CHAPTER 7

RISK AND IN SURANCE MANAGEMENT

By: Assefa M. ([Link]@[Link])

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Outline
Risk; Basic Concepts and its Management
◦ Classification of Risk
◦ The Process/Steps/ of Risk Management

Insurance: Basic Concepts and its Management

◦ Insurable and Uninsurable Risks

Fundamental Legal Principles of Insurance

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After reading this unit students will be able to know:
– The various types of business risks that an entrepreneur may encounter
– The major hazards and causes/perils of these risks
– The process/steps of risk handling/management
– Basic concepts and principles of risk and insurance

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 CHAPTER 07
RISK AND INSURANCE MANAGEMENT

RISK MANAGEMENT
Definition: Risk is the probability of exposure to bad/adverse consequences
(such as loss, loss of property, etc) due to unexpected changes in the future.

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Classification of Risk

The various types of business risks that an entrepreneur

may face can be classified into four major groups as
indicated below.

•Property Cantered Risks

•Employee Centered Risks
•Market-Centered Risk
•Personal/Individual Centered Risks

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1. Property Cantered Risks
Entrepreneur’s, big or small, own properties or assets of
different kinds such as buildings, machinery, materials, etc.
◦ These assets may be fully or partially damaged, destroyed, lost or
theft due to fire, earth quake, lightening tornado, windstorm, etc.
◦ Property centered risk cause direct financial loss and/or
◦ indirect/consequential loss

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2. Employee Centered Risks: These risks are directly or
indirectly related to employee circumstances of the
entrepreneur such as:
–Work-place accidents and professional hazards which may lead to
employee injury, partial or total disabilities.
–Employee strike which may cause considerable trouble and loss of
income
–Employee frauds such as forgery, over-stating or under-stating checks
and other illegal acts of an employee(s).
–Loss of key employees/executive who have valuable specialized skill
and experience which cannot be easily replaced.

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3. Market-Centered Risk: The actions and reactions between
the entrepreneur and the external environment coupled with
other environmental changes may sometimes lead to
undesirable consequences /risks/ to the entrepreneur. Such
types of risks include
–Business recession or economic decline in general
–Undesirable price fluctuation
–Production process and/or product obsolescence
–Bad debt or risk or risk of uncollectible accounts receivable if a
customer who bought on accounts dies or disappears.
–Liability risk which refers to losses or any other bad consequences

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4. Personal/Individual Centered Risks: These are risks which
directly affect personal circumstances of the entrepreneur
and lead to complete loss or reduction of earned income,
depletion of financial assets, and/or extra expenses.
Examples of such risks are:
◦ Risk of premature death
◦ Risk of old age
◦ Risk of poor health
◦ Risk of unemployment, etc.

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•Based on their ultimate effect, the above mentioned types of business risks
are grouped into two broad categories are:
A. Pure Risks
– which refer to the risks which produce the possibilities of adverse consequences
(loss) or natural (no loss) situation. In this case, the possible ultimate effects are loss
if risk occurs or no loss if risk doesn’t occur. The above mentioned property-centered
and personal risks fall under this category.

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B. Speculative Risks
•which refer to risks which produce the possibilities of adverse consequences
(loss) or favorable situation (profit). In this case, the ultimate effects are either
profit or loss. Market centered risks are good examples of this category.

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Risk, Peril and Hazard:
An entrepreneur need to clearly distinguish between what is called
◦ the peril which is the main cause of a particular risk and
◦ a hazard which refers to a condition which creates and/or
increases the probability of occurrence and severity of a
particular risk.
◦ For example, while fire is a peril/ (the cause) for property
damage, defective electric wiring is the hazard

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The three major types of hazard are:
1. Physical Hazard which refer to a physical condition which increases the chance
or risk such as:
•Icy road which aggravates auto accident
•Defective wiring which aggravates fire risk
•Defective door-lock which aggravates theft.
2. Moral Hazard refers to dishonesty, fraudulent claims or deliberate character
defects of an individual which increase the frequency and severity of risk such as:
•Intentionally burning unsold merchandize
•Intentionally inflating insurance claims, etc.
3. Morale Hazard which refers to inadvertent/ unintentional carelessness,
negligence or indifference to risk/loss because of the existence of insurance such
as:
•Leaving ignition ken/knowledge in the car and increasing the chance of loss
•Leaving doors unlocked and increasing the chance of burglary /theft .
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 The Process/Steps/ of Risk Management

