CHAPTER 1

RISK AND ITS TREATMENT

A. Objective Risk or degree of risk

1. Defined as the relative variation of actual loss from expected loss
2. Declines as the number of exposure units increases
3. Can be measured by using the standard deviation or coefficient of
variation
Example 10000 houses insured and 1% on average will burn ( i.e
100 houses). If 90 or 110 houses are burn there will be variation. So that
is Objective Risk
B- Subjective Risk
1. Defined as uncertainty based on one’s mental condition or state of
mind
2. Difficult to measure
Example If a driver is drinking heavily in a bar, he may be
uncertain whether he will arrive his home safely without being arrested by police
for drinking. This mental uncertainty is called Subjective Risk.
PERIL AND HAZARD
Peril: A Peril is defined as " the direst cause of a loss”. People are surrounded
by potential loss because the environment is filled with a lot of perils such as
collision, theft, accidents …. etc.".
Examples of Peril:
I) If your car is damaged in a collision with another car, the collision is the peril
or direct cause of loss.
II) If your flat is stolen, the theft is peril, or cause of loss. Commonly perils
include collision, fire, burglary, theft, explosion, hail, tornadoes, and
earthquakes, epidemic, vandalism, windstorm. A single peril may cause more
than one type of loss. The collision of car with another can may result in some
killed persons and some others injured.

Hazard: A hazard is defined as "a condition that creates or increases the

chance of loss due to a particular peril". For example, Poor car brakes are a hazard
making loss due to the collision peril more likely.
There are three types of hazard:
Physical hazard – Morale hazard – Morale hazard
I) Physical hazard: is a physical condition that increases the chance of loss.
In other words, the tangible conditions of the environment that affect the
frequency and severity of loss.
Examples of physical hazard:
- Poor car brakes - slippery roads that increase the chance of cars accidents
- Defective wiring in house that increases the chance of loss
– Icy roads (slippery roads )
- Defective lock on a door of house that increases the chance of loss - Dry
forests.
II) Moral Hazard is the dishonesty or character defects in insured (Peron has
insurance policy) that increase the frequency and / or severity of loss. In other
words, a moral hazard exists when the insured person is one who may
dishonestly cause loss. Generally, moral hazard exists when a person can gain
from occurrence of a loss.

1. Classification of Risks:
Risks may be classified in many ways, but from our viewpoint we can classify the
risks as either 1-pure risks or 2- speculative risks.
 Pure risks mean the situations that result only in loss or no loss. One of the
best examples for pure risks is ownership of property for example
ownership of a house will have a fire or it will not. Also, ownership a car will
be stolen or it will not be. The possible outcomes are loss or no loss.
Premature death, flood, lightening is considered other examples for pure
risks.
 Speculative risks mean the situations that result in loss or gain. Gambling is
a good example of a speculative risk. In a gambling situation, risk is
deliberately created in the hope of gain. A person who bets on ball games
may either loss or wins. Business venture involve many speculative risks.

Other,
 Diversifiable Risk and No diversifiable Risk – A diversifiable risk (particular
risk) affects only individuals or small groups (car theft). It is also called
nonsystematic or particular risk. – A no diversifiable risk (fundamental or
general risk) affects the entire economy or large numbers of persons or
groups within the economy (hurricane). It is also called systematic risk or
 fundamental risk. Notice: Government assistance may be necessary to
insure no diversifiable risks.

 Enterprise risk encompasses all major risks faced by a business firm, which
include: pure risk, speculative risk, strategic risk, operational risk, and
financial risk – Strategic Risk refers to uncertainty regarding the firm’s
financial goals and objectives. – Operational risk results from the firm’s
business operations. – Financial Risk refers to the uncertainty of loss
because of adverse changes in commodity prices, interest rates, foreign
exchange rates, and the value of money.

Pure risks that exist for individual and business companies can be
classified into 3
types, they are:
I) Personal risks are risks that directly affect an individual .They involve that
possibility of loss of income or assets as a result of the loss of the ability to
earn income.
There are five major personal risks:
* Premature death risk * Disability risk * old age risk * Sickness risk *
Unemployment risk
II) Property risks are risks that affect not on individual but they affect his/her
property. That is, any person owns property (car – house – ship – airplane ….
etc) is exposing to property risks. Simply because such possessions can be
 Premature risks
 Disability
 Sickness
 Old age
 Unemployment
 Fire
 Marine
 Collision
 Theft
 Aviation
 Bodily
injury for
other
 persons
Property
damage
 owned
by other
persons
 Risks
 Pure Risks
 Personal risks Property risks Liabilities risks
 Speculative risks
 Purchasing of shares
 in stock of exchange
 Investment in real
 estate
destroyed or stolen. For example, car can be damaged or destroyed because of
collision. Also, Real estate and personal property can be destroyed or damaged
because of fire, windstorms, Tornado, lightning and numerous other causes.

