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LESSON ONE
RISK MANAGEMENT AND INSURANCE

Content
 Risk and Risk management
 Nature and Sources of Risks
 Classification of Risk
 Risk Exposure and Mitigation
 Nature of insurance
 Functions of insurance
 Importance of insurance
 Role of Insurance to the Economy
 Revision Exercise

RISK AND RISK MANAGEMENT

Insurance is a way of reducing uncertainty of occurrence of an event as well as an investment. Its
basic purpose is to derive plans to counteract the financial consequences of unfavorable events
and formulates a financial mechanism, which provides a pool to which the persons exposed to
risk may contribute and compensation made.

Thus, insurance is a cooperative device to share the sufferings of fellow persons. This is a part of
human nature. Therefore, we find human beings always live not in isolation, but in a community.
Insurance is a social device for eliminating or reducing the cost to society of certain types of risks.

Concepts and Nature of Risk

Risk has been defined as the possibility of occurrence of an unfavourable deviation from the
expected i.e. what you want to happen does not happen or vice versa When such unexpected
events occur there is invariably a sense of loss, which may or may not be measurable in terms of
money. Since an unfavourable deviation from the expected always results in loss, we can also
define risk as the possibility of occurrence of loss.

Mehr: Defined risk as the possibility or chance of meeting danger, suffering loss or injury or
exposure to adversity or danger”

Risks have several meanings that differ according to their field of use but generally is uncertainty.
Uncertainty refers to unknown result of an event whose result may be helpful or harmful to
human interest. It is a blessing because it gives rise to discussion, hope, planning,
accomplishment and progress. It is a curse so far as it gives rise to discipline, fear, defensive
tactics, failure and retrogression. There is maximum feeling of uncertainty when we believe that

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 an event may either harm or help us; each one being equally likely.

A person never knows what is going to happen, but he or she has a belief that possibilities
are in hisfavor but all forces that work are not known, so, the outcome is not foreknown. If the
exact outcome of an event is foreknown, whether it involves loss or does not, then thereis
certainty. It cannot be called a “risk”. Complete certainty of loss or gain is impossible.So we plan
to reduce uncertainty. Our past experiences help us to increase our knowledge about events.
That in turn increases the factor of certainty and reduces risks or uncertainty.

Examples of common risks are:-

o The risk of a person being injured in or by a motor vehicle, aeroplane, railway train, ship or
boat.
o The risk of the premises of a business or any of its “contents” (money, furniture, machines,
equipment, stocks of materials or goods for sale) being damaged or destroyed by fire or
water.
o The risk of farm or domestic animals falling sick, being injured or killed or stolen.
o The risk of money, machines, equipment, motor vehicles, stocks of raw materials or goods
for sale, or some other valuable item(s) being stolen.
o The risk of injury to a person due to an accident in the work-place. That person might be an
employee, a customer, or some other person permitted access to the premises or other
area, or even a person who was not authorised to enter a work-place, such as a building site.
o The risk of ill health necessitating medical expenses, the loss of life or limb, the loss of a
family’s “bread winner”.

Nature and Sources of Risks

If the future events occur exactly or very close to our belief, there is certainty or no risk. For
example, if we can foretell the possibility of an earthquake, storm or rain, then thereis no risk.
But this is difficult. Therefore, there is always a gap between our belief about the event,
occurrence and its actual occurrence.

Scientific observation, past experience ofevents may bring in some certainty or reduction in risk.
Our judgment about the future is based on our past experience. If we observe that an event,
which happened in the past, repeats, under similar circumstances in the same manner, then this
pattern of recurrence gives us a feeling of coming certainty. If we can recognize or identify many
events and observe that their pattern of happening is constant (repetitive), then we go towards
certainty.
 Uncertain pattern
We feel certain that events will occur but are uncertain about the pattern. For example there
will be sufficient rainfall in a particular year but its distribution over different months or days

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 is uncertain. So there is risk of crop failure by achange in pattern of distribution of rain.

 Inaccuracy of Observation
Our experiences of past events are modified by our personal feelings and prejudice. It is called
bias or self-interest. As for example, we all place great importance and become serious about
loss due to accident. But facts show that victims of diseases are more in number and they
suffer greater disability than those who meet accidents.

 Facts and Future Planning

Our belief of certainty or uncertainty about events is influenced by factsalready available
and future plans. As for example, in laying a road, we face uncertainty about traffic. But we
may plan for our present need with provision for future increase. The facts about past traffic
in volume and value reduce uncertainty to a great extent.

Risk as we have seen is all about losses. In the absence of possibility of loss there would be no
risk thus it is important to know about the factors, which cause or contribute towards the
occurrence of loss or extent of loss. There are two such factors and these are Perils and Hazards.

A. Perils
Perils cause the deviation in events from those that we expect. They are the immediate cause
of loss. Their very existence ensures that we are surrounded by risk for example flood, death,
sickness, theft, terrorism etc. and these are discussed below.

i Natural Perils:
There are unexpected natural phenomena, which year in and year out cause untold misery,
loss of life and property. There is no stopping the fury of nature and the havoc that it plays
with mankind. Volcanic eruptions, fire due to lightning, landslides, cyclones, hurricanes,
storms, floods, the vagaries of weather, unseasonal rainfall and prolonged dry spells,
hailstorms are some other examples of natural risks that can cause losses.

These perils are also called Act of God perils, and there is little that mankind can do to stop
them, he can only learn to live with them and devise means to lessen the negative impact.

ii Man Made Perils:

Man-made perils cause loss, these are an outcome of our society and are the violent actions
and unethical practices of people, which result in deviation from the expected.
 Theft: Not only outsiders but insiders also steal. Employees steal tools, equipment and
goods from their employers worth millions every year.

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  Riots, Strikes and Malicious Damage: - These are perils, which every property owner faces.
During Riots miscreants’ damage, Public and Private property, loot stores, inflict injury or
death to innocent people and the police personnel and bring business to a standstill causing
untold damage. Similarly strikes sometimes turn violent resulting in damage to life and
property.

