Insurance -Concept of Insurance -Purpose and need of Insurance -Concepts of Risk, Peril and Hazard

 

TOPICS COVERED

• Concept of Insurance
• Purpose and need of Insurance
• Concepts of Risk, Peril and Hazard

1. CONCEPT OF INSURANCE

The business of insurance aims to protect the economic value of assets or life of a person. Through a contract of insurance the insurer agrees to make good any loss on the insured property or loss of life (as the case may be) that may occur in course of time in consideration for a small premium to be paid by the insured.

DIFFERENTIATION INSURANCE AND GUARANTEE

Insurance is a contract of indemnity whereby Insurer agrees to indemnify, or pay, the insured for certain types of loss while in a contract of guarantee, one party agrees to act on behalf of another should that second party default. In plain terms, this means that if an individual fails to pay her guaranteed debt or to perform some other duty or obligation, the guarantor -- the party who has agreed to act on behalf of another -

- will step in to pay or perform the obligation.

There are two major differences between insurance and guarantees. One difference is that insurance is a direct agreement between the insurance provider and the policyholder, while a guarantee involves an indirect agreement between a beneficiary and a third party, along with the primary agreement between the principal and beneficiary. A second difference is that insurance policy calculations are based on underwriting and possible loss, while a guarantee is focused strictly on performance or nonperformance. In addition, insurance providers or policyholders can cancel policies with notice, while guarantees often cannot be canceled. The difference between a contract of Insurance and a contract of guarantee are as given below:

INSURANCE GUARANTEE

• In a contract of insurance, there are two parties i.e. insurer and insured
• In a contract of Guarantee there are three parties i.e. Main Debtor, Creditor & Surety.
• Insurance contract is generally Cancellable. Contract of Guarantee is Non-Cancellable
• Insurance premium is based on the probability and quantum of losses
• In contract of business, loss cannot be estimated generally so fee is charged for the guarantee service rendered An insurance contract transfers the Risk There is No Transfer of Risk in a contract of guarantee

INSURANCE AND WAGER

A contract of Insurance, i.e. life, accident, fire, marine, etc. is not a wager though it is performable upon an uncertain event. It is so because; the principle of insurable interest distinguishes insurance from a wagering contract. Insurable interest is the interest which one has in the safety or preservation of the subject matter of insurance. Where insurable interest is not present in insurance contracts, it becomes a wagering contract and is therefore void.

The following are the points of distinction between wagering agreements and insurance contracts.

• The parties have no insurable interest iii a wagering agreement. But the holder of an insurance policy must have an insurable interest.
• In wagering agreement, neither party has any interest in happening or non-happening of an event. But in a contract of insurance, both parties are interested in the subject-matter.
• Contracts of insurance are contracts of indemnity except life insurance contract, which is a contingent contract. But a wagering agreement is a conditional contract.
• Contract of insurance are based on scientific and actuarial calculation of risks, where as wagering agreements are a gamble without any scientific calculation of risk.
• Contracts of insurance are regarded as beneficial to the public and hence encouraged by the State but wagering agreements serve no useful purpose.
• A contract of insurance is a valid contract where as a wagering agreement is void being expressly declared by law.

DISCLOSURES

The principle of Uberrimae fidei applies to all types of insurance contracts and is a very basic and primary principle of insurance. According to this principle, the insurance contract must be signed by both parties (i.e insurer and insured) in absolute good faith or belief or trust.

The person getting insured must willingly disclose and surrender to the insurer all relevant complete true information regarding the subject matter of insurance. The insurer's liability is voidable (i.e legally revoked or cancelled) if any facts, about the subject matter of insurance are either omitted, hidden, falsified or presented in a wrong manner by the insured.

The principle forbids either party to an insurance contract, by non-disclosure or mis-representation of a material fact, which he knows or ought to know, to draw the other into the bargain, from his ignorance of that fact and his believing the contrary. The duty of the utmost good faith is implied in insurance contracts because they are entered into by parties who have not the same access to relevant information. In this, they differ from contracts of sale to which the maxim caveat emptor (let the buyer beware) applies.

Although the duty rests upon both parties, it is the duty of the proposer which needs to be discussed in some detail for he usually has the advantage of knowing most of the particulars relating to the subject-matter. Until a definite offer to enter into an insurance contract has been unconditionally accepted the duty of the utmost good faith must be strictly observed. The obligation arises again prior to each renewal and, to a limited extent, when the insured desires an alteration in the policy. In the latter case, he must inform the insurer of any facts material to the alteration.

MATERIAL FACTS

Material fact is every circumstance or information, which would influence the judgment of a prudent insurer in assessing the risk.

Or

Those circumstances which influence the insurer’s decision to accept or refuse the risk or which affect the fixing of the premium or the terms and conditions of the contract, must be disclosed.

