CHAPTER TWO

INSURANCE AND RISK

 2.1. The concept of risk and
insurance
• Insurance is one of the basic tools of risk management and it is also the
most important illustration of the transfer technique and the keystone of
most risk management programs.
• Insurance means a promise of compensation for any potential future
losses.
• Insurance is a form of contract agreement under which one party agrees
in return for a consideration to pay an agreed amount of money to
another party to make good a loss, damage or injury to something of
value in which the insured has a interest as a result of some uncertain
event.
• However, in its simplest aspect it has two fundamental characteristics:
 Transferring or shifting risk from an individual or group to other.
 Sharing losses, on some equitable basis, by all members of the party.
 cont’d
• In general, Insurance can be defined from two points of view
• First, insurance is the protection against financial loss provided
by an insurer.
 It is an economic device whereby an individual substitutes a small
certain cost (the premium) for a large uncertain financial loss
which would exist if it were not for the insurance.
• Second, insurance is a device by means of which the risks of
two or more persons or firms are combined through actual or
promised contributions to a fund out of which claimants are
paid.
 From the viewpoint of the insured insurance is a transfer device.
 From the viewpoint of the insurer, insurance is a retention and
combination device.
 2.2 Basic Characteristics of Insurance
 Pooling of losses/Risks
• Pooling of risks or the sharing of losses is the heart of insurance.
• Pooling of losses means the spreading of losses incurred by the few
over the entire group, so that in the process, average loss is
substituted for actual loss.
• In simple words, pooling in an insurance context implies two things:
 Sharing of losses by the entire group, and
 Using the law of large numbers to predict future losses.
 Payment of unexpected losses
• The insurer should cover losses that are unforeseen and unexpected
and occurs as a result of chance.
• To put it differently, the loss should be an accidental one and a
result of chance and not deliberately caused.
 Cont’d
 Risk transfer
• In this, a pure risk is transferred from the insured to the insurer
who typically is in a stronger financial position and is willing to
pay the loss than the insured (example, the risk of premature
death, poor health, destruction or theft of property)
 Indemnification (compensation)
• Indemnification means the insured is restored to his or her
approximate financial position prior to the occurrence of the
loss.
 2.3 Legal Principles of Insurance

• Insurance is affected by legal agreements known as contracts or

policies.
• The specific legal doctrines that underlie the insurance contract
are the following:
1. Principle of Indemnity
2. Principle of Insurable Interest
3. Principle of Subrogation
4. Principle of Utmost Good Faith
5. Principle of Contribution
6. Principle of Proximate Cause
 Principle of Indemnity

• The principle of indemnity sates that a

person may not collect more than the actual
loss in the event of damage caused by an
insured peril.
• The person cannot make a profit by
collecting more than the actual loss, if the
property is destroyed.
• Only contracts in property and liability
insurance are subject to this principle.
7
 Cont…
• Life and most health insurance policies are not
subject to contracts of indemnity.
• No money payment can indemnify for loss of
life or for bodily injury to the insured, and that
is why life insurance is an exception to the
general rule.
• The principle of indemnity is closely related to
insurable interest.
• The problem in insurable interest is to
determine whether any loss is suffered by a
person insured, whereas in indemnity the
problem is to obtain a measure of that loss. 8
 Methods of Providing Indemnity
• There are four basic methods of providing an
indemnity:
• Cash: Many claims are settled by means of a
cash payment to insured.
• The cash payment is the measure of indemnity,
or extent of the insurer’s liability for any given
loss.
• Repair: An adequate repair constitutes an
indemnity.
• Example; in motor insurance, where the insurer
settles the repair bill direct with the garage
concerned. 9
 Cont…
• Replacement: is a replacement of an item
rather than to pay cash.
• With a very new item or with such things as
jewelry and furs, depreciation is likely to be
insignificant and the insured may well be
content with a new replacement.
• Reinstatement. They is a term usually found
in fire insurance and concerns the
restoration or rebuilding of premises (not
necessarily on the same site) to their former
condition. 10
 Principle of Insurable Interest

• Insurable interest refers to the interest of a

person, financial or otherwise in obtaining
insurance for a person or property.
• Example; you have an insurable interest in your
car because you may loss financially if the car
damage or stolen.
• Insurable interest Must be supported by;
 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured’s loss
in property insurance.
 Cont…
The essentials of insurable interest are as follows:
• Presence of subject matter to be insured.
• Existence of monetary relationship between the
subject matter and they would be policyholder.
• The relationship existing between the policyholder
and the subject matter need to be legal.
• The policyholder must be economically benefited by
the survival or suffer an economic-loss from the
damage of destruction of the subject matter.
• An insurable interest may be applied on life,
property, or potential liability.
 Life

Self Insurance:
• An individual has an insurable interest in his own
life, and there is no limit to the sum for which a man
may insure his own life
Husband and Wife:
• A wife may insure the life of her husband because his
continued existence is valuable to her and she would
suffer a financial loss upon his death.
• Likewise, a husband may insure the life of his wife
because her continued existence is valuable to him
and he could suffer a financial loss upon her death.
• A father may insure the life of a minor-child.
 Property

• Insurable interest in property may arise as follows:

Ownership:
• This is the most obvious form and in addition to full
ownership, part or joint ownership gives the right to
insure.
• With part ownership, the insurable interest is strictly
limited to the financial involvement, but a part
owner may insure the property for the full value, as
he will be deemed to be acting as an agent for the
other co-owners.
• Any amount he receives from the insurance, over
and above his own interest, is to be held in trust for
the co-owners.
 Cont…
• Husband and wife: A husband has an insurable interest
in his wife’s property as he is legally entitled to share her
enjoyment of it, and a wife similarly has an insurable
interest in her husband’s property as their relationship is
reciprocal.
• Administrators, Executors and Trustees: These are all
persons entrusted with the estate and affairs of others.
They have a right to insure the property for which they
are responsible.
• Bailess: These are persons or entities legally in
possession of goods belonging to others, and the like
have the right to insure for losses to goods in their
custody representing interest of the owner.
 Cont…
Creditors and Debtors:
• A creditor stands to loss if his debtor dies without paying
the debt. Thus, he has the right to insure the debtor up to
the amount of the loan.
Partners:
• The death of a partner could well cause financial loss to
the survivor(s), who therefore, have a right to insure him.
• This could arise with a professional firm or perhaps with
theatrical performers.
• The amount of insurable interest would be difficult to
ascertain, but legally it is limited to the financial
involvement in the person insure.
 Principle of Subrogation

• The principle of subrogation refers to the

practice of substitution of a person or group
by another in case of debt claims in insurance.
• Subrogation is an important component of
indemnity principle.
• It effectively defines the rights of the
insurance company both before and after it
has paid claims made against a policy.
 Principle of Utmost Good Faith

• This principle imposes a higher standard of

honesty on parties to an insurance agreement than
is imposed in ordinary commercial contracts.
• Insurance contracts are based upon mutual trust
and confidence between the insurer and the
insured.
• The application of this principle may best be
explained in a discussion of;
 representation,
 concealments, and
 warrantees.
 Representations

• A representation is a statement made by an applicant

for insurance before the contract is effects.
• It is a statement in response to a question by the
insurer.
• An example of representation in life insurance would
be “Yes” or “no” to a question
• If a representation is relied upon by the insurer in
entering in to the contract, and
• if it proves to be false at the time it is made or
becomes false before the contract is made, there
exists legal grounds for the insure to avoid the
contract.
 Concealments

• Concealment is intentional failure of the applicant

for insurance to reveal a material fact to insurer.
• It is the failure of an applicant to reveal a fact that
is material to the risk.
• Because insurance is a contract of utmost good
faith, it is not enough that the applicant answer
truthfully all questions asked by the insurer before
the contract is affected.
• The applicant must also volunteer material facts,
even if disclosure of such facts might result in
rejection of the application of the payment of a
higher premium.
 Warrantees
• A warranty is a sentence in an insurance
contract holding that before the insurer is liable,
a certain fact, condition, or circumstance
affecting the risk must exist.
• Warrantees may be expressed or implied:
– Express warranties are those stated in the
contract,
– Implied warranties are not found in the
contract, but are assumed by the parties to the
contract.
 Principle of contribution

• Contribution is the right of an insurer who has

paid under a policy, to call upon other insurers
equally or otherwise liable for the same loss to
contribute to the payment.
• Where there is over insurance because a loss is
covered by policies affected with two or more
insures, the principle of indemnity still applies.
 Cont…
Basis of Contribution
• At the time of a claim, insurers usually
inquire(ask) whether any other insurance
exists covering the loss.
• Where other insurances do exist and each
policy is subject to a valid claim, contribution
will apply so that the respective insurers share
the loss ratably.

Hunde T. OSU 23
 Principle of Proximate Cause
• When loss is caused by more than one
causes, the proximate or the nearest or
the closest cause should be taken into
consideration to decide the liability of the
insurer.
• If the proximate cause is insured, the
insurance company pays the
compensation and vice versa
 Requirements of Insurance Contracts

• An insurance policy is based on the law

of contracts.
• To be legally enforceable, insurance
contracts must meet four basic
requirements:
– offer and acceptance,
– consideration,
– competent parties, and
– legal purpose.
 Offer and Acceptance

• In most cases, the applicant for insurance

makes the offer, and the company accepts or
rejects the offer.
• A binder is a temporary contract for insurance
and can be either written or oral.
 Consideration

• Consideration refers to the value that each party

gives to the other.
• The insured’s consideration is payment of the
first premium plus an agreement to abide by the
conditions specified in the policy
• The insurers consideration is the promise to pay
certain things as specified in the contract.
• This promise can include paying for a loss from
an insured peril, providing certain services,
such as loss prevention and safety services, or
defending the insured in a liability lawsuit.
 Competent parties

• The parties must have legal capacity to enter in

to a binding contract.
• Most adults are legally competent to enter in to
insurance contracts, but there are some
expectations.
• Insane persons, intoxicated persons, and
corporations that act outside the scope of their
authority can not enter in to enforceable
insurance contract.
• Children normally are not legally, competent to
enter in to biding insurance contract.
 Legal Purpose

• An insurance contract that encourages or

promotes something illegal or immoral is
contrary to the public interest and cannot be
enforced.
• In order to make a valid contract, the object of
the agreement must be lawful.
• An object is lawful if it is-
– Not forbidden by law, or
– Is not immoral, or
– Opposed to public policy, or
– Which does not defeat any provision of any law
 Safety first,
Insurance comes next
Thank
you!