ADDIS ABABA MEDICAL COLLEGE

DEPARTMENT OF B/MANAGEMENT

COURSE:-RISK MANAGEMENT& INSURANCE

CHAPTER-ONE
INTRODUCTION
BY BEYENE,H(MBA,PhD Candidate in MGT)
Academic year, 2025GC

1
 CHAPTER ONE
1. RISK AND RELATED TOPICS

Meaning of Risk: There Is no single definition of

risk.
Writers, particularly in the USA have produced
number of definitions of risk.
These are usually accompanied by lengthy
arguments to support the particular view they put
forward.
Consider the following definitions:
Risk is the possibility of an unfortunate
occurrence.
 CONT….
• Risk is unpredictability – the
tendency that actual results
may differ from predicted
results.
• Risk is uncertainty of loss.
• Risk is possibility of loss
 Uncertainty
• Certainty is lack of doubt. In Webster’s New
Collegiate Dictionary, one meaning of the term
“certainty” is “a state of being free from doubt.
• The antonym of certainty is “uncertainty” which
is “doubt about our ability to predict the future
outcome of current actions.
• Clearly, the term “uncertainty describes a state
of mind. Uncertainty arises when an individual
perceives that outcomes cannot be known with
certainty.”
 CONT…

• Uncertainty is doubt about our

ability to predict the future.
• Uncertainty arises when an
individual perceives risk.
• Uncertainty is a subjective
concept, so it cannot be
 PERIL AND HAZARD
• The terms peril and hazard should not be
confused with the concept of risk discussed
earlier.
• Peril is defined as the cause of loss.
• If your house burns because of a fire, the peril, or
cause of loss, is the fire.
• If your car is damaged in a collision with another
car, collision is the peril, or cause of loss.
• Common perils that cause property damage
included fire, lightning, windstorm, earth quakes,
theft and robbery.
 Hazard
A hazard is a condition that creates or increases
the chance of loss. There are four major types
of hazards:
• Physical hazard
• Mortal hazard
• Morale hazard
• Legal hazard
 CONT…
• Physical hazard: A physical hazard is a
physical condition that increases the chance of
loss. Examples of physical hazards include icy
roads that increase the chance of a car accident,
defective wiring in a building that increases the
increases of fire, and a defective lock on door
that increases the chance of theft.
• Moral hazards: Moral hazard is dishonesty or
character defects in an individual that increase
the frequency or severity of loss.
 CONT…
• Examples of moral hazard include faking an
accident to collect from an insurer, submitting a
fraudulent claim, inflating the amount of a
claim, and intentionally burning unsold
merchandise that is insured.
• Morale hazard: Morale hazard is carelessness
or indifference to a loss because of existence of
insurance
 Categories of Risk
• Pure and Speculative Risks:
• Pure Risk: Pure risk is defined as a situation in
which there are only the possibilities of loss or not
loss.
• The only possible outcomes are adverse (loss) and
neutral (no loss).
• Examples of pure risk include premature death,
industrial accidents, terrible medical expenses,
and damage to property from fire, lightning,
flood, or earthquake
 CONT…
• Speculative Risk: 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
stock increases but would loss if the price declines.
• Other examples, of speculative risk include betting
on horse race, card games, investing in real estate,
and going into business for your self. In these
situations, both profit and loss are possible.
 Types of pure risk:
• Personal Risks: Personal risks are risks that directly
affect an individual.
• They involve the possibility of the complete loss or
reduction of earned income, extra expenses, and the
depletion of financial assets.
There are four major personal risks.
• Risk of premature death.
• Risk of insufficient income during retirement.
• Risk of poor health.
• Risk of unemployment.
 CONT…
• Property Risks: Persons owning property are exposed
to property risks – the risk of having property
damaged or lost from numerous causes.
• Direct loss: A direct loss is defined as financial
loss that results, from the physical damage,
destruction, or theft of the property. For example, if
you own a hotel that is damaged by a fire, the
physical damage to the hotel is known as a direct loss.
• Indirect loss: An indirect loss is a financial loss that
results indirectly from the occurrence of a direct
physical damage or theft loss.
 CONT…
• Liability Risk:
Liability risks are another important type of
pure risk that most persons face. Under our
legal system, you can be held legally liable if
you do something that result in bodily injury or
property damage to someone else
 Fundamental and Particular Risks.