Property risks involve two types of loss (I) Direct Loss

(II) Indirect or Consequential loss.
The previous two types of property risks can be determined by this example:
If your house is destroyed by fire, you lose the value of the house, this is a
direct loss. Over the time required to rebuild your house, you will charge
additional expenses for living somewhere else by paying, a rent for other flat.
This loss of use of the destroyed house is indirect loss.
III) Liability risks: By virtue of these risks a person can be held legally if he
does something that result in bodily injury or property damage to other
person. Consequently, the court may order the person to pay substantial
damages to the injured person. The liability risks may result from
intentional or unintentional injury of other persons or damage to them
property through negligence or carelessness.

BURDEN OF RISK ON SOCIETY

 • The presence of risk results in three major burdens on society:
– In the absence of insurance, individuals would have to maintain large
emergency funds
– The risk of a liability lawsuit may discourage innovation, depriving
society of certain goods and services
– Risk causes worry and fear

Risk Financing:
Risk Financing refers to techniques that provide for payment of losses after they
occur and comprise three major methods. They are:
 Risk Retention
Risk retention is considered the most common method of dealing with risk. It
means
the risks are kept (retained) by individuals or organizations exposed to them. It is
known that individuals and organization face an unlimited array of risks. So, when
nothing is done about these risks. That are individuals or organizations do not
take
positive action to avoid, reduce or transfer these risks. We can say, the losses
involved in these risks are retained.
Examples of Deliberately Retention
 A homeowner may retain a small part of the risk of damage to home by
purchasing a homeowner’s policy with substantial deductible.
 Drivers of cars may retain the risk of a small collision loss by purchasing a
car insurance policy with a L.E. 500 or higher deductible.
Consequently, we can conclude, the deliberately retention may involve losses
that are too small
Noninsurance Companies:
By virtue of this method, the risk shifted to (transfer to) someone else other than
insurance companies, and there are 3 method’s, they are
 Transfer the risk by contract
Example of risk transfer to noninsurance companies:
o The risk of equipment breakage in laboratory in a school can be
transferred to
students by collecting 30 S.R "breakage fee" from all students in the school
taking chemistry classes at the beginning of semester.
o The risk of a defective household appliances (Television – Receiver – Video
– Stereo ….. etc) can be transferred to the retailer shop in exchange of
responsibility for all repairs after the warranty expires.
 Hedging is a technique for transferring the risk of unfavorable price
fluctuations to a speculator by purchasing and selling futures contracts
on an organized exchange
 Incorporation of a business firm transfers to the creditors the risk of
having
Insurance:
The previous methods may not solve the problem of dealing with risks, but
insurance can handle these risks by transferring them to an insurance
organization. So, Insurance is the most practical method for handling major
risks, for most people and organizations because it has 3 characteristics, they
are: -
 Risk transfer is used because a risk is transferred to the
insurer.
 The pooling technique is used to spread the losses of the
few over the entire group
 The risk may be reduced by application of the law of large
numbers by which an insurer can predict future loss
experience with greater accuracy.
 CHAPTER 2
INSURANCE AND RISK
Risk of fire as an Insurable Risk:
Requirements
 Large number of exposure units
 Accidental and unintentional loss Yes. With the exception of arson, most
 Determinable and measurable Yes. If there is disagreement over the
loss
 No catastrophic loss
 Calculable chance of loss
 Economically feasible premium
ADVERSE SELECTION AND INSURANCE:
Does the risk of fire satisfy the
requirements?
Yes. Numerous exposure units are present
fire losses are accidental and
unintentional.
amount paid, a property
insurance policy has provisions for
resolving disputes.
Yes. Although catastrophic fires have
occurred, all exposure units
normally do not burn at the same time.
Yes. Chance of fire can be calculated, and
the average severity of a
fire loss can be estimated in advance.
Yes. Premium rate per $100 of fire
insurance is relatively low
When the insurance is sold, insurers must deal with the problem of
Adverse
Selection. So, what is Adverse Selection?
The answer is “Adverse selection is the tendency of persons with a higher
than-average chance of loss to seek insurance at standard rates “

