ABMF3273 INSURANCE MANAGEMENT

Chapter 1: Fundamental of Risk Management, Insurance &

Terminology
Introduction to the fundamentals of risk management, insurance and
terminology.

• Definition of insurance and loss

• Various forms of risks

• Benefits of insurance to society

• Defining insurable events

What is Risk?

Risk can mean hazard, danger, and chance of loss or injury, the degree of
probability of loss, a person, thing, or factor likely to cause loss or danger. Risk
is also used as a verb.

For example, ‘to risk crossing a busy street’ is to risk being exposed to the
hazard or to incurring the chance of unfortunate consequences by doing
something.

With a large number of similar loss exposures, an insurance company can

predict an expected loss; however, there is an element of uncertainty as the
actual loss may not be the same as the expected loss.
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Definition of Risk

• Risk is the possibility of an unfortunate occurrence

• Risk is a combination of hazards

• “Risk is the uncertainty relating to possible unfavourable result in a given

situation”

• Risk can be defined as the variation in outcomes in each given situation

and can be referred to as: -

a) Possibility of loss

b) Exposure to danger

c) Subject matter of insurance

Various Forms of Risks

There are four main types of risk:

1. Fundamental risk is a risk that arises from causes outside the control of
anyone individual or group of individuals and is felt by large numbers of
people. It cannot be measured in financial terms.

2. Particular risk is a risk that the form of risk arises from individual cause
and affects the individual in their consequences. It only affects
individuals, as opposed to affecting society as a whole.

3. Pure risk is uncertainty that involves a loss or at best a breakeven

situation with no possibility of gain. traditionally the basis of insurance
cover.

4. Speculative risk is often referred to as the risks of business which

involves the possibility of a loss, breakeven, or gain situation where there
is a possibility of financial gain.
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Types of Pure Risks

1. Personal Risk: involve injury, incapacity, or death to an individual e.g.

premature death, old-age disability, or poor health

2. Property Risk: involve losses from three areas:

(i) damage to the property itself, loss of use of the property,

(ii) loss of income derived from it, and
(iii) indirect/consequential losses as a result of property damage

3. Liability Risk: comprise of action or inaction resulting in loss, damage, or

injury to third party individuals and property which arise from statute or
common law or under the contract.

Hazard: refers to condition that increase the chance of a loss. There are four
(4) types of hazards:

1) Physical Hazard: refers to the physical condition that increase the

probability of a loss

2) Moral Hazard: refers to the character of an individual (dishonesty/

untrustworthy/ unethical) in an individual that increases the probability of
loss

3) Morale Hazard: refers to carelessness / indifference to a loss because

of the existence of insurance

4) Legal Hazard: refers to system / regulatory environment that increase

the frequency / severity of losses
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What is Loss in insurance?

Loss is the value placed on property damage or injury due to peril/s or an

accident caused by another’s negligence or a breach of contract or other
wrongdoing.

Insurable loss: An undesired, unplanned reduction of economic value.

Uninsurable Loss:planned reduction of economic value (e.g.

depreciation of asset/s).

There are two (2) categories of losses:

(a) Direct losses: the financial loss or damage that immediately results
from a disaster, accident, or perils. (e.g. flood damage)

(b) Indirect losses: financial loss that often results as a consequence

of the direct loss. (e.g. Loss of use)

What is Insurance?
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What is Takaful?

Insurance is the pooling of fortuitous losses by transfer of such risks to

insurers, who agree to indemnify insureds for such losses, to provide other
pecuniary benefits on their occurrence, or to render services connected with
the risk.

Insurance is a contract whereby one person or party (the insured) agrees to

pay money (the premium) to another person (the insurer) in order to secure
some benefit, usually in the form of payment of a sum of money or its
equivalent on the happening of a specified event that is generally averse to the
interests of the insured.’’

Functions of Insurance

There are three functions that are interrelated:

1. Risk transfer

2. Creation of a common pool

3. Equitable premiums
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1) Sound Risk Transfer Mechanism: In exchange for protection, the
insured pays a sum of the premium to the insurance company and
transfers the responsibility of carrying the risk of loss or damage to the
insurer. Upon acceptance of the risk, the primary insurer is in the same
position as the insured, in relation to the various uncertainties associated
with the risk.

2) Creation of the Common Pool: The concept of the common pool was
introduced in the early days of marine insurance wherein the merchants
contributed to anyone who suffered a loss during a voyage. Insurers today
also have pools which are better known as a class of portfolio e.g. fire,
into which all the premiums collected for that class of business are
placed. In the event of any loss suffered by anyone contributing to this
pool, the loss amount will be paid out from this pool.

3) Calculation of Equitable Premiums: The premium each insured

contributes to the pool has to be equal to the risk brought to the pool. In
other words, although the class of insurance may be similar, each insured
will pay a premium that will justify the level of risk brought to the pool.

