Chapter 2 risk management

1. Chapter 2
Risk Management
By: Alemayehu M 1
4/28/2024

2. Discussion Questions
 What is risk management?
 How can we manage risk of different
type?
4/28/2024
2
By: AM

3. 2.1. Definition of Risk Management
 It involves the application of general management concepts to a
specialized area (risk…)
 Risk management is defined as a systematic process for the
identification and evaluation of pure loss exposures faced by an
organization or individual, and for the selection and
implementation of the most appropriate techniques for treating
such exposures.
 It is a scientific approach to dealing with pure risks (not
speculative risks) by anticipating possible accidental losses and
designing and implementing procedures that minimize or avoid
the occurrence of loss or the financial impact of the losses that
do occur.
 It helps a business handle its exposures to accidental and
ordinary losses in most economic and effective way.
 Risk management is not an option.
4/28/2024
3
By: AM

4. 2.2. Objectives of Risk Management
1. Ensuring survival of the firm
2. Provides Peace of mind
3. Lowers risk management/handling costs and thus
higher profits
4. Avoiding or minimizing the interruption of the firms
operation, enabling fairly stable earnings.
5. Maintaining (developing) good will.
6. Satisfying the firm’s sense of social responsibility.
7. Satisfaction of externally imposed legal and other
obligations
4/28/2024
4
By: AM

5. Pre-loss Objectives

6. - Economy goal
- Reduction of anxiety
- Meet any legal obligations

7. Post-loss Objectives:

8. -Survival of the firm
-Continued operation
-Stability of earnings
-Continued growth
-Social responsibility

9. 2.3. Process of risk
management
2.3.1. Risk
Identification
2.3.2. Risk
measurement
2.3.3. Risk
Administration
4/28/2024
9
By: AM

10. 2.3.1. Risk Identification
Definition:
 Risk identification is the process by
which a business systematically and
continually identifies property,
liability, and personnel exposures as
soon as or before they emerge.
Probe: Risk identification is not a one
time task. Why?
4/28/2024
10
By: AM

11. 1. Sources of risk
 In risk identification, the first step is to
identify the sources of risk which can be
classified in various ways.
4/28/2024
By: AM
11

12. Source of risk
 Physical Environment
 Social environment
 Political environment
 legal environment
 Operational environment
 Economic environment
4/28/2024
By: AM
12

13. 2. Categories of Risk /Loss
exposure
 In the risk identification process, the
following three types of pure losses
mainly considered by the risk managers.
property losses
third party liability losses and
personal losses
4/28/2024
13
By: AM

14. i. Property losses
 Property loss is a type of pure risk that arises
simply because some one owns/posses a
property.
 Property exposure to risk can be classified in
four ways; according to:
 the class of property affected
 the causes of the gain or loss
 whether the outcome is direct, indirect, or
time element in nature, and
 the nature of the organization’s interest
in the property
 Reading assignment (Williams and Heins page
89---) 4/28/2024
14
By: AM

15. Cont’d….
 Major property risks include the
following:
 Physical damage to personal property
because of a fire, windstorm, flood or other
cause
 Theft of personal property
 Physical damage or theft of a property
4/28/2024
By: AM
15

16. Valuation of Potential physical Asset Losses
 Once the risk manager identified the organization’s
exposures to property losses, the task of valuing the
amount at risk is the next activity. Several
alternative methods are recognized by appraisers.
1. Original cost
2. Original cost less depreciation
3. Tax appraisal value
4. Market Value
5. The economic or use value
6. Reproduction value
7. Replacement cost for new
8. Replacement cost for new less depreciation
 …… there is no one best method of valuing a property
exposure
4/28/2024
16
By: AM