Examples
1- High drivers who seek auto insurance at standard rates
2- Persons with serious health problems who seek life or health insurance
at
standard rates
3- Business firms that have been repeatedly robbed or burglarized seek
crime
insurance at standard rates.
So, this problem (adverse selection), If not controlled by underwriting, will
results in higher-than-expected loss levels.
Hence, insurance companies try to control Adverse selection by:
o careful underwriting (selection and classification of applicants
for insurance)
o policy provisions (e.g., suicide clause in life insurance)
INSURANCE AND GAMBLING COMPARED:
In order to make comparison between Insurance and Gambling listen to this
Example in class? explain
Gambling ----------------------- Two horses
Insurance ----------------------- Fire insurance
After that, we can explain the confusion between Insurance and Gambling by the
following comparison
Insurance
• Insurance is a technique for handing an already existing pure risk
• Insurance is always socially productive, because both parties have a common
interest in the prevention of a loss
• Insurance restore the insured financially in whole or in part if a loss occurs
Gambling
• Gambling creates a new speculative risk
• Gambling is not socially productive, because the winner’s gain comes at the
expense of the loser
• Gambling generally never the loser to his former financially position
Types of Insurance:
Some of institutions for insurance are private organizations and some others are
governmental organizations. Consequently, insurance may be classified into many
classifications. So, there are several ways in which the various kinds of insurance
can be classified, they are:
The first method: Insurance may be divided into personal or commercial
insurance depending on protecting individuals or protecting organization.
The second method: Insurance can be divided into voluntary or involuntary,
depending upon whether or not it is required by law.
The third method: Insurance may be divided into types that protect against loss
of income. That is life – health insurance (such as death, or disability, or
unemployment) and the types that pay for damage to property. That is property
and liability insurance.
The fourth method: Insurance can be classified into private insurance or
governmental insurance (i.e. social insurance). In fact, the previous classifications
of insurance may differ from country to other. So there is no single criterion that
can be used to distinguish private insurance from governmental insurance.
For example. In United States of America some insurance is sold by government
and not all compulsory is governmental insurance (i.e. social insurance).

Life insurance Life insurance is a contract between an insurer and a policyholder.

A life insurance policy guarantees the insurer pays a sum of money to named
beneficiaries when the insured policyholder dies, in exchange for the premiums
paid by the policyholder during their lifetime.
Health insurance: This type of insurance covers medical expenses from sickness.
These expenses include doctor hospital bills, the cost of medicines, private
nursing care. Health insurance may also pay the income that an insured person is
unable to earn during period of disability.
Property and liability insurance ( Property and casuality insurance ) Property
insurance indemnifies property owners against the loss or damage of real or
personal property.
Liability insurance covers the insured’s legal liability arising out of property
damage or bodily injury to others.
Casualty insurance refers to insurance that covers whatever is not covered by
fire, marine, and life insurance.
Marine insurance is a broad line divided into ocean marine and inland marine.
Fire insurance covers the loss or damage to real estate (house – factory – store)
and personal property because of fire, lightning. Moreover, fire insurance may
comprise other risks such as hail, vandalism and windstorm. In addition, fire
insurance may cover indirect loss including rent and profit and extra expenses as
a result of loss from interruption of business.

Car insurance is considered the largest line in property insurance. Under the car
insurance, the available coverages include protection against legal liability claims,
payment of medical expenses, payment for theft or damage to insured cars and
protection against uninsured motorists.
BENEFITS OF INSURANCE TO SOCIETY:
In effect, the insurance has an essential benefit. It is the cooperation among
insureds that who expose to the same risk by sharing losses. Moreover, many
other benefits are provided by insurance. Some of these benefits are social and
some others are economic benefits. These benefits can be summarized in the
following points:
I) Reduction of uncertainty and worry: By insurance, the worry and fear may be
reduced whether before or after a loss:
 Persons insured for long-term disability do not have to worry about
the loss of earnings if a serious illness or accident occurs.
 Homeowners who are insured enjoy greater peace of mind because
they know they are covered if a loss occurs.
 Family heads who have adequate sum insured of life insurance
policy,
they are less worry about the financial security of their dependents in
the event if premature death.