A material fact is one which would have influenced the judgment of a prudent insurer in deciding whether he would accept the risk in whole or in part and, if so, at what amount of premium. The materiality of a fact depends upon the application of this test to the particular circumstances of the case as at the date that the fact should have been communicated.

Material facts may have a bearing on the physical hazard or on the moral hazard, or they may show that if a loss occurs the insurer's liability is likely to be greater than would normally be expected.

FACTS, WHICH MUST BE DISCLOSED

• Facts, which show that a risk represents a greater exposure than would be expected from its nature e.g., the fact that a part of the building is being used for storage of inflammable materials.
• External factors that make the risk greater than normal e.g. the building is located next to a warehouse storing explosive material.
• Facts, which would make the amount of loss greater than that normally expected e.g. there is no segregation of hazardous goods from non-hazardous goods in the storage facility.
• History of Insurance (a) Details of previous losses and claims (b) if any other Insurance Company has earlier declined to insure the property and the special condition imposed by the other insurers; if any.
• The existence of other insurances.
• Full facts relating to the description of the subject matter of Insurance

EXAMPLES OF MATERIAL FACTS

• In Fire Insurance: The construction of the building, the nature of its use i.e. whether it is of concrete or Kucha - having thatched roofing and whether it is being used for residential purposes or as a godown, whether firefighting equipment is available or not.
• In Motor Insurance: The type of vehicle, the purpose of its use, its age (Model), Cubic capacity and the fact that the driver has a consistently bad driving record.
• In Marine Insurance: Type of packing, mode of carriage, name of carrier, nature of goods, the route.
• In Personal Accident Insurance: Age, height, weight, occupation, previous medical history and occupation especially if it is likely to increase the chance of an accident. Proclivity of substance abuse has to be disclosed as well- eg. alcohol or drug addiction.
• Burglary Insurance: Nature of stock, value of stock, type of security precautions taken.

The above are just indicatory of the type of material facts that must be disclosed. Details of previous losses are a material fact that has to be disclosed in all cases.

FACTS, WHICH NEED NOT BE DISCLOSED

• Facts of Law: Ignorance of law is not excusable - everyone is deemed to know the law. Overloading of goods carrying vehicles is legally banned. The transporter cannot take shelter behind the excuse that he was not aware of this provision; in the event of an accident.
• Facts which lessen or diminishes the Risk: The existence of a good fire fighting system in the building.
• Facts of Common Knowledge: The insurer is expected to know the areas of strife and areas susceptible to riots and of the process followed in a particular trade or Industry. Any fact which is known or which, by law, may be presumed to be known to the insurer the insurer is presumed to know matters of common notoriety or knowledge, and matters which an insurer, in the ordinary course of his business, ought to know.
• Facts which could be reasonably discovered: For e.g.the previous history of claims which the Insurer is supposed to have in his record.
• Facts which the insurer’s representative fails to notice: In burglary and fire Insurance it is often the practice of Insurance companies to depute surveyors to inspect the premises and in case the surveyor fails to notice hazardous features and provided the details are not withheld by the Insured or concealed by him them the Insured cannot be Unless inquiry is made, it is not necessary to disclose the following facts. Any fact which it is superfluous to disclose by reason of an express or implied condition.
• Any fact as to which information is waived by the insurer.
• Any fact as to which insurer is given sufficient information to put him on inquiry.

EFFECT OF NON-DISCLOSURE

Where there has been non-disclosure, whether innocent or fraudulent, sometimes called concealment the contract is voidable at the option of the insurer. This is the position where the matter is not dealt with by a policy condition. The ground is usually covered by a policy condition which may do no more than state the common law rule.

REPRESENTATIONS

Representations are statements made during the negotiations with the object of inducing the other party to enter into the contract: they must be distinguished from statements which are introduced into the contract, and upon the truth of which the validity of the contract is made to depend. Representations may be as to a matter of fact, and, if material must be substantially correct. Where there has been misrepresentation it is necessary to decide whether it was fraudulent or innocent. A fraudulent misrepresentation is one which was known to be false ; or which was made without belief in its truth, or recklessly, careless whether it was true or false. Fraudulent misrepresentation of a material fact entitles the insurer to avoid the policy.

Every material fact which the insured ought to know in the ordinary course of business must be stated; an innocent misrepresentation of such a fact would entitle the insurer to avoid the policy. This must be so, otherwise the duty to disclose material facts and to state them accurately would not be correlative.

ACTIVE AND PASSIVE DUTY OF DISCLOSURE

The question here is what method is used to acquire the material information.

