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CHAPTER 1
NATURE OF RISKS, CHAPTER 4
INSURANCE, CHAPTER 6
PRINCIPLE OF…
CHAPTER 1
NATURE OF RISKS
The Meaning of Risk
Risk is condition which there is the possibility of adverse deviation from a desired outcome that expected or hoped for
The Concept of Loss, Peril and Hazard
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Probability Theories
Empirical Probability
- determined on basis of historical data
- eg transport company which operates fleet of 1000 vehicles has
50/1000 @ 0.05 probability of accident occurring next year
- Ops Sikap implemented by Malaysian police during festive seasons uses this probability theory to estimate probability of accident on particular season
Judgemental Probability
- determined based on judgement of person predicting the outcome
- used when there is lack of historical data or credible statistics
- eg this probability used in insurance of nuclear plants because of lack of credible statistics
A Priori Probability
- determined when total number of possible events is known
- eg the probability of getting a two on roll of dice is 1/6 @ 0.16666
- priori concept has limited practical application in study of risk because situations where a number of possible outcomes known are very rare
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The Types of Pure Risk
Property Risk
indirect loss
loss in consequence of direct loss such as property damage
eg loss of profit as result of business interruption following damage to business premises
eg when factory damaged by fire the production have to stop this will result to loss of profit
therefore direct loss is loss of profit or income which in consequence of their loss
extra expenses
extra costs incurred as result of loss
eg if owner of above factory rents another building to resume business as usual he needs to incur additional cost of renting such building
therefore the additional cost of getting or renting a temporary premise at alternative site is example of extra expenses
direct loss
damage to property by peril
eg mr sivaji's premise destroyed by fire
direct loss suffered by mr sivaji includes loss of value of premise as result of fire (the peril)
Liability Risk
- under our system of law you can be held legally liable if you do something that result in bodily injury or property damage to someone else
- you will be sued because neglect, malpractice, or causing willful injury either to another person or someone else's property
- eg construction worker the owner of construction company (employer) will be liable for any injury that happens to workers at construction site
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CHAPTER 4
INSURANCE
Definition
Agreement whereby group of individuals facing similar risks can share the fortuitous losses of unlucky few by the transfer of such risks to insurer who agrees to compensate the losses
Concept of Common Pool
- insurance uses common pool concept
- in nutshell it involves contributions from many insured pooled together to pay for losses suffered by few
- common pool mechanism involves:-
a. insurance company set itself to operate the pool
b. it takes contributions in form of insurance premium from many insureds and pay for losses of few
c. operation of common pool is very much based on successful application of the 'law of large number' (the law states that the larger group of similar risks the closer the actual losses experienced by group will approach the unexpected losses)
d. when people facing common risk pool their resources they create accumulation of funds from which individuals losses can be paid such arrangement transfers risk from individual to group because group shares cost of risk among all of its members
e. all insurance no matter what type or sold by which company is form of this kind of arrangement
Law of Large Number
- the greater the number of similar risk the more accurate the insurer can be in predicting future losses
- mathematical principle probability is called the law of large numbers in insurance a prediction must be made from past loss experience or statistical analysis of number of losses to be expected within group exposures the law of large number tells us that actual losses will be more accurate as the number of units of exposure increases
- this principle known as the law of large numbers states that as the number of observations of event increase, the close the predicted outcome will be to actual outcome
- insurers know within very narrow margin how many homes will be damaged each year by fire although they do not know which homes will be damaged this uncertainty introduces risk and makes it possible to insure homes against fire loss
-assume 1000 homes in area are each worth $50,000 also assume that statistics shows that five of these homes can expected to be burn this year if each of 1000 homeowners contributes their share $250 of expected $250,000 loss into fund at beginning of the year an adequate insurance pool will exist to pay for losses if they occur
- the application of law allows insurer to fix premium/contribution to pool in advance the effect of this is that the person insuring knows he will not have to pay any more premium at the end of period of insurance
- in fixing premium, the insurer has to access the risk and fix a premium which reflects the hazard and value of risk which an insured brings to pool eg the premium charge must be enough to cover the losses arising from the risk transferred
Functions of Insurance
Secondary Function
remove fear and worry
removal of fear and worry of such losses helps to establish confidence and improve personal efficiency of business executives
reduction of losses
insurers help to reduce losses both in frequency and severity through their actions and recommendation in rating, survey, inspection and salvage activities
stimulate business enterprise
- risk transfer mechanism provided by insurance had made possible and has helped to maintain the present day large scale industrial and commercial organizations
- such large-scale enterprise could not have started without the transference of many of their risk to insurers
- insurance also facilitates financing of property by banks and other financial institutions & overseas trade
savings
- by protecting the individual against unforeseen events, insurance provide climate in which savings are encouraged
- life insurance (endowment insurance) is often used as means of savings
releasing funds otherwise tied up in reserves
- through purchase of insurance business enterprises and others are able to avoid the necessity of freezing capital to provide financial protection against losses
- the fund released would be available for investment
social benefits
- compensation paid by insurers to insureds which reduced the cost of social services
- workers of factory destroyed by fire might have to face unemployment had the factory been uninsured
Indirect Function
investment of funds
- insurers accumulate large funds which they hold as custodians and out of which claim are met