Risk management is defined as a systematic process for the

identification and evaluation of pure loss exposure faced by
an organization or individual and for the selection and
implementation of the most appropriate techniques for
treating such exposures”

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 Steps
1. Analyzing the situation and identifying potential risks.
•In this first step is conducting environmental scanning i.e.
retrospective or past, current or present and prospective
future situation analysis with special reference to the
probabilities of exposures to adverse or undesirable
consequences.
2. Evaluating and determining the frequency of occurrence
and severity or magnitude of possible losses due to
anticipated risks.

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3. Selecting the appropriate risk handling strategy for
handling anticipated risk(s).
The most common risk handling strategies/ techniques
A. Risk control techniques
• (minimizing or avoiding losses through risk prevention or
avoidances)

B. Risk financing techniques (paying for the loss if risk

happens)

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4. Implementing the chosen/selected risk handling strategy:
based on the situation, an entrepreneur may choose one or
combination of the above mentioned technique(s). The chosen
technique(s) need to be implemented or put into action.

5. Monitoring and evaluating the implementation of the chosen

risk management strategy.
Finally, conducting impact assessment or evaluating, unusually at
the end of the planning period, is essential in order to identify the
efficiency and effectiveness of the chosen strategy.

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 INSURANCE MANAGEMENT
A. Definition of Insurance:
It is defined as a legal contract between the insurer and the insured
◦ the insurer or insurance company agrees to reimburse, recover or
indemnify another party, called the insured (an individual, a
group, organization, etc) if the latter (the insured) suffers a
specified monetary loss.
◦ the insured transfer his/her potential risk(s) to the insurance
company.

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The insurance policy-document among other things, need to
contain the following elements:
1. Declarations: Statements which provide information about:
• the name, address, sex, age, etc for a person
• identification and location of the property, period of
protection, amount of premium and other relevant
information’s.
2. Definition of key works and phrases
3. Insurance agreements which summarize the major promises
of the insurer and the insured as well as the conditions under
which assets are to be paid.

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4. Exclusive such as:
• Excluded periods such as unclear radiation
• Excluded losses such as losses due to negligence
• Excluded property such as animals and birds in case of
home insurance.
5. Conditions or provisions that quality or place limitation
on the insurer’s promise
6. Other miscellaneous provisions such as, the manner of
relationships between the insurer and insured, the
insured/insurer and the third party, etc.

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B. Insurable and Uninsurable Risks
•Depending upon the nature of the property, type of risk,
perils and hazards; while some risks are insurable, others
are uninsurable.
•Generally, insurable risks need to meet the following
requirements.
–There must be a large number of exposure units
–The expected loss need to be calculable, determinable and
measurable: (in terms of time, place and amount).
–The loss need to be accidental and un international.
–Calculable chance of loss: i.e. the average frequency and
severity of anticipated future losses.

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 Cont… insurable risks

◦ The expected loss must be financially serious and the premium needs to
be economically feasible to the insured.
◦ The loss need not be catastrophic in a sense that a larger portion of
exposure units (insured) should not incur losses at the same time.

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Fundamental Legal Principles of Insurance
the insurance contract between the insurer and the insured are
governed by the following legal principles:
•The Principles of Indemnity: these principles state that the
insured should not collect more than the actual loss in the event
of risk/ damage. like
– Valued policy
– Replacement cost insurance
– Life insurance

•The Principle of Insurable Interest: This principle refers to the financial

interest of the insured towards the subject insured.

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The Principle of Subrogation: The principle states that the insurer
who indemnified/compensated/ the insured’s loss is entitled to
be recovered from any liable third party/ parties responsible for
the loss. In insurance, the principle of subrogation substitutes the
insurer in place of the insured for the purposes of claiming
compensation /indemnity/ for a loss covered by the insurer from
a liable third person.
The Principle of Utmost Good Faith: This principle states that
high degree of honesty is imposed on both parties to the
insurance contract.
The Principle of Contributions: This one supports the principle of
indemnity. It is applied to a situation where a person or firm, for
some reason, purchase insurance from two or more insurers to
cover the same subject matter against loss or damage.

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