17. ii. Liability losses
 Liability risk refers to injuries caused to other people
or damages caused to their property, because of their
operating activities.
 The following are some of the factors leading to liability losses.
1. Product Liability: is associated with the manufacture and sell of
a particular product. Quality problems, breach of warranty,
misleading advertisement, etc are some of the factors that lead
to liability losses.
2. Motor Vehicles: Operation of motor vehicles could lead to
killing of people or injuries and damages of property of other
people due to accidents such as collisions, fire, crash, etc.
3. Industrial Accidents: factory employees are likely to suffer
physical injuries at work sites or they may be exposed to job
related diseases due to dust inhalation and pungent chemical
smell that can cause occupational diseases.
4/28/2024
17
By: AM

18. Liability risk……
4. Industrial Waste: industrial wastes released into air
or thrown into rivers and lakes are major sources of
environmental pollution. ….there is then a potential
liability loss if the firm's activities pollute the
environment and a law suit is filed against its
activities.
5. Professional Activities: in the filed of consultancy,
medicine, construction, and other professional
activities, liability losses are likely to emerge because
of the deficiencies inherent in the services rendered
due to negligence, errors, intentional concealment and
the like.
6. Ownership of immovable: this refers to building, land
and machinery owned. The use of such immovable by
people may bring liability losses for injuries might be
4/28/2024
18
By: AM

19. iii. Personal losses
 Death of key personnel (loss of reputation,
customers, …)
4/28/2024
19
By: AM

20. 3. Risk identification techniques
1. The risk analysis questionnaire
2. Financial statement method
3. Flow-chart method
4. On-site inspections
5. Interactions with other departments
6. Statistical Records of losses
7. Analysis of the environment
8. Checklist (property checklist, personnel checklist)
9. Others (organizational chart, )
4/28/2024
20
By: AM

21. Cont’d…
 None of them are best, the best depends
on:
Availability of resources
Size of the firm
The nature of the organization
4/28/2024
21
By: AM

22. 2.3.2. Risk
Measurement
22
 After the risk manager has
identified the various types of
potential losses faced by his or
her firm, these exposures
must be measured in order to
determine their relative
importance and to obtain
information that will help the
risk manager to decide upon
most desirable combination of
risk management tools.
By: AM 4/28/2024

23. Dimensions to be measured
 Information is needed concerning two dimensions
of each exposure/loss:
The loss frequency or the number of losses
that will occur and
The loss severity (amount of loss)
 Two commonly used measure of loss severity are:
the maximum possible loss (worst loss that could
possibly happen), and the maximum probable
loss (worst loss that is likely to happen)
4/28/2024
23
By: AM

24. Risk Management and Probability Distribution
 Using the probability distribution, it is
possible to measure the various aspects of a
risk; such as:
the total birr losses per year
the number of occurrences per year
the birr losses per occurrence
4/28/2024
24
By: AM

25. Example: A hypothetical probability distribution
Total birr Losses per Year (In Birr) Probability
0 0.606
500 0.273
1,000 0.100
2,000 0.015
5,000 0.003
10,000 0.002
20,000 0.001
1.000
4/28/2024
25
By: AM

26. Cont’d….
 If the risk manager can estimate accurately
the probability distribution of the total birr
losses per year, he or she can obtain useful
information concerning:
 the probability that the business will incur
some birr loss,
 the probability that "severe" losses will occur,
 the average loss per year, and
 The risk or variation in the possible results
4/28/2024
26
By: AM

27. Discussion questions based on the above example
1. What is the probability of suffering no
loss?
2. What is the probability of loss exceeding
Br. 5000?
3. How much is the expected loss?
4. How can you measure the risk of the
firm?
4/28/2024
27
By: AM

28. Computation of Standard deviation (STD)
(1)
Value (xi)
(2)
Value -average
(3)
(Value-average)2
(4)
Probability
3 x 4
$ 0
500
1000
2000
5000
10,000
20,000
0 – 321
500 – 321
1000 – 321
2000 – 321
5000 – 321
10,000 – 321
20,000 – 321
Br. (-321)2
(179) 2
(679) 2
(1679) 2
(4679) 2
(9679) 2
(19679) 2
0.606
0.273
0.100
0.015
0.003
0.002
0.001
62,443
8,747
46,104
42,286
65,679
187,366
387,263
799,888
4/28/2024
28
By: AM

