to offer specialized
services to clients, but at the same time consolidate functions that can best be coordinated from one
central office (e.g. actuarial, financial management, and accounting).

Multiple line organization

Companies commonly described as multiple line are firms that underwrite many types of property and
liability insurance within the administrative framework of a single organization. Only rarely may such
companies handle life insurance directly, but usually must do so through a separate company. The
multiple line type of organization permits the simplification of insurance contracts. Most insurance
authorities suggest that requiring a separate policy for every type of coverage is in efficient and
unnecessary. Why not combine, say, fire, windstorm, automobile, residence liability, residence
burglary, and a personal property floater in to one "package policy" designed for the home owner, who
would then have just one company, one policy, and one agent for most insurance needs? The agent
would have a much larger commission from personal lines and would be able to service each customer
more satisfactorily. Further more, the customer would be likely to buy more coverage in a package
than individually, thus enabling the insurer to obtain a wider spread of risks. The success of the
homeowner's contract demonstrates the soundness of this reasoning.
Multiple line legislation has opened up new fields to insurers. The new types of contracts that multiple
line laws have permitted have become known as multi-peril policies. These are policies under which
several different types of perils, formerly written under separate contracts, are now combined into one.
They include both home owners' policies and commercial multiple peril contracts.

All line Organization

All line organization refers to an arrangement by which an insurer may write all lines of insurance
under one administrative charter.

@ #@ # $ % & * # $ % & *@ # $ %@ # $ % & * & * $ % & *

 CHAPTER – IV
FUNDAMENTALS OF INSURANCE CONTRACT
4.1 LEGAL PRINCIPLES UNDERLYING INSURANCE CONTRACTS
4.1.1. PRINCIPLE OF INDEMNITY

The principle of indemnity is one of the most important legal principles in insurance. The principle of
indemnity states that the insurer agrees to pay no more than the actual amount of the loss; stated
differently, the insured should not profit from a loss. Most property and liability insurance contracts are
contracts of indemnity. If a covered loss occurs, the insurer should not pay more than the actual
amount of the loss.
The principle of indemnity has two fundamental purposes. The first purpose is to prevent the insured
from profiting from a loss. For example, if Kristin's home is insured for $100,000, and a partial loss of
$20,000 occurs, the principle of indemnity would be violated if $100,000 were paid to her. She would
be profiting from insurance.

The second purpose is to reduce moral hazard. If dishonest insureds could profit from a loss, they
might deliberately cause losses with the intention of collecting the insurance. If the loss payment does
not exceed the actual amount of the loss, the temptation to be dishonest is reduced.

Actual Cash Value

The concept of actual cash value underlies the principle of indemnity. In property insurance, the basic
method for indemnifying the insured is based on the actual cash value of the damaged property at the
time of loss. The courts have used three major methods to determine actual cash value:
♦ Replacement cost less depreciation
♦ Fair market value
♦ Broad evidence rule

Replacement Cost Less Depreciation Under this rule, actual cash value is defined as replacement
cost less depreciation. It takes into consideration both inflation and depreciation of property values
over time. Replacement cost is the current cost of restoring the damaged property with new materials
of like kind and quality. Depreciation is a deduction for physical wear and tear, age, and economic
obsolescence.

For example, Shannon has a favorite couch that burns in a fire. Assume she bought the couch five
years ago, the couch is 50 percent depreciated, and a similar couch today would cost $1000. Under the
actual cash value rule, Shannon will collect $500 for the loss because the replacement cost is $1000,
and depreciation is $500, or 50 percent. If she were paid the full replacement value of $1000, the
principle of indemnity would be violated. She would be receiving the value of a new couch instead of
one that was five years old. In short, the $500 payment represents indemnification for the loss of a
five-year-old couch. This calculation can be summarized as follows:
Replacement cost = $1000
Depreciation = (couch is 50 percent depreciated)
Actual cash value = Replacement cost - Depreciation
$ 500 = $ 1000 - $ 500

Fair Market Value - Some courts have ruled that fair market value should be used to determine actual
cash value of a loss, Fair market value is the price a willing buyer would pay a willing seller in a free
market.

The fair market value of a building may be below its actual cash value based on replacement cost less
depreciation. This difference is due to several reasons, including a poor location, deteriorating
neighborhood, or economic obsolescence of the building.
In one case, a building valued at $170,000 based on the actual cash value rule had a market value of
only $65,000 when a loss occurred. The court ruled that the actual cash value of the property should be
based on the fair market value of $65,000 rather than on $170,000.

Broad Evidence Rule - Many states now use the broad evidence rule to determine the actual cash
value of a loss. The broad evidence rule means that the determination of actual cash value should
include all relevant factors an expert would use to determine the value of the property. Relevant factors
include replacement cost less depreciation, fair market value, present value of expected income from
the property, comparison sales of similar property, opinions of appraisers, and numerous other factors.
 4.1.2. PRINCIPLE OF INSURABLE INTEREST

The principle of insurable interest is another important legal principle. The principle of insurable
interest states that the insured must be in a position to lose financially if a loss occurs. For example,
Abebe has an insurable interest in his car because he may lose financially if the car is damaged or
stolen. He has an insurable interest in his personal property, such as a television set or computer,
because you may lose financially if the property is damaged or destroyed.
Purposes of an insurable interest

To be legally enforceable, all insurance contracts must be supported by an insurable interest. Insurance
contracts must be supported by an insurable interest for the following reasons.
♦ To prevent gambling
♦ To reduce moral hazard
♦ To measure the amount of the insured's loss in property insurance

Firs, an insurable interest is necessary to prevent gambling. If an insurable interest were not required,
the contract would be a gambling contract and would be against the public interest. For example, one
could insure the property of another and hope for a loss to occur. One person could similarly insure the
life of another person and hope for an early death. These contracts clearly would be gambling contracts
and would be against the public interest.
Second, an insurable interest reduces moral hazard. If an insurable interest were not required, a
dishonest person could purchase a property insurance contract on someone else's property and then
deliberately cause a loss to receive the proceeds. But if the insured stands to lose financially, nothing is
gained by causing the loss. Thus, moral hazard is reduced.
Finally, in property insurance, an insurable interest measures the amount of the insured's loss. Most
property contracts are contracts of indemnity, and one measure of recovery is the insurable interest of
the insured. If the loss payment cannot exceed the amount of one's insurable interest, the principle of
indemnity is supported.

