CHAPTER 7
RISK AND INSURANCE MANAGEMENT
Course Instructor: Rezene M
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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:
[Link] 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 . 13
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. 24