Notes: Introduction to Business [For BBA, B.

Com]

CHAPTER 9

INSURANCE & BUSINESS RISK

Q. DEFINE INSURANCE [2022, 2020]

Insurance is a contract, represented by a policy, in which an individual or entity receives financial

protection or reimbursement against losses from an insurance company. The company pools clients' risks to
make payments more affordable for the insured. Or

A contract between two parties in which one party promises to indemnify (protect against or underwrite)
the loss suffered by other party against a premium. Or

According to the Insurance Ordinance 2000, insurance means the business of entering into and carrying
out policies or contracts, by whatever name called, whereby, in consideration of a premium received, a
person promises to make payment to another person contingent upon the happening of an event,
specified in the contract, on the happening of which the second-named person suffers loss, and includes
reinsurance.

Insurer: As per the Insurance Ordinance 2000, ‘Insurer is any company carrying on the business of
insurance, incorporated under any law for the time being in force in Pakistan’.

Insured (sometimes called the assured) is the one who receives the payment, except in the case of life
insurance, where payment goes to the beneficiary named in the life insurance contract.

Premium is the consideration paid by the insured—usually annually or semiannually—for the insurer’s
promise to reimburse. The contract itself is called the policy. The events insured against are known as risks
or perils.

Basic Characteristics of Insurance

■ Pooling of losses: Pooling is the spreading of losses incurred by the few over the entire group, so that in
the process, average loss is substituted for actual loss.
■ Payment of fortuitous (happening by chance rather than intention) losses.
■ Risk transfer.
■ Indemnification (security against hurt, loss, or damage).

Characteristics of an Ideally Insurable Risk

Private insurers generally insure only pure risks. Pure risk refers to risks that are beyond human control and
result in a loss or no loss with no possibility of financial gain. Fires, floods and other natural disasters are
categorized as pure risk, unforeseen incidents, such as acts of terrorism or untimely deaths.
However, some pure risks are not privately insurable. From the viewpoint of a private insurer, an insurable
risk ideally should have certain characteristics. There are ideally six characteristics of an insurable risk:

■ There must be a large number of exposure units (see definition below).

■ The loss must be accidental and unintentional.
■ The loss must be determinable and measurable.
■ The loss should not be catastrophic (see definition below).
■ The chance of loss must be calculable.
■ The premium must be economically feasible (reasonable/ achievable/ possible).

Exposure Units

In insurance terms, exposure refers to an individual, business, or entity’s susceptibility (exposure,

vulnerability, proneness) to various losses or risks they might encounter (meet, come across) in life or in the
ordinary course of business. Basically, it refers to their potential for accidents or other types of losses like
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crime, fire, earthquake, etc. The greater the exposure to potential losses, the higher the insurer can expect
premium to be, as the insurer needs to charge more to profitably insure you. Exposure units also shows
potential loss for insurer not in monetary amount, but in units.

Catastrophic event

A catastrophe is defined by the insurance industry as an event that causes insured property losses in excess
of established monetary amounts and impacts a significant number of policyholders and insurers.

PRINCIPLES or ESSENTIALS OF INSURANCE

1. Good faith
Both parties in the contract must disclose all facts for the benefit of each other. False information or non-
disclosure of any important fact makes the contract avoidable.

2. Insurable Interest

When you have an insurable interest in something, it means you own it; and you would suffer a
monetary loss if that something were damaged, lost or destroyed. Insurance contract without the
existence of insurable interest is not legally valid and cannot be claimed in Court.

3. Cancellation
Both parties have right to cancel the policy before its expiry date. The protection provided by the
insured stops from the date of cancellation and premium is returned to insurer.

4. Mitigation (reduction) of loss

According to this principle the insured should take steps to minimize the loss. Otherwise the insurance
company can refuse to compensate the insured due to this negligence.

5. Attachment of Risk
An insurance contract cannot be enforced without the element of definite risk. So the element of risk is
always mentioned in policy otherwise it will be considered invalid.

