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Meaning of RiskRisk is the potential that a chosen action or activity (including
the choice of inaction) will lead to a loss (an undesirable outcome)
ORRisk is an uncertainty concerning the occurrence of a lossIn 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 RiskObjective Risk: relative variation of actual loss from expected
lossFor 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 RiskSubjective 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 ProbabilitiesObjective 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───────────────────Number of Possible Losses
Peril and Hazardperil 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 HazardsPhysical hazardMoral HazardMorale hazardLegal hazard
Physical HazardPhysical condition that increases the chance
of lossExamples-Icy roads that increase the chance of an auto
accidentDefective wiring in a building that increases
the chance of fireworking from heights, including ladders,
scaffolds, roofs, or any raised work area
Moral HazardDishonesty 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 HazardCarelessness or indifference to a loss because of the existence
of insurance
ExamplesLeaving car keys in an unlocked car which increases the
chance of theftLeaving 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 HazardCharacteristics of the legal system or regulatory environment
that increase the frequency or severity of lossesExamples:Laws that require insurers to include coverage for certain
benefits in health insurance plans, such as alcholism
Categories of RisksPure and Speculative RisksFundamental and Particular RisksEnterprise Risk
Pure Risk & Speculative RiskPure risk : there are only the possibilities of loss or no lossExamples: Damage to property from fire, lightning, flood or
earthquake etcSpeculative risk : either profit or loss is possibleExamples: investment in shares or real estate, betting on horse
raceONLY Pure Risks are insured but exceptions always exist…..
Like some insurers will insure institutional portfolio investments
Fundamental & Particular RisksFundamental 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 RiskRelatively new term that encompass major risks faced by a
business firmPure RiskSpeculative RiskStrategic Risk: uncertainty regarding the firm’s financial goals
and objectivesOperational 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 RisksPremature DeathInsufficient income during retirementPoor healthUnemploymentProperty risksLiability 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 relationsOffer and acceptanceConsiderationCertainty of termsConsensus ad idem (a genuine meeting of minds)Legality of purposePossibility of performance
Requirements of an Insurance ContractOffer and acceptanceConsiderationCompetent partiesLegal Purpose
Requirements of an Insurance Contract Offer and Acceptance: Applicant for insurance makes the offer and the
company accepts or rejects the offerAn 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 insurerA conditional premium receipt is given to the applicant after filling the
application form
ConsiderationConsideration is the value that each party gives to the
other
Competent PartiesEach party must be legally competent/ must have legal
capacity to enter into a binding contractMost adults are legally competent to enter into the
insurance contracts but there are some exceptions likeInsane persons, intoxicated persons, minorsAlso, insurer must be licensed to sell insurance in that
country
Legal PurposeAn 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
Aleatory ContractUnilateral ContractPersonal ContractConditional ContractContract of Adhesion
Distinct Legal Characteristics of Insurance Contracts
Distinct Legal Characteristics of Insurance ContractsAleatory 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 ContractsConditional 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 InsuranceUtmost Good FaithInsurable InterestIndemnityCorollaries of IndemnityProximate Cause
Utmost Good FaithUberrima 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
RepresentationsStatements made by the
applicant for insuranceFor 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 insurerMaterial - 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 misleadingReliance – the insurer relies on the
representation in issuing the policy at specified premium
Contract is voidable if the
representation is
ExamplesKarim 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 InsuranceThe 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
MisrepresentationIf 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.