Fundamentals of Insurance

CHAPTER 2: RISK AND INSURANCE

Contents

Learning Outcomes

Introduction

2A Risk

2B Components of Risk

2C Classification of Risks

2D Characteristics of Insurable Risks

2E Methods of Handling Risks

Chapter Summary

Test Your Understanding

Learning Outcomes

After studying this chapter, you should be able to:

Highlight the components of risk

Explain the characteristics of insurable risks
Explain the methods of handling risks

Introduction

There is no single definition that has been advanced for

no one can separate risk from insurance. In this chapter we shall attempt to
define explore the components, characteristics and
classification of insurable risks as well as the methods of handling risks.

In this chapter, we will cover the following topics:

Risk
Components of Risk
Classification of Risks
Characteristics of Insurable Risks
Methods of Handling Risks

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2A Risk

Insurable risk refers to the conditions that are vulnerable to danger of loss to a
person or property. It can be defined as:

The chance of loss, where chance implies doubt about the outcome in a
given situation which is favourable.
The possibility of loss.
The probability of any outcome being different from the one expected.
A combination of hazards.
The uncertainty of loss.
A condition in which loss or losses are possible.

Generally, a condition is an insurable risk if:

The peril insured against shall produce a definite loss not under the control
of the insured,
There is a large number of homogeneous exposures subject to the same
perils,
The loss is calculable and the cost of insuring it is economically feasible,
The peril is unlikely to affect all insured simultaneously, and
The loss produced by a risk is definite and has potential to be financially
serious.

2B Components of Risk

Risk has three vital levels:

2B1 Uncertainty

This implies some doubt about the future based on either lack or imperfection
of knowledge. Uncertainty exists even when the person exposed to risk does
not know of its existence. For example, in our daily lives, we may not know
when one will die or get involved in an accident; whether a house will be
broken into or whether it will catch fire.

2B2 Levels of risk

Some risks are minor and occur frequently but with minimal impact/severity.
For instance, shoplifting occurs frequently but has low severity to those
affected. Some other risks occur rarely but the impact is severe; for example,
plane crashes and marine accidents (low frequency with high severity).

2B3 Risk as the cause of the loss

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The terms peril and hazard are sometimes used interchangeably with each
other and with risk
Risk is often used to mean peril and hazard.
Peril is the prime physical cause of the loss. Examples include theft, fire, or
hailstorm.
A hazard is the condition that may increase or decrease the effect of the
peril; for example, the nature of construction in Fire Insurance or the state
of health in Life Assurance.
Hazards may relate to the physical characteristics that may increase
hazards in fire insurance. Examples include: the type of construction;
location of the building; age and place where the vehicle is kept.
Moral-nature and behaviour of human beings connected with the subject
matter of insurance; for example, withholding material facts, lodging
fraudulent claims, exaggerated losses, carelessness.

2C Classification of Risk

2C1 Financial Vs Non-Financial

Financial if outcomes can be measured in monetary terms such as

material damage to the building after fire, or theft of goods.
Non-monetary if outcome though undesirable cannot be quantified, such
as emotional attachments.

2C2 Pure Vs Speculative Risks

Pure risk involves loss or break-even situations. These risks might not only
be unfavourable but may leave a person in the position he/she enjoyed
before the loss such as fire/burglary risks.
Speculative risks involve loss, break-even and the possibility of gain, such
as buying shares or inventing a new product.

2C3 Fundamental Vs Particular Risks

Fundamental Risks Are beyond the control of human beings and are
indiscriminate in nature. Examples include earthquakes, storm and
tempest, and landslides, which were in the past uninsurable but can now
be insured.
Particular Risks These are personal in nature and consequences affect a
particular individual. Examples include fire, theft and motor accidents, and
these are insurable risks.

2D Characteristics of Insurable Risks

Insurable risks are characterised:

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As fortuitous or accidental in nature as far as the insured is concerned. It is

therefore not possible to insure against an event that will definitely occur.
In monetary terms. For Property Insurance, the value is easy to determine.
In Life Assurance, the value of life may not be measurable but the sum
assured would be determined at inception, being generally limited by the
ability of the assured to pay premium.
As an insurable interest. There must be a legal relationship between the
insured and the subject matter of insurance.
By homogeneous exposure. A large number are exposed to similar losses.
By pure risks. Unlike speculative risks, pure risks are insurable.
As particular risks. They are personal in origin and consequences (e.g. fire,
theft and motor accidents) unlike fundamental ones, which beyond o
control (earthquakes, hurricanes). Fundamental risks such as war and
unemployment may also arise out of the nature of the society.
Insurable risks must never be against the public policy in terms of what
society considers just and moral. For example, we cannot insure a stolen
property.

2E Methods of Handling Risks

Given the negative consequences the insurable risks present to individual and
business lives, there is need to devise ways of handling them. These include:

2E1 Risk Avoidance

Here one realizes the risk exists and decides to keep away from the event that
exposes one to that risk. You may forbid your motor vehicle from plying a
route that is considered insecure, for instance.

2E2 Risk Retention

Funds may be retained intentionally or unintentionally. Intentionally,

individuals realize the existence of the risk and therefore decide to create fund
from which losses are paid. Under involuntary retention, individuals or
organizations do not see the existence of the risk. Here we need to consider
factors such as the frequency, severity of risks. However, large unpredictable
risk requires insurance.

2E3 Risk Reduction

Measures are taken to minimize the frequency and severity of risks. Here we
have pre-loss risk reduction. Examples include police escort in Money
Insurance; employment of guards and burglar proofing; fixing fire sprinklers,
et cetera.

2E4 Risk Transfer

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Here financial consequences of an event are shifted to another party. For

example, the landlord may shift the risk of the house catching fire to the
tenants; a transporter can shift the risk of loss or damage to the owner of
goods. Risk transfer is usually done through suitable worded contracts.
Insurance is an example of risk transfer in that we spread an individual risk
across many people in order to make it more bearable for individuals exposed
to such risks.

Alternative methods of handling risks

Chapter Summary

The key ideas covered this chapter can be summarized as below:

Insurable risk refers to the conditions that are vulnerable to danger of loss
to a person or property and it can be defined as:

- The chance of loss, where chance implies doubt about the outcome in a
given situation which is favourable;
- The possibility of loss;
- The probability of any outcome being different from the one expected;
- A combination of hazards;
- The uncertainty of loss;
- A condition in which loss or loss are possible

Risk has three vital levels:

- Uncertainty
- Levels of risk
- Risk as the cause of the loss

Risk can be classified as:

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 Fundamentals of Insurance

- Financial Vs Non-Financial
- Pure Vs Speculative Risks
- Fundamental Vs Particular Risks

Insurable risks may be characterised as:

- Fortuitous or accidental
- Monetary
- Insurable interest
- Homogeneous exposure
- Pure risks
- Particular risks
- Never against the public policy

Methods of handling risks include:

- Risk avoidance
- Risk retention
- Risk reduction
- Risk transfer

Test Your Understanding

1. Give six definitions of the term risk

2. Explain the differences between:

a) Fundamentals and particular risks

b) Pure and speculative risks
c) Financial and non-financial risks

3. List at least six characteristics of insurable risks.

4. Explain the three methods of handling risks.

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