6. Cause of loss
If there are so many reasons of a loss then first of all causes of loss will be determined. If loss is occurred
due to insured cause then claim will be paid otherwise not.

7. Principle of subrogation
If a loss arises due to the negligence of a third party then the loss can be recovered from only one party
either from the insurance company or from the third party.
[Subrogation: the substitution of one person or group by another in respect of a debt or insurance claim,
accompanied by the transfer of any associated rights and duties.]

8. Principle of indemnity
Insurance is a contract of indemnity. Indemnity is the protection against a loss. The amount is claimed
after a loss has occurred. Insurance company compensates the loss up-to the insured amount limit. If
there is no loss then no claim is acceptable.

9. Arbitration

Arbitration is the hearing and determining of a dispute or the settling of differences between parties by
a person chosen or agreed to by them.
The arbitration is to be appointed in writing by both the parties. Due to this the chances of litigation can
be reduced.

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Q. WHAT IS THE IMPORTANCE OF INSURANCE IN MODERN BUSINESS? [2020]

The insurance device reduces the aggregate amount of risk in the economy by substituting certain costs
for uncertain losses. The primary function of insurance is the creation of security.

• Some people seem to believe that they have somehow wasted their money in purchasing
insurance if a loss does not occur and indemnity is not received.
• Some even feel that if they have not had a loss during the policy term, their premium should be
returned. Both viewpoints constitute the essence of ignorance.

Relative to the first, we already know that the insurance contract provides a valuable feature in the
freedom from the burden of uncertainty. Even if a loss is not sustained during the policy term, the insured
has received something for the premium: the promise of indemnification if a loss had occurred.

With respect to the second, one must appreciate the fact that the operation of the insurance principle is
based on the contributions of the many paying the losses of the unfortunate few. If the premiums were
returned to the many who did not have losses, there would be no funds available to pay for the losses of
the few who did. Thus, basically, the insurance device is a method of loss distribution.

Risk Reduction through Pooling-

In addition to eliminating risk at the level of the individual through transfer, the insurance mechanism
reduces risk (and the uncertainty related to risk) for society as a whole.

The Economic Contribution of Insurance-

When a house or building burns, society has lost a want-satisfying good. Insurance as an economic device
is justified because it creates certainty about the financial burden of losses. In providing a mechanism [tool,
device] through which losses can be shared and uncertainty reduced, insurance brings peace of mind to
society’s members.

Insurance also provides for a more optimal [ideal, top, best] utilization of capital. Without the possibility of
insurance, individuals and businesses would have to maintain relatively large reserve funds to meet the risks
that they assume. These funds would be in the form of idle cash or would be invested in safe, liquid, and
low-interest-bearing securities. This would be an inefficient use of capital. When the risk is transferred to the
professional risk bearer, the deviations from expected results are minimized. As a consequence, insurers are
obligated to keep much smaller reserves than would be the case if insurance had not existed.
Thus, the released funds are then available for investment in more productive pursuits, resulting in a much
greater productivity of capital.

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Q. WHAT ARE MAJOR ADVANTAGES OF INSURANCE TO BUSINESS COMMUNITY? [2017]

i. Security and Safety

It gives a sense of security and safety to the businessman. It enables him to receive compensation
against actual loss. Businessman can concentrate on his business with a secure feeling that in case of
losses arising from insurable risk, his losses will be compensated.

ii. Helps to Minimize Financial Losses

Different types of insurance can help prevent potentially ruinous (disastrous) situations for your
business. From repairing or replacing property damaged by a covered loss to helping cover the legal
costs from a lawsuit; business insurance can help your business through the unexpected. Without
business insurance, you could be on the hook [to be on the hook is to be caught in a bad situation or to
owe money] to pay for repairs, legal fees, replacement costs, medical costs etc.

iii. Increases the Credibility of Your Business

If you show your clients or customers proof of insurance, it gives them peace of mind and can
increase your business’s credibility. Your customers will be aware that they’re working with a
protected business.

iv. Encourage International Trade:

International trade involves many risks in transporting goods from one country to another. In the
absence of insurance, the traders will always be worried for the safe arrival of goods. The quantum of
trade will be limited because of uncertainties and risk involved during transit. Insurance provides
protection against all types of sea-risks. It has helped the development of international trade on a
large scale.

v. Easy to get loans

A trader can get bank loans easily if his stock or property is insured, as insurance provides a sense of
security to the lenders.

vi. Welfare of employees

The welfare of employees is the responsibility of the employer. Therefore, the employer has to look
after the welfare of his employees which can be provided for early death, provision for disability and
provision for old age. These requirements are easily met by the life insurance. The employees will
devote their maximum capacities to complete their jobs when they are assured of the above
benefit.

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Q. BRIEFLY EXPLAIN VARIOUS TYPES OF INSURANCE [2022, 2020]

Insurance may be classified into two broad categories.

1. Non-Life Insurance
2. Life Insurance

A. Non-Life Insurance

As per Insurance Ordinance 2000, non-life insurance business includes:

• Fire and property damage business

• Marine, aviation and transport business
• Motor third party compulsory business
• Liability business
• Workers’ compensation business
• Credit and suretyship business
• Accident and health business
• Agriculture insurance including crop insurance
• Proportional treaty business

Fire and property damage insurance indemnifies property owners against the loss or damage of real or
personal property caused by various perils (threats, risks, hazards), such as fire, lightning, windstorm, or
tornado.

Marine, aviation (flight) and transport insurance means effecting and carrying out contracts of insurance
against loss to the policy holder arising from:

(i) loss or damage arising out of or in connection with the use of:

(a) means of transport, including motor vehicles and railway rolling stock used on land, vessels used on
the sea or on inland waters, and aircraft; or
(b) the machinery, furniture or equipment of those means of transport.

(ii) loss of or damage to merchandise [goods], luggage and all other goods in transit, irrespective of the
form of transport.

Motor third party compulsory insurance means effecting and carrying out contracts of insurance against
loss to the policy holder arising from liabilities incurred to third parties arising out of or in connection with the
use of motor vehicles on land, as specified in the Motor Vehicles Act, 1939.

Liability insurance means effecting and carrying out contracts of insurance against loss to the policy holder
arising from liabilities incurred to third parties.

Workers’ compensation insurance means effecting and carrying out contracts of insurance against loss to
the policy holder arising from liabilities incurred to workers arising out of or in connection with the
employment of the workers by the insured persons;

Credit and suretyship insurance” means effecting and carrying out:

(i) Contracts of insurance against loss to the policy holder arising from failure, whether through insolvency
or otherwise, of debtors to pay debts when they fall due; or
(ii) Contracts of insurance against loss to the policy holder arising from his non-performance of contracts of
guarantee entered into by him; or
(iii) Contracts for, performance bonds, administration bonds, bail bonds, custom bonds, fidelity* bonds or
similar contracts of guarantee;
[A fidelity bond is a form of business insurance that offers an employer protection against losses that are
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caused by its employees' fraudulent or dishonest actions. This form of insurance can protect against
monetary or physical losses.]

Accident and health insurance means carrying out contracts of insurance, the duration of which under the
contract is not more than one year, providing fixed monetary benefits or benefits in the nature of indemnity
or a combination of both, against risks of the policy holder:
▪ sustaining injury or dying as a result of an accident;
▪ becoming incapacitated in consequence of a disease; or
▪ suffering loss, including medical expenses, attributable to sickness or disability;

Agriculture insurance means carrying out contracts of insurance against loss to the policyholder arising
from loss of or damage to agriculture related property including crops.

Miscellaneous insurance means carrying out contracts of insurance of types not included in any other
class.

Proportional treaty business” means effecting and carrying out of contracts of treaty re-insurance, whether
obligatory or otherwise, of such a nature that a proportion of premium or of a separately identified part of
premium on insurance contracts which are the subject matter of the treaty is payable to the reinsurer by
the cedent* and an identical proportion of claims or of a separately identified part of claims on those
contracts is payable to the cedent by the re-insurer, and including without limitation treaties of quota-
share and surplus classifications.