4.1.3 PRINCIPLE OF SUBROGATION

Gambling

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Purposes of Subrogation
Subrogation has three basic purposes. First, subrogation prevents the insured from collecting twice for
the same loss. In the absence of subrogation, the insured could collect from the insurer and from the
person who caused the loss. The principle of indemnity would be violated because the insured would
be profiting from a loss.

Second, subrogation is used to hold the guilty person responsible for the loss. By exercising its
subrogation rights, the insurer can collect from the negligent person who caused the loss.

Finally, subrogation helps to hold down insurance rates. Subrogation recoveries can be reflected in the
rate making process, which tends to hold rates below here they would be in the absence of subrogation.

4.1.4 . PRINCIPLE OF UTMOST GOOD FAITH

An insurance contract is based on the principle of utmost good faith that is, a higher degree of honesty
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The legal significance of a representation is that the insurance contract is avoidable at the insurer's
option if the representation is (1) material, (2) false, and (3) relied on by the insurer. Material means
that if the insurer knew the true facts, the policy would not have been issued, or it would have been
issued on different terms false means that the statement is not true or is misleading. Reliance means
that the insurer relies on the misrepresentation in issuing the policy at a specified premium.

For example, Jamana applies for life insurance and states in the application that he has not visited a
doctor within the last five years. However, six months earlier, he had surgery for lung cancer. In this
case, he has made a statement that is false, material, and relied on by the insurer. therefore, the policy
is voidable at the insurer's option. If Jamana dies shortly after the policy is issued, say three months,
the company could contest the death claim on the basis of a material misrepresentation.

Concealment
The doctrine of concealment also supports the principle of utmost good faith. A concealment is
intentional failure of the applicant for insurance to reveal a material fact to the insurer. Concealment is
teh same thing as nondisclosure; that is, the applicant for insurance deliberately withholds material
information from the insurer. The legal effect of a material concealment is the same as a
misrepresentation the contract is voidable at the insurer's option.

For example, Joseph DeBellis applied for a life insurance policy on his life. Five months after the
policy was issued, he was murdered. The death certificate named the deceased as Joseph DeLuca, his
true name. The insurer denied payment on the grounds that Joseph had concealed a material fact by not
revealing his true identity and that he had an extensive criminal record.

Warranty
The doctrine of warranty also reflects the principle of utmost good faith. A warranty is a statement of
fact or a promise made by the insured, which is part of the insurance contract and must be true if the
insurer is to be liable under the contract. For example, in exchange for a reduced premium, the owner
of a liquor store may warrant that an approved burglary and robbery alarm system will be operational
at all time. The clause describing the warranty becomes part of the contract.

4.2VALID ELEMENTS OR REQUIREMENT OF AN INSURANCE CONTRACT

An insurance policy is based in the law of contracts. To be legally enforceable, an insurance contract
must meet four basic requirements: offer and acceptance, consideration, competent parties, and legal
purpose.

Offer and Acceptance

The first requirement of a binding insurance contract is that there must be an offer and an acceptance
of its terms. In most cases, the applicant for insurance makes the offer, and the company accepts or
rejects the offer. An agent merely solicits or invites the prospective insured to make an offer. The
requirement of offer and acceptance can be examined in greater detail by making a careful distinction
between property and liability insurance, and life insurance.
In property and liability insurance, the offer and acceptance can be oral or written. In the absence of
specific legislation to the contrary, oral insurance contracts are valid. As a practical matter, most
property and liability insurance contracts are in written form. The applicant for insurance fills out the
application and pays the first premium (or promises to pay the first premium). This step constitutes the
offer. The agent then accepts the offer on behalf of the insurance company. In property and liability
insurance, agents typically have the power to bind their companies through use of a binder. A binder is
a temporary contract for insurance and can be either written or oral. Thus, the insurance contract can
be effective immediately, because the agent accepts the offer on behalf of the company. This procedure
is usually followed in personal lines of property and liability insurance, including homeowners policies
and auto insurance. However, in some cases, the agent is not authorized to bind the company, and the
application must be sent to the company for approval. The company may then accept the offer and
issue the policy or reject the application.
In life insurance, the procedures followed are different. A life insurance agent does not have the power
to bind the insurer. Therefore, the application for life insurance is always in writing, and the applicant
must be approved by the insurer before the life insurance is in force. The usual procedure is for the
applicant to fill out the application and pay the first premium.

Consideration
The second requirement of a valid insurance contract is consideration the value that each party gives to
the other. The insured's consideration is payment of the first premium (or a promise to pay the first
premium) plus an agreement to abide by the conditions specified in the policy. The insurer's
consideration is the promise to do certain things as specified in the contract. This promise can include
paying for a loss from an insured peril, providing certain services, such as loss prevention and safety
services, or defending the insured in a liability lawsuit.

Competent Parties
The third requirement of a valid insurance contract is that each party must be legally competent. This
means the parties must have legal capacity to enter into a binding contract. Most adults are legally
competent to enter into insurance contracts, but there are some exceptions. Insane persons, intoxicated
persons, and corporations that act outside the scope of their authority cannot enter into enforceable
insurance contracts. Minors normally are not legally competent to enter into binding insurance
contracts; but most states have enacted laws that permit minors to enter into a valid life insurance
contract.

The insurer must also be legally competent. Insurers generally must be licensed to sell insurance in the
state, and the insurance sold must be within the scope of its charter or certificate of incorporation.

Legal Purpose
A final requirement is that the contract must be for a legal purpose. An insurance contract that
encourages or promotes something illegal or immoral is contrary to the public interest and cannot be
enforced. For example, a street pusher of heroin and other illegal drugs cannot purchase a property
insurance policy that would cover seizure of the drugs by the police. This type of contract obviously is
not enforceable because it would promote illegal activities that are contrary to the public interest.
4.3 UNIQUE CHARACTERISTICSOFINSURANCECONTRACTS
Insurance contracts have distinct legal characteristics that make them different from other legal
contracts. Several distinctive legal characteristics have already been discussed. As we noted earlier,
most property and liability insurance contracts are contracts of indemnity; all insurance contracts must
be supported by an insurable interest; and insurance contracts are based on utmost good faith. Other
distinct legal characteristics are as follows:
♦ Aleatory contract
♦ Unilateral contract
♦ Conditional contract
♦ Personal contract
♦ Contract of adhesion
Aleatory Contract
An insurance contract is aleatory rather than commutative. An aleatory contract is a contract where the
values exchanged may not be equal but depend on an uncertain event. Depending on chance, one party
may receive a value out of proportion to the value that is given. For example, assume that Lorri pays a
premium of $500 for $100,000 of home owners insurance on her home. If the home were totally
destroyed by fire shortly thereafter, she would collect an amount that greatly exceeds the premium
paid. On the other hand, a homeowner may faith fully pay premiums for many years and never have a
loss.