29. Cont’d…
STD= √(x-x~)p
√799,888 = 894
 Note: When there is much doubt about what will
happen because there are many outcomes with
some reasonable chance of occurrence, the
standard deviation will be large and vice versa.
4/28/2024
29
By: AM

30. Probability distributions
 The three most commonly used theoretical
probability distributions are:
Poisson distribution method
Binomial distribution method, and
Normal distribution method
4/28/2024
30
By: AM

31. 1. Poisson Distribution
 The Poisson probability distribution can be used for the analysis of risk
measurement. The Poisson distribution works well when:
 there are at least 50 units exposed independently to loss, and
 The probability that any particular unit will suffer a loss is the same for all
units and is less than 0.1 (1/10).
 These conditions can be satisfied in two ways.
 First, the business can have at least 50 persons, properties, or activities each
of which can suffer at most one occurrence per year, and the probability being
less than 0.1 (1/10) that any particular unit will have an occurrence.
 Second, the number of persons, properties, or activities may be less than 50,
but each unit can have more than one occurrence during the exposure period.
 The only information that is crucial in constructing a Poisson probability
distribution is the expected number of accidents (the mean).
4/28/2024
31
By: AM

32. Cont’d….
 The probability of any number of accidents can
be easily calculated using the following formula:
𝑷 𝒓 =
𝑴𝒓𝒆−𝒎
𝒓!
Where: M = Expected number of accidents
r = number of occurrences (example: accidents)
r! = r(r -1) (r-2) (r -3)… (2) (1), with 0! =1
e = a constant, a base of natural logarithms (e= 2.71828)
4/28/2024
32
By: AM

33. Example 1.
 Assume that there are 5 cars and each has
experiencing about one collision every two years.
1. What is the probability of facing no risk?
2. What is the probability of 1, 2, 3… accidents?
3. What is the probability of facing more than 3
accidents ?
 Note: First construct the probability distribution of
possible outcomes.
 P=1/2 = 0.5
4/28/2024
33
By: AM

34. Cont’d…
Number of
collusions
Probabil
ity
Cumula
tive
0 0.6065 0.6065
1 0.3033 0.9098
2 0.0758 0.9856
3 0.0126 0.9982
4 0.0016 0.9998
5 0.0002 1
Sum
1
4/28/2024
34
By: AM
 Answer the Following:
 Probability of no
accident….
 Prob of 1
accident=______
 Prob of 2
accident=______
 Prob of 3
accident=______
 Prob of more than 3
accident=____

35. Example 2:
 Refer the handout distributed in advance
and answer the following questions:
4/28/2024
35
By: AM

36. A. Construct a probability distribution for the number of
accidents using a assuming a poison distribution.
B. What is the probability of facing three or more than three
accidents?
C. What is the probability of at least three accidents?
D. What is the probability of accidents exceeding 12?
E. What is the probability of accidents facing at least 3 and at
most 13?
F. How much is the expected number of accidents?
G. Calculate the expected amount of loss associated with the
accidents?
H. How much is the expected monetary loss per accident?
I. Calculate the standard deviation of number of accidents.
J. Calculate the standard deviation of the total monetary loss.
K. Calculate risk measures (Rm and Rn)
4/28/2024
36
By: AM

37. B) Using Binomial Distribution
Assumptions to use the distribution:
1. The objects are independently exposed to loss;
2. Each exposed unit suffered (experience) only one loss in a
year (or other budget period). Thus, the probability that the
firm will suffer r occurrences during the year is calculated
using the formula:
P(r) = n! pr(1 – p)n-r
n! (n-r)!
Where: n = number of exposures
r = number of accidents (occurrences)
p = probability of occurrence
4/28/2024
37
By: AM