Two different approaches are used in this respect. The first - an “active” duty of disclosure, and the second approach is characterized as a “passive” duty of disclosure. The former argues that the duty to assess what information is material for the insurer rests with the person effecting the insurance. On the other hand, a passive duty of disclosure implies that the insurer will have to define what information is material through a questionnaire. A passive duty of disclosure implies that information not asked for is not material.

The common law systems seem mainly to apply an active duty of disclosure, but elements of a passive duty of disclosure is found in some countries in the form of proposals.

MORAL HAZARDS

Moral hazard is a situation in which one agent decides on how much risk to take, while another agent bears (parts of) the negative consequences of risky choices.

The person who buys insurance is protected against monetary damages. Therefore, he may engage in more risky behavior than if he has to bear the risk himself.

Moral hazard can arise in the insurance industry when insured parties behave differently as a result of having insurance. There are two types of moral hazard in insurance: ex ante and ex post. Ex-Ante Moral Hazard - Ed the Aggressive Driver: Ed, a driver with no auto insurance, drives very cautiously because he would be fully responsible for any damages to his vehicle. Ed decides to get auto insurance and, once his policy goes into effect, he begins speeding and making unsafe lane changes. Ed's case is an example of ex-ante moral hazard. As an insured motorist, Ed has taken on more risk than he did without insurance. Ed's choice reflects his new, reduced liability.

Ex-Post Moral Hazard - Marie and Her Allergies: Marie has had no health insurance for a few years and develops allergy symptoms each spring. This winter she starts a new job that offers insurance and decides to consult a physician for her problems. Had Marie continued without insurance, she may never have gone to a doctor. But, with insurance, she makes an appointment and is given a prescription for her allergies. This is an example of ex-post moral hazard, because Marie is now using insurance to cover costs she would not have incurred prior to getting insurance.

Insurers try to decrease their exposure by shifting a portion of liability to policyholders in the form of deductibles and co-payments. Both represent the amount of money a policyholder must pay before the insurance company's coverage begins. Policyholders can often opt for lower deductibles and co-payments, but this will raise their insurance premiums.

2. PURPOSE AND NEED OF INSURANCE

The process of insurance has been evolved to safeguard the interests of people from uncertainty by providing certainty of payment at a given contingency. The insurance principle comes to be more and more used and useful in modern affairs.

Not only does it serve the ends of individuals, or of special groups of individuals, it tends to pervade and to transform our modern social order, too. The role and importance of insurance, here, has been discussed in three phases: (i) uses to individual, (ii) uses to a special group of individuals, viz., to business or industry, and (iii) uses to the society.

USES TO AN INDIVIDUAL :

• 1. Insurance provides Security and Safety:

The insurance provides safety and security against the loss on a particular event. In case of life insurance payment is made when death occurs or the term of insurance is expired. The loss to the family at a premature death and payment in old age are adequately provided by insurance. In other words, security against premature death and old age sufferings are provided by life insurance.

Similarly, the property of insured is secured against loss on a fire in fire insurance. In other insurance, too, this security is provided against the loss at a given contingency.

The insurance provides safety and security against the loss of earning at death or in golden age, against the loss at fire, against the loss at damage, destruction or disappearance of property, goods, furniture and machines, etc.

• 2. Insurance affords Peace of Mind:

The security wish is the prime motivating factor. This is the wish which tends to stimulate to more work, if this wish is unsatisfied, it will create a tension which manifests itself to the individual in the form of an unpleasant reaction causing reduction in work.

The security banishes fear and uncertainty, fire, windstorm, auto-mobile accident, damage and death are almost beyond the control human agency and in occurrence of any of these events may frustrate or weaken the human mind. By means of insurance, however, much of the uncertainty that centers about the wish for security and its attainment may be eliminated.

• 3. Insurance protects Mortgaged Property:

At the death of the owner of the mortgaged property, the property is taken over by the lender of money and the family will be deprived of the uses of the property. On the other hand, the mortgagee wishes to get the property insured because at the damage or destruction of the property he will lose his right to get the loan replayed.

The insurance will provide adequate amount to the dependents at the early death of the property-owner to pay off the unpaid loans. Similarly, the mortgagee gets adequate amount at the destruction of the property.

• 4. Insurance eliminates dependency:

At the death of the husband or father, the destruction of family needs no elaboration. Similarly, at destruction of, property and goods, the family would suffer a lot. It brings reduced standards of living and the suffering may go to any extent of begging from the relatives, neighbors or friends.

The economic independence of the family is reduced or, sometimes, lost totally. What can be more pitiable condition than this that the wife and children are looking others more benevolent than the husband and father, in absence of protection against such dependency? The insurance is here to assist them and provides adequate amount at the time of sufferings.

