1. Give a technical definition of risk.

With
examples, Also literally explain risk to a
lay man.

2. In relation to risk explain these concepts:

 Measurement of risk
 Psychological aspect of risk
 Frequency and severity of risk

3. (a) Trace the historical development of insurance

in ancient Europe.
(b) What role is the Lloyds incorporation playing
to stabilize world insurance industry?

4. With three examples each and discuss insurers

classification of risk.

5. (a) What is insurance contract.

(b) Discuss five essential features of insurance
contract.

6. Does insurance have any benefit to the individual

and society? Discuss.

1
1. Definition of risk
Risk has been defined in varying ways. This is because risk is not only the centre
of insurance but also inseperable from life. Risk is at the centre of life, itself and, as a
result, many people, in different walks of life are concerned with it. Educationists,
economists, doctors, psychologists, businessmen, engineers, etc., are all interested in the
concept of risk.
Risk can be defined as the quantifiable likelihood of loss or less-than-expected
returns. Examples: currency risk, inflation risk, principal risk, country risk, economic
risk, mortgage risk, liquidity risk, market risk, opportunity risk, income risk, interest rate
risk, prepayment risk, credit risk, unsystematic risk, call risk, business risk, counterparty
risk, purchasing-power risk, event risk. Also, most risk professionals define risk in terms
of an expected-also known as anticipated variability. According to Factor Analysis of
Information Risk, risk is, “The probable frequency and probable magnitude of future
loss”. This definition was accepted by The Open Group (an industry consortium to set
vendor and technology- neutral open standards for computing infrastructure). In statistics,
risk is often mapped to the probability of some event seen as undesirable. Usually, the
probability of that event and some assessment of its expected harm must be combined

2
into a believable scenario (an outcome), which combines the set of risk, regret and reward
probabilities into an expected value for that outcome.

Risk To A Lay Man.

There is no doubt that the common usage of the word “risk” sees only the
downside. Asking the man in the street if he would like to have a risk happen to him will
nearly always result in a negative response. “Risk is bad for you”. This is reflected in the
traditional definitions of the word, both in standard dictionaries and in some technical
documents, But what about the professional bodies, who may have a different view from
the lay man?
The Institute of Risk Management (IRM) rather surprisingly appears to have no
official definition of “risk” although IRM documents use phrases such as “chance of bad
consequences, or exposure to mischance”. It can also be said that “risk is any uncertainty
which can affect achievements of objectives either positively or negatively”. Risk is also
said to be an umbrella term, with two varieties: “opportunity” which is a risk with
positive effects and “threat” which is a risk with negative effects. For example according
to a lay man’s definition of happiness: “Happiness involves Active Risk-taking:
Obviously this because people have to take risk to make a-step-better. By common sense,
human can never do anything exactly 100% right without any errors”.

2. (a) Measurement of Risk.

A set of possibilities each with quantified probabilities and quantified losses.
Example: “there is a 40% chance the proposed oil well will be dry with a loss of $12
million in exploratory drilling costs”.
In this sense, Hubbard uses the terms so that one may have uncertainty without risk but
not risk without uncertainty. We can be uncertain about the winner of a contest, but
unless we have some personal stake in it, we have no risk. If we bet money on the
outcome of the contest, then we have a risk. In both cases there is more than one
outcome.

(b) Psychological Aspect of Risk.

Ten patients with a diagnosis of malignant mesothelioma were assessed for
history of asbestos exposure, acquisition of and reaction to risk information, smoking
behavior and feelings about their disease and the asbestos industry. Mean age was 59
years; median span of time from diagnosis to interview was 10 months. Only two of
seven patients with direct occupational asbestos exposure acquired risk information from
a professional source. Lack of concern and denial are the reactions reported most
frequently to risk information. Behavioral findings support the attitudinal reactions. None
of the eight smokers in the sample stopped smoking after receiving increased risk
information. Not a single patient increased his visits to a physician. Patients commonly
expressed feelings of being unlucky in reactions to the disease. Seven of the ten patients
denied any feelings of anger toward the asbestos industry. These preliminary findings
suggest the need for better information and education of high risk individuals.

(c) Frequency and Severity of Risk.