38. Example:
 Refer the handout and answer the
following questions:
1. Construct a binomial probability
distribution
2. Calculate risk measures (STD, Rm and
Rn)
4/28/2024
38
By: AM

39. Risk Measures
 m = n*p
 STD = √npq or √np(1-p)
 Rm = STD/mean
 Rn = STD/n
4/28/2024
By: AM
39

40. C) Using Normal probability distributions
 Assumptions:
 68.27% of the observations fall within the
range of one standard deviation of the mean
(1).
 95.45% of the observations fall within the
range of two standard deviation of the mean
(2).
 99.73% of the observations fall within the
range of three standard deviations of the mean
(3). 4/28/2024
40
By: AM

41. Example:
 Assume that a mean monetary loss of an accident
due to fire is Br.100 and standard deviation of the
potential loss is Br.20.
Required:
1. What is the probability of facing monetary loss
between the men and Br. 120?
2. What is the probability of facing monetary loss
greater than Br. 160?
3. What is the probability of facing ML between Br.
80 and Br.140?
4/28/2024
41
By: AM

42. Risk and Law of Large Number
 Law of large number states that as the number
of exposure units increases, risk decreases. That
means risk and numbers of exposure units are
inversely related but not proportional.
 How can you prove this?
-----------------------------------------------------------------------
--------------------------------------------------------------------
------------
4/28/2024
42
By: AM

43. Law of large number …
n M STD Rm Rn
40 6 2.4495 0.408 0.06124
50 7.5 2.7386 0.365 0.05478
100 15 3.8730 0.258 0.03873
4/28/2024
By: AM
43

44. What can you learn from the above table?
------------------------------------------------------------------------
----------------------------------------------
4/28/2024
By: AM
44

45. Calculating number of exposure units
 Given Rm or Rn we can find out the number of
exposure units that enable the firm limit the
level of risk.
i. Poison
𝑹𝑴 = 𝒏𝒑/𝒏𝒑
ii. Binomial
RM= 𝒏𝒑𝒒/𝒏𝒑
iii. Normal
RM= z. 𝒏𝒑𝒒/𝒏𝒑
4/28/2024
45
By: AM

46. Example:
1. Suppose the risk manager wants to have Rm of 20
%, and to achieve the level of variation he wants to
know the number of exposure units. From the
historical data the manager has determined that the
probability of accident is equal to 0.4.
 Answer=37.5 (assuming binomial distribution)
2. Suppose that the risk manager wants to have Rn of
10% with a probability of 0.6827. what should be the
number of exposure units to satisfy the requirements
of the risk manager?
 Answer: n= 24 (assuming binomial distribution)
4/28/2024
By: AM
46

47. Note the following .…
1. Suppose p= 0, Rm and Rn =___________
2. Suppose p= 1, Rm and Rn = ___________
3. Suppose P= 0.5, Rm and Rn = __________
NB: Rn reaches its max when p = 0.5, where
as RM reaches its max when p
approaches 0.
4/28/2024
By: AM
47

48. 2.3.3. Selecting the appropriate Risk
Handling Tools
 After the risks facing the firm
are identified and measured,
the risk manager must decide
how to handle/manage them.
 Risk can be handled in
several ways. However, we
can classify them into two
broad measures/approaches.
 They are risk control tools
and risk financing tools
4/28/2024
48
By: AM

49. A. Risk Control Tools
 Risk control approaches are designed to reduce the firm’s
expected losses and to make the annual loss experience more
predictable.
 Helps to avoid a risk, prevent loss, lessen the amount of
damage if a loss occurs, or reduce undesirable effects of risk
on an organization.
 The application of risk control techniques to achieve these
ends may range from simple and low cost to complex and
costly approaches
 The activities that constitute one organization’s risk control
efforts may vary from organization to organization as a
consequence of creativity and innovation.
 Regardless of such difference, a typology of risk control tools
and methods still exist, which includes:
4/28/2024
49
By: AM