In contrast, other commercial contracts are commutative. A commutative contract is one in which the
values exchanged by both parties are theoretically equal. For example, the purchaser of real estate
normally pays a price that is viewed to be equal to the value of the property.

Unilateral Contract
An insurance contract is a unilateral contract. A unilateral contract means that only one party makes a
legally enforceable promise. In this case, only the insurer makes a legally enforceable promise to pay a
claim or provide other services to the insured. After the first premium is paid, and the insurance is in
force, the insured cannot be legally forced to pay the premiums or to comply with the policy
provisions. Although the insured must continue to pay the premiums to receive payment for a loss, he
or she cannot be legally forced to do so. However, if the premiums are paid, the insurer must accept
them and must continue to provide the protection promised under the contract.

In contrast, most commercial contracts are bilateral in nature. Each party makes a legally enforceable
promise to the other party. If one party fails to perform, the other party can insist on performance or
can sue for damages because of the breach of contract.
Conditional contract
An insurance contract is a conditional contract. That is, the insurer's obligation to pay a claim depends
on whether the insured or the beneficiary has complied with all policy conditions. Conditions are
provisions inserted in the policy that qualify or place limitations on the insurer's promise to perform.
The conditions section imposes certain duties on the insured if he or she wishes to collect for a loss.
Although the insured is not compelled to abide by the policy conditions, he or she must do so to collect
for an insured loss. The insurer is not obligated to pay a claim if the policy conditions are not met. For
example, under a homeowners policy, the insured must give immediate notice of a loss. If the insured
delays for an unreasonable period in reporting the loss, the insurer can refuse to pay the claim on the
grounds that a policy condition has been violated.

Personal Contract
In property insurance, insurance is a personal contract, which means the contract is between the
insured and the insurer. Strictly speaking, a property insurance contract does not insure property, but
insures the owner of property against loss. The owner of the insured property is indemnified if the
property is damaged or destroyed. Because the contract is personal, the applicant for insurance must be
acceptable to the insurer and must meet certain underwriting standards regarding character, morals,
and credit.
A property insurance contract normally cannot be assigned to another party without the insurer's
consent. If property is sold to another person, the new owner may not be acceptable to the insurer. In
contrast, a life insurance policy can be freely assigned to anyone without the insurer's consent because
the assignment does not usually alter the risk or increase the probability of death.

Contract of Adhesion
A contract of adhesion means the insured must accept the entire contract, with all of its terms and
conditions. The insurer drafts and prints the policy, and the insured generally must accept the entire
document and cannot insist that certain provisions be added or deleted or the contract rewritten to suit
the insured. Although the contract can be altered by the addition of endorsements or other forms, the
endorsements and forms are drafted by the insurer. To redress the imbalance that exists in such a
situation, the courts have ruled that any ambiguities or uncertainties in the contract are construed
against the insurer. If the policy is ambiguous, the insured gets the benefit of the doubt.

CHAPTER- V
INSURANCE CONTRACTS

"Insurance contracts are complex legal documents that reflect both general rules of law and insurance
law". When buying an insurance contract, the buyer is expected to be paid for a covered loss. Whether
he or she can collect and the amount paid is governed by insurance law. Insurance contracts are also
termed as "technical documents designed for a specific purpose. These contracts create a binding
agreement between two parties, allowing one party to transfer an exposure to loss to another party".

BASIC PARTS OF AN INSURANCE CONTRACT

Despite their complexities, insurance contracts generally can be divided in to five parts, according to
nd
C. Arthur Williams’s [Link]. (Principles of Risk Management and Insurance, 2 Edition vol.2) They are:
• Declarations
• Insurance Agreement
• Exclusions
• Conditions
• Miscellaneous Provisions
th
Where as Mark S. Dorfman (Introduction to Risk Management & Insurance, 4 Edition, 1991) says
that all commercial and personal property insurance policies have several of the following common
elements:
i.
ii. Declarations
iii. Insurance agreement
iv. Deductibles
v. Definitions
vi. Exclusions
vii. Conditions
viii. Endorsements or Riders
These basic parts of an insurance contract are shown graphically as the building blocks below:

➢ Establishes "named insured"

➢ Provides Rating information

➢ Creates binding agreement between insures & insured

➢ Sub agreements provide specific coverage

➢ Cause insured to bear first Birr amount of covered losses.

➢ Control insurance costs and morale hazard.

➢ Establish meaning of important words found in the policy, there by

reducing room for ambiguity

➢ Limits insurance coverage by specifically identifying perils, people, and

property or time period not covered.

➢ Specify the rights and duties of the insurers and insured under the
contract.

➢ Amends contract to create more coverage.

Although all insurance contracts do not necessarily contain all the above parts in the order given, such
a classification provides a simple and convenient framework for analyzing most insurance contracts.
Declarations
Declarations are statements that provide information about the property or life to be insured.
This information is used for underwriting and rating purposes and for identification of property or life
to be insured.