• 5. Life Insurance encourages saving:

The elements of protection and investment are present only in case of life insurance. In property insurance, only protection element exists. In most of the life policies elements of saving predominates. These policies combine the programs of insurance and savings.

The saving with insurance has certain extra advantages

• Systematic saving am possible because regular premiums are required to be compulsorily paid. The saving with a bank is voluntary and one can easily omit a month or two and then abandon the program entirely.
• In insurance the deposited premium cannot be withdrawn easily before the expiry of the term of the policy. As contrast to this, the saving which can be withdrawn at any moment will finish within no time.
• The insurance will pay the policy money irrespective of the premium deposited while in case of bank-deposit; only the deposited amount along with the interest is paid. The insurance, thus, provides the wished amount of insurance and the bank provides only the deposited amount,
• The compulsion or force to premium in insurance is so high that if the policy-holder fails to pay premiums within the days of grace, he subjects his policy to causation and may get back only a very nominal portion of the total premiums paid on the policy.

For the preservation of the policy, he has to try his level best to pay the premium. After a certain period, it would be a part of necessary expenditure of the insured. In absence of such forceful compulsion elsewhere life insurance is the best media of saving.

• 6. Life Insurance provides profitable Investment:

Individuals unwilling or unable to handle their own funds have been pleased to find an outlet for their investment in life insurance policies. Endowment policies, multipurpose policies, deferred annuities are certain better form of investment.

The elements of investment i.e., regular saving, capital formation, and return of the capital along with certain additional return are perfectly observed, in life insurance.

In India the insurance policies carry a special exemption from income-tax, wealth tax, and gift tax and estate duty. An individual from his own capacity cannot invest regularly with enough of security and profitability. The life insurance fulfils all these requirements with a lower cost. The beneficiary of the policy-holder can get a regular income from the life-insurer; if the insured amount is left with him.

• 7. Life Insurance fulfils the needs of a person:

The needs of a person are divided into (A) Family needs, (B) Old-age needs, (C) Re-adjustment needs, (D) Special needs, (E) The clean-up needs.

(A) Family Needs:

Death is certain, but the time is uncertain. So, there is uncertainty of the time when the sufferings and financial stringencies may be fall on the family. Moreover, every person is responsible to provide for the family.

It would be a more pathetic sight in the world to see the wife and children of a man looking for someone more considerate arid benevolent than the husband or the father, who left them unprovoked.

Therefore, the provision for children up to their reaching earning period and for widow up to long life should he made. Any other provision except life insurance will not adequately meet this financial requirement of the family. Whole life policies are the better means of meeting such requirements.

(B) Old-age heeds:

The provision for old-age is required where the person is surviving more than his earning period. The reduction of income in old-age is serious to the person and his family.

If no other family member starts earning, they will be left with nothing and if there is no property, it would be more piteous state. The life insurance provides old age funds along with the protection of the family by issuing various policies.

(C) Re-adjustment Needs:

At the time of reduction in income whether by loss of unemployment, disability, or death, adjustment in the standard of living of family is required. The family members will have to be satisfied with meager income and they have to settle down to lower income and social obligations.

Before coming down to the lower standard and to be satisfied with that, they require certain adjustment income so that the primary obstacles may be reduced to minimum. The life insurance helps to accumulate adequate funds. Endowment policy anticipated endowment policy and guaranteed triple benefit policies are seemed to be a good substitute for old age needs.

(D) Special Needs:

There is certain special requirement of the family which is fulfilled by the earning member of the family. If the member becomes disable to earn the income due to old age or death, those needs may remain unfulfilled and the family will suffer.

• Need for Education. There are certain insurance policies, and annuities which are useful for education of the children irrespective of the death or survival of the father or guardian.
• Marriage. The daughter may remain unmarried in case of father's death or in case of inadequate provision for meeting the expenses of marriage. The insurance can provide funds for the marriage if policy is taken for the purpose.
• Insurance needs for settlement of children. After education, settlement of children takes time and in absence of adequate funds, the children cannot be well placed and all the education go to waste.

(E) Clean-up funds:

After death, ritual ceremonies, payment of wealth taxes and income taxes are certain requirements which decrease the amount of funds of the family member. Insurance comes to help for meeting these requirements. Multipurpose policy, education and marriage policies, capital redemption policies are the better policies for the special needs.

USES TO BUSINESS :

The insurance has been useful to the business society also. Some of the uses are discussed below:

1. Uncertainty of business losses is reduced:

In world of business, commerce and industry a huge number of properties are employed. With a slight slackness or negligence, the property may be turned into ashes. The accident may be fatal not only to the individual or property but to the third party also. New construction and new establishment are possible only with the help of insurance.