• Fundamental Risk:
• A fundamental risk is a risk that affects the entire
economy or large numbers of persons or groups
within the economy.
• Examples include rapid inflation, cyclical
unemployment, and war because large numbers
of individuals are affected.
 CONT…
• The risk of a natural disaster is another
important risk.
• Hurricanes, tornadoes, earthquakes, floods,
and forest and grass fires can result in billions
of dollars of property damage and numerous
deaths. More recently, the risk of a terrorist
attack is rapidly emerging as fundamental risk.
 CONT…
• Particular Risk:
• A particular risk is a risk that affects only
individuals and not the entire community.
Examples include car thefts, gold thefts, bank
robberies, and dwelling fires. Only individuals
experiencing such losses are affected, not the
entire economy.
 CHAPTER TWO
THE RISK MANAGEMENT PROCESS

• Meaning of Risk Management

 Risk management is a process that identifies loss exposures
faced by an organization and selects the most appropriate
techniques for treating such exposures.
 Objectives of Risk Management
• Steps in the Risk Management Process:
• The risk management process involves four steps:
• Step 1: Identifying potential losses (Risk Identification)
• Step 2: Evaluate Potential losses (Risk Measurement)
• Step 3: Select the appropriate techniques for treating loss
exposure, and
• Step 4: Implement and administer the program.
•
 RISK IDENTIFICATION
• The first step in the risk management process is
to identify all major and minor loss exposures.
• A loss exposure is a potential loss that may be
associated with a specific type of risk.
• Loss exposures typically classified as (Sources of
Risks.
 CONT…
• Loss Exposures (Sources of Risks):
• Property Loss Exposures:
– Buildings, Plants, Other Structures
– Furniture, Equipments, Supplies
– Electronic data processing equipments; Computer
Software
– Inventory
– Accounts receivables, Valuable papers and records
• Company planes, boats, mobile equipments
 CONT…
• Business Income Loss Exposures:
– Loss of income from a covered loss
– Continuing exposures after a loss
– Extra expenses
– Contingent Business income losses.
• Human Resources Exposures:
– Death of key employees/disability of key employees
– Retirement or unemployment
– Job-related injuries or disease experienced by
workers
 CONT…
• Crime Loss Exposures:
– Holdups, robberies
– Employees theft and dishonesty
– Fraud and Embezzlement
– Interest and computer crime exposures
 CONT…
• Employee Benefit Loss Exposures:
– Failure to comply with government regulation
– Failure to pay promised benefits
– Group life and health and retirement plan exposures
• Foreign Loss Exposures:
– Acts of terrorism
– Plants, business property, inventory
– Foreign currency risks
– Kidnapping of key persons
– Political risks
 CONT…
• Liability Risks:
– Defective Products
– Sexual harassment of employees, discrimination
against employees, wrongful termination
• Misuse of internet and e-mail transactions
 RISK MEASUREMENT (RISK EVALUATION)
• This step involves on estimation of the potential
frequency and severity of loss.
• Loss frequency refers to the probable number of
losses that may occur during the some given period
of time.
• Loss severity refers to the probable size of the losses
that may occur.
• In addition, the relative frequency and severity of
each loss exposure must be estimate so that the risk
manager can select the most appropriate technique
or combination of techniques for handling each
exposure.
 TOOLS OF RISK MANAGEMENT