Contents of the Property Insurance

o Identification of the insurer
o Name of the insured
o Location of the properly
o Period of protection
o Amount of insurance
o Amount of the premium
o Size of the deductible (if any)
o Any other relevant information
Contents of the Life insurance
o Identification of the insurer
o Name of the insured
o The age of issue
o The premium
o The issue date of contract
o
Insuring Agreement
The insuring agreement summarizes the major promises of the insurer. These promises and the
conditions under which losses are to be paid are described in the insuring agreement. There are two
basic forms of an insuring agreement:
a. Named-Perils Coverage and
b. All risk coverage
Named-Perils Policy: Those perils specifically listed in the policy are covered. For example, in the
homeowner's policy, the property damage from fire or lighting is covered, since
these perils are listed and flood damage is not covered, since flood is not a listed
peril.
"All-Risk" Policy: All-risks policy is also called as open perils policy. It covers all losses
except those losses specifically excluded.
e.g. > loss resulting from war
> mechanical breakdown
> breakage of fragile articles
Insurers now-a-days have deleted the word "all-risks" policy forms. Instead American Insurance
Services Office uses the term called "risks of direct loss to property". They have also drafted a
"special causes-of-loss from that is used in commercial property insurance. Both these terminology is
interpreted to mean that all losses are covered except those losses excluded.
Life Insurance is a typical example of an "all risks" policy. Most life insurance contracts cover all
causes of death whether by accident or by disease. The major exceptions are death caused by suicide
during the first two years and, in some contracts, death caused by war.

Deductibles
A deductible is a provision by which a specified amount is deducted from the total loss
payment that otherwise would be payable. Deductibles typically are found in property, health, and
automobile insurance contract. It is not applied in life insurance because the insured's death is a total
loss. Also, a deductible generally is not used in personal liability insurance because the insurers must
provide a legal defense, even for a small claim. Property, health & automobile insurance policies
commonly provide for the insured to pay the first birr of an insured loss.

Purpose of Deductibles
⇨ To eliminate small claims
⇨ To reduce premiums
⇨ To reduce moral and morale hazard

A deductible eliminates small claims that are expensive to handle and process. It makes no
economic sense for the insurer to incur Birr 200 of expenses to settle a Birr 50 claim. Hence, small
losses can be better budgeted out of personal or business income.
Deductibles are also used to reduce premiums. Since small losses are eliminated, more of the
premium birr can be used for the larger claims. The savings from reduced expenses and loss claims are
reflected in lower premium rates. The concept of using insurance premium to pay for large losses
rather than for small losses is often called the "large loss principle." The objective is to cover large
losses that can financial ruin and individual and exclude small losses that can be budgeted out of the
person's income.

Deductibles are used to reduce both moral and moral hazard, since the insured may not profit if a loss
occurs. It encourages persons not to be dishonest and deliberately cause a loss in order to profit from
insurance and also encourage them to be more careful with respect to the protection of their property
and prevention of loss.

Types of Deductibles:
Insurance contracts contain a wide variety of deductibles. There some common deductibles
frequently found in property insurance contracts and health insurance contracts separately.

Deductibles for Deductibles for

Property Insurance Health Insurance
⇨ Straight Deductibles ⇨ Calendar Year Deductibles
⇨ Aggregate Deductibles ⇨ Corridor Deductibles
⇨ Franchise Deductibles ⇨ Elimination (waiting) Period.

Straight deductible: With a straight deductible the insured must pay a certain number of birr of loss
before the insurer is required to make a payment. Such a deductible typically applies to each loss.
Straight deductible is mostly typically found in automobile collision insurance. For instance, assume
that Merit has her 2001 Toyota car insured for a collision loss, subject to a 250 birr deductible. If she
makes a claim for a collision loss of 5000 birr, she would receive only 4750 birr.

Aggregate deductible: In some property insurance contracts, an aggregate deductible may be used; by
which all covered losses during the year are added together until they reach a certain level. If total
covered losses are below the aggregate deductible, the insurer pays nothing. Once the deductible is
satisfied, all losses thereafter are paid in full. For example, assume that a property insurance contract
contains a 1000 birr aggregate deductible for the calendar year. If a loss of 500 birr occurs in
January, the insurer pays nothing. If a 2000 birr loss occurs in February, the insurer would pay 1500.
At this point, the aggregate deductible of 1000 has now been satisfied for the year. If a 5000 loss
occurs in March, it is paid in full. Any other covered losses occurring during the year would also be
paid in full.

Franchise deductible: A franchise deductible is expressed either as a percentage or birr amount, under
which there is no liability on the part of the insurer unless the loss exceeds the amount stated. But once
the loss exceeds this amount, however, the insurer must pay the entire claim. Sometimes this franchise
deductible is termed "disappearing deductible", because the deductible has no effect once the loss
reaches the specified amount. In ocean marine insurance it is common to use a franchise agreement
expressed as a percentage, since shippers expect minor losses from bad weather, rolling ships, and the
frequent handling of cargo and major losses caused by fire, sinking, stranding, and collision. For
example, assume that an exporter from Ethiopia is shipping goods to India that are valued at 100,000
birr, and a 5% franchise deductible is present in the contract. Any loss of 5000 birr or less is paid by
the insured. However, if the actual loss exceeds 5000 birr, the entire amount is paid in full by the
insurer. In effect, this type of deductible acts as a disappearing deductible, since small losses are not
paid, but a large loss exceeding the deductible amount is paid in full.

Calendar-year deductible: A calendar-year deductible is a type of aggregate deductible that is

commonly found in basic medical expense and major medical insurance contracts. Eligible medical
expenses are accumulated during the calendar year, and once they exceed the deductible amount,
the insurer must then pay the benefits promised under the contract. Once the deductible is satisfied
during the calendar year, no additional deductibles are imposed on the insured.

Corridor deductible: Employers with basic medical expense plans often wish to supplement
the basic benefits with major medical benefits. A corridor deductible is a deductible that is frequently
used to integrate a basic medical expense plan with a supplemental major medical expense plan. The
corridor deductible must be satisfied before the major medical plan pays any benefits. The corridor
deductible applies only to eligible medical expenses that are not covered by the basic medical expense
plan. For example, assume that Gidey has 5000 birr of covered medical expenses, of which 4000 birr
are paid by the basic medical expense plan. If the supplemental major medical plan has a 100 birr
corridor deductible, the supplemental plan will cover the remaining 900 birr of expenses, subject to
any limitations or percentage participation clause (coinsurance) that apply.

Elimination (waiting) period: A deductible can also be expressed as an elimination period. An

elimination period is a stated period of time at the beginning of a loss during which no insurance
benefits are paid. An elimination period is appropriate for a single loss that occurs over some time
period, such as the loss of work earnings. Elimination periods are commonly used in disability income
contracts. For example, disability income contracts that replace part of a disabled worker's earnings
typically have elimination periods of seven to ninety days, or even longer. Some contracts pay
disability income benefits from the first day of an accident, but they may require an elimination period
in the event of sickness.