In absence of it, uncertainty will be to the maximum level and nobody would like to invest a huge amount in the business or industry. A person may not be sure of his life and health and cannot continue the business up to longer period to support his dependents. By purchasing policy, he can be sure of his earning because the insurer will pay a fed amount at the time of death.

Again, the owner of a business might foresee contingencies that would bring great loss. To meet such situations they might decide to set aside annually a reserve, but it could not be accumulated due to death. However, by making an annual payment, to secure immediately, insure policy can be taken.

2. Business-efficiency is increased with insurance:

When the owner of a business is free from the botheration of losses, he will certainly devote much time to the business. The care free owner can work better for the maximisation of the profit. The new as well as old businessmen are guaranteed payment of certain amount with the insurance policies at the death of the person; at the damage, destruction or disappearance of the property or goods.

The uncertainty of loss may affect the mind of the businessmen adversely. The insurance, removing the uncertainty, stimulates the businessmen to work hard.

3. Key Man Indemnification:

Key man is that particular man whose capital, expertise, experience, energy, ability to control, goodwill and dutifulness make him the most valuable asset in the business and whose absence will reduce the income of the employer tremendously and up to that time when such employee is not substituted.

The death or disability of such valuable lives will, in many instances, prove a more serious loss than that by fire or any hazard. The potential loss to be suffered and the compensation to the dependents of such employee require an adequate provision which is met by purchasing adequate life-policies.

The amount of loss may be up to the amount of reduced profit, expenses involved in appointing and training, of such persons and payment to the dependents of the key man. The Term Insurance Policy or Convertible Term Insurance Policy is more suitable in this case.

4. Enhancement of Credit:

The business can obtain loan by pledging the policy as collateral for the loan. The insured persons are getting more loans due to certainty of payment at their deaths. The amount of loan that can be obtained with such pledging of policy, with interest thereon will not exceed the cash value of the policy. In case of death, this value can be utilised for setting of the loan along with the interest.

If the borrower is unwilling to repay the loan and interest, the lender can surrender the policy and get the amount of loan and interest thereon repaid. The redeemable debentures can be issued on the collateral of capital redemption policies. The' insurance properties are the best collateral and adequate loans are granted by the lenders.

5. Business Continuation

In any business particularly partnership business may discontinue at the death of any partner although the surviving partners can restart the business, but in both the cases the business and the partners will suffer economically.

The insurance policies provide adequate funds at the time of death. Each partner may be insured for the amount of his interest in the partnership and his dependents may get that amount at the death of the partner.

With the help of property insurance, the property of the business is protected against disasters and the chance of disclosure of the business due to the tremendous waste or loss.

6. Welfare of Employees:

The welfare of employees is the responsibility of the employer. The former are working for the latter. Therefore, the latter has to look after the welfare of the former which can be provision for early death, provision for disability and provision for old age.

These requirements are easily met by the life insurance, accident and sickness benefit, and pensions which are generally provided by group insurance. The premium for group insurance is generally paid by the employer. This plan is the cheapest form of insurance for employers to fulfill their responsibilities.

The employees will devote their maximum capacities to complete their jobs when they are assured of the above benefits. The struggle and strife between employees and employer can be minimised easily with the help of such schemes.

USES OF SOCIETY :

Some of the uses of insurance to society are discussed in the following sections.

1. Wealth of the society is protected :

The loss of a particular wealth can be protected with the insurance. Life insurance provides loss of human wealth. The human material, if it is strong, educated and care-free, will generate more income.

Similarly, the loss of damage of property at fire, accident, etc., can be well indemnified by the property insurance; cattle, crop, profit and machines are also protected against their accidental and economic losses.

With the advancement of the society, the wealth or the property of the society attracts more hazardous and, so new types of insurance are also invented to protect them against the possible losses.

Each and every member will have financial security against old age, death, damage, destruction and disappearance of his wealth including the life wealth. Through prevention of economic losses, instance protects the society against degradation.

Through stabilization and expansion of business and industry, the economic security is maximised. The present, future and potential human and property resources are well-protected. The children are getting expertise education, working classes are free from botherations and older people are guiding at ease. The happiness and prosperity are observed everywhere with the help of insurance.

2. Economic Growth of the Country:

For the economic growth of the country, insurance provides strong hand and mind, protection against loss of property and adequate capital to produce more wealth. The agriculture will experience protection against losses of cattle, machines, tools and crop.

This sort of protection stimulates more production hi agriculture, in industry, the factory premises, machines, boilers and profit insurances provide more confidence to start and operate the industry welfare of employees create a conducive atmosphere to work: Adequate capital from insurers accelerate the production cycle.

Similarly in business, too, the property and human material are protected against certain losses; capital and credit are expanded with the help of insurance. Thus, the insurance meets all the requirements of the economic growth of a country.