 Accidents: - Accidents are caused by people and they cause injury to themselves or to
others and also damage to property. Automobile accidents alone contribute the maximum
share of losses due to this peril.

iii Economic Perils:

The third category of Perils or cause of Risk is economic in nature and the examples of this type
of Risk are Depression, Inflation, Local fluctuations and the instability of Industrial firms.
Depression in the market leads to low production levels and an increase in unemployment.
Low production results in reduced profits or losses for business houses whereas
unemployment stops the income of individuals causing mental and physical suffering.

During Inflation in economy the buying power of money declines and the real value of savings
and income is reduced. People whose livelihood is based on fixed income such as pensioners
during such periods are the hardest hit and may find it impossible to make both ends meet.
This fluctuation in the general economy can cause unfavourable deviation from the
expectations and create risks for both Industries firms as well as individuals.

Sometimes it so happens that even though the general economic condition in the country is
stable there are some areas, which may experience recession. These are known as local
fluctuations and can affect the Individuals or the business houses in the same manner as the
general fluctuation in economy i.e. Depression & Inflation. When particular area is effected the
value of investments made in the area declines and jobs are also lost.

At time it is the individual firms which are to blame. The owners lose part or whole of their
investment and workers lose their jobs. There are many towns and communities, which are
dependent on one single Industry for their well-being and when this Industry fails or decides
to shift operation the entire town or community is exposed to risk.

B. Hazards
Hazards are the underlying factors which increase the probability of occurrence of loss. There
are conditions, which are more hazardous than others e.g., working, as an electrician is a more
hazardous occupation than that of a banker as it is more susceptible to accidents. There are three
kinds of hazards:

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 i. Physical Hazard: These are hazards, which are related to the physical aspects of the property,
which may influence the chances that the property may be damaged or which may increase
or decrease the losses incurred due to a particular risk. The location of a building affects its
vulnerability to losses due to fire, floods, earthquakes etc. A residential building close to a unit
manufacturing crackers will be more susceptible to losses than a building located in a purely
residential area.

ii. Moral Hazard: Moral hazard also affects the probability of loss occurring and the risk is
increased. A dishonest person may set his own house or property on fire to avail the Insurance
benefit. An unscrupulous trader may arrange for a robbery in his own store to get the benefits.
Whenever persons of doubtful integrity buy an Insurance policy the risk increases because
loss becomes a certainty.

iii. Morale Hazard: This is not to be confused with moral hazard, which involves dishonesty but
morale hazard is an attitude of lack of concern about the outcome of his actions. An example
of this is a person who is careless about stubbing out cigarettes and just throws them around
not in the least bothered that his action may cause fire. Bad housekeeping is another example
of a morale hazard as this also increases the chances of loss occurring.

Classification of Risk
There are several different ways of looking at risk, and different kinds of risks can be categorized
by considering their effects.
a. Fundamental Risks
These tend to affect large numbers of people, perhaps areas of countries, or whole countries, or
even a number of countries or a geographical region. Their affects are either on the community
in general or on groups of people, and they cannot be controlled - even partially - by any one
person.

Such a risk is present in the “forces of nature”; the weather, for example, cannot be controlled or
influenced by individual action. Incidences of volcanic eruption, tidal waves and tsunami, floods,
earthquakes, and similar “natural” phenomena cannot be controlled, and the extent of damage
or devastation which they might - or might not - cause, cannot be predicted.

Another example of fundamental risk is the economy of a country. That is because the effects of,
say, “inflation” (increases in costs, prices, etc.) or mass unemployment, are beyond the influence
of individuals. In many countries today fundamental risks are regarded as being the domain of
society and government, and the State undertakes to deal with the consequences of events such
as unemployment, retirement, or riot. Such risks as war, earthquakes, famines, etc., are generally

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 dealt with by the governments of the country or countries concerned, or by international
organizations.

b. Particular Risks
Particular risk refer to risks whose future outcomes or effects can be partially controlled
(although not predictably) by individuals or groups of people. They arise, for example, from an
individual’s decision to drive a motor vehicle, or to own property, or even to cross a road. Much
depends on the individual’s action and level of care (or lack of care and attention). Because
particular risks are the responsibility of individuals, each person must live with their
consequences, although in many cases the effects can be alleviated by insurance; we say that
such risks are ‘insurable’.

c. Pure Risks
These are risks that can result only in loss, its outcome of an event is certain. Pure risk provides
only one outcome i.e. loss. There is no question of earning profit. For example, an enterprise
starts manufacturing, there is uncertainty whether it will succeed or fail. Success is profitable,
failure means loss. Another example is in tossing a coin or throwing a dice. The result of tossing
or throwing is uncertain, but gives either party a chance to gain or lose. Processing adestructible
property is an example of pure risk. Its destruction is always possible but not certain. It’s
destruction result in sure loss but preservation does not itself yield anyincrease in value or profit.
Pure risks are insurable because they are capable of statistical measurement. The majority of
insurable risks are what are called ‘pure risks’ which include fire, accidents, theft, etc, which offer
no prospect of gain, but only of loss if the risk becomes a reality

d. Speculative or Dynamic Risks

Speculative risks may result in either a profit or a loss, which may be either large or small. These
risks are uninsurable because there is no way of measuring their effect and offer possibility of
loss or gain.
 Market (change of fashion, bad or good trading conditions).
 Finance (class of interest or profit duet to selling conditions).
 Production (strikes by workers, lockout by owners and stopproduction).

e. Insurable Risk
An insurable risk is one which can be insured on standard terms and conditions or otherwise.
Insurable risk can further be divided in three categories:
i. Standard Risk: This type of risk is also known as formal or average risk. In insurance, the
dictionary meaning of the word” standard” is an insurance written on a basis of the regular
mortality and underwriting assumption used by the company.

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 ii. Sub-standard Risk:. It lies in between the standards and uninsurable risk. It has been defined
as those risks which do not meet the standards set for insurance at regular rates and are
below standard at “mortality risk”. Substandard risk is again classified into the following:
o Constant Extra-Risk: A risk which remains constant throughout the policy term comes
under this category as for example blindness, deafness or loss of teeth.
o Increasing Extra-Risk: A risk which increase with the increase in age comes under this
category as for example, patients of diabetes, high blood pressure and overweight.
o Decreasing Extra-Risk: A risk which tends to decrease due to increase in age as for
example, person of defective past history.

iii. Super standard Risk: A super standard risk is one which is above the standard and presents
almost no risk. This is also known as preferred risk. Generally, the insurer does not prefer to
issues preferred risk policies as it increases the premium in other standard risk which may
cause reduction in loss of business.

f. Uninsurable of Risk:
It refers to those lives where the mortality rate is so high as to make the premium for the assured
completely prohibitive or to make the insurer feel that the risk is almost a certainty rather than a
probability in that individual case, Proposals of such lives are altogether rejected by the insurance
companies: For example, proposal received from person who are suffering from cancer or serious
heart ailment or tuberculosis of the last stage where the death is sure to happen in near future
would be the uninsurable risk.