Definition
Insurers often provide definitions of words they consider important or subject to misinterpretation.
Insurance contracts typically contain a definition of the insured under the policy. The contract must
indicate the person or persons for whom the protection is provided. Several possibilities exist
concerning the persons who are insured under the policy.

1. The policy may insure only one person.

For example, in many life and health insurance contracts, only one person is specifically
named as insured under the policy.
2. The policy may contain a formal definition of the Named Insured. The named insured is the
person or persons named in the declarations section of the policy as opposed to someone who
may have an interest in the policy but is not named as an insured.
For example, the named insured under the personal auto policy includes the person named in
the declarations and his or her spouse if a resident of the same household.
3. The policy may also cover Additional Insured's even though they are not specifically named in
the policy.
For example, in addition to the named insured, a homeowner's policy also covers the
following:
⇨ resident relatives of the named insured or
⇨ spouse,
⇨ a son or daughter under age 21 who is in the care of an insured,
⇨ a child in a foster home.
⇨ relatives who are attending college and are away from home.
 The personal auto policy covers the following:
⇨ named insured and spouse,
⇨ resident relatives,
⇨ any other person using the automobile with the permission of the named insured.
A group medical expense policy can also cover the following:
⇨ worker's dependents

Here are some definitions from the Homeowner's Policy.

In this policy, "you" and "your" refer to the "named insured" shown in the
Declarations and the spouse if a resident of the same household. "We", "us"
and "our" refer to the Company providing this insurance.
In addition, certain words and phrases are defined as follows:
Bodily injury > means bodily harm, sickness or disease, including required care, loss of
services and death that result.
Business > includes trade, profession or occupation.
Insured > means you and residents of your household who are:
a) your relatives; or
b) other persons under the age of 21 and in the care of any person
named above.
Insured Location > means:
a) the residence premises;
b) the part of other premises, other structures and grounds used by you
as a residence and:
• which is shown in the Declarations; or
• which is acquired by you during the policy period for your use as a
residence;
Occurrence > means an accident, including exposure to conditions, which results,
during the policy period, in:
a) bodily injury; or
b) damage to property.
Property Damage > means physical injury to, destruction of, or loss of use of tangible
property.

The definitions may appear as a glossary found at the beginning of the policy, or elsewhere in
the body of the text. In both Homeowner's and Personal Auto Policy, boldface type is used to alert the
reader that a particular term has been defined by the insurer.

Exclusions
Exclusions in an insurance contract are listing of the perils, losses, and property that are excluded from
coverage. When the policy states it will not pay for the following losses, and a list of excluded losses
is given, it means the insured has no right to collect payment under the circumstances listed. As such
there are three major types of exclusions.
⇨ Excluded perils
⇨ Excluded losses
⇨ Excluded property
Excluded perils
The contract may exclude certain perils, or causes of loss. Several examples can illustrate this
type of exclusion. Under the typical homeowner's policy, the perils of flood, earth movement, and
nuclear radiation are specifically excluded. In the physical damage section of a personal auto policy,
collision is specifically excluded if the automobile is used as a public taxicab. Finally, in life
insurance and disability income policies, the peril of war if often excluded.

Excluded losses
Certain types of losses may also be excluded. For example, in a homeowner's policy,
earthquake losses are not covered without a special endorsement. In the personal liability section of a
homeowner's policy, a liability lawsuit arising out of the negligent operation of an automobile is
excluded. Nor are professional liability losses covered; a specific professional liability policy is
needed to cover this exposure. Finally, under a health insurance policy that covers only accidents,
losses due to sickness and disease are not covered.

Excluded property
The contract may also exclude or place limitations on the coverage of certain property. For
example, in a homeowner's policy, certain types of personal property are excluded, such as
automobiles, airplanes, animals, birds, and fish. In a liability insurance policy, property of others in
the care, control, and custody of the insured is usually excluded.

Reasons for exclusions

Exclusions are necessary for the following reasons.
• Uninsurable perils
• Presence of extraordinary hazards
• Coverage provided by other contracts
• Moral hazard
• Coverage not needed by typical insureds

Exclusions are necessary because the peril may be considered uninsurable by commercial
insurers. There may be an incalculable catastrophic loss; a loss (such as an intentional, self-inflicted
injury) may be within the direct control of the insured; or a loss may be due to a predictable decline in
value (property, such as depreciation, wear and tear), are not insurable.

Exclusions are also used because extraordinary hazards are present. For example, the premium
for liability insurance under a personal auto policy is based on the assumption that the automobile is
normally used for personal and recreational use and not as a public taxicab. The chance of an accident,
and a resulting liability lawsuit, is much higher if the automobile is used as a public taxicab. Therefore,
to provide coverage for a public taxicab at the same premium rate for a family automobile could result
in inadequate premiums for the insurer and unfair rate discrimination against other insureds who are
not using their vehicles as taxicabs. To avoid this problem, public taxicabs are in a separate rating
category, and losses due to the operation of the vehicle as a public taxicab are specifically excluded
under the personal auto policy.

Exclusions are also necessary because coverage is provided by other contracts. Exclusions are
used to avoid the duplication of coverage and to confine the coverage to the policy best designed to
provide it. For example, an automobile is excluded under a homeowner's policy because it is covered
under the personal auto policy and other automobile insurance contracts. If both policies covered the
loss, there would be unnecessary duplication.

Certain property is excluded because of moral hazard or difficulty in determining and

measuring the amount of loss. For example, the standard fire policy excludes money, and the
homeowner contracts limit the coverage of money to $200 in America. If unlimited amounts of money
were covered, fraudulent claims could increase. Also, loss adjustment problems in determining the
exact amount of the loss could increase. Thus, because of moral hazard, exclusions are used.

Finally, exclusions are used because the protection is not needed by the typical insured. Since
a particular peril may not be common to a large group of persons, the insured's should not be required
to pay for coverage that they will not need or use. For example, to cover aircraft as personal property
under the homeowner's policy would be grossly unfair to the majority of insureds who do not own
airplanes but who would be required to pay substantially higher premiums.

Conditions
Conditions are provisions inserted in the policy that qualify or place limitations on the insurer's
promise to perform. They explain many of the important relationships, rights, and duties between the
insurer and insured. They also provide a framework for the insurance policy. If the policy conditions
are not met, the insurer can refuse to pay the claim.