50. 1. Avoidance
 Avoidance of risk exists when the individual or the firm frees itself from the
exposure through (1) abandonment, or (2) refusal to accept the risk from the
very beginning (proactive avoidance). In a simple term, to avoid the risk the
individual or the firm need to avoid the property, person or activity with which
the exposure is associated.
 Avoidance is an effective approach to the handling of risk. By avoiding a risk,
the company can avoid the uncertainty that the company experiences.
However, the company losses the benefit that might have been derived from
that risk.
 In some cases it would be impossible to use avoidance:
1. The production of some products and the provision of some service may
provide rewards whose expected value far exceeds potential loss pr costs at
the margin.
2. It is impossible to avoid all the properties
3. The context of the decision also may make avoidance impossible. A decision
to avoid a risk might actually create a new risk else ware or enhance some
existing risk.
4. The risk may be so fundamental to the organization’s reason for being that
avoidance cannot be contemplated. Ex. mining firm may not avoid the risk of
4/28/2024
50
By: AM

51. 2. Loss Control Measures
 Loss control measures attack risk by lowering the chance a
loss that will occur (loss frequencies) or by reducing the
amount of damage when the loss does occur (loss severity).
Loss control tools can be classified as: loss prevention and
loss reduction measures.
a) Loss Prevention (LP)
 Loss prevention programs seek to reduce the number of
losses or to eliminate them entirely. Loss prevention
activities are focused on:
 Altering or modifying the hazard
 Altering or the modifying the environment in which the hazard
exists
 Intervening in the process whereby hazard and environment
interacts.
4/28/2024
51
By: AM

52. Cont’d…
b) Loss Reduction Measures
 Loss reduction activities on the other hand are
designed to reduce the potential severity of a loss once
the peril happened. Such a system does not reduce the
probability of loss, instead, they reduce the amount of
damage if a peril occurs.
 Loss reduction activities are post loss measures.
 Examples of LR measures are:
 employing fire extinguishers
 using active and trained guards
 installing automatic sprinkler
4/28/2024
52
By: AM

53. 3. Risk transfer
 Transfer as a risk control tool refers to transferring the
risk that causes a loss to some entity other than the one
experiencing it to bear the burden of the loss through
contractual agreement.
 Transfer may be accomplished in two ways:
1. The activity or property responsible for the risk can be
transferred to some other person or groups of persons.
“what makes transfer different from avoidance?”
__________
2. The risk, but not the property or activity, may be
transferred. For example, a manufacturer may be able
to force a retailer to assume responsibility for any
damage to products that occur after the products leave
4/28/2024
53
By: AM

54. 4. Separation
 This refers to scattering the firm’s property
exposed to risk to different places. The principle is
“do not put all your eggs in one basket.”
4/28/2024
54
By: AM

55. 5. Combination
 some how similar to separation as it involves
increasing the number of exposure units to make loss
exposures more predictable.
 combination (pooling) increases the number of
exposure units under the control of the firm.
Combination follows the law of large numbers
Examples:
 A taxi owner increasing the number of fleets
 Merger with other firms
 Use of spare parts and reserve machines
4/28/2024
55
By: AM

56. 6. Diversification
 Used to handle most speculative risks
 Businesses diversify their product line so
that a decline in profit of one product could
be compensated by profits form other
product lines
4/28/2024
56
By: AM

57. B. Risk Financing Tools
 Some losses occur in spite of the best risk control efforts. This
means some measures must be used to finance losses that do
occur. Risk control measures by altering the loss itself, either
reduce the potential losses or make those losses more predictable.
 The risk financing tools, on the other hand, are ways of financing
the losses that do occur. It includes:
1. Retention (Self-Insurance)
 The most common and easiest method of risk handling tools
 It is an arrangement under which the firm or an individual
experiencing the loss bears the direct financial consequences. The
person or the firm consciously or unconsciously, decides to assume
the risk
 Retention may be passive or active, unconscious or conscious,
unplanned or planned.
 The risk may be remote
4/28/2024
57
By: AM