II) Prevention of loss: In all forms of insurance, increasing emphasis is placed on

prevention of loss. Through improved construction, installation of safeguards and
rehabilitation, insurance companies have made material contributions to society.
Everyday insurance companies employ a wide variety of loss prevention including
safety engineers and specialists in fire prevention, occupational safety and
products liability.

 Prevention of Auto thefts

 Prevention of boiler explosions
 Fire prevention
 Educational program on loss prevention
 Prevention and detection of arson losses.
III) Indemnification for loss: In many forms of insurance, particularly in property
and liability indemnification permits, individual, families, business firms and
society to restored to their former financial position after a loss occurs.
Examples:
 If the individuals and families have insurance policies, they can
maintain their financial security if they have indemnification because
they are restored either in part or in whole after a loss occurs.
Moreover, they are less likely to apply for public assistance or to seek
financial assistance from relatives and friends.

 If the business firms collected indemnification. It also permits firms

to remain in business and employees to keep their jobs.
 Suppliers of firms will continue to receive orders and customers can
still receive the goods and services they desire.

IV) Insurance is a source of investment funds: It is worthwhile to mention that

insurance industry is an important source of funds for capital investment and
accumulation. That is due to premiums, which are collected in advance of loss and
funds not needed to pay immediate losses. Consequently, a lot of these funds are
invested in different business.
For Example:
 Structure of hospital and factories
 Housing developments
 Purchasing new machines and equipment
V) Enhancement of credit for persons and firms: In effect, insurance enhances a
person's credit and as well firms' credit. Insurance permits person or firm to
borrow a loan because it gives greater assurance that the loan will be repaid.
For example:
 When a person purchases a house, the bank requires property
insurance policy on the house before the mortgage loan is granted.
The property insurance policy protects the bank if the house is
damaged or destroyed.
 When business firm seeking a temporary loan for seasonal business
may be required to insure its inventories before the loan is made.
 When a person purchases a car and financed by a bank. The latter
requires physical damage insurance on the car before the loan is
made.
COSTS OF INSURANCE:
• Indemnification for Loss
– Contributes to family and business stability
• Reduction of Worry and Fear
– Insureds are less worried about losses
• Source of Investment Funds
– Premiums may be invested, promoting economic growth
• Loss Prevention
– Insurers support loss-prevention activities that reduce direct and
indirect losses
• Enhancement of Credit
– Insured individuals are better credit risks than individuals without
insurance

• Cost of Doing Business

– Insurers consume resources in providing insurance to society
– An expense loading is the amount needed to pay all expenses,
including commissions, general administrative expenses, state
premium taxes, acquisition expenses, and an allowance for
contingencies and profit
• Cost of Fraudulent and Inflated Claims
– Payment of fraudulent or inflated claims results in higher premiums
to all insureds, thus reducing disposable income and consumption of
other goods and services
Calculable Chance of Loss:
A fourth requirement is that the chance of loss should be calculable. The insurer
must be able to calculate both the average frequency and the average severity of
future losses with some accuracy.
This requirement is necessary so that a proper premium can be charged that is
sufficient to pay all claims and expenses and yield a profit during the policy
period.
Certain losses, however, are difficult to insure because the chance of loss cannot
be accurately estimated, and the potential for a catastrophic loss is present.

Example: floods, wars, and cyclical unemployment occur on an irregular basis,

and prediction of the average frequency and the severity of losses are difficult.
Thus, without government assistance, these losses are difficult for private
companies to insure.

Economically Feasible Premium:

It is the final requirement that the premium should be economically feasible. The
insured must be able to pay the premium.
Also, for the insurance to be an attractive purchase, the premiums paid must be
substantially less than the face value, or amount, of the policy.
Since the insurance pool is structured to be sufficiently large, the price charged by
the insurer for buying the risk is generally low. It should be sufficient to cause the
rich for the insurer as well as viable for the insured.
CHAPTER 3
INTRODUCTION TO RISK
MANAGEMENT
Identify Loss Exposures
1. Property loss exposures
■ Building, plants, other structures
■ Furniture, equipment, supplies
■ Computers, computer software, and data
■ Inventory
■ Accounts receivable, valuable papers, and
records
■ Company vehicles, planes, boats, and mobile
equipment
2. Liability loss exposures
■ Defective products
■ Environmental pollution (land, water, air, noise)
■ Sexual harassment of employees, employment
discrimination, wrongful termination, and failure
to promote
■ Premises and general liability loss exposures
■ Liability arising from company vehicles
■ Misuse of the Internet and e-mail transmissions
■ Directors’ and officers’ liability suits
3. Business income loss exposures
■ Loss of income from a covered loss
■ Continuing expenses after a loss
■ Extra expenses
■ Contingent business income losses
4. Human resources loss exposures
■ Death or disability of key employees
■ Retirement or unemployment exposures
■ Job-related injuries or disease experienced by
workers
5. Crime loss exposures
■ Holdups, robberies, and burglaries
■ Employee theft and dishonesty
■ Fraud and embezzlement
■ Internet and computer crime exposures
■ Theft of intellectual property