Characteristics of Insurable Risks

Insurance products are designed in accordance with some basic principles that define which risks
are insurable. In general, for a risk—a potential loss—to be considered insurable, it must have
the following characteristics:
 the loss must occur by chance.
 the loss must be definite.
 the loss must be significant.
 the loss rate must be predictable.
 the loss must not be catastrophic to the insurer.

The Loss Must Occur by Chance

For a potential loss to be insurable, the element of chance must be present. The loss must result
either from an unexpected event or from an event that the insured person did not intentionally
cause.
For example, people generally cannot control whether they become seriously ill, and as a result,
insurers can offer medical expense insurance policies to protect against the financial losses

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 caused by the chance event that an insured person will become ill and incur medical expenses.
When this principle of loss is applied in its strictest sense to life insurance, an apparent problem
arises: death is certain to occur. The timing of an individual’s death, however, is usually out of the
individual’s control. Therefore, although the event being insured against, death, is a certain event
rather than a chance event, the timing of that event usually occurs by chance.

The Loss Must Be Definite

For most types of insurance, an insurable loss must be definite in terms of time and amount. In
other words, the insurer must be able to determine when to pay policy benefits and how much
these benefits should be. Death, illness, disability, and old age are generally identifiable
conditions. The amount of the financial loss resulting from these conditions, however, can be
subject to interpretation.

One of the important terms of the contractual agreement between an insurance company and
the policy owner is the amount of the policy benefit that will be payable if a covered loss occurs
while the policy is in force. Depending on the way in which a policy states the amount of the
policy benefit, every insurance policy can be classified as being either a contract of indemnity or
a valued contract.

The Loss Must Be Significant

As described earlier, insignificant losses, such as the loss of an umbrella, are not normally insured.
The administrative expenses of paying benefits when a very small loss occurs would drive the cost
for such insurance protection so high in relation to the amount of the potential loss that most
people would find the protection unaffordable.
On the other hand, some losses would cause financial hardship to most people and are
considered to be insurable. For example, a person injured in an accident may lose a significant
amount of income if she is unable to work. Disability income insurance coverage is available to
protect against such a potential loss.

The Loss Rate Must Be Predictable

No one can predict the losses that a specific person will experience. We do not know when a
specific person will die or whether a person will become disabled or need hospitalization, let
alone how much these events may cost. However, insurers must have some way of predicting
future losses so that they can determine the proper premium amounts to charge policy owners.

Although individual losses cannot be predicted, insurers can provide a specific type of insurance
coverage if they can predict the loss rate—the frequency of losses—that the insureds are likely
to experience. To predict the loss rate for a given group of insureds, the insurer must be able to
predict the number and timing of covered losses that will occur in that group of insureds.

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 Insurers can predict with a fairly high degree of accuracy the number of people in a given large
group who will die, become disabled, or require hospitalization during a given period of time.
These predictions are based on observations of past events and a concept known as the law of
large numbers.

The law of large numbers states that, typically, the more times we observe a particular event,
the more likely that our observed results will approximate the true probability—or likelihood—
that the event will occur in the future.

The Loss Must Not Be Catastrophic to the Insurer

A potential loss is not considered insurable if its occurrence is likely to cause or contribute to
catastrophic financial damage to the insurer. Such a loss is not insurable because the insurer could
not responsibly promise to pay benefits for the loss and still meet its other obligations.

To prevent the possibility of catastrophic loss and ensure that losses occur independently of each
other, insurers spread the risks they choose to insure.

For example, major natural disasters such as hurricanes or earthquakes can damage or destroy a
large number of properties in a concentrated area. In the past, some insurers failed because they
were unable to pay claims following a disaster. For this reason, property insurance companies
today usually limit the number of properties they will insure in any particular geographic area.

Risk Exposure
Risks as we have seen are inevitably a part of our lives and every individual or business house is
exposed to the possibility of loss. The risks faced by the individual or family and industry are
common but they differ in nature and the extent of loss.

a. Family Risks
The term family for all practical purposes henceforth includes an individual who may be living
with the family or separately.
i. Personal Risks
 Death: When a person dies the income that he earns with his efforts stops. When death will
strike is uncertain and the risk is there at any age. In addition to the loss of income when the
head of family dies the family is subjected to expenses on last illness, funeral expenses and
settlement of estate not to mention the mental and social burden which cannot be
measured in monetary terms but is without doubt very high.

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  Disability: This may not be as serious as death but it has definite impact on the income.
Expenses will increase due to medical care for the disabled family member. Poor health as
a result of an accident or illness is one of the most important risks which a family has to face.
 Retirement: A person may survive pre-mature death or disability but he still faces loss of
income to maintain a reasonable standard of living during retired lifetime.
 Unemployment: This risk is also an important one for every family. The current industrial &
economic scenario is not very conducive for employment and a lot of companies industrial
houses are downsizing, cutting down on the labour force. Voluntary Retirement Scheme and
Retrenchment are the order of the day.

ii. Property Risk

All families in addition to the risk of loss of income or increased expenses also face the risk of
loss to property. Loss to property results not only in reduction of Assets but also in loss of
income. Examples of property risk are innumerable but to illustrate the extent and nature
some are being mentioned here. Homes may be destroyed by fire, floods and storms; cars may
be damaged in an accident, burnt, be lost, stolen or destroyed; Savings may be lost in stock
market crashes or failure of banks.

iii. Liability Risk

An individual because of his negligence may become responsible for injury to the person or
damage to the property of others for which he has to pay compensation and expose the family
to such a risk. With a greater awareness amongst the common man the liability risks is ever
increasing and the courts in their judgements appreciating the value of human life and right
are awarding huge amounts as compensation for which any individual or family can be beyond
imagination and intolerable.

b. Business Risks
Businesses also face the same risks as the family but in a different manner and the magnitude
may even be bigger.
 Personal Risks: The death or disability of an employee who is instrumental in the successful
running of the business enterprise can result in loss of business and profits. If a partner in a
partnership concern dies, the partnership is dissolved and the surviving partners can suffer
loss of Income. In the case of disability of a key employee or partner the firm may be burdened
with his medical expenses and may be obliged to continue paying his salary. Firms also to have
face the risk of the death or injury to their employees and the burden, which has been
transferred to them by law or by contract.

