Chapter-7 RISK AND INSURANCE

Risk

Risk can be defined as uncertainty, unexpected outcomes, or chances of loss in the future. In the context of finance, business, insurance, and everyday life, risk is a fundamental concept that involves the chance of negative results or deviation from expected results.

 

Types of Risk:

1. Pure risk and speculative

Pure risk

Pure Risk refers to a type of risk where there is only a possibility of loss or no loss, but no chance of gain. It includes risks like accidents, theft, fire etc. where the best possible outcome is nothing happening, and the worst outcome is a loss.

Speculative Risk

Speculative Risk refers to a type of risk where there is a possibility of loss, no loss, or gain. It is common in activities like investing or gambling, where the outcome is uncertain, and there is a chance of making a profit or facing a loss.

2. Fundamental and Particular Risk

Fundamental risk

Fundamental risk refers to the risk that affects the entire market or economy, such as natural disasters, economic recessions, or political instability. This type of risk cannot be controlled by individual businesses and impacts all industries and sectors. Since it is unavoidable, businesses and investors must plan strategies to manage its effects.

Particular risk

Particular risk is a type of risk that affects only a specific individual, business, or industry rather than the entire market. Examples include fire in a factory, theft in a shop, or a company’s financial loss. Unlike fundamental risk, particular risk can be controlled or minimized through proper management and precautions.

3. Objective Risk and Subjective Risk

Objective Risk

The difference between the actual loss and the predicted loss is known as objective risk. In other words, the variation between expected loss and actual loss is known as objective risk, which can be measured by the standard deviation or coefficient of variation.

Subjective Risk

Subjective risk refers to an individual's personal perception or judgment of risk. It is based on emotions, beliefs, and experiences. Subjective risk can be influenced by factors such as personality, culture, past experiences, and current circumstances.

Management of Risk
Risk management is the process of identifying, analyzing, and taking steps to minimize or control risks that may affect a business or individual. It involves strategies like avoiding risk, reducing its impact, transferring it through insurance, or accepting it with proper planning. Effective risk management helps in reducing losses and ensuring stability.

Objective of Risk Management

Pre-loss objectives:

Ø To prepare for potential loss with economy

Ø To reduce anxiety

Ø To fulfill legal obligation

Post-Loss objectives:

Ø To survive firm

Ø To continue business

Ø To stabilize earnings

Ø To fulfill social responsibility

Insurance

Insurance is a legally binding contract between an insurer and an insured party. The insurance offers financial protection for any losses the policyholder may incur in specific situations.

Benefits of Insurance

Providing Security
Providing Security refers to the financial protection given by insurance to individuals or businesses against unexpected losses. It ensures that in case of damage, loss, or death, the insured or their dependents receive compensation, maintaining financial stability.

 

Shifting of Risk
Shifting of Risk means passing the risk of loss to an insurance company. Instead of suffering a big loss alone, a person or business pays a small amount (premium) to the insurer, who takes responsibility for covering any future losses.

 

Encouraging Saving
Encouraging Saving happens because insurance requires regular premium payments, which help people save money over time. In life insurance, if the insured person survives the policy term, they receive the saved amount with bonuses, making it a secure way to build savings.

 

Generation of investable Funds
Insurance companies collect money from policyholders in the form of premiums. This collected money is not kept idle; instead, it is invested in businesses, infrastructure, and development projects. These investments help in economic growth by creating jobs, building facilities, and supporting various industries.

 

Improve Credit Standing
When a person or business has insurance, it reduces the risk for lenders by protecting valuable assets. This makes banks and financial institutions more willing to give loans. With insurance coverage, borrowing money becomes easier, and loan terms improve.

 

Promotes social welfare
Insurance helps people by providing financial support during difficult times, such as accidents, illnesses, or natural disasters. It reduces the burden on families and society by covering unexpected losses. This support creates stability and improves overall well-being in the community.

 

Promotes economic growth
Insurance supports economic growth by protecting businesses and individuals from financial losses, allowing them to take risks and invest in new opportunities. It also provides long-term funds that can be used for infrastructure projects like roads, hospitals, and factories. This creates jobs, increases productivity, and strengthens the overall economy.

Principles of Insurance 

1. Principle of Insurable interest

According to the principle of insurable interest, the insured must have an interest in the subject matter to be insured. Insurable interest means that if the subject matter to be insured is safe, then the insured will benefit, and if the subject matter is not safe or there is a loss, then the insured will suffer a loss.

2.   Principle of Utmost good faith

At the time of insurance, it is believed that both parties have submitted true information, and this belief is called the principle of utmost good faith. Both parties must observe the utmost good faith from the beginning to the end of the contract.

3. Principle of indemnity

The principle of indemnity says that insurance is done only for coverage of the loss; hence, insurers should not make any profit from the insurance contract. In other words, the insured should be compensated for the amount equal to the actual loss and not the amount exceeding the loss.

4.Principle of subrogation

The principle of subrogation refers to the belief that the right of the insurance company is established over the damaged property after compensation has been provided to the insured.

5.   Principle of contribution

According to the principle of contribution, if a subject matter is insured by more than one insurance company, then the compensation should be borne by all insurance companies in proportion to the insured amount. Damages are not paid in such a way that there is any additional benefit due to the insured.

6.  Principle of proximate cause ( Causa Proxima)

Damages or losses to the subject matter insured can be due to various reasons. The principle that compensation is provided based on the most proximate cause among various causes is known as the principle of proximate cause.

7. Principle of mitigation of loss

According to the principle of mitigation of loss, if the subject matter of insurance meets with an accident, then the insured should have taken all the necessary steps to minimize the loss to the subject matter of insurance. The insurer can deny compensation to the insured for losses resulting from their irresponsible or negligent behavior, even if the insured subject matter is insured.