(A cedent is a party in an insurance contract who passes the financial obligation for certain potential
losses to the insurer. Cedent — a ceding insurer or a re-insurer. A ceding insurer is an insurer that
underwrites and issues an original, primary policy to an insured and contractually transfers (cedes) a
portion of the risk to a re-insurer.

Reinsurer---A reinsurer is a company that provides financial protection to insurance companies. Re-insurers
handle risks that are too large for insurance companies to handle on their own and make it possible for
insurers to obtain more business than they would otherwise be able to. )

B. Life insurance

Life-insurance provides for your family or some other named beneficiaries on your death. Two general
types are available: term insurance provides coverage only during the term of the policy and pays off only
on the insured’s death; whole-life insurance provides savings as well as insurance and can let the insured
collect before death.

As per Insurance Ordinance 2000, Life insurance business includes:

(a) a contract of insurance that provides for the payment of money on the death of a person or on the
happening of a contingency dependent on the termination or continuance of human life;
(b) a contract of insurance that is subject to payment of premiums for a term dependent on the
termination or continuance of human life;
(c) a contract of insurance that provides for the payment of an annuity (a form of insurance entitling the
investor to a series of annual sums) for a term dependent on the continuance of human life;
(d) a contract providing an indemnity for medical expenses;
(e) a continuous disability income contract.

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Q. WHAT ARE THE MAJOR TYPES OF RISK FACED BY A BUSINESSMAN? [2022]

Q. WHAT ARE DIFFERENT TYPES OF RISK? HOW DOES INSURANCE POLICY HELP TO REDUCE THESE RISKS? [2017]

Risk is defined as uncertainty concerning the occurrence of a loss.

1. Pure risk is defined as a situation in which there are only the possibilities of loss or no loss. The only possible
outcomes are adverse (loss) and neutral (no loss). Examples of pure risks include premature death, job-
related accidents, catastrophic [terrible] medical expenses, and damage to property from fire, lightning,
flood, or earthquake.

- Personal risks are risks that directly affect an individual or family. They involve the possibility of a loss or
reduction of earned income, extra expenses, and the depletion (reduction) of financial assets. Major
personal risks that can cause great economic insecurity includes premature death, poor health,
unemployment and insufficient income during retirement.

- Commercial Risks
Business firms also face a wide variety of pure risks that can bankrupt the firm if a loss occurs. These risks
include property risk, liability risk, loss of business income, and other risks.

2. Speculative risk is defined as a situation in which either profit or loss is possible. For example, if you
purchase 100 shares of common stock, you would profit if the price of the stock increases but would lose if
the price declines.

3. Diversifiable risk is a risk that affects only individuals or small groups and not the entire economy. It is a
risk that can be reduced or eliminated by diversification. For example, a diversified portfolio of stocks,
bonds, and certificates of deposit is less risky than a portfolio that is 100 percent invested in stocks.
Losses on one type of investment, say stocks, may be offset by gains from bonds and certificates of
deposit. Likewise, there is less risk to a property and liability insurer if different lines of insurance are
underwritten rather than only one line. Losses on one line can be offset by profits on other lines. Because
diversifiable risk affects only specific individuals or small groups, it is also called nonsystematic risk or
particular risk.

4. Non-diversifiable risk [systematic risk or fundamental risk] is a risk that affects the entire economy or
large numbers of persons or groups within the economy. It is a risk that cannot be eliminated or reduced by
diversification. Examples include rapid inflation, cyclical unemployment, war, hurricanes
[cyclones/tornadoes], floods, and earthquakes because large numbers of individuals or groups are
affected.

5. Enterprise risk is a term that encompasses [covers] all major risks faced by a business firm. Such risks
include pure risk, speculative risk, strategic risk, operational risk, and financial risk. We have already
explained the meaning of pure and speculative risk.

• Strategic risk refers to uncertainty regarding the firm’s financial goals and objectives; for example, if
a firm enters a new line of business, the line may be unprofitable.

• Operational risk results from the firm’s business operations. For example, a bank that offers online
banking services may incur losses if “hackers” break into the bank’s computer.