 Property Risk: Business houses suffer direct and indirect losses due to property risk. Direct
losses can be as a result of various perils much the same as for the family such as destruction

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 of building, machinery and stocks in fire or due to other perils such as storms and flood. In
addition dishonest employees may steal from the firm not only material goods but also ideas
causing great loss. In this competitive era business houses spend a lot of money on research
and development of new concepts but if these are stolen and handed over to other firms in
the same field the returns expected from these investments are lost causing great loss.
Equipment and property may be damaged or destroyed by rioters or employees on strike.
Strike also cause loss of production. These direct losses may only be a part of the total loss
because apart from direct losses due to property damage the business houses also have to
bear the indirect loss incurred due to stoppage of operations, disruption in production (Loss
of profits) that they may have to face.

 Liability Risk: As in the case of family business, firms also are liable to others for bodily injury
or property damage but the exposure is greater than the family as the firm is responsible for
the acts of a large number of employees as also the products or services that it deals in.

Mitigations of Risks
a. Pure Prevention - Preventive measures that are introduced at the structure or construction
are the best. For example, fire resistant buildings, non-removable guards of machine.
Probably, a few of the most striking examples of preventive steps are elimination of yellow
fever in Canal Zone and Gold states of USA and small pox in India. Its success depends upon
the feelings and sentiments of the community or people. Demand for a safety code or safety
law is a positive sign for preventive steps. The codes must be revised with change in hazards.
Development of good preventive practices depends upon knowledge of hazards. The
insurance plays a major role in this regard. This step reduces loss cost, insurance cost. The
rates of premium are reduced to improved conditions. The people are encouraged to take up
more insurance at chapter cost.

b. Protection – It is less than pure prevention. It should not cost more than what is protects
(the value of property). Some costs of protection are quite high. It is not possible by an
individual. It has to be undertaken by the government or community as a whole. One such
example is maintaining police department, factory or boiler inspectors. Another common
effort is campaign of education to demonstrate ‘safety first’. A suitable reduction for
individuals, who are protecting property, in their premium rates is a good incentive. It is
equitable because one should pay according to his share of contribution to risk. He should pay
less if his risk is low. In some European countries punishment is prescribed for failure to
protect. If the person could not prove that the fire in his house was not preventable, then he
has to pay for cost of fire brigade and also for damages to his neighbors.

c. Minimizing Loss – Most money for prevention is spent on this item. On his heading falls

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 expenditure of fire departments, of water supplies, and emergency equipment. The need of
such expenses will be reduced if prevention andprotection measures are good and working
well. In military, emphasis is more on inoculation against typhoid than to rely on hospital
facility.

d. Salvage: this is recovery of materials of damaged things. If salvaged goods in value exceed
the cost of salvage then it is profitable. Insurer gains by salvaging. As for example, insurance
company pays Kshs. 7,000 to insured and gets Kshs. 2,000 out of selling salvaged goods. Then
it gains Kshs. 2,000 by way of reducing the actual cost of compensation to it.

e. Risk Avoidance: The simplest way to deal with risk is to avoid it together. If a factory is to be
located on the banks of a river, which is prone to floods every year then it may be decided to
shift the site to a safer location. Some people avoid the risk of death or injury in an aeroplane
crash by traveling by surface transport only. Organisation like the Armed forces and even
some corporate houses restrict the number of their officers traveling in a single aircraft or
vehicle together to avoid the risk of all of them dying in an accident. Though this is the simplest
way it is not always practicable.

f. Loss Prevention and Reduction: Possible loss due to risks may be eliminated or minimized by
Loss Prevention and Reduction measures. Some measures such as strict enforcement of “No
Smoking” regulations may eliminate fire losses whereas measures such as installation of
sprinkler systems and other appliances may reduce the extent of loss due to fire. Good
manufacturing units spend a lot on safety devices and measures and enforce strict rules of
conduct within their premises to eliminate or reduce the occurrence of accidents thus
minimise their losses & expense incurred on treatment and compensation to employees.
Segregation of hazardous processes from others in a manufacturing unit and isolation of
hazardous goods such as petroleum products from non-hazardous goods in a storage facility
are some examples of the method of loss Prevention and Reduction.

g. Risk Retention: It may be consciously decided to retain some risks. Small losses, which may
occur frequently may be absorbed by the firm as normal operating expenses such as minor
damage or loss of goods in transit. A financially sound firm may create an Insurance fund to
which regular payments are credited and from which losses are paid as and when they occur.
This method is used to take care of the domiciliary medical expenses of employees by some
large companies having a big workforce. Some individuals retain the risk of contracting cancer
due to smoking not knowing that smoking causes cancer and other even though knowing of it
rationalize and pretend that the risk does not exist by saying. “It won’t happen to me”.

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 h. Transfer of Risk: Risk transfer occurs when the activity that creates the risks is transferred to
another. For example if a particular process of manufacture is hazardous the firm may decide
to get it outsourced i.e. get the job done from a specialized subcontractor outside so that the
associated risks are transferred. Similarly when a person hires an equipment the owner may
insert a condition in the contract that any damage to the equipment shall be the responsibility
of the hirer. Lease and rental agreements are an example of this method of handling risk. A
rental agreement carries the clause that the equipment shall be returned to the owner in good
condition, ordinary wear & tear accepted. Guarantees are also a form of risks transfer where
the buyer transfers the risk of purchasing a defective new item back to the manufacture. Most
consumer goods coming in the market now are sold with the guarantee that in case of any
manufacturing defect or non-performance the equipment will be replaced/ repaired by the
manufacturer. Earlier it was not so and the buyer used to purchase the materials at his own
risk and in case of defect had to bear the loss.

Insurance Manager vs. Risk Manager.