58. Cont’d…
 Planned retention exist for a number of reasons.
Some of these are:
It is impossible to transfer the risk, ex.
speculative and dynamic risks
Attitudes of individuals or firms
towards risk
The value of the goods to be insured is
lower than the insurance costs
4/28/2024
58
By: AM

59. Cont’d…
 The choice is between retention and insurance. The major
factors to be considered in making the choice are:
1. The maximum probable cost relative to the firm’s
capacity for bearing the risk
2. Expected loss and risk
3. Restrictions or legal limitations applying to risk
transfers
4. Opportunity costs related to investment of funds
that is going to be paid as a premium if the risk is
transferred to the insurance companies
5. Quality of service provided by the insurance
companies. 4/28/2024
59
By: AM

60. Cont’d….
2. Transfer
 “Risk financing transfer” is an arrangement
under which some entity other than the one
experiencing the loss bears the direct
financial consequences.
 Example: Insurance
4/28/2024
60
By: AM

61. Selections of risk management tool
 a risk manager should be knowledgeable
enough to make analysis and select the
“best” risk handling tool(s).
 Cost-benefit analysis is important in
selecting an appropriate risk management
tool(s).
4/28/2024
61
By: AM

62. Step 4:Implement
and administer
Develop risk Management Policy
and Manual
Act according to the policy and
manual
62
eeeee
4/28/2024

63. END of chapter 2
…….. Next chapter 3:
Overview of Insurance
4/28/2024
By: AM
63

64. Chapter 3
Insurance: An overview

65. Chapter Objective
 To enable learners understand the basic concept
of insurance

66. Chapter Coverage
 Meaning of insurance
 Characteristics of insurable risks
 Social and economic value of insurance
 Cost of insurance
 Legal principles of insurance

67. What is insurance?
 Article 654(1) of the commercial code of Ethiopia states
insurance as follows:
 "A contract whereby a person called the insurer
undertakes against payment of one or more
premiums to pay a person, called the beneficiary,
sum of money where a specified risk materializes".
 Insurance is defined as "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."

68. Cont’d…
 From the definitions, it can be learned that:
1. Insurance is a system used to transfer risk of individuals or firms
for payment of premium.
2. The insured considers insurance as a transfer device whereas from
the point of view of the insurer, it is regarded as retention and
combination device.
3. It is a scheme that establishes a common fund out of which
financial compensation is made to those who faces accidental
losses.
4. It is a pooling of risks of many people who are exposed to the same
risk.
5. It is a device used to spread the loss suffered by an individual or
firm to the members in the group.
6. It is a method to provide security to the insured person against
the probable loss.

69. Your reflection
 Why insurance companies accept our risk?

70. Why insurance companies accept our risk?
 They have the knowledge and the skill to apply
various risk reduction and risk control measures;
 Combination or pooling of similar risks will enable
the insurer to predict the actual loss experience with
a reasonable accuracy.
 They have financial capacity to assume/ take risk
 They are in a position to enforce loss reduction and
prevention measures
 For losses that are beyond their capacity, insurers
arrange a reinsurance mechanism.

71. INSURANCE, GAMBLING, AND SPECULATION
Gambling Insurance
 Creates risk which did not exist
previously
 Protects the insured against the risk
 There is a possibility of gain  No gain for the insured
 The gambler accepts
deliberately the risk of loss
 The insured accepts deliberately
the certainty of a small loss in
exchange for freedom from risk
 Gambler bears the risk  Insured transfers risk
 Is socially unproductive (when
one gains the other losses)
 Socially productive

72. Speculation Vs Risk
Speculation Insurance
Is risk transfer method Is risk transfer method
individuals enter into a risk
deliberately in the anticipation
of profits
Insured transfers risk to
the insurer and no gain
at all
handling risks that are typically
uninsurable
Handles pure risks
Involves risk transfer Involves risk transfer and
reduction

