Meaning of Risk
 Risk is the potential that a chosen action or activity (including
the choice of inaction) will lead to a loss (an undesirable
outcome)
OR
 Risk is an uncertainty concerning the occurrence of a loss
 In insurance industry we define risk to identify the property or
life being insured
 “that driver is a poor risk”, “cancer patient is an unacceptable
risk”
Types of Risk
 Objective Risk: relative variation of actual loss from expected
loss
 For eg: An insurer has 100000 cars insured for a long period of
time, and on the average 10000 cars meet with at least one
accident and claim for damages each year. However, for a
particular year, it is unlikely that there will be exactly 10000
claims. Under certain assumptions, it can be proven that over a
long period of time, the deviation of the number of claim in a
year from 10000 will, on the average be 100.
 Thus there is a variation of 100 claims from the expected
number of 10000 or a variation of 1%.
 This relative variation of actual loss from expected loss is
known as objective risk
Types of Risk
 Subjective Risk-an uncertainty in the individual’s personal
estimate of the chance of loss.
 It can vary from one person to another.
 For eg-Somebody who has lost a lot of money in the stock
market will probably feel more risk investing in the market
than someone who has profited handsomely.
 Subjective risk may alter the behavior of the risk taker if it is an
undesirable risk
Types of Probabilities
 Objective probability is the probability of an occurrence,
calculated by either deduction or induction
 Subjective probability is a person’s perception of the
likelihood of an event.
Chance of Loss
 is the probability that a loss will occur, which can either be
an expected loss or an actual loss
Chance of Loss =
Expected or Actual Loss
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Number of Possible Losses
Peril and Hazard
 peril is something that can cause a loss. Examples include falling,
crashing your car, fire, wind, hail, lightning, water, volcanic eruptions,
choking, or falling objects
 Hazard is a condition that creates or increases the chance of loss
Types of Hazards
 Physical hazard
 Moral Hazard
 Morale hazard
 Legal hazard
Physical Hazard
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Physical condition that increases the chance of loss
ExamplesIcy roads that increase the chance of an auto accident
Defective wiring in a building that increases the
chance of fire
 working from heights, including ladders, scaffolds,
roofs, or any raised work area
Moral Hazard
 Dishonesty or character defects in an individual that
increase the frequency or severity of loss
 Examples Submitting a fraudulent claim,
 inflating the amount of a claim,
 Intentionally burning unsold merchandise that is
insured
Morale Hazard
 Carelessness or indifference to a loss because of the existence
of insurance
 Examples
 Leaving car keys in an unlocked car which increases the
chance of theft
 Leaving a door unlocked that allows a burglar to enter
 “Its insured so why should I worry about safety of my
house/property/own health. If anything goes wrong, insurer is
there to indemnify me. So, Why should I worry about safety?”
Legal Hazard
 Characteristics of the legal system or regulatory environment
that increase the frequency or severity of losses
 Examples:
 Laws that require insurers to include coverage for certain
benefits in health insurance plans, such as alcholism
Categories of Risks
 Pure and Speculative Risks
 Fundamental and Particular Risks
 Enterprise Risk
Pure Risk & Speculative Risk
 Pure risk : there are only the possibilities of loss or no loss
 Examples: Damage to property from fire, lightning, flood or
earthquake etc
 Speculative risk : either profit or loss is possible
 Examples: investment in shares or real estate, betting on horse
race
 ONLY Pure Risks are insured but exceptions always exist…..
Like some insurers will insure institutional portfolio
investments
Fundamental & Particular Risks
 Fundamental risk affects the entire economy or large number of
persons or groups within the economy – rapid inflation,
cyclical unemployment, war, natural disaster, terrorist attack
 Particular Risk affects only individuals and not the entire
community . For e.g.. Car thefts, bank robberies, dwelling fires
Enterprise Risk
 Relatively new term that encompass major risks faced by a
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business firm
Pure Risk
Speculative Risk
Strategic Risk: uncertainty regarding the firm’s financial goals
and objectives
Operational Risk: results from the firm’s business operations
like a bank that offers new online banking services may incur
losses if hackers break into the bank ‘s computers
Enterprise Risk contd…
 Financial risk: refers to the uncertainty of loss because of
adverse changes in commodity prices, interest rates, foreign
exchange rates, an the value of money
 Examples A food company that agrees to deliver a commodity at a fixed
price to a supermarket in six months may lose money if grain
price rises
Types of Pure Risks
 Premature Death
 Insufficient income during retirement
 Poor health
 Unemployment
 Property risks
 Liability risks
A Contract
 An agreement between two or more parties to do or
abstain from doing an act
 Create a legally binding relationship
Essentials of a valid Contract The intention to create legal relations
 Offer and acceptance
 Consideration
 Certainty of terms
 Consensus ad idem (a genuine meeting of minds)
 Legality of purpose
 Possibility of performance
Requirements of an Insurance Contract
 Offer and acceptance
 Consideration
 Competent parties
 Legal Purpose
Requirements of an Insurance Contract
 Offer and Acceptance: Applicant for insurance makes the offer and the
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company accepts or rejects the offer
An agent merely solicits the prospective insured to make the offer
In property & Liability insurance especially personal line insurance – auto ,
home insurance , the agents typically have the power to bind the insurer
through the use of binder.