3. Reduction in Inflation:

The insurance reduces the inflationary resource in two ways. First, by extracting money in supply to the amount of premium collected and secondly, by providing sufficient funds for production narrow down the inflationary gap.

With reference to Indian context it has been observed that about 5.0 per cent of the money in supply was collected in form of premium.

The share of premium contributed to the total investment of the country was about 10.0 per cent. The two main causes of inflation, namely, increased money in supply and decreased production are properly controlled by insurance business, Insurance Need and Selling.

3. CONCEPT OF RISK, PERIL AND HAZARD

WHAT IS RISK?

Risk is part of every human endeavor. From the moment we get up in the morning, drive or take public transportation to get to school or to work until we get back into our beds (and perhaps even afterwards), we are exposed to risks of different degrees. What makes the study of risk fascinating is that while some of this risk bearing may not be completely voluntary, we seek out some risks on our own (speeding on the highways or gambling, for instance) and enjoy them. While some of these risks may seem trivial, others make a significant difference in the way we live our lives. On a loftier note, it can be argued that every major advance in human civilization, from the caveman’s invention of tools to gene therapy, has been made possible because someone was willing to take a risk and challenge the status quo.

Risk is the potential of loss (an undesirable outcome, however not necessarily so) resulting from a given action, activity and/or inaction. The notion implies that a choice having an influence on the outcome sometimes exists (or existed). Potential losses themselves may also be called "risks". Any human endeavor carries some risk, but some are much riskier than others.

Risk can be defined in seven different ways

1. The probability of something happening multiplied by the resulting cost or benefit if it does.

2. The probability or threat of quantifiable damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.

UNCERTAINTY

Uncertainty is at the very core of the concept of risk itself. It is uncertainty about the outcome in a given situation. Uncertainty does not exist in the natural order of things though there are a number of outcomes, which are uncertain. For example: the weather for the test match; the possibility of being made redundant; the risk of having an accident. There is surely uncertainty surrounding all of these events.

In 1921, Frank Knight summarized the difference between risk and uncertainty thus: "… Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. … The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating.

It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an un-measurable one that it is not in effect an uncertainty at all."

Risk is incorporated into so many different disciplines from insurance to engineering to portfolio theory that it should come as no surprise that it is defined in different ways by each one. It is worth looking at some of the distinctions:

(a) Risk versus Probability: While some definitions of risk focus only on the probability of an event occurring, more comprehensive definitions incorporate both the probability of the event occurring and the consequences of the event. Thus, the probability of a severe earthquake may be very small but the consequences are so catastrophic that it would be categorized as a high-risk event.

(b) Risk versus Threat: In some disciplines, a contrast is drawn between risk and a threat. A threat is a low probability event with very large negative consequences, where analysts may be unable to assess the probability. A risk, on the other hand, is defined to be a higher probability event, where there is enough information to make assessments of both the probability and the consequences.

(c) All outcomes versus Negative outcomes: Some definitions of risk tend to focus only on the downside scenarios, whereas others are more expansive and consider all variability as risk. The engineering definition of risk is defined as the product of the probability of an event occurring, that is viewed as undesirable, and an assessment of the expected harm from the event occurring.

Risk = Probability of an accident * Consequence in lost money/deaths

In contrast, risk in finance is defined in terms of variability of actual returns on an investment around an expected return, even when those returns represent positive outcomes. Building on the last distinction, we should consider broader definitions of risk that capture both the positive and negative outcomes

PERIL AND HAZARD

The terms "peril" and "hazard" should not be confused with the concept of risk discussed earlier. Let us first consider the meaning of peril.

Peril

We often use the word risk to mean both the event which will give rise to some loss, and the factors which may influence the outcome of a loss. When we think about cause, we must be clear that there are at least these two aspects to it. We can see this if we think back to the two houses on the river bank and the risk of flood. The risk of flood does not really make sense, what we mean is the risk of flood damage. Flood is the cause of the loss and the fact that one of the houses was right on the bank of the river influences the outcome.

Flood is the peril and the proximity of the house to the river is the hazard. The peril is the prime cause; it is what will give rise to the loss. Often it is beyond the control of anyone who may be involved. In this way we can say that storm, fire, theft, motor accident and explosion are all perils.

Peril is defined as the cause of loss. Thus, if a house burns because of a fire, the peril, or cause of, loss, is the fire. If a car is totally destroyed in an accident with another motorist, accident (collision) is the peril, or cause of loss. Some common perils that result in the loss or destruction of property include fire, cyclone, storm, landslide, lightning, earthquakes, theft, and burglary.