• After identifying and evaluating exposures to

risk, systematic consideration can be given to
alternative methods for managing each
exposure. The four basic methods available to
handling risks are
• Risk Avoidance
• Loss Control
• Risk Retention and
• Risk Transfer
 RISK AVOIDANCE
• Avoidance means a certain loss exposure is
never acquired, or an existing loss exposure is
abandoned.
• Risk avoidance is conscious decision net to
expose oneself or one’s firm to a particular risk
of loss.
• In this way, risk avoidance can be said to
decrease one’s chance of loss to zero.
• Example: A pharmaceutical firm that markets a
drug with dangerous side effects can withdraw
the drug from the market.
 CONT…
• The major advantage of risk avoidance is that
the chance of loss is reduce to zero if the loss
exposure is never acquired.
• , however has two major disadvantages first,
the firm may not be able to avoid all losses.
Example, a company may not be able to avoid
the premature death of a key executive.
Second, it may not be feasible or practical to
avoid the exposure
 LOSS CONTROL
 Actions may be taken to reduce the losses associated
with them.
 Types of Loss Control
1. Focus of Loss Control
 Some loss control measurers are designed primarily to
reduce loss frequency.
 This form of loss control is referred to as “frequency
reduction” (Loss Prevention)
 For example, measurers that reduce truck accidents
include driver examinations, zero tolerance for alcohol
or drug abuse and strict enforcement of safety rules.
 CONT…
• In contrast to frequency reduction, consider an
auto manufacturer having airbags installed in the
company fleet off automobiles.
• form is engaging in “severity reduction” (Loss
Reduction).
• The air bags will not prevent accidents from
occurring, but they will reduce the probable
injuries that employees will suffer if an accident
does happen.
 CONT…
• Two special forms of loss reduction are
“Separation” and “Duplication”.
• Separation involves the reduction of maximum
probable loss associated with some kinds of
risks.
 Risk financing techniques
• RISK RETNTION :
• Retention means that the firm’s retains part or all of the
losses that can result from a given loss.
• Retention can be Actives (Planned) or Passive
(Unplanned)
• Retention can be effectively used in a risk management
program under the following conditions:
 No other method of treatment is available
 The worst possible loss is not serious
 Losses are highly predictable.
 Advantages of Retention
• Save Money:
The firm can save money in the long run if its actual loses
are less then the loss component in the insurance’s
premium.
Lower Expenses:
 The services provide by the insurer may be provided by
the firm at a lower cost.
 Some expenses may be reduced, including loss
adjustment expenses, general administrative expenses,
commissions and brokerage fees, loss control expenses,
taxes and fees and the insurer’s profit.
 CONT…
• Encourage Loss Prevention:
• Because the exposure is retained, there may be a
greater incentive for loss prevention.
Increase Cash Flow:
• Cash flow may be increased because the firm can
use the funds that normally would be paid to the
insurer at the beginning of the policy period.
 Disadvantages of Retention
• Possible higher losses:
• Possible higher expenses:
• Possible higher taxes
 RISK TRANSFER
Type of
Loss frequency severity RM techniques
1. Low low retention
2. high low loss prevention
3. low high insurance
4. High High Avoidance
 CHAPTER THREE
INSURANCE
• Definition of Insurance
• “Insurance is the pooling of accidental losses by transfer of such
risks to insurers, who agree to indemnify insureds for such
losses, to provide other financial benefits on their occurrence, or
to render services connected with the risk”.

• BASIC CHARACTERISTICS OF INSURANCE:

• Based on the preceding definition, an insurance plan or
arrangement typically includes the following characteristics.
• Pooling of Losses
• Payment of Accidental Losses
• Risk Transfer
•
 Pooling of Losses
• Pooling or the sharing of losses is the heart of
insurance.
• Pooling is the spreading of losses incurred by
the few over the entire group, so that in the
process, average loss is substituted for
actuarial.
• Thus, pooling implies (1) the sharing of losses
by the entire group, and (2) prediction of
future losses with some accuracy based on the
law of large numbers.
 Payment of Accidental Losses

• An accidental loss is one that the unforeseen and

unexpected and occurs as a result of chance.
• Risk Transfer
• Risk transfer means that a pure risk is transferred
from the insured to the insurer, who typically is in
a stronger financial position to pay the loss than
the insured.
 REQUIREMENTS OF AN INSURANCE RISK