3
 Risk assessment is the process of quantifying the risk events documented in the
process of quantifying the risk events documented in the preceding identification stage. A
risk assessment has two aspects. The first determines the likelihood of a risk occurring
(risk frequency); risks are classified along a continuum from very unlikely to very
probable. The second judges the impact of the risk should it occur (consequence
severity). Risks affect project outcomes in diverse ways. Risks effects are usually
apparent in direct project outcomes by increasing costs or schedules. Some risks
influence the project by affecting the public, public perception, the environment, or safety
and health considerations. Risk can also affect projects in indirect ways by requiring
increased planning, review and management oversight activity. The risk assessment
phase has as its primary objectives the systematic consideration of risk events, their
likelihood of occurrence and the consequence of such occurrences.

3. (a) Historical Development of Insurance in Ancient Europe.

The Commercial Revolution was a period of European economic expansion,
colonialism and mercantilism which lasted from approximately the 16th century until the
early 18th century. It was succeeded in the mid-18th century by the Industrial Revolution.
Beginning with the Crusades, the Europeans rediscovered spices, silks, and other
commodities rare in Europe. This development created a new desire for trade, and trade
expanded in the second half of the Middle Ages. European nations, through voyages of
discovery, were looking for new trade routes in the 15th and 16th centuries, which allowed
the European powers to build vast, new international trade networks. Nations also sought
new sources of wealth. To deal with this new-found wealth, new economic theories and
practices were created. Because of competing national interest, nations had the desire for
increased world power through their colonial empires. The Commercial Revolution is
marked by an increase in general commerce and in the growth of non-manufacturing
pursuits such as banking, insurance and investing.
Trade in this period was risky business: war, weather and other uncertainties often
kept merchants from making a profit, and frequently an entire cargo would disappear all
together. To mitigate this risk, the wealthy got together to share the risk through stock:
people would own shares of a venture, so that if there was a loss, it would not be an all
consuming loss costing the individual investor everything in one transaction.
Other ways of dealing with the risk and expense associated with all of the new trade
activity include insurance and joint stock companies which were created as formal
institutions. People had been informally sharing risk for hundreds of years, but the formal
ways they were now sharing risk was new.
Even though, the ruling classes would not often directly assist in trade endeavors and
individuals were unequal to the task, rulers such as Henry VIII of England established a
permanent Royal Navy with the intention of reducing piracy and protecting English
shipping.
Insurance companies were another way to mitigate risk. Insurance in one form or another
has been around as far back as there are records. What differed about insurance going
into the 16th and 17th centuries was that these informal mechanisms became formalized.
Lloyd’s of London came into being in 1688 in English coffee shops that catered to
sailors, traders and others involved in trade. Interestingly, Lloyd’s coffeehouse published
a newspaper, which gave news from various parts of the world and helped the

4
underwriters of the insurance at the coffeehouse to determine the risk. This innovation
was one of many that allowed for the categorization of risk. Another innovation was the
use of ship catalogs and classifications. Other forms of insurance began to appear as well.
After the Great Fire of London, Nicholas Barbon began to sell fire insurance in 1667.
Laws were changed to deal with insurance issues, such as l’Ordonnance de la Marine (by
1681).

(b) Lloyds Incorporation Role In The Stabilizing The World Insurance Industry.
Today Lloyd’s is the world’s leading insurance market, housed in an award-
winning modern building in Lime street. Its origins, however lay in the more modest
surroundings of a 17th century coffee shop. Unlike most other insurance brands, Lloyd’s
is not a company, it’s a market where members join together as syndicates to insure and
re-insure risk.
The investing institutions are those which collect savings and invest them into securities
market and other long-term assets. The main investment institutions insurance
companies, pension funds, unit trusts and investment trusts. Together they make a vast
resource of funds which are invested in securities and other assets. They own around 58%
of British shares. The British insurance industry is highly sophisticated and serves
millions of policyholders in Britain and overseas. Policyholders include governments,
companies and individuals. The British insurance is the fourth largest in the world and in
proportion to its GDP is the highest in any country. There are 2 categories of insurance:
long-term insurance for many years, such as life insurance, permanent health (medical)
insurance; and general insurance for a year or less, which covers risks of damage, such as
loss of property, accidents and short-term health insurance. In 1995 there were about 830
authorized to carry on insurance business in Britain. The industry as a whole employs
some 207,000 people, plus about 126,000 are employed in activities related to insurance.
Lloyd’s is an incorporated society of private insurers in London. Originally it dealt with
marine insurance. Today it deals with other classes of insurance. Long-term life and
financial guarantee is not covered. Insurance brokers as intermediaries are a valuable part
of the insurance market. Lloyd’s insurance brokers play an important role in the Lloyd’s
market. Institute of London Underwriters was formed in 1984 as an association for
marine underwriters. Today it provides a market where member insurance companies
transact marine, energy, commercial transport and aviation insurance business. The
Institute issues combined policies in its own name on risks which are underwritten by
member companies. About a half of the 58 member companies are branches or
subsidiaries of overseas companies.

