Principles of Risk and Insurance
Introduction to the Principles of Risk and Insurance
We are exposed to many situations that many cause a loss (perils). The primary purpose
of insurance is to provide economic protection against losses that may be incurred due to
a chance of an event happening such as death, illness, or accident. This type of protection
is provide through an insurance policy, which is simply a device used by companies to
accumulate funds to have enough reserves to meet these uncertain losses.
DEFINITIONS
Risk
Risk can be defined as uncertainty regarding loss:

the inability to work and earn an income due to disability is a risk

the destruction of a home due to hurricane is a risk the loss of family income due
to death is a risk

the potential for an automobile accident is a risk

the chance of someone slipping on your icy driveway is a risk
Insurable Risks
Risks are generally divided into two classes: Pure risks and Speculative risks.
Pure Risks- these risks involve only the chance of loss, there is never an opportunity for
gain or profit.
Examples: injury from an accident, loss of home from an earthquake.
Only Pure Risks are Insurable
Speculative Risks- These risks involve both the chance of gain or loss.
Examples: Gambling at the race track, or investing in the real estate market.
Speculative Risk is not Insurable
Elements of an Insurable Risk

Loss must not be Catastrophic

Loss must be Unexpected or Accidental

Loss produced by the risk must be Definite and Measurable

Must be a significantly large number of homogeneous exposure units to make the
losses reasonable predictable
Risks can also be evaluated on an economic scale comparing static and dynamic risks:
Static Risks are the losses that are caused by factors other than a change in the economy
(for example- hurricanes, earthquakes, other natural disasters)
Dynamic Risks are the result of the economy changing (examples- inflation, recession,
and other business cycle changes). Dynamic risks are not insurable.
Self-Insurance - Self-insurance is the process of an individual or company acting like an
insurance company to cover its own risks. This involves evaluating a large number of
similar potential losses, the ability to predict the overall losses with some degree of
accuracy, and the establishment of a formal fund for future losses and their possible
fluctuations.
Self-Insurance for both companies and individuals has its pros and cons:
Advantages:

Avoid the cost of premiums for commercial or personal insurance

Reserves can be invested in short-term money market instruments and later used
by the company or individual when the insurance is no longer needed
Disadvantages:

Company/individual is exposed to a catastrophic loss

Services provided by the insurance company are assumed

Income taxes may be due on the interest/profit from the reserve cash
RISK MANAGEMENT PROCESS
The objective of risk management is to choose efficiently among methods to handle risk
so as to avoid catastrophic losses. Risk management includes insurance management, but
it should be used to measure both insurable and non-insurable risks.
The process of risk management has six distinct steps:
STEP 1- Identify risk management goals and objectives
STEP 2- Gather pertinent data to determine the risk exposure
STEP 3- Analyze and Evaluate the client's status
STEP 4- Develop and Present risk management recommendations
STEP 5- Implementation
STEP 6- Ongoing Monitoring
RESPONSE TO RISK
Risk Avoidance
A risk may be avoided if the individual refuses to accept risk by not engaging in an action
that creates a risk (removal of the peril).
Consider the following risk avoidance instances:

Taking the bus rather than buying a car

Renting a home rather than buying it

Not buying an office building without a sprinkler system
Risk Diversification
Risk diversification, also known as risk sharing, is a method of reducing your total
exposure to risk by sharing the responsibility with another party.
Consider the following risk diversification strategies:

Forming a limited partnership for your business

Hedging contracts

Health insurance with deductibles and co-payments
Risk Reduction
Risk reduction is the process of diminishing risk through the implementation of loss
prevention methods or implementing safety features or improvements.
Consider the following risk reduction techniques:

Mounting smoke detectors in your building

Installing hurricane shutters on your home

Put a burglary system on your vehicle
Risk Retention
Risk retention is the act of accepting risk and confronting it if and when it occurs. In this
process, no action is taken to avoid, transfer, or reduce risk.
Consider the following risk retention actions:

Self-insurance

Coinsurance in various insurance policies

Utilizing deductibles in insurance contracts
Risk Transfer
Risk transfer is the practice of shifting risk responsibility either through an individual or
an insurance contract. The most effective way to handle risk is to transfer it so that the
loss is consumed by another party.
Consider the following risk transfer solutions:

Purchasing an insurance policy

Obtaining high protection limits on your auto policy

Reassign the risk to another individual
LEGAL ASPECTS OF INSURANCE
Principle of Indemnity
The indemnity principle applies to most insurance contracts whereby the insurer seeks to
reimburse the insured for approximately the amount lost, no more and no less. The
purpose of an indemnity contract is to return the insured back to his or her original
financial position.
Subrogation- In the event that a claim is paid, the insurer acquires the insured's right to
action against any negligent third party that may have caused or contributed to the loss.
Value Contract- A value contract differs from indemnity in that it pays a stated sum,
regardless of the actual amount of the loss. An example of a value contract is a life
insurance policy that pays a $50,000 death benefit.
Insurable Interest
An important element of a valid insurance contract is insurable interest. This is a
relationship between the applicant and individual being insured whereas the person
seeking the contract (applicant) must be subject to loss upon the destruction, damage,
illness, disability, or death of the insured.
Important: Insurable interest must exist at the inception of contracts; however, with life &
health contracts it does not have to exist at the time of claim. Property and casualty
insurance policies require that the insurable interest must exist at the time of the claim.
Principles of Risk and Insurance - Contract Requirements
An insurance policy is a contract. Contracts are agreements that are enforceable by law.
We have contracts in insurance to allow two parties, typically an insurance company and
an insured, to reach a mutual agreement to bind each other to certain promises- such as
the insurer covering a particular risk of loss, and the insured agreeing to pay a premium
(cost) for this protection. However, in order for a contract to be valid and enforceable, it
must contain certain fundamentals.
To be Legally Binding an insurance contract must have the following five elements:
1) Offer and Acceptance
To be legally enforceable, a contract must be made with a definite, unqualified offer by
one party and the acceptance of its exact terms by the other party.
The Offer- with many insurance contracts, the offer is made when the applicant submits
the application with the initial premium.
The Acceptance- the acceptance is confirmed when the insurance company accepts the
offer and issues a policy. The company may counteroffer and then the applicant has the
choice to accept or reject the new terms.
No Initial Premium- When the applicant does not submit an initial premium with the
application, the role of offer and acceptance is reversed. The insurer can respond by
issuing a policy (the offer) that the applicant can accept by paying the planned premium
when the policy is delivered.
2) Consideration
In order for an insurance contract to be legally binding, there must be an exchange of
value. Consideration is the value given in exchange for the services sought after.
The submission of the completed application (offer) plus the payment of the initial
premium (consideration) to the insurance company generally creates a binding contract
provided that the application passes the underwriting process.
3) Legal Intent
The subject of the insurance contract must be of legal purpose and/or a legal business
entity in order for the contract to be enforceable. A contract whereas one party agrees to
commit a crime for payment of services would not be enforceable in court because the
subject matter is not of legal content.
4) Competent Parties
To cement a valid contract, the parties involved (individuals, groups, or businesses) must
be capable of entering into a contract per the law. For an insurance contract, the insurer
(insurance company) is considered competent if it is licensed or approved by the state or
states in which it conducts business.
The applicant is presumed to be a competent party, unless one of these exceptions apply:

Mentally Incompetent

Minor

Under the influence of alcohol or drugs
If one of the parties is not competent, then the contract is voidable by the incompetent
party.
5) Legal Form
Contracts must also follow the laws and guidelines of state regulations. For example- not
all contracts are required to be in written form, but state laws might mandate a written
contract to make it binding.
State Insurance Regulation attempts to accomplish the following (MAPS):