- these funds are usually invested (to earn interest/income) in public and private sector
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invisible exports
- insurance can contribute considerably to country's balance of payments as invisible exports
- eg whilst britain is net exporter of insurance
malaysia is net importer of insurance
Primary Function
- primary function of insurance is to act as risk transfer mechanism
- through insurance the individuals/business enterprise/public authorities/association can transfer their financial consequences of risk to insurers in return for paying premium
- through insurance they are able to substitute known cost for unknown event involving unknown cost
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Benefits of Insurance
social benefits
- fact that the owner of business has funds available to recover from loss means that jobs may not be lost and goods or services can still be sold
- social benefits of this are the people keep their jobs their resources of income are maintained and they can continue to contribute towards the national economy
- not suggested that insurance alone keeps people in jobs but it does play significant role in ensuring there would not be unnecessarily economic hardship that could give negative affect on community
investment of funds
- insurance companies have large amount of money at their disposal due the fact that there is time gap between their receipt of premium and payment of claim (insurer has money and can invest it)
- use of this money within economy as whole is where the benefits lies; both of government and industry has access to large pool of working money
- in one sense the existence of insurance market really brings about form of enforced savings
loss control
- normally come into the fray when buyers of insurance meet the surveyor (employed by insurer or insurance broker) to get advice on loss control
- surveyor will assess the extent of risks (eg fire security liability etc) and they offer advice in form of pre-loss control or post-loss control
- best time to consult surveyor is at planning stage of project
invisible earnings
- in case of insurance services it is intangible & invisible but the principles remains the same in terms of people outside the country buy the services and paid for (invisible exports that bring money into country)
- hence it would favour our balance of trade (we export more than what we import)
peace of mind
- knowledge of insurance exists to meet financial consequences of certain risks provides form of peace of minds
- its important for either private individuals (eg insure house/car) or industry and commerce (allows entrepreneur transfer at least some of risk of being in business to insurer)
- hence with this peace of mind it can develop its business activities
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ASSIGNMENT
- is the transfer of rights and liabilities of one person to another
- in insurance the transfer of all rights and liabilities of insured to new insured is referred to as an assignment of policy
- eg the seller of house cannot assign his fire policy to purchaser concerned agrees to substitution of seller by the purchaser as new insured
- an assignee the person who takes over the assignment rights will have no better rights than those enjoyed by assignor
- insurance contracts are generally referred to as personal contract (contract matters to reinsurer who the insured is)
- to transfer the insurance policy to person, insured should get the permission from insurer to do so (prior consent)
Exception to the rule:
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other certain policies
certain policies have policy condition which provides for automatics assignment of policy if transfer of interest in subject matter of insurance is made by will of operation of law
marine policies
- freely assignable by statutory provision
- in practice only cargo policies are freely assignable while hull policies usually contain clause which prohibits assignment of policies without insurer's consent
Assignment of Policy Proceeds
- arises when insured instructs his insurer to pay the policy proceeds to third party
- eg there is assignment of policy proceeds when insured instructs his insurer to pay the amount of indemnity to his repairer
- the insurer remains party to insurance contract and continues to assume liability under it
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THREE TYPES OF HAZARD:
- physical hazard is a condition that increases the possibility of loss
- moral hazard is character defect in individual which increases the chance of loss
(the losses which result from dishonesty)
- morale hazard is attitudinal defect in individual which increases the chance of loss with knowledge that insurance exists
pure risk normally predictable because it is easier to apply the law of large number to such risks this also implies that pure risk can generally handled by insurance techniques whilst speculative risk are rarely insured
PURPOSE OF RISK MANAGEMENT
to enable organization progress toward its goal and objectives (mission) in most direct, efficient and effective path
LOSSES CLASSIFIED AS
- damage to building (direct damage)
- loss of profits due to business interruption (indirect damage)
- court award to third party since fire
was caused by negligence of owner of building (liability)
key employees (eg GM CEO) dies in fire (loss of key employees)
risk identification tools
- risk tools:-
a. orientation
b. inspections
c. flow charts
d. questionnaires
e. insurance policy checklists
f. analysis of financial statements
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UNDER INSURANCE
occurs when amount for which property is insured is
less than the value of such property
OVER INSURANCE
situation where insured has bought so much coverage that exceeds the actual cash value of risk property insured
C³ OIL
- consideration: pay premium and pay losses
- capacity: 18 years in malaysia
- consent: consensus ed-inem (meeting of minds)
- offer & acceptance: proposal form & policy form
- intention: readiness of both parties to be bound by agreement
- legality: legal & not against public policy
BUT in insurance contract C³ OIL not enough because:
- insurance is intangible
- insurance is related to risk and it happen in future (maybe or maybe not happen
- insurance is just promise
THEREFORE 6 principles of insurance is needed in order to make contract enforceable
TYPES OF DEFECTIVE CONTRACTS
- void contracts: contract which lacks any one of essentials elements of commercial contract
- voidable contract: voidable contract will remain valid and in force until the aggrieved party exercises the option to treat it void
- unenforceable contract: it is resulted from failure to comply with legal formalities (eg need for certain contract to be in writing such as section 22 of marine insurance act 1996 requires marine insurance contract to be in writing)
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