The Risk manager is always wrongly called the insurance manager or manager of insurance
department. The appropriate title should have been insurance buyer (who buys a policy for the
employer). Risk manager should be the title of the person who is responsible for management of
risk. The manager deals with risk problems. Insurance may be the principal means of meeting it,
but it is not the only means. Risk management should not be confused with insurance
management. Historically, risk management has had strong links with insurance and loss
prevention measures. However, risk management is a much broader concept.

Basic difference between Insurance management and Risk management is as follows:

Insurance Management Risk Management
1. It confines itself solely to the use of the 1. It requires the quantitative consideration
insurance transaction as the means of of all aspects of uncertainty including
treating risk. o Identification of risk to locate anddefine
the different sources of possible loss.
o Measurement of Risk: the amount that can
be lost from a single incident or from a
series of incidents.
o Treatment of Risk: to find out the available
alternatives either to avoid/eliminate the
uncertainty as to mitigate the effect of
potential loss.
2. The skills and experience required of an 2. Determination and valuation of risk is the
insurance manager primarily is a number one function of risk management.
technical knowledge of the insurance 3. The risk manager and his staff must take a

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 policies and a familiarity with insurance very professional approach to risk
market. management. He must step outside the
3. Its major objective is the efficient operation from time to time. He must make
negotiation and placement of insurance a complete analysis of risk. He has to gather
coverage on behalf of the insured firm. several data to avoid disaster.

Risk management is a plan to prevent earnings from becoming intolerably impaired by an event
that destroys company owned assets or contributing resources. It represents continuous effort
to be aware of operational uncertainties and to minimize the loss potential. If unplanned
incidents or losses should occur, the adverse effect upon the firm’s fiscal integrity and current
operations will be minimized. Risk management provides a precise plan for such contingencies
(Oliver, J. Hocker and Dorothy M. Watson; Risk Management: More than Insurance, Management
accounting, August 1984, p. 22).

Reasons for Rise of Risk of Management.

We find there is great increase in risk. Increase and its different aspects of developmenthave
taken place due to industrial changes. The reasons are:
a. Increase in size, diversification, and spread of activities of business has grown.
b. Complication of evaluating risk of each and every aspects has increased
c. Multiplicity of relation of business with suppliers, consumers, employees and government
has become complex.
d. Physical hazards have increased and changed in shape due to raw materials, process,
products, machines etc. coming into production.
e. National laws are allowing liberal claims and public has learnt now of asserting more rights
or imaginary.
f. Increased and large investment increased the importance of protection and preservation and
compensation in case of loss.
g. Business operates now on small margin of profit and faces many contingencies due to severe
competition between enterprises. The heavy cost of replacing physical assets and the limited
availability of funds for development need increasing attention to risk and its consequences.
h. Preventive methods are proper and they need planning.
i. Insurers, insurance contracts, and rating methods – all have responded or changed to adjust
with new developments. What was a simple matter of choice has become highly technical
now.

In planning insurance the steps to be taken are:

1. It is necessary to set down first the desires of the buyer,
2. Then learn how they might be covered by insurance and
3. What would it cost?

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 4. Items of desires are to be selected and adjusted according to money available. As for
example, one person desires to have protection like:
(i) his widow would maintain the style as she does now, after his death also;
(ii) his three children would go to college as normal;
(iii) his mortgage on house will be paid off;
(iv) his funeral expenses will be paid for; and
(v) expenses to provide for reorientation of the family are covered.

The premiums for such insurance may go far beyond his means to pay. The selection has to be
limited to a few. It is a matter of personal taste and capacity. This is a part of risk management.

Steps in Risk Management Plan

The different steps that risk manager must take are:
(i) Identifying risk. The risk manager is to determine where the risks for the company lie. This
includes fixed assets and property, other areas of potential loss are like property borrowed
or got under lease, business interruption. Unusual risks like flood, earthquake, extra
expenses; research activities, and third party liability.
(ii) Measurement of risk. Once the analysis of the possible loss of exposure is complete the
manager should calculate the need for insurance coverage. He should calculate premiums
for risk’s and what deductions are available. He should make a loss study using historical data
to eliminate future losses. Some losses of small values may be ignored and retained by the
company. Losses beyond certain values should be covered by insurance. A stop loss
technique may be used. Information about assets must be gathered by inspection or from
internal reports. Replacement costs should be calculated. The aggregate loss must be found.
(iii) Treatment of risk. Upon completion of the risk analysis the problem is to decide what risks
may be retained and what risks will be transferred. Some risks are there which cannot be
insured, and some others are compulsory by law. Except these two, all other risks may be
wholly or partially self-insured. The consideration is not to assume risk too much so as to
expose the company to casual loss. Self-insurance is to be decided under the three
consideration:
(a) Some risk/also can be borne by company. Except destitute all can bear some loss, the
larger the company the smaller is transfer of risk.
(b) Self-insurance becomes cheaper than cost of purchasing insurance. One has to
compare cost of self-insurance with cost of insurance with others and choose the
cheaper of the two.
(c) There are risks for which insurance is not available or insurance companies don’t deal
with. These losses have unfavorable characteristics. The principle is that insurance
should be the last line of defense against risk of loss – not the first. But complete
determination of all risks of casual loss isimpossible. Sometimes the cost of elimination

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 may be too high. The Risk manager has the job of determining these matters.

INSURANCE
Insurance is defined as: “ a co-operative device to spread the loss caused by a particularrisk over
a number of persons who are exposed to it and who agree to insure themselves against that risk.
Insurance is a social device for eliminating or reducing the cost to society of certain types of risk”
(Mowbray and Blanchard).

Insurance has been well defined as: “that social device for making accumulations to meet
uncertain losses which is carried out through the transfer of the risks of manyindividuals
to one person or to a group of persons” (Allan H. Willett).

Dictionary of Business and Finance defines insurance as: “a form of contract or agreement under
which one party agrees in return for a consideration to pay an agreed amount of money to
another party to make good for a loss, damage or injury to something of value in which the
insured has pecuniary interest as a result of some uncertain event.”

Insurance may also be defined as:” a contract between two parties whereby one party (the
insurer) agrees to protect the other party (the insured) against a loss (which may arise or may
not) when it takes place through the risk insured (in case of property) or pay a fixed amount on
the happening of a certain event (death or expiry of the term) in exchange of a fixed sum
(premium)”.