• 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. For example, a food company that
agrees to deliver cereal [Anaaj: Wheat, Maize, Rice, and Barley, Oats.] at a fixed price to a
supermarket chain in six months may lose money if grain prices rise. A bank with a large portfolio of
Treasury bonds may incur losses if interest rates rise.

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Q. WHAT IS BUSINESS RISK? HOW RISK CAN BE AVOIDED/ REDUCED? [2015]

Business risk

The term business risk refers to the possibility of a commercial business making inadequate profits due
to uncertainties - for example: changes in taste, change in consumer preferences, strikes, increased
competition, change in government policy, obsolescence etc.

External risks are out of your control. These include, but are not limited to, interest rates, exchange
rates, politics, weather, pandemic, new technology that makes you obsolete etc.

Internal risks are in your control and include breaches [violations], non-compliances, fire hazards, high
employee turnover, a key employee leaving, loss of customer data, theft, embezzlement etc.

Ways to reduce risk

Risk management is a form of insurance in itself and is an imperative step for sustainable success.
Following are the ways to manage or reduce risk.

i. Set up a Risk-Management Team

Because risk management is a long-term effort that’s ongoing throughout the year, it’s a good
idea to have the same person or people involved in protecting your company. Pick people
from different departments, including accounting, sales, HR, IT and production. You might put
one person in charge, but have her meet with your department heads at least once each
quarter.

ii. Create Prevention Plans

Try to come up with plans to defend against each potential problem. Even if certain problems
are unavoidable, you can take steps to minimize the disruption [disturbance/ trouble] to your
business. This often involves creating a Plan B.

iii. Meet with a Legal Expert

One key way to reduce risks to your business is to make sure you know all of the local, provincial
and federal laws that might affect your company. This will help you reduce the chances of
government fines and employee or customer lawsuits.

iv. Set up Internal Controls

Internal controls reduce the chance of monetary theft or overspending. For example, you might
set up guidelines for having travel expenses approved in advance, rather than simply paying
expense reports after employees return from trips. You might require purchases over a certain
amount to be bid to at least three vendors. You might require two signatures on checks over a
certain amount. Having surprise and annual audits performed by an outside auditor makes it
harder for employees to steal goods or money over the long-term, and helps spot honest
mistakes that would otherwise continue for months or years.

v. Manage Your Money Closely

Having a budget and a rainy day fund aren’t enough to protect your small business from
unforeseen problems. For example, can you quickly replace a lender who stops offering you
credit? What if a major customer leaves? If your computers are hacked and you don’t have
access to your funds for days or weeks. Having separate operating accounts with cash in them
can help you keep going.

vi. Get insurance.

Getting insurance allows you to protect your business when an accident or natural disaster
happens. It also gives you peace of mind because you know that you will be compensated in
case of loss.

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vii. Diversify your products or services.

Don’t put all of your eggs in one basket.
Whether you are offering products, services, or both, diversifying your business offerings is a
great idea. Not only does this help you offer more options to your customers, but it also helps
you have various streams of income as well. Plus, diversifying your products or services help
maintain the public’s interest in your company. It also can give you an edge over your
competitors.

viii. Limit your business loan.

Business loans are just so attractive that many businesses always take them. They may provide
you enough capital to launch or expand a business, but they pose risks to your business as well.
If you cannot avoid getting a business loan, make sure that the one you’re getting is
manageable and has the least interest. Compare plans from different banks beforehand, and
make sure you can actually afford the monthly payments. Only apply for a loan if you really
need it. Otherwise, just focus on marketing your business. By doing this, you can eliminate one
financial risk and increase your sales.

ix. Implement a Quality Assurance Program

A good reputation is imperative [vital/ crucial/ important] if you want a sustainable [continuous,
viable, feasible] business. Customer service is key to success. Be sure to test your products and
services in order to assure the highest quality.

x. Limit High-Risk Customers

If you’re just getting started, immediately implement a rule that customers with poor credit must
pay ahead of time, which will avoid complications down the road.

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