The 165 lines of the 1943 New York Standard Fire Insurance Policy (SFP) contain most of the
conditions frequently found in current policy forms. The SFP served as the main building block of all
property insurance forms. Today it has been widely replaced by forms written in more modern,
simplified English.

Common conditions in a contract include the following that are to be fulfilled by the insured on
the occurrence of the losses.
1. Requirement to protect property after a loss. For example, undamaged property must be
protected. If a fire on the roof exposes furniture to damage from the weather, the furniture
should be removed to a warehouse. If property is not protected and suffers damage because of
the lack of care, the insurer need not pay for the subsequent damage. Requiring protection of
undamaged property reduces the morale hazard.
2. File a proof of loss with the company. Prompt notice of loss must be given immediately. Police
must be notified. Inventories must be completed. Insurer should be informed as early as
possible. The purpose of immediate notice provision is to allow the insurer to investigate the
claim promptly. If the insurer can investigate promptly, as is the insurer's right under the policy,
the insured has fulfilled the requirement of the contract.
3. Actively cooperate with the company in determining the amount of loss. Insurers have a right
to a complete inventory, signed and sworn to by the insured. Any substantial concealment or
misrepresentation at this stage allows the insurer to void the contract.
4. Cooperate with the company in the event of a liability lawsuit in fixing the house (in case the
house is on fire).

Endorsements and Riders

Insurance contracts also contain endorsements and riders. The terms "endorsements and riders"
are often used interchangeably and meaning the same thing. An endorsement is a written provision
that adds to, deletes, or modifies the provisions in the original contract. The term "rider" is mostly
used in life and health insurance policies to describe a document that amends or changes the original
policy.

For example, when added to the standard fire policy, the extended coverage endorsement
extends the fire insurance policy to certain additional specified perils. In life and health insurance,
numerous riders can be brought in, such as:
⇨ Add an increase or decrease benefits
⇨ Waive a condition of coverage present in the original policy or amend the basic policy.
For example, after a six-month waiting period, all future premiums may be waived for the
confirmed disability.

Approximately 100 different endorsements can be added to homeowner's policy. These include
the following:
⇨ Theft Coverage Extension (broadens the definition of the peril).
⇨ Scheduled Personal Property Endorsement (adds coverage for valuable furs, jewelry and similar
Declarations
items).
⇨ Business Pursuits (modifies standard policy exclusion and provides liability coverage for a few
business pursuits, including sales and instructional occupations, etc.)
⇨ Watercraft (remove the standard policy exclusion restricting liability coverage for watercraft).
⇨ Home Day Care Coverage Endorsement
Insuring Agreements (extends coverage for home day care business
conducted on the premises).

COINSURANCE

Many property policies contain a clause requiring the insured to purchase some minimum
Deductibles
amount of insurance if the insured wants full coverage on all losses. It the insured purchases less than
the minimum amount, there will be only partial recovery for losses. The minimum amount of
insurance the company required usually is stated as a percentage of the replacement cost of the insured
property. In health insurance and credit insurance the coinsurance clause is simply a straight
deductible, expressed as a percentage.
Definitions

Nature of Coinsurance
Exclusions
A coinsurance clause inserted in a property for a stated percentage of its actual cash value at the
time loss. If the insured fails to meet the coinsurance requirement at the time of loss, he or she must
share in the loss a coinsurer. For example:

In health insurance ⇨ The insured bear 20% of every loss. This controls the fraudulent claims.
In fire insurance ⇨ The insured bear a portion of every loss only when underinsured.
Conditions
Underinsurance is looked upon as undesirable for two reasons:
a) Insurance companies are supposed to restore their policyholders to their original positions.
b) It costs relatively more to insure the business of individuals who are underinsured than it does
to handle the business Endorsements
of individuals &who purchase insurance equal to the full value of the
object. Riders
This follows because most losses are partial, and the probability of partial losses is higher than
the probability of total losses. The typical coinsurance clause prorates any partial losses between the
insurer and the insured in the proportion that the actual insurance carried bears to the amount required
under the clause. Usually 80% or 90% of the sound value is the amount required. Sound value means
the actual cash value of the property; that is, the replacement cost less an allowance for
depreciation. Thus, if there is a building with a 10,000 birr sound value written with a 90%
coinsurance clause, 9,000 birr of insurance is required. The insured who carries at least this amount
collects in full for any partial loss. But the insured, who carried half of this amount, or 4,500 birr,
collects only half of any partial loss. The insured who carries 6,000 birr collects two-thirds of any
partial loss.

To determine whether in insured has met the coinsurance requirement on the dwelling, insurers
use the following formula:
Insurance carried
x Amount of Loss = Amount Payable by the insurer
Insurance required
If the loss equals or exceeds the amount required under the clause (if the loss is nearly total), there is
no penalty invoked by the coinsurance clause. Thus, if in the above case the loss were 9,000 birr at a
time when the insured is carrying only 6,000 birr of insurance, substitution in the above formula yields
the following;

6,000
x 9,000 = 6,000 birr
9,000
The recovery is 6,000 birr, the amount of insurance carried, and there is no penalty other than
the fact that the insured did not carry sufficient insurance to cover the entire loss.
Purpose of Coinsurance
1. To achieve equity in rating
2. To make underinsurance unattractive to the insured
3. To make the insured to pay a penalty based on the amount of underinsured.

The fundamental purpose of coinsurance is to achieve equity in rating. It happens to be the case
that property insurance rates are expressed as an amount per 100 birr of value. Most property insurance
losses are partial and not total losses. But if every one insures only for the partial loss rather than for
the total loss, the premium rate for each 100 birr of insurance must be higher. This would be
inequitable to the insured who wishes to insure his or her property to its full value. If every one insures
to full value, the pure premium rate for fire insurance will be reduced for each 100 birr of insurance. If
the property owner purchases insurance equal to only 50% of the value of the covered property when
the insurer requires 80% coverage, that insured will receive only partial recovery for a loss.
@#&%$@#&%$@#&%$@#&%$

CHAPTER SIX
6. LIFE INSURANCE

Life Insurers pay death benefits to designated beneficiaries when the insured dies. The death
benefits are designed to pay for funeral expenses, uninsured medical bills, estate taxes, and other
expenses as a result of death.