Insurance is a device for transfer of risk of individual’s entities to an insurer, who agrees for a
consideration (called the premium), to assume to a specified extent loss suffered bythe insured.
(Dr. W. A. Dinsdale).

note that for all the definitions discussed above highlight the following characteristics of
insurance:
- Insurance is a social device. It tries to reduce the cost of loss to society by reducing risk.
- It accumulates funds to meet individual losses. The fund is the way of transferring individual
loss to a group. The loss was uncertain from individual’s side. But for a group the loss
becomes certain. It is a mechanism of spreading risk falling on one over many facing the
risk. In legal sense one promise to make good the loss of another for a small but regular fixed
payment. This is business insurance.
- Insurance cannot stop an event from happening. Even if we insure property,loss of fire or
storm or accident will take place. But the loss to the individual will be reduced. Society will
get a replacement of the asset, which was lost.

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 Nature of Insurance:
On the basis of the definitions of insurance discussed above, one can observe the following nature
or characteristics:
 Contract and Consideration: Insurance is a contract between the insurance company and the
policyholder wherein the policyholder (insured) makes an offer and the insurance company
(insurer) accepts his offer. The contract of insurance is always made in writing. Like other
contracts, there must be lawful consideration in insurance also. The consideration is in the
form of premium which the insured agrees to pay to the insurer.
 Co-operative Device: All for one and one for all is the basis for cooperation. The insurance is
a system wherein large number of persons, exposed to a similar risk, are covered and the risk
is spread over among the larger insurable public. Therefore, insurance is a social or
cooperative method wherein losses of one is borne by the society.
 Protection of financial risks: An insurer is protected from financial risks which can be
measured in terms of money. As such insurance compensates only financial or monetary loss
or risks.
 Risk sharing and risk transfer: Insurance is a social device for division of financial losses which
may fall on an individual or his family on the happening of some unforeseen events. When
insured, the loss arising out of the events are shared by all the insured in the form of premium.
 Based upon certain principles: The insurance is based upon certain principles like insurable
interest, utmost good faith, indemnity, subrogation, causa-proxima, contribution, etc.
 Regulated by Law: Insurance companies are regulated by statutory laws in almost all the
countries.
 Value of Risk: Before insuring the subject matter of the insurance contract, the risk is
evaluated in order to determine the amount of premium to be charged on the insured. Several
methods are being adopted to evaluate the risks involved in the subject matter. If there is an
expectation of heavy loss, higher premiums will be charged. Hence, the probability of
occurrence of loss is calculated at the time of insurance.
 Payment at contingency: An insurer is liable to pay compensation to the insureds only when
certain contingencies arise. In life insurance, the contingency — the death or the expiry of the
term will certainly occur. In such cases, the life insurer has to pay the assured sum. In other
insurance contracts, the contingency — a fire accident or the marine perils, may or may not
occur.
 Insurance is not gambling: An insurance contract cannot be considered as gambling as the
person insured is assured of his loss indemnified only on the happening of such uncertain
event as stipulated in the contract of insurance, whereas the game of gambling may either
result into profit or loss.
 Insurance is not a charity: Premium collected from the policyholders under an insurance is
the cost of risk so covered. Hence, it cannot be taken as charity. Charity lacks the element of
contract of indemnity and compensation of loss to the person whosoever makes it.

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  Investment portfolio: Since insurers’ liability to pay compensation to the insured arises on
the happening of certain uncertain event, the insurers do not have to keep the collected
premium with them. They invest the premium received in selected securities and earn interest
and dividend on them.

Functions of Insurance
Different types of insurance give some common benefits. This is available to the buyer of policy.
These two classes of people belong to society. We shall see these two aspects of insurance
benefits and the important part played by insurance in business enterprise. The different benefits
will be discussed under several headings.

I. Individual
(a) Financial security to an individual: Insurance guarantees protection againstlarge and
uncertain losses in return of small but certain payment. This service is common to all forms
of insurance. Each insurance gives protection against a particular risk. The insured (may be
businessman) contracts to pay a small premium at fixed interval. The insurance company
assumes on his behalf the risk of large but uncertain loss.

(b) Insurance provides assistance to business enterprise. There is heavy capital investment in
modern industry especially in building, machinery, and plant equipment. This investment is
exposed to loss or damage by fire, theft, accident and other perils. The provision for these
losses may be very costly. Business enterprises may have to block large amount of capital as
insurance fund if they themselves have to meet the risk. But insurance gives protection to
these properties in return for a small payment called premium. This gives many advantages
to businessmen.
• They need to have self-insurance provision
• They save cost and blocking capital or capital is released.
• Properties got security.

(c) Financial stability to commerce, and industry. A serious loss will not only cause material
damage to buildings, plant and machinery, but production will be disturbed with other
consequences like loss of profit, unemployment or loss of trade. So a loss affects the owners
of properties and others also. Insurance in fire and engineering protect against consequential
losses. It covers net profits wages, taxes and other standing charges and increase in cost of
working during stoppageof production. These classes of insurance lend stability to industry.
This helps society to maintain economic equilibrium.

(d) Basis of credit. Modern business prospers on credit. We may say credit is the mainstay of
business expansion. This has become possible due to insurance. We can examine certain

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 examples and derive the conclusion easily.

(e) Mortgage upon real estate. No mortgage is willing to lend money unless he knows that the
property is protected against fire.

(f) Retailer and wholesaler. No manufacturer advances money or gives goods on credit to
wholesaler, or a wholesale to his retailer unless he knows that goods are insured against fire.
The banks these days are giving credit in large scale. They allow loans against goods if they
know that they are insured in addition to other conditions.

(g) Insurance plays a vital part in the reduction of losses. Insurance encourages reducing loss in
many ways;
i. Through rating methods. Rating or premium charged to undertake insurance itself is
helpful for reducing loss. It gives incentives for reducing loss by lowering premium and
negatively by charging higher premium for undesirable features of risk.
ii. Insurers may join different agencies engaged in loss prevention works (fire, cargo loss
prevention and industrial and road safety). A few of such agencies started by insurers in
India, for example are:
o Loss Prevention Association of India. It works for increasing awareness among
people for loss prevention and implementing various measures for loss prevention.
o The Salvage Corps of Loss Prevention Association of India. It works with the fire
brigades when fire occurs. Fire brigade subsides the fire, the salvage corps save
further damage by water, smoke and heat. It saves goods from deterioration further.
o Survey and inspection of risks. Insurers arrange survey and inspection of risks
before acceptance in fire, engineering and accident.This reduces potentiality of loss.
o Specialized Knowledge and Experience on Risks. Insurers out of long years in
business acquire special knowledge on different classes of risks. Thorough
knowledge renders vital service to the community in minimizing economic waste.

