1. RISK MANAGEMENT AND INSURANCE
Chapter 1
FUNDAMENTALS
AND TERMINOLOGY

2. Risk – is the possibility of bearing unwanted events.
Who are under RISK?
Individuals, Companies, etc face with loss from natural disasters.
Risk Management: The art and science of anticipating these potential losses and developing a plan to survive them.
Financial Definition of Insurance:
Insurance is a financial arrangement that redistributes the costs of unexpected losses.

3. LEGAL DEFINITION
- Insurance is a contractual arrangement whereby one party agrees to compensate another party for losses.
- Insurer: Party agreeing to pay for the losses.
- Insured: Party who loss causes the insurer to make a claims payment.
- Premium: is the payment insurer receives.
- Policy: is the insurance contract
- Exposure to Loss: the insured’s possibility loss. (The exposure is transferred to the insurer by purchasing an insurance policy)

4. Insurance System
It redistrubutes the cost of losses by collecting a premium payment from every participant (insured) in the systam
Insurer promises to pay the insured’s claims in the event of covered loss.
Only a small percentage of insured suffers losses.

5. Loss Loss: being without something previously possessed.
Insurable Loss: an undisred, unplanned reduction of economic value arising from chance.
(Depreciation and other expenses are exluded)
DIRECT LOSSES
Immediate, first result of an insured peril
Property Insurance, Car Insurance
INDIRECT LOSSES
Consequential losses
Secondary result of an insured peril

6. Chance of Loss It refers to a fraction A priory chance of loss:
Actual or expected number of losses
Number of exposures to loss
A priory chance of loss:
expected no. of loss
exposure units
An ex-post (actual) chance:
actual no. of losses
total no. of exposure units

7. PERIL : is the cause of loss.
HAZARDS : are the conditions that increase either the frequency or the severity of losses.
Moral Hazard : If a person does a harm on a property to have the money for the loss, the loss is said to result from the moral hazard.
Morale Hazard : refers to an attitude of indifference to loss created by the purchase of an insurance contract.
“Why should I care?, I am insured”
PROXIMATE CAUSE
The first cause in an unbroken chain of events leading to a loss. The cause without which the loss would not have occurred. It is the most important concept in insurance.

8. RISK: -is the uncertainty concerning a possible loss.
- the variations in possible outcomes of an event based on chance. (greater the number of
* different outcomes that may occur , the greater the risk.
The Degree of Risk: is a measure of the accuracy with which the outcome of an event based on chance can be predicted.
(Health certificate, occupations)
PURE RISK : is the situation that can result in only loss or no change.
SPECULATIVE RISK: refers to those exposures that can result in loss, gain or no change.

9. The Mathematical Basis for Insurance
Losses needs to be predicted accurately
Law of Large Numbers: The greater the number of observationsof an event based on chance, the more likely the actual results will approximate the expected results.
This system allows an insurance to reduce risk.
Example of Barns
UNDERWRITING : The process of pricing the insurance and selecting the insured is called underwriting.

10. Cash Flow Underwriting
It describes the practice of trying to attract new business by pricing insurance “at a loss”.
Loss ratio: % of the earned premium represented by losses.
incurred losses/ earned premiums
Expense ratio:
Total Expenses/ written premiums
Unearned premiums: written premiums-earned premiums
Combined Ratio: sum of the losses and the expense ratio.
At some cases even with combined ratios above 100 %, the insurance industries may be making profit because investment earnings exceeded underwritting losses. Insurance industry making loss in insurance underwritting but offsetting them by investment income.

11. The Benefits and Costs to Society of Insurance System
-Resourses used: Labour, the land and capital
(Does not include the cost of the losses
- Fraudulent Attempts: Property insurance fraud, health insurance fraud
Benefits:
- Stability in families,
- Insurance aids the planning process as planners will know that property loss will not mean financial ruin.
- Insurance facilitates credit transactions (death of key person)
- Only large corporations would be able to stay in business as small would not be able to sustain losses and remain in operation....Monopoly problem.
- Financier recognise that availability of insurance has a tendency to lower firms cost of capital.

12. The Benefits and Costs to Society of Insurance System (cont.)
Insurance companies directly contribute to society’s welfare in many ways:
-loss prevention, medical research
Insurance companies are very important financial intermediaries. They collect savings and re-invest into the economy.

13. Arson: Who Really Pays for Insured Losses
Arson: Deliberate, malicious burning of a building or other property to collect insurance proceeds.
-Unprofitable businesses such as restaurants and hotels
-selling and reselling the same property between conspirators, each sale at a higher price with the final highly inflated “market” value being insured.
-Over all, it is the honest, premium-paying insured, not the insurer, who pays for the loses.