73. CHARACTERISTICS OF INSURABLE RISK
The following are the characteristics of insurable
risks:
1. Large number of exposure units
2. Accidental and unintentional
Why should losses be accidental? -----------------------------
3. Determinable and measurable
4. Calculable chance of loss
5. Premiums should be economically feasible
6. The loss should not be catastrophic

74. SOCIAL AND ECONOMIC VALUES OF
INSURANCE
1. Indemnification
2. Reduction of uncertainty
3. Encourages savings
4. Help businesses continue without interruption of
operation
5. Provide funds for investment
6. Keeps families together
7. Provides a basis for credit
8. Promotes loss control systems
9. It provides financial stability to the community
10. Stimulates international trade and commerce

75. Discussion
 It is obvious that insurance has various
socio-economic benefits. Do you think that
insurance has a limitation? If yes identify
them?
---------------------------------------------------------------
-------------------------------------------------------------
-------------------------------------------------------------
-

76. COSTS OF INSURANCE
Disadvantages/ Costs of Insurance
1. It encourages fraud to collect dishonest claims
(moral hazard problems).
2. Increases carelessness in life (morale hazard
problem
3. Cost of Insurance: insurers incur operating
expenses such as loss control costs, loss adjustment
expenses, expense involved in acquiring insured,
(advertisement cost), state premium taxes, and
general administrative costs. In addition to these
expenses, the insured is expected to cover a
reasonable amount for profit and contingencies.
4. Adverse selection

77. LEGAL PRINCIPLES OF INSURANCE CONTRACT
1. Insurable Interest
 refers to the existence of financial relationship to the subject
matter insured.
 Conditions to be fulfilled:
 There must be some subject matter of insurance such as
physical object or potential liability;
 There must be risk to which the subject matter is exposed
 The insured must have some legally recognized relationship
with the subject matter insured.
 The insured should stand to benefit by the safety of the subject
matter and should incur loss by its destruction or damage; and
 The subject matter should be measurable in terms of money.
 When should is exist? ---------------------------------------
 Why insurable interest? ------------------------------------

78. 2. Utmost good-faith
 Insurance contracts are based upon mutual trust and
confidence between the insurer and the insured.
 This principle requires each party to tell the other
"the truth, the whole truth and nothing but the
truth".
 Material facts are of the following types:
 those which affect the nature or incidence of risk; &
 those which affect the character of insured.
 Non-disclosure, concealment, innocent
misrepresentation, and fraud may lead to avoidance
or cancellation of the insurance contract by one of the
parties to the contract.

79. 3. Indemnity
 states that the insured, in the event or loss, receives financial
compensation equal to the amount of the loss or the face value of the
policy, which ever is lower.
 It is the controlling principle in insurance contract that limits
compensation.
 Indemnity implies that:
 There must be an actual loss
 The loss should have occurred through the risk insured
 The loss must be capable of calculation in terms of money
 The payment made by another person (third party) should not exceed
the actual loss suffered.
 Indemnity can take different forms: cash payment, replacement of
property or reinstatement of the property or repair.

80. 4. Subrogation
 Subrogation is the right to an insurer who has paid a
claim under a policy issued by him to receive the
benefit of all rights and remedies of the insured.
 Principle of subrogation is a supplement to the
principle of indemnity.
 The reason behind this principle is to eliminate the
profit motive of the insured.
 Subrogation implies that:
 The insurer makes payment to the insured for his actual loss
 The insurer after making good the loss, places himself in the
position of the insured and has all the rights and remedies of
the insured
 The insurer cannot recover anything more than he has paid to
the insured

81. 5. Contribution
 Contribution is also corollary of /or supplement of the principle of
indemnity.
 The doctrine of this principle preaches for an "equitable
distribution" of any loss among insurers.
 Contribution is the right of an insurer who has paid a loss under a
policy to recover a proportionate amount from other insurers who
are liable for the same loss.
It is enforceable only under the following conditions:
 The policies must cover the same period
 The policies must have been in force at the time of loss
 They must protect the same peril
 The subject matter of insurance must be the same, and
 The insured must be the same person.