Premature Death: - can be defined as the death of a family head with outstanding unfulfilled financial
obligations, such as dependents to support, children to educate, and a mortgage to pay off.
Costs of Premature Death
1. The family's share of the deceased bread winner's earnings is lost forever.
2. additional expenses are incurred because of funeral expenses, uninsured medical bills, estate
settlement costs,
3. because of insufficient income, some families will experience a reduction in their standard of
living
4. certain non economic costs are incurred, such as emotional grief, loss of a parental role model,
and counseling and guidance for the children.

Types of Life Insurance

Life insurance policies can be classified as either term insurance or cash value life insurance. Term
insurance provides temporary protection, while cash value life insurance has a savings component and
builds cash values.

Term Insurance
First, the period of protection is temporary, such as 1, 5, 10, or 20 years. Unless the policy is renewed,
the protection expires at the end of the period.
Most term insurance policies are renewable, which means that the policy can be renewed for
additional periods without evidence of insurability.
Most term insurance policies are also convertible, which means the term policy can be
exchanged for a cash value policy without evidence of insurability.
Finally, term insurance policies have no cash value or savings element. Although some long
term policies develop a small reserve, it is used up by the contract expiration date.

Whole Life Insurance

In contrast to term insurance, which provides short term protection, Whole life insurance is a cash
value policy that provides lifetime protection. The following two types of whole life insurance:
- Ordinary life insurance
- Limited payment life insurance

Ordinary Life Insurance Ordinary Life insurance (also called straight life and continuous premium
whole life) provides lifetime protection to age 100, and the death claim is a certainty. If the insured is
still alive at age 100, the face amount of insurance is paid to the policy owner at that time.
In addition, premiums do not increase from year to year but remain level throughout the
premium paying period.
Ordinary life insurance also has an investment or saving element called a cash surrender value.
The cash values are due to the overpayment of insurance premiums during the early years. For
example, in many ordinary life policies, a $100,000 policy issued at age 20 would have at least
$50,000 of cash value at age 65.
Finally, ordinary life insurance contains cash surrender or non forfeiture options (if
participating), and settlement options that can be used to meet a wide variety of financial needs and
objectives.
Limited payment life insurance: A limited payment policy is another type of traditional whole life
insurance. The insurance is permanent, and the insured has lifetime protection. The premiums are
level, but they are paid only for a certain period. For example, Shannon, age 35, may purchase a 20
year limited payment policy in the amount of $25,000. After 20 years, the policy is completely paid
up, and no additional premiums are required even though the coverage remains in force.

Endowment Insurance
Endowment insurance is another traditional form of life insurance. An endowment policy pays the face
amount of insurance if the insured dies within a specified period, if the insured survives to the end of
the endowment period, the face amount is paid to the policy owner at that time. For example, if At
Gashow, age 35, purchased a 20 year endowment policy and died any time within the 20 year period,
the face amount would be paid to her beneficiary. If he survives to the end of the period, the face
amount is paid to him.

Modified Life Insurance

A modified life policy is a whole life policy in which premiums are lower for the first three to five
years and higher thereafter. The initial premium is slightly higher than for term insurance, but
considerably lower than for an ordinary life policy issued at the same age.

Juvenile Insurance
Juvenile insurance:- refers to life insurance purchased by a parent or adult on the lives of children
younger than a certain age, such as age 14 or 15. Insurers generally require the child to be at least one
month old before he or she can be insured. Some insurers, however, will insure a child as young as one
day old.

Industrial Life Insurance

Industrial life insurance - (some called debit insurance) is a class of life insurance that is issued in
small amounts, and the premiums are payable weekly or monthly. In the past, teh premiums were
collected at the insured's home by an agent of the company. More than nine out of ten such policies
were cash value policies.
In recent years, industrial life insurance has also been called home service life insurance,
reflecting the fact that individual policies are serviced by agents who call at the policy owner's home to
collect the premiums.

Group Life Insurance

Group life insurance is a type of insurance tha provides life insurance on a group of people in a single
master contract.

Rate Making in Life Insurance

Our discussion of rate making so far has applied largely to property and liability insurance. This
section briefly examines the fundamentals of life insurance rate making.

Net Single Premium

Life insurance policies can be purchased with a single premium, or with annual, semiannual, quarterly,
or monthly premiums. Although most policies are not purchased with a single premium, the net single
premium forms the foundation for the calculation of all life insurance premiums.
The net single premium (NSP) can be defined as the present value of the future death benefit. It
is that amount, which together with compound interest, will be sufficient to pay all death claims. In
calculating the NSP, only mortality and investment income are considered. Insurance company
expenses or the loading element are considered later, when the gross premium is calculated.
The NSP is based on three basic assumptions: (1) premiums are paid at the beginning of the
policy year, (2) death claims are paid at the end of the policy year, and (3) the death rate is uniform
throughout the year.

Term Insurance: The NSP for term insurance can be calculated easily. The period of protection is
only for a specified period or to a stated age. The face amount is paid if the insured dies within the
specified period, but nothing is paid if the insured dies after the period of protection expires.

The NSP for yearly renewable term insurance is considered first. Assume that a $1000 yearly
renewable term insurance policy is issued to a male age 45. The cost of each year's insurance is
determined by multiplying the probability of death by the amount of insurance multiplied by the
present value of $1 for the time period the funds are held. By referring to the 1980 CSO mortality chart
we see that out of 10 million males alive at age zero, 9,210,289 are still alive at the beginning of age
45. Of this number, 41,907 persons will die during the year. Therefore, the probability that a person
age 45 will die during the year is 41,907/9,210,289. This fraction is then multiplied by $1000 to
determine the amount of money the insurer must have on hand from each policy owner at the end of
the year to pay death claims.