Hazard

Factors, which may influence the outcome, are referred to as hazards. These hazards are not themselves the cause of the loss, but they can increase or decrease the effect should a peril operate. The consideration of hazard is important when an insurance company is deciding whether or not it should insure some risk and what premium to charge. So a hazard is a condition that creates or increases the chance of loss. There are three major types of hazards: Hazard can be physical or moral or Morale.

Physical hazard

Physical hazard relates to the physical characteristics of the risk, such as the nature of construction of a building, security protection at a shop or factory, or the proximity of houses to a riverbank. Therefore a physical hazard is a physical condition that increases the chances of loss. Thus, if a person owns an older building with defective wiring, the defective wiring is a physical hazard that increases the chance of a fire.

Another example of physical hazard is a slippery road after the rains. If a motorist loses control of his car on a slippery road and collides with another motorist, the slippery road is a physical hazard while collision is the peril, or cause of loss.

Moral hazard

Moral hazard concerns the human aspects which may influence the outcome. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. For example, a business firm may be overstocked with inventories because of a severe business recession. If the inventory is insured, the owner of the firm may deliberately burn the warehouse to collect money from the insurer. In effect, the unsold inventory has been sold to the insurer by the deliberate loss. A large number of fires are due to arson, which is a clear example of moral hazard.

Moral hazard is present in all forms of insurance, and it is difficult to control. Dishonest insured persons often rationalise their actions on the grounds that "the insurer has plenty of money". This is incorrect since the company can pay claims only by collecting premiums from other policy owners.

Because of moral hazard, premiums are higher for all insured, including the honest. Although an individual may believe that it is morally wrong to steal from a neighbour, he or she often has little hesitation about stealing from an insurer and other policy owners by either causing a loss or by inflating the size of a claim after a loss occurs.

Morale hazard

This usually refers to the attitude of the insured person. Morale hazard is defined as carelessness or indifference to a loss because of the existence of insurance. The very presence of insurance causes some insurers to be careless about protecting their property, and the chance of loss is thereby increased. For example, many motorists know their cars are insured and, consequently, they are not too concerned about the possibility of loss through theft. Their lack of concern will often lead them to leave their cars unlocked.

The chance of a loss by theft is thereby increased because of the existence of insurance.

Morale hazard should not be confused with moral hazard. Morale hazard refers to an Insured who is simply careless about protecting his property because the property is insured against loss.

Moral hazard is more serious since it involves unethical or immoral behaviour by insurers who seek their own financial gain at the expense of insurers and other policy owners. Insurers attempt to control both moral and morale hazards by careful underwriting and by various policy provisions, such as compulsory excess, waiting periods, exclusions, and exceptions.

When used in conjunction with peril and hazard we find that risk means the likelihood that the hazard will indeed cause the peril to operate and cause the loss. For example, if the hazard is old electrical wiring prone to shorting and causing sparks, and the peril is fire, then the risk, is the likelihood that the wiring will indeed be a cause of fire.

BASIC CATEGORIES OF RISK

With regards insurability, there are basically two categories of risks;

1. Speculative or dynamic risk; and

2. Pure or static risk

Speculative or Dynamic Risk

Speculative (dynamic) risk is a situation in which either profit OR loss is possible. Examples of speculative risks are betting on a horse race, investing in stocks/bonds and real estate. In the business level, in the daily

Understanding and Managing Risk conduct of its affairs, every business establishment faces decisions that entail an element of risk. The decision to venture into a new market, purchase new equipments, diversify on the existing product line, expand or contract areas of operations, commit more to advertising, borrow additional capital, etc., carry risks inherent to the business. The outcome of such speculative risk is either beneficial (profitable) or loss.

Speculative risk is uninsurable.

Pure or Static Risk

The second category of risk is known as pure or static risk. Pure (static) risk is a situation in which there are only the possibilities of loss or no loss, as oppose to loss or profit with speculative risk. The only outcome of pure risks are adverse (in a loss) or neutral (with no loss), never beneficial. Examples of pure risks include premature death, occupational disability, catastrophic medical expenses, and damage to property due to fire, lightning, or flood.

It is important to distinguish between pure and speculative risks for three reasons. First, through the use of commercial, personal, and liability insurance policies, insurance companies in the private sector generally insure only pure risks. Speculative risks are not considered insurable, with some exceptions.

Second, the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large numbers is important in insurance because it enables insurers to predict loss figures in advance. It is generally more difficult to apply the law of large numbers to speculative risks in order to predict future losses. One of the exceptions is the speculative risk of gambling, where casinos can apply the law of large numbers in a very efficient manner.

Finally, society as a whole may benefit from a speculative risk even though a loss occurs, but it is harmed if a pure risk is present and a loss occurs. For instance, a computer manufacturer's competitor develops a new technology to produce faster computer processors more cheaply. As a result, it forces the computer manufacturer into bankruptcy. Despite the bankruptcy, society as a whole benefits since the competitor's computers work faster and are sold at a lower price. On the other hand, society would not benefit when most pure risks, such as an earthquake, occur.