(h) Insurance provides funds for investments. Some forms of insurance combine with insurance
feature an investment element. It is incidental only. But it serves very useful purpose. Life
insurance usually collects more money in the early period from an insured under level
premium palms. The insurance company can invest these funds in bonds and securities. In
other forms of insurance also insurers may utilize a part of fund – the excess of funds received
over current expenses liabilities, and reserves in government securities, municipal bonds,
loans, mortgages and equities. It helps pubic in two ways:
• They contribute to the wealth of the nation by financing economic development and
• By reducing the cost of insurance. Because investment income is adjusted in the value
of future premiums. That means by the amount of investment income premiums are

BFM203: V Wanje 19
 reduced.

(i) Insurance earns foreign exchange. Insurance is as good a source of foreign exchange earnings
as export trade, shipping and banking services. Indiana insurance is transferred in overseas
countries particularly in the Middle East, Africa and South –East Asia through branches.

(j) Insurance tries to distribute cost equitably. Modern method of insurance is basedon correct
distribution of cost. It is based on large number of risks. It must have a systematic method
of determining premiums. Customers are interested in correct cost. Insurance companies
employ expert mathematicians, actuaries to find insurance premiums, surrender values,
reserves and loans. In fire and marine insurance large number of factors are considered for,
fixing premiums. Only under an organized system of insurance these things can be done. The
systematic cooperation of many to share the loss of a few cannot be done without insurance
plan.

(k) Capitalization of earning powers. This is a way of expression. It tells certain incomes in terms
of capital value. Suppose a machine is producing income of Kshs. 2000 after repairs,
depreciation and interest on its value. Its life is 25 years. Its capital value is 2000 x 25 = Kshs.
50,000. The same method may be applied to human life. The points to be considered are
probable lifetime of the earner, percent of employment at different age, and loss in
earning of thatperson and present value of future incomes. This is calculated by actuaries.
This capital is a loss to the family if the person dies. In business it is a capital loss if the machine
is destroyed by fire or by accident. The insurance premium is of the same nature as that of
allowances for depreciation. It provides for unpredictable depreciation whereas depreciation
is a natural foreseen contingency. Insurance protects this valuable human capital and adds
importance to its value.

(l) Insurance makes saving possible. It is a hedge – a cover for wrong decision very much familiar
in business transactions. Savings plans are beneficial to them who:
• Are fortunate to survive till the full planned amount is achieved, and
• Are determined and able to continue the savings till the end without difficulty or outside
help. Insurance assures a saving and guarantees the amount.
Some firms prefer self-insurance. They set apart a part of income every year in a separate
fund. It is a protection fund against loss. If has certain risk. If a fire or a large compensation
damage suit is to be faced sooner than expected the self- insurance fund may be insufficient
to meet the loss.

(m) Insurance promotes thrift. This is more clearly found in Life Insurance. Because in life
insurance there is provision for advance notice short period before due date of premium due,

BFM203: V Wanje 20
 and provision against withdrawal. In non-life insurance the money paid to insurance company
leaves certain margin of excess of income i.e., premium over the actual expenditure over the
actual expenditure. The excess is kept as a reserve. This would otherwise have not been
available. This is a by- product of insurance. This would be wasted had it not been given to
insurance. The individual small saving may be consumed in expenditure but insurance
company changes its character to a community saving.

II. Society
a. Community benefits of insurance. Insurance gives many benefits. Some of these are direct
and quite apparent. Others are indirect and remote. We enjoy these benefits but cannot
appreciate. Direct benefits go to insurer and insured. When many such person enter into
agreements they create other indirect benefits. We discuss some of these. So far the benefits
described are individual in character.Benefits accrued to individual policy holder who paid the
premium. Insurance also performs certain services which are not meant to benefit any
particular individual. The benefits have the effect of community benefit. Among these services
the following may be mentioned:
(i) Fire and other property insurance provide for the present and also forfuture events
that may be anticipated. Adequate future provision is the sign of a civilized society, and
marks the difference between stability and instability in business. It increases sense
responsibility and strengthens community connections. Property and casualty insurance
are attempts to stabilize business conditions and property rights.
(ii) Insurance fulfils certain needs for which state might have to provide. The provision for
old age, sickness and disability of persons in general. Some who have their insurance
don’t become a burden on state insurance plan.In case of fire, defalcations, failures,
explosions, tornadoes another calamities that would tend to impoverish (render poor)
families wouldhave been relieved of the financial shock if adequate insurance had been
maintained.
(iii) All forms of insurance lessen the number of person who are rendered destitute through
misfortune. They are able to maintain the standard of living. They reduce the destitution
and misery. These could lower the ideals and standards of conduct of entire communities.
(iv) A well-organized system of insurance tends to distribute equitably the cost of accidental
events. In the absence of insurance this would have been paid in a haphazard manner.
For example the cost of fire insurance is reflected in house rent. In the absence of
insurance some tenants would pay higher rents than others.
(v) All forms of insurance, tend to reduce the extent of evils they are meant toalleviate. The
most effective argument for reducing of fire losses, is that smaller losses will make smaller
premiums possible.
(vi) Insurance accumulates from the small deposits of many persons, a large fund that may
be invested and used in the development of Indian enterprises. In other words, vast funds

BFM203: V Wanje 21
 are made available as capital which otherwise would never be brought together in one
place. The reserves of life, fire, compensation and casualty insurance companies
represent the contribution of millions. Each of these contributions is significant, but in
total they amount to a gigantic amount. This vast sum is distributed among the securities
of government and non-government enterprises. Between the time of insurance
contract and the time of the event of lossthe insurance carrier works as a bank or an
investment trust.