82. example
Contribution= sum insured with particular insurer
Total sum insured will all insurers

83. Cont’d….
 Note that:
Principle of indemnity, subrogation and
contribution are not applicable to life
insurance policies.

84. Insurance contracts
 Insurance contracts are agreements between the
insurance companies and the insured for the
purpose of transferring from the insured to the
insurer part of the risk or loss arising out of
contingent events.
 The contract serves the following functions:
 Define the risk to be transferred
 Explain the procedures for selling loss claims.
 State the conditions under which the contract parties
should know such as premium and performance of
certain acts.

85. REQUIREMENTS OF AN INSURANCE CONTRACT
 An insurance policy is based on the law of contracts. To be
legally enforceable, an insurance contract must meet four
basic requirements:
Offer and Acceptance
Consideration.
Competent Parties.
Legal Purpose.

86. DISTINCT LEGAL CHARACTERISTICS OF INSURANCE
CONTRACTS
 Insurance contracts have distinct legal
characteristics that make them different from
other legal contracts.
 Probe:
What do you think are these characteristics?
-----------------------------------------------------------------
---------------------------------------------------------------
-------------------------------------

87. 1. Aleatory Contract
 An aleatory contract is one in which the values
exchanged are not equal. Depending on chance,
one party may receive a value out of proportion to
the value that is given.
 So an insurance contract is aleatory rather than
commutative.
 In contrast, other commercial contracts are
commutative. A commutative contract is one in
which the values exchanged by both parties are
theoretically even.

88. 2. Unilateral Contract
 An insurance contract is a unilateral contract. A
unilateral contract means that only one party
makes a legally enforceable promise. In this case,
only the insurer makes a legally enforceable
promise to pay a claim or provide other services to
the insured.
 In contrast, most commercial contracts are bilat-
eral in nature. Each party makes a legally
enforceable promise to the other party

89. 3. Conditional Contract
 An insurance contract is a conditional contract.
This means the insurer's obligation to pay a claim
depends on whether or not the insured or the
beneficiary has complied with all policy conditions.
 The insurer is not obligated to pay a claim if the
policy conditions are not met.

90. 4. Personal Contract
 In property insurance, insurance is a personal contract. This
means the contract is between the insured and the insurer. Strictly
speaking, a property insurance contract does not insure property,
but insures the owner of property against loss.
 Because of this, property insurance policy cannot be assigned to
another party without the insurer's consent. If property is sold to
another person, the new owner may not be acceptable to the
insurer. Thus, the insurer's consent is normally required before the
policy can be validly assigned to another party.
 In contrast, a life insurance policy is not a personal contract.
Therefore, it can be freely assigned to anyone without the insurer's
consent.
 The loss payment can, however, be freely assigned to another party
without the property insurer's consent. Although the insurer's
consent is not required, the contract may require that the insurer
be notified of the assignment of the proceeds to another party.

91. 5. Contract of Adhesion
 A contract of adhesion means the insured must
accept the entire contract, with all of its terms and
conditions. The insurer drafts and prints the policy,
and the insured generally must accept the entire
document and cannot insist that certain provisions
be added or deleted or the contract rewritten to suit
the insured.
 However, to redress the imbalance that exists in such
a situation, the courts have ruled that any
ambiguities or uncertainties in the contract are
construed against the insurer. If the policy is
ambiguous, the insured gets the benefit of the doubt.

92. 6. Contracts of Uberrimae Fidei
 The literal meaning of "Uberrimae Fidei" is utmost
good faith that can be restated as the highest
standard honesty.
 Insurance contracts are contracts of the utmost
good faith. Both parties to the contract are bound to
disclose all the facts relevant to the transaction.
Neither party is to take advantage of the other's
lack of information.

93. End of Chapter 3
4/28/2024
93