The present value of $1 at 5 percent interest is 0.9524. Thus, if the probability of death at age 45 is
multiplied by $1000, and the sum is discounted for one year's interest, the resulting net single premium
is $4.33. This calculation is summarized as follows

If 44.33 is collected in advance from each of the 9,210,289 persons who are alive at age 45, this
amount together with compound interest will be sufficient to pay all death claims.
If the policy is renewed for another year, the NSP at age 46 would be calculated as follows:
The NSP for a yearly renewable term insurance policy issued at age 46 is $4.69. Premiums for
subsequent years are calculated in the same manner.
Now consider the NSP for a five year term insurance policy in the amount of $1000 issued to a
person age 45. In this case, the company must pay the death claim if the insured dies any time within
the five year period.
The cost of insurance for the first year is determined exactly as before, when we calculated the
net single premium for yearly renewable term insurance. Thus, we have the following equation:

The next step is to determine the cost of insurance fore the second year. Referring back to
Exhibit we see that at age 46,45,108 people will die during the year. Thus, for the 9,210,289 persons
who are alive at age 45, the probability of dying during age 46 is 45,108/9,210,289. Note that the
denominator does not change but remains the same for each probability fraction.
Thus, for the second year, we have the following calculation:

For each of the remaining three years, we follow the same procedure. If the insurer collects $22.74 in a
single premium from each of the 9,210,289 persons who are alive at age 45, that sum together with
compound interest will be sufficient to pay all death claims during the five year period.

Exhibit
Figuring the NSP for a Five Year Term Insurance Policy

Probability of Amount of Present Value of $1 of Cost of Insurance

Age Death Insurance 5%

45 X $1000 X 0.9524 = $ 4.33 (year 1)

46 X $1000 X 0.9070 = 4.44 (year 2)

47 X $1000 X 0.8638 = 4.55 (year 3)

48 X $1000 X 0.8227 = 4.65 (year 4)

X X =
49 $1000 0.7835 ( year 5)
NSP =

Ordinary Life Insurance:- In calculating the NSP for an ordinary life policy, teh same method
described earlier for the five year term policy is used except that the calculations are carried out to the
end of the mortality table (age 99). Thus, in our illustration, the NSP for a $1000 ordinary life
insurance policy issued at age 45 would be $270.84

Net Annual Level Premium

Most life insurance policies are not purchased with a single premium because of the large amount of
cash required. Consumers generally find it more convenient to pay for their insurance in installment
payments. If premiums are paid annually, the net single premium must be converted into a net annual
level premium, the net annual level premium (NALP) is determined by dividing the net single
premium by the present value of a life annuity due (PVLAD) of $1 for the premium paying period.
thus, we obtain the following:

Term insurance - Consider the net annual level premium for a five year term insurance policy in the
amount of $1000 issued at age 45. Recall that the net single premium for a five year term insurance
policy at age 45 is $22.74. This sum must be divided by the present value of a five year temporary life
annuity due of $1. For the first year, a $1 payment is due immediately. For the second year, the
probability that a person age 45 will still be alive at age 46 to make the second payment of $1 must be
determined. Referring back to Exhibit 9,210,289 persons are alive at age 45. Of this number, 9,168,382
are still alive at age 46. Thus, the probability of survival is 9,168,382/9,210,289. This fraction is
multiplied by $1, and the resulting sum is then discounted for one year's interest. Thus, the present
value of the second payment is $0.948. Similar calculations are performed for the remaining three
years. The various calculations are summarized as follows:

Age 45 $1 due immediately = $1.000

PVLAD of $1 = $4.503

The present value of a five year temporary life annuity due of $1 at age 45 is $4.50. If the net single
premium of $22.74 is divided by $4.50, the net annual level premium is $5.05.

Ordinary Life Insurance:- The net annual level premium for a $1000 ordinary life insurance policy
issued at age 45 is calculated in a similar manner. The same procedure is used except that the
calculations are extended to the end of the mortality table. Thus, the present value of a whole life
annuity due of $1 for ages 45 through 99 must be calculated. If the calculations are performed, the
present value of a whole life annuity due of $1 at age 45 is $15.312. The net single premium ($270.84)
is then divided by the present value of a whole life annuity due of $1 at age 45 ($15.312), and the net
annual level premium is $17.69.
Gross Premium - The gross premium is determined by adding a loading allowance to the net annual
level premium. The loading must cover all operating expenses, provide a margin for contingencies,
and, in the case of stock life insurers, provide for a contribution to profits. If the policy is a
participating policy, the loading must also reflect a margin for dividends.

Three major types of expenses are reflected in the loading allowance: (1) production expenses, (2)
distribution expenses, and (3) maintenance expenses. Production expenses are the expenses incurred
before the agent delivers the policy, such as policy printing costs, underwriting expenses, and the cost
of the medical examination. Distribution expenses are largely selling expenses, such as the first year
commission, advertising, and agency allowances. Maintenance expenses are the expenses incurred
after the policy is issued, such as renewal commissions, costs of collecting renewal premiums, and
state premium taxes.

Exhibit
Commissioners 1980 Standard Ordinary Mortality Table, Male Lives

Age at Number Living Number Dying Ate at Number Living at Number Dying
Beginning of Beginning of During Beginning Beginning of during
of Year Designated year Designated Year of Year Designated year Designated year
1 10,000,000 41,800 25 9,663,007 17,104
2 9,958,200 10,655 26 9,645,903 16,687
3 9,947,545 9,848 27 9,629,216 16,466
4 9,937,697 9,739 28 9,612,750 16,342
5 9,927,958 9,432 29 9,596,408 16,410
6 9,918,526 8,927 30 9,579,998 16,573
7 9,909,599 8,522 31 9,563,425 17,023
8 9,901,077 7,921 32 9,546,402 17,470
9 9,893,156 7,519 33 9,528,932 18,200
10 9,885,637 7,315 34 9,510,732 19,021
11 9,878,322 7,211 35 9,491,711 20,028
12 9,871,111 7,601 36 9,471,683 21,217
13 9,863,510 8,384 37 9,450,466 22,681
14 9,855,126 9,757 38 9,427,785 24,324
15 9,845,369 11,322 39 9,403,461 26,236
16 9,834,047 13,079 40 9,377,225 28,319
17 9,820,968 14,830 41 9,348,906 30,758
18 9,806,138 16,376 42 9,318,148 33,173
19 9,789,762 17,426 43 9,284,975 35,933
20 9,772,336 18,177 44 9,249,042 38,753
21 9,754,159 18,533 45 0,210,289 41,907
22 9,735,626 18,595 46 9,168,382 45,108
23 9,717,031 18,365 47 9,123,274 48,536
24 9,698,666 18,040 48 9,074,738 52,089
25 9,680,626 17,619 49 9,022,649 56,031
Harambe College Risk and Insurance Management