OTHER RISKS

Besides insurability, there are other classifications of Risks. Few of them are discussed below:

Fundamental Risks and Particular Risks

Fundamental risks affect the entire economy or large numbers of people or groups within the economy. Examples of fundamental risks are high inflation, unemployment, war, and natural disasters such as earthquakes, hurricanes, tornadoes, and floods.

Particular risks are risks that affect only individuals and not the entire community. Examples of particular risks are burglary, theft, auto accident, dwelling fires. With particular risks, only individuals experience losses, and the rest of the community are left unaffected.

The distinction between a fundamental and a particular risk is important, since government assistance may be necessary in order to insure fundamental risk. Social insurance, government insurance programs, and government guarantees and subsidies are used to meet certain fundamental risks in our country. For example, the risk of unemployment is generally not insurable by private insurance companies but can be insured publicly by federal or state agencies. In addition, flood insurance is only available through and/or subsidized by the federal government.

Subjective Risk

Subjective risk is defined as uncertainty based on a person's mental condition or state of mind. For example, assume that an individual is drinking heavily in a bar and attempts to drive home after the bar closes. The driver may be uncertain whether he or she will arrive home safely without being arrested by the police for drunken driving. This mental uncertainty is called subjective risk.

Objective Risk

Objective risk is defined as the relative variation of actual loss from expected loss. For example, assume that a fire insurer has 5000 houses insured over a long period and, on an average, 1 percent, or 50 houses are destroyed by fire each year. However, it would be rare for exactly 50 houses to burn each year and in some years, as few as 45 houses may burn. Thus, there is a variation of 5 houses from the expected number of 50, or a variation of 10 percent. This relative variation of actual loss from expected loss is known as objective risk.

Objective risk declines as the number of exposures increases. More specifically, objective risk varies inversely with the square root of the number of cases under observation. Now assume that 5 lacs instead 5000 houses are insured. The expected number of houses that will burn is now 5000, but the variation of actual loss from expected loss is only 50. Objective risk is now 50/5000, or 1 percent.

Objective risk can be statistically measured by some measure of dispersion, such as the standard deviation or coefficient of variation. Since objective risk can be measured, it is an extremely useful concept for an insurance company or a corporate risk manager.

As the number of exposures increases, the insurance company can predict its future loss experience more accurately because it can rely on the “Law of large numbers.” The law of large numbers states that as the number of exposure units increase, the more closely will the actual loss experience approach the probable loss experience. For example, as the number of homes under observation increases, the greater is the degree of accuracy in predicting the proportion of homes that will burn.

Static Risks

Static risks are risks connected with losses caused by the irregular action of nature or by the mistakes and misdeeds of human beings. Static risks are the same as pure risks and would, by definition, be present in an unchanging economy.

Dynamic Risk

Dynamic risks are risks associated with a changing economy. Important examples of dynamic risks include the changing tastes of consumers, technological change, new methods of production, and investments in capital goods that are used to produce new and untried products.

Static and dynamic risks have several important differences –

(a) Most static risks are pure risks, but dynamic risks are always speculative risks where both profit and loss are possible.

(b) Static risks would still be present in an unchanging economy, but dynamic risks are always associated with a changing economy.

(c) Dynamic risks usually affect more individuals and have a wider impact on society than do static risks.

(d) Dynamic risks may be beneficial to society but static risks are always harmful.

Financial and Non-financial Risks

A financial risk is one where the outcome can be measured in monetary terms.

This is easy to see in the case of material damage to property, theft of property or lost business profit following a fire. In cases of personal injury, it can also be possible to measure financial loss in terms of a court award of damages, or as a result of negotiations between lawyers and insurers. In any of these cases, the outcome of the risky situation can be measured financially.

There are other situations where this kind of measurement is not possible. Take the case of the choice of a new car, or the selection of an item from a restaurant menu. These could be construed as risky situations, not because the outcome will cause financial loss, but because the outcome could be uncomfortable or disliked in some other way. We could even go as far as to say that the great social decisions of life are examples of non-financial risks: the selection of a career, the choice of a marriage partner, having children.

There may or may not be financial implications, but in the main the outcome is not measurable financially but by other, more human, criteria.

Insurance is primarily concerned with risks that have a financially measurable outcome. But not all risks are capable of measurement in financial terms. One example of a risk that is difficult to measure financially is the effect of bad publicity on a company - consequently this risk is very difficult to insure.

However, this is a good point to stress how innovative some insurers are in that they are always looking for ways to provide new covers, which the customers want. The difficult part is to be innovative and still make a profit.