Binder is a temporary contract for insurance
In life insurance, agent does not have the power to bind the insurer
A conditional premium receipt is given to the applicant after filling the
application form
Consideration
 Consideration is the value that each party gives to the
other
For Insured: Payment
of first premium plus
an agreement to abide
by the conditions
specified in the policy
For insurer: Promise to
do certain things as
specified in the
contract. For e.g.:
paying for a loss from
the insured peril
Competent Parties
 Each party must be legally competent/ must have legal
capacity to enter into a binding contract
 Most adults are legally competent to enter into the
insurance contracts but there are some exceptions like
 Insane persons, intoxicated persons, minors
 Also, insurer must be licensed to sell insurance in that
country
Legal Purpose
 An insurance contract that encourages something illegal or
immoral is contrary to the public interest and can not be
enforced
 For e.g. policy can not cover seizure of the drugs by the
police
Distinct Legal Characteristics of
Insurance Contracts
 Aleatory Contract
 Unilateral Contract
 Personal Contract
 Conditional Contract
 Contract of Adhesion
Distinct Legal Characteristics of
Insurance Contracts
 Aleatory Contract: where the values exchanged may not be
equal but depend on an uncertain event . For e.g..- ??????????
(Commutative Contract?)
 Unilateral Contract: only one party makes a legally
enforceable promise. Only the insurer makes a legally
enforceable promise to pay a claim . After the first premium is
paid, the insured can not be legally forced to pay the premiums
(Bilateral Contract?)
 Personal Contract: the contract is between the insured and the
insurer
Distinct Legal Characteristics of
Insurance Contracts
 Conditional Contract: Insurer’s obligations to pay a claim
depends on whether the insured has compiled with all policy
conditions
 For e.g. In a homeowner’s policy , the insured must give
immediate notice of loss. If the insured delays for an
unreasonable period in reporting the loss, the insurer can refuse
to pay the claim
 Contract of Adhesion: means the insured must accept the
entire contract, with all of its terms and conditions
Principles of Insurance
 Utmost Good Faith
 Insurable Interest
 Indemnity
 Corollaries of Indemnity
 Proximate Cause
Utmost Good Faith
 Uberrima fides is a Latin phrase meaning "utmost good faith”
.This means that all parties to an insurance contract must deal
in good faith, making a full declaration of all material facts in
the insurance proposal
 A minimum standard that requires both the buyer and seller in a
transaction to act honestly toward each other and to not mislead
or withhold critical information from one another
 A positive duty voluntarily to disclose ,accurately and fully, all
facts material to the risk being proposed ,whether requested or
not
Representations
 Statements made by the
applicant for insurance
 For e.g. If you apply for life
insurance, you may be
asked questions
concerning your age,
weight, height, occupation,
state of health, family
history etc. Your answers to
these questions are the
representations
Representation
Contract is voidable if
the representation is
 (A)Material
 (B)False
 (C)Relied on by the insurer
 Material - If the insurer knew the true facts, the
policy would not have been issued, or it would have
been issued on different terms
 False-the statement is not true or misleading
 Reliance – the insurer relies on the representation in
issuing the policy at specified premium
Examples
 Karim applied for life insurance and states in the
application that he has not visited a doctor within the
last five years
 However, six months earlier he had surgery for lung
cancer. So, the statement made by him is false,
material and relied on by the insurer
Misrepresentation in Motor Insurance
 The insured misrepresented that she had no traffic
violations in the prior three-year period. After the
claim, a check of her record revealed that she had two
traffic violations in that period. The insurer denied the
coverage.
 Court Decision-The insured claimed that she had
forgotten about the two violations she had made and
therefore, she had no intention to deceive. The court
ruled that it is unlikely she would forget both events .
Decision is for the insurer
Misrepresentation
 If an applicant for insurance states an opinion that
later turns out to be wrong , the insurer must prove
that the applicant spoke fraudulently and intended to
deceive the company
 An innocence misrepresentation of a material fact, if
relied on by the insurer , also makes the contract
voidable.