Measure and Analyze Loss Exposures

• Estimate the frequency and severity of loss for each type of loss exposure
– Loss frequency refers to the probable number of losses that may occur
during some given time period
– Loss severity refers to the probable size of the losses that may occur
• Once loss exposures are analyzed, they can be ranked according to their
relative importance
• Loss severity is more important than loss frequency:
– The maximum possible loss is the worst loss that could happen to the
firm during its lifetime
– The probable maximum loss is the worst loss that is likely to happen

Select the Appropriate Combination of Techniques for Treating the Loss

Exposures
• Risk control refers to techniques that reduce the frequency and severity of
losses
• Methods of risk control include:
– Avoidance
– Loss prevention
– Loss reduction
• Avoidance means a certain loss exposure is never acquired, or an existing loss
exposure is abandoned
– The chance of loss is reduced to zero
– It is not always possible, or practical, to avoid all losses

Risk Financing Methods: Retention

• Retention means that the firm retains part or all of the losses that can result
from a given loss
– Retention is effectively used when:
Notes By Rwubahuka Jean Claude, MBA-IB, MSc. Fin.&Bank, BBA
Fin. E: rwubahukajc@gmail.com, T: 0788427626, Website:
www.de250.com
• No other method of treatment is available
• The worst possible loss is not serious
• Losses are highly predictable
– The retention level is the dollar amount of losses that the firm will
retain
• A financially strong firm can have a higher retention level than
a financially weak firm
• The maximum retention may be calculated as a percentage of
the firm’s net working capital
– A risk manager has several methods for paying retained losses:
• Current net income: losses are treated as current expenses
• Unfunded reserve: losses are deducted from a bookkeeping
account
• Funded reserve: losses are deducted from a liquid fund
• Credit line: funds are borrowed to pay losses as they occur
• A captive insurer is an insurer owned by a parent firm for the purpose of
insuring the parent firm’s loss exposures
– A single-parent captive is owned by only one parent
– An association or group captive is an insurer owned by several parents
– Many captives are located in the Caribbean because the regulatory
environment is favorable
– Captives are formed for several reasons, including:
• The parent firm may have difficulty obtaining insurance
• To take advantage of a favorable regulatory environment
• Costs may be lower than purchasing commercial insurance
• A captive insurer has easier access to a reinsurer
• A captive insurer can become a source of profit
– Premiums paid to a captive may be tax-deductible under certain
conditions
• Self-insurance is a special form of planned retention
– Part or all of a given loss exposure is retained by the firm
– Another name for self-insurance is self-funding
– Widely used for workers compensation and group health benefits
• A risk retention group is a group captive that can write any type of liability
coverage except employer liability, workers compensation, and personal lines
– Federal regulation allows employers, trade groups, governmental units,
and other parties to form risk retention groups
– They are exempt from many state insurance laws

Risk Financing Methods: Non-insurance Transfers

• A non-insurance transfer is a method other than insurance by which a pure risk
and its potential financial consequences are transferred to another party
– Examples include:
• Contracts, leases, hold-harmless agreements
Risk Financing Methods: Insurance
• Insurance is appropriate for loss exposures that have a low probability of loss
but for which the severity of loss is high
– The risk manager selects the coverages needed, and policy provisions:
• A deductible is a provision by which a specified amount is
subtracted from the loss payment otherwise payable to the
insured
• An excess insurance policy is one in which the insurer does not
participate in the loss until the actual loss exceeds the amount a
firm has decided to retain
– The risk manager selects the insurer, or insurers, to provide the
coverages
– The risk manager negotiates the terms of the insurance contract
• A manuscript policy is a policy specially tailored for the firm
• Language in the policy must be clear to both parties
• The parties must agree on the contract provisions,
endorsements, forms, and premiums
– The risk manager must periodically review the insurance program