Benefits of Insurance to Society

The direct and indirect benefits of insurance are as follows:

1. Peace of Mind

2. Cost Stabilization

3. Forced Savings

4. Capital for Investment

5. Creation of Employment

6. Loss Control

7. Social Benefits
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a) Peace of Mind:
The knowledge that insurance exists to meet the financial consequences of
certain risks provides a form of peace of mind.
E.g. individual banks require the borrower to take up the mortgage reducing
term insurance before releasing the loan. In an aspect of business activity in
many sectors where some forms of insurance are compulsory by law (motor
insurance, Foreign Worker Compensation Scheme, etc) and others are
required to be in force under the terms of contracts (construction
insurance) to have the security of knowing that the people they are doing
business with are protected by insurance.

b) Cost Stabilisation:
Insurance acts as a stimulus for the activity of a business that is already in
existence. This is done through the release of funds for investment in the
productive side of the enterprise, which would otherwise be required to be
held in easily accessible reserves to cover any future loss. Therefore,
insurance provides a means of stabilizing the costs involved in managing risks
by the payment of the fixed and pre-determined amount of premiums for
the required insurance coverage.

c) Forced Savings:
With insurance, individuals are committed to compelled long-term saving by
putting aside funds for retirement or old age. For example, life endowment
plans provide for the payment of the sum assured with bonus (for
participating policies) upon maturity as well as protection against loss of
income in the event of premature death or disablement.

d) Capital for Investment:

Insurance companies have large amounts of money at their disposal because
there is a time gap between the receipt of a premium and the payment of a
claim. The investment of funds constitutes a wide range of different forms
such as long, medium, and short-term investments which provide a source of
capital for industry and commerce and help the government access borrowing
which in turn contributes towards the overall national economic development.

e) Creation of Employment:
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The insurance industry provides employment to professionals as well as
others in insurance companies, insurance broking firms, loss adjusting,
financial advisory services as well as to life and general insurance agents.

f) Loss Control:
Insurers have a common interest in reducing the frequency and severity of
losses, not only to enhance their own profitability but also to contribute to a
general reduction in the economic waste which follows from losses.
Traditionally, the expertise of surveyors was concentrated on pre- loss
control (minimizing the chance that something will happen) or post-loss
control (after an event has occurred) of risks for which commercial
insurance was available. Increasingly, the services include identification and
control of all risks faced by organizations, as part of a wider risk and
enterprise management service.

g) Social Benefits:
Insurance provides business owners with the funds available to recover from
a loss to continue the employment of the workforce and the production of
goods and services to ensure that there are no unnecessary economic
hardships to the community at large and at the same time contributes to the
national economy.

Important Terms
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Insurable Matrix
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Nature of Insurable Risks

For pure risks to be insurable, certain conditions or guidelines must be satisfied

before an insurance contract can be in effect or in force:

1. The Loss Must Be Fortuitous

▪ These are losses that are unexpected or unforeseen and happen purely by
chance. Such losses are accidental and occur randomly based on the law of
large numbers. If an event is certain to occur, then there is no “uncertainty
of loss” not insurable.

▪ Although the principle of “uncertainty of loss” applies to all types of

insurable risks, life insurance contracts must be looked upon in a different
manner. This is because although death is a certainty for every individual,
the time of death is uncertain. It is this risk that is transferred to a life
insurance company.

2. The Loss Must Not Be Catastrophic

▪ In paying out compensation, it is only logical that no business organization

can absorb or sustain a large number of losses. It is for this reason that
insurers normally exclude catastrophic losses.

▪ In geographical areas, where such calamities are rare occurrences, insurers

may be willing to take such risks and the part of the losses are also usually
borne by reinsurers.

▪ In general, if insurers were to absorb catastrophic losses, it would defeat

the fundamental concept of “pooling of risks” or “sharing of losses” as the
impact of large losses will not make insurance arrangements feasible.

3. The Loss Must Be Quantifiable

Insurance contracts can only make good of the losses by means of

compensation or payments on a monetary basis. For a contract of insurance
to be effective, the loss or maximum limit of such loss must be quantifiable
in monetary terms.
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4. Premiums Must Be Reasonable

Policy owners who intend to purchase insurance policies will be willing to pay
premiums which they see as “reasonable”, with reference to the risk
transferred. If one perceives that the premium is not reasonable, then it will
be more likely that he “retains the risk” himself.

5. There Must Be a Significant Number of Homogenous Risk Units

▪ For insurers to engage a “reasonable” amount of premium for a particular

peril and risk, the probability of a loss must be ascertainable. From
records, statistics & historical data, insurers can determine the
frequency and severity of losses when considering a specific type of risk.
This can only be done when the information available is based on similar
types of uniform risk exposures.

▪ Example: In the case of fire insurance contracts: Residential houses,

constructed using bricks and concrete, provide an accurate data as to the
probability and severity of losses as a result of the occurrence of damage
due to fires. It is such information that forms the basis of determining
premiums for fire insurance policies.

6. Insurable Interest Must Always Be Present

▪ As insurance contracts essentially provide compensation and payments
upon the occurrence of a loss, it is essential to establish Insurable
interest, that the party to be paid is the one who has suffered such a
loss. Payments are made only to parties who have a financial & legal
interest to the risk that is to be insured.
▪ In the absence “Insurable Interest” of such “interested parties”, the
insurance contract deemed to be “invalid” or “cannot take effect".
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7. Compensation Payable Must Not Be Against Public Policy

“No one should benefit from his own wrong”. Insurers are not willing to take
risks and pay compensation for acts or activities which are deemed to be wrong
in the eyes of the law. Intentionally doing a wrong or illegal act and
consequently incurring a loss is not fortuitous. Therefore, it is against the
fundamental principles of insurance.