Maintain competition

Available coverage to all that want and need it

Protect policy owners against insurer mistreatment

Save the solvency of insurers
If an insurance contract lacks one of the five characteristics of a valid contract above, the
contract will not posses legal effect and cannot be enforced by either party.
Contract Characteristics
Law of Agency- Insurance Brokers vs. Insurance Agents
1) Insurance Brokers- A broker is a representative of the policy owner that acts as a
marketing mediator between the insurer and the policy owner.
2) Insurance Agent- An agent is a legal representative of the insurance company
authorized to offer the sale of its goods and services. An agent's authority to legally bind
the insurer stems from three sources- Express, Implied, or Apparent Authority.
Agent's authority to Legally Bind a Principal:
Express
Authority
Implied
Authority
Apparent
Authority
Company\'s Appointment of Agent to act on its behalf
i.e. agent is given the authority to solicit applications (agent agreement)
Public is led to believe the individual has this authority
i.e. agent runs TV ads noting themselves as a rep of the company
Company creates the impression that a relationship exists with the agent
i.e. agent is supplied with applications, sales materials, etc...
Aleatory
Insurance contracts are considered to be aleatory because the outcome is affected by
chance and may be unequal.
a) There is an element of chance for both parties involved in the contract, and
b) The dollar values exchanged may not be equal
Unilateral
Insurance contracts are considered unilateral because only the insurance company
(insurer) makes a promise under the contract. The insurer promises to pay a benefit upon
the happening of a certain event, such as an auto accident, death, disability, etc... The
applicant does not make any promise- they can even elect to stop paying premiums if
they desire. The insurer will however have the right to cancel the policy if premiums are
neglected to be paid.
Conditional
Insurance contracts are conditional contracts; whereas, the payment of benefits by the
insurance company is conditioned upon the insured or owner paying the premium.
Incontestable Clause
An incontestable clause is an unusual feature sometimes found in life insurance contracts
which makes the policy indisputable by the insurer after being enforce for a period of two
years or more.
Personal Contracts
Most insurance contacts are personal contracts between the insurance company and the
applicant/insured and they are non-transferable. Life insurance contracts are the exception,
as they can transfer ownership by was of assignment.
Adhesion
An insurance contract is considered a contract of adhesion because the applicant adheres
to the terms of the contract if they want the benefit to remain in effect. The contract is
prepared by one party (insurance company) and accepted by the insured. These contracts
are not negotiated between the two parties.
Insurance Ownership and Beneficiaries
Policy Ownership
Most insurance contracts are considered to be personal contracts, which means they are
an agreement between the insurer and the individual that desires to cover a particular risk.
They cannot be transferred to another party without the approval of the insurance
company. In most cases the insurance company must do their own independent risk
assessment of the situation in order to offer coverage- because of this policyholders
cannot transfer their policy.
However, life insurance is the exception to the personal contract rule. In this case, the
insurer makes a promise to pay a benefit in the untimely death of the insured. The owner
of the policy has no bearing on the amount of the risk that the insurer has assumed, so
owners can transfer their ownership right as they desire. This transfer of ownership is
known as assignment.
Designation of Beneficiary
The person that is listed to receive the benefits from a
policy is known as the beneficiary. The beneficiary can be primary, contingent, revocable,
or irrevocable.
Primary- this is the main beneficiary of the contract.
Contingent- this is the secondary beneficiary, if the primary beneficiary dies the
contingent will receive the proceeds.
Revocable- owner of the policy reserves the right to change the beneficiary at their own
will.
Irrevocable- owner of the policy has restrictions on changing beneficiaries.
Beneficiaries should be clearly defined by including their full name, current residence,
share of the proceeds to be received, and date of birth or social security number. They can
be listed in various forms such as: individuals, trusts, estates, minors, and charitable
organizations.
Analysis and Evaluation of Risk Exposure
Introduction to the Evaluation of Risk Exposure
When individuals consider risk management they must look at the risks associated with
four crucial areas including: personal, property, liability, and business. Each of the four
areas has special risks associated with it, and individuals should evaluate those risks and
then determine a plan on how to cover, transfer, or eliminate those risks.
PERSONAL
Personal risks are those risks that we all face on a daily basis in the course of our
everyday life- they include the perils of death, disability, bad health, unemployment, and
Superannuation. Most personal risks center on the ability to earn an income and provide
for your family.
When we consider the consequences of uncovered personal risks, we think about
protecting these areas of importance by entering into insurance contracts for life, health,
disability, and income for life.
Death
None of us like to consider death, but as the old clique goes... "There are only two things
guaranteed in life...that's death and taxes". So, in order to protect the ones we love, cover
our debts, pay for funeral expenses, send your children to college, or whatever the reasonmany individuals need to protect their income stream in the event of their untimely death
and life insurance is a way of doing that.
An individual faces three mutually exclusive risks centering around the uncertainty of
death, they include:
1) Superannuation- outliving your income and assets,
2) Premature Death- dying when others remain dependent on your income,
3) Protecting your Estate- paying for taxes in the event of your death
Source : http//:http://www.investopedia.com/investing
Vanitha Muguntharaj
Assistant Manager- Health Team