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 individuals 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 persons 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 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

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

business firm Pure Risk Speculative Risk Strategic Risk: uncertainty regarding the firms financial goals and objectives Operational Risk: results from the firms 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

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: Insurers obligations to pay a claim

depends on whether the insured has compiled with all policy conditions For e.g. In a homeowners 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
(A)Material
(B)False (C)Relied on by the insurer

Contract is voidable if the representation is

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
Shriram 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.