1.Large Number of Exposure Units :

 The first requirement of an insurable risk is a large
number of exposure units.
 Ideally, there should be a large group of roughly
similar, but not necessarily identical, exposure units
that are subject to the same peril or group of perils.
2. Accidental and Unintentional Loss:
 A second requirement is that the loss should be
accidental and unintentional; ideally, the loss should
be accidental and outside the insured’s control
 Determinable and Measurable Loss:

3. A third requirement is that the loss should be

both determinable and measurable. This
means the loss should be definite as to cause,
time, place and amount.
4. The fourth requirement is that ideally the loss
should not be catastrophic.
 This means that large proportion of exposure
units should not incur losses at the same time.
 As we stated earlier, pooling is the essence of
insurance.
 CONT…
5.Calculable Chance of Loss:
 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 al claims and expenses and yield a profit
during the policy period.
 CONT…
6. Economically Feasible Premium
 A final requirement is that the premium
should be economically feasible.
 The insured must be able to pay the premium.
 CHAPTER FOUR
LEGAL PRINCIPLES OF INSURANCE CONTRACTS

• PRINCIPLE OF INDEMNITY
The principle of indemnity states that the insurer agrees to
pay no more than the actual amount of the loss; stated
differently, the insured should not profit from a loss.
The principle of indemnity has two fundamental purposes.
 to prevent the insured from profiting from a loss.
 to reduce moral hazard
Exception of principles of indemnity
 Value Policy: A valued Policy is a policy that pays the
face amount of insurance if a total loss occurs.
 Because of the difficulty of determining the actual value
of the property at the time of loss, the insured and
insurer both agree on the value of the property when
the policy is first issued.
 Valued Policy Laws
• A valued policy law is a law that exists in some states
that required payment of the face amount of insurance
to the insured if a total loss to real property occurs
from a peril specified in the law.
• For example a building insured for $200,000 may have
an actual cash value of $175,000. If a total loss from a
fire occurs, the face amount of $200,000 would be
paid. Because insured would be paid more than the
actual cash value, the principle indemnity would be
violated.
Replacement Cost Insurance
• Replacement cost insurance means there is not
deduction for depreciation in determining the amount
paid for a loss.
Life insurance is another exception to the principle of indemnity.
 PRINCIPLE OF INSURABEL INTEREST

• The principle of insurable interest

states that the insured must be in a
position to loss financially if a loss
occurs.
• Insurance contract must be supported
by an insurable interest for the
following reasons.
 To prevent gambling
 To reduce moral hazard
 To measure the amount of the insured’s loss in
property insurance
 PRINCIPLE OF SUBROGATION
• The principle of subrogation strongly supports the
principle of indemnity.
• Subrogation means substitution of the insurer in
place of the insured for the purpose of claiming
indemnity from a third person for a loss covered by
insurance
• For Example, assume that a negligent motorist fails
to stop at a red light and smashes into X’s car,
causing damage in the amount of $5,000. If X has
collision insurance on her car, her company will
pay the physical damage loss to the car and then
attempt to collect from the negligent motorist who
cause the accident.
 CONT…
• Purposes of Subrogation:
Subrogation has three basic purposes.
• First, Subrogation prevents the insured from
collecting twice for the same loss.
• Second, Subrogation is used to hold the
guilty person responsible for the loss.
• Finally, Subrogation helps to hold down
insurance rates.
 PRINCIPEL OF UTMOT GOOD FAITH
• An insurance contract is based on the principle of
utmost good faith – that is, a higher degree of
honest is imposed on both parties to an insurance
contract than is imposed on parties to other
contracts.
• Thus, the principle of utmost good faith
imposed a high degree of honesty on the
applicant for insurance.
• The principle of utmost good faith is supported by
three important legal doctrines:
• Representations
• Concealment
• Warranty
 CONT…
• Representations: Representations are
statements made by the applicant for insurance.
For example if you apply life insurance you may be
asked questions concerning you age, weight,
height, occupation, state of health, family history,
and other relevant questions.
• Your answers to these questions are called
representations.
• The legal significance of a representation is that
the insurance contract is violable at the insurer’s
option if the representation is (1) material, (2)
false, and (3) relied on by the insurer.
 CONT…
• Material means that if the insurer knew the true
facts, the policy would not have been issued, or it
would have been issued on different terms.
• False means, that the statement is not true or is
misleading.
• Reliance means that the insurer relies on the
misrepresentation in issuing the policy at a
specified premium
 CONT…
• Concealment is intentional failure of the applicant
for insurance to reveal a material fact to the
insurer.
• A warranty is a statement of fact or a promise
made by the insured, which is part of the
insurance contract and must be true if the insurer
is to be liable under the contract.
 PRINCIPLE OF CONTRIBUTION