III. To Business
It is common knowledge that if risk and uncertainty is reduced efficiency will rise. The prices
go down if risk is reduced. On the other hand, the most uncertain is the most inefficient
business. The proprietor of such enterprises remain busy and bother much over large financial
risks such as protection of premises against fire or riot, stock against theft etc. if these risks
are transferred to insurance underwriters then owner will look to details of production and
increase efficiency. Some of them are:-
1. Increase in export trade. Young entrepreneurs fully trained and ready do not take up
trade due to transportation risk, fire and dishonesty. Insurance relieves them of such
uncertainties.
2. Delegation of work. Employers will not entrust large sums of money and important duties
to subordinates unless they make sure that such losses can be re-imbursed. If they don’t
delegate their energy will be wasted on small matters which servants may do.
3. Partnership dissolution. If one partner dies his heirs must get back the deceased partner’s
share. But immediately money is not available so business will run short of money.
Insurance may solve the problem and remaining partners will not worry about funds.
4. Employees cooperation. Employers can have good relations with employees by insuring
employees against life, accident, and sickness etc. Satisfied persons are best workers.

Insurance helps small business to compete successfully with the large enterprises. Element of
risk is very high in business. A small business cannot afford to take much risk. A large business
is able enough and its risks are sufficiently diversified and distributed to makesuch a fund
effective. But for a small business such fund is a pure gamble. Insurance is therefore special
benefit to small manufacturer, merchant and property owner.

Importance of Insurance
 Provide safety and security: Insurance provide financial support and reduce uncertainties in
business and human life. It provides safety and security against particular event. The Life
Insurance provides security against premature death and payment in old age to lead the
comfortable life. Similarly in general Insurance, the property can be insured against any
contingency i.e. fire, earthquake etc.

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  Generates financial resources: Insurance generate funds by collecting premium. These funds
are invested in government securities and stock. These funds are gainfully employed in
industrial development of a country for generating more funds and utilised for the economic
development of the country. Employment opportunities are increased by big investments
leading to capital formation.
 Promotes economic growth: Insurance generates significant impact on the economy by
mobilizing domestic savings. Insurance turn accumulated capital into productive investments.
Insurance enables to mitigate loss, financial stability and promotes trade and commerce
activities those results into economic growth and development.
 Medical support: A medical insurance considered essential in managing risk in health. Anyone
can be a victim of critical illness unexpectedly. And rising medical expense is of great concern.
Medical Insurance is one of the insurance policies that cater for different type of health risks.
The insured gets a medical support in case of medical insurance policy.
 Spreading of risk: Insurance facilitates spreading of risk from the insured to the insurer. The
basic principle of insurance is to spread risk among a large number of people. A large number
of persons get insurance policies and pay premium to the insurer. Whenever a loss occurs, it
is compensated out of funds of the insurer.
 To provide Peace of Mind: The uncertainty due to fire, accident, death, illness, disability in
the human life, it is beyond the control of the human beings. By way of Insurance, he may be
compensated financially but not emotionally. The financial compensation provides not only
peace of mind but also motivates to work more and more.
 To Eliminate Dependency: On the death of the breadwinner, the consequences need not be
explained. Similar to the destruction of property and goods the family would suffer a lot. It
could lead to reduction in the standard of living or begging from relatives, friends or
neighbours. The economic independence of the family is reduced. The Insurance is the only
way to assist and provider them adequate at the time of sufferings.
 To Encourage Savings: Life Insurance provides protection and investment while general
Insurance provides only protection to the human life and property respectively. Life Insurance
provides systematic saving because once the policy is taken then the premium is to be
regularly paid otherwise the amount will be forfeited.
 To fulfill the needs of a person: Family needs; Old age needs; Re-adjustment needs; Special
needs: Education, Marriage, health; The clean-up needs: After death, ritual ceremonies,
payment of wealth tax and income taxes are certain requirements, which decreases the
amount of funds of the family members.
 To Reduce the Business Losses: In business the huge amount is invested in the properties i.e.
Building and Plant and Machinery. These properties may be destroyed due to any negligence,
if it is not insured nobody would like to invest a huge amount in the business and industry.
The Insurance reduced the uncertainty of business losses due to fire or accidents etc.

BFM203: V Wanje 23
  Welfare of Employees: The welfare of the employees is the responsibility of the employer.
The employer is supposed to look after the welfare of the employees. The provisions are being
made for death, disability and old age. Though these can be insured through individual life
Insurance but an individual may not be insurable due to illness and age. But the group policy
will cover his Insurance and the premium is very low in group Insurance. The expenditure paid
on account of premium will be allowable expenditure.

Insurance has evolved as a process of safeguarding the interest of people from loss and
uncertainty. It may be described as a social device to reduce or eliminate risk of loss to life and
property. Insurance contributes a lot to the general economic growth of the society by provides
stability to the functioning of process. The insurance industries develop financial institutions and
reduce uncertainties by improving financial resources.

Role of Insurance to the Economic

Part from contributing to the economy by preserving human life values and assets and protecting
loss, Insurance also aids in economic development.
 To grow economy, the Govt. needs capital to finance infrastructure i.e. Roads, bridges,
industrial farm communication and Railways lines which requires the huge investment.
 Investments are essential ingredients for economic development of any nation. Investments
by Insurance companies are in social sector, infrastructure development and government
security, papers and bonds.
 Life insurance plays a major role in mobilization of pubic savings, as life insurance contracts
are long term contacts.
 Savings out of life insurance fund are utilized in investments for growth,
 Looking to non-life side business, industry and trade would be seriously handicapped in the
absence of insurance cover relating to losses due to fire, earthquake, flood, and storm -
natural calamities.
 Wide-spread of Insurance brings in indirectly the following advantages
o Better living standards

o Higher productivity

o Improved Law and Order

o Higher Gross Domestic Product

o Discourages bad habits and practices causing damage to human life

o Enhanced self-esteem

o Creative Minds

o Entrepreneurship qualities

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 Revision Exercise
1. Define risk and name various sources of risk?
2. What do you understand by pure risk and speculative risk?
3. Distinguish between an insurance company and a re-insurance company.
4. Insurance products are distributed through intermediaries. Mention the various
intermediaries in the insurance market and explain their functions
5. What are the different types of perils?
6. Distinguish between Moral and Morale hazard.
7. What are various sources of risk?
8. Distinguish between Pure Risks & Speculative risks

BFM203: V Wanje 25