• Where there is over insurance because

a loss is covered by policies affected
with two or more insurers, the
principle of indemnity still applies.
ESSENTIAL REQUIREMENTS OF AN INSURANCE
CONTRACT
1.The agreement must be for a legal purpose; it must
be not against public policy or be otherwise illegal.
2. The parties must have legal capacity to contract.
3. There must be evidence of agreement of the parties to the
promises. In general this is shown by an offer by one party and
acceptance of that offer by the other.
 CHAPTER FIVE
LIFE AND HEALTH INSURANCE

The risk management tool that is most appropriate

for dealing with the exposure of premature death
is “Life Insurance”.
Characteristics of Life Insurance
1. The event insured against is an eventual certainty.
No one lives forever or maintains his economic
value. Yet we do not violate the requirements
of an insurable risk in the case of life insurance
for it’s is not the possibility of death itself that
we insurance against, but rather untimely death.
 CONT…
2.Life insurance is not a contract of indemnity.
The principle of indemnity applies on a
modified form in the case of life insurance.
3.Insurance as a legal principle, very contract of
insurance must be supported by an insurable
interest, but in life insurance the requirement
of insurable interest is applied somewhat
differently than in property and liability
insurance.
 CONT…
4.Life contract are long-term contracts. Nearly
all life policies are intended to continue until
the insured’s death or at least for several years.
Other forms of insurance policies may be
renewed many times, but are usually twelve-
month contracts, which may be terminated by
either party.
5.Finally, the question of over insurance is
immaterial in life insurance contracts
 Types of Life Insurance Contracts
1.TERM INSURANCE
 Term insurance provided protection only for a
definite period (term) of time.
 A term insurance policy is contract between the
insured and the insurer where by the insurer
promises to pay face amount of the policy to a
third party (the beneficiary) should the insured die
within a given period of time.
• Common types of term life insurance are 1 year
term, 5 year term, 10 years term, 20 years term,
and term to age 60 to 65.
 Uses of Term Insurance
• If the amount of income that can be spent on life
insurance is limited, term insurance can be
effectively used.
• Term insurance is appropriate if the need for
protection is temporary.
• Term insurance can be used to guarantee future
insurability.
Limitation of Term Insurance:
• Term insurance premiums increase with age and
eventually reach prohibitive levels.
• Term insurance is inappropriate if you wish to save
 WHOLE LIFE INSURANCE
In contrast to term insurance, which provides short
term protection, whole life insurance is a cash-
value policy that provides lifetime protection.
Ordinary Life Insurance:
 Ordinary life insurance also called straight life and
continuous premium whole life provides lifetime
protection to age 100, and the death claim is a
certainty.
 If the insured is still alive age 100, the face
amount of insurance is paid to the policy owner at
that time.
 ENDOWMENT INSURNCE
 An endowment policy pays the face amount of
insurance if the insured dies within a specified
period; if the insured survives to the end of the
endowment period, the face amount is paid to
the policy owner at that time.
 For example, if Stephanie, age 35, purchased a
20-year endowment policy and dies any time
within the 20-year period, the face amount
would be paid to her beneficiary. If she survives
to the end of the period, the face amount paid to
her.