4. Insurers Classification of Risks with Examples.

With regards insurability, there are basically two categories of risks;
~ Speculative or Dynamic risk
~ Pure or Static risk
But others include:
~Fundamental risk and
~Particular risk

5
Speculative or Dynamic Risk
Speculative (dynamic) risk is a situation in which either profit or loss is possible.
Examples of speculative risks are betting on a horse race, investing in stocks/bonds and
real estate. In the business level, in the daily conduct of its affairs, every business
establishment faces decisions that entail an element of risk. The decision to venture into a
new market, purchase new equipments, diversify on the existing product line, expand or
contract areas of operations, commit more to advertising, borrow additional capital, etc.,
carry risks inherent to the business. The outcome of such speculative risks is either
beneficial (profitable) or loss.
Speculative risk is uninsurable.
Pure or Static Risk
The second category of risk is known as pure or static risk. Pure (static) risk is a
situation in which there are only the possibilities of loss or no loss, as oppose to loss or
profit with speculative risk. The only outcome of pure are adverse (in a loss) or neutral
(with no loss), never beneficial. Examples of pure risks include premature death,
occupational disability, catastrophic medical expenses and damage to property due to
fire, lightning or flood.
It is important to distinguish between pure and speculative risks for three reasons. First,
through the use of commercial, personal and liability insurance policies, insurance
companies in the private sector generally insure only pure risks. Speculative risks are not
considered insurable, with some exceptions.
Second, the law of large numbers can be applied more easily to pure risks than to
speculative risks. The law of large numbers is very important in insurance because it
enables insurers to predict loss figures in advance. It is generally more difficult to apply
the law of large numbers to speculative risks in order to predict future losses. One of the
exceptions is the speculative risk of gambling, where casinos can apply the law of large
numbers in a very efficient manner.
Finally, society as a whole may benefit from a speculative risk even though a loss occurs,
but it is harmed if a pure risk is present and a loss occurs. For instance, a computer
manufacturer’s competitor develops a new technology to produce faster computer
processors more cheaply. As a result, it forces the computer manufacturer into
bankruptcy. Despite the bankruptcy, society as a whole benefits since the competitor’s
computers work faster and are sold at a lower price. On the other hand, society would not
benefit when most pure risks, such as earthquake, occur.
Types of Pure (static) Risk
The major types of pure risk that are associated with great economic and financial
insecurity include;
~personal risks
~property risks and
~liability risks.
Personal risks are risks that directly affect an individual. They involve the possibility of
loss or reduction of income of extra expenses and the elimination of financial assets.
There are four major personal risks;
~premature death
~old age
~poor health

6
 ~unemployment
Premature death risk is defined as the risk of the death of the head of an household with
unfulfilled financial obligations. These can include dependents to support, a mortgage to
be paid off, or children to educate.
Old age is a risk of insufficient income during retirement. When older workers retire,
they lose their normal amount of earnings. Unless they accumulated sufficient assets
from which to draw on, they would be facing a serious problem of economic insecurity.
Risk of poor health includes both catastrophic medical bills and the loss of earned
income. The cost of health care has increased substantially in recent years. The loss of
income is another major cause of financial instability. In cases of severe long term
disability, there is a substantial loss of earned income, medical bills are incurred,
employee benefits may be lost and savings depleted.
The risk of unemployment in another major threat to most families. Unemployment can
be the result of a industry cycle downswing, economic changes, seasonal factors and
frictions in the labor market. Regardless of the cause, unemployment can create havoc in
the average families by way of loss of income and employment benefits.
Property risk is the risk of having property damaged or loss from numerous perils.
Property loss can occur as a result of fire, lightning, windstorms, hail, and a number of
other causes.
Liability risks are another important type of pure risks that many people face. More than
ever, we are living in a litigious society. One can be sued for any frivolous reason. One
has to defend himself when sued, even when the sit is without merit.

Fundamental Risks and Particular Risks.

Fundamental risks affect the entire economy or large numbers of people or groups
within the economy. Examples of fundamental risks are high inflation, unemployment,
war and natural disasters such as earthquakes, hurricanes, tornadoes and floods.
Particular risks are risks that affect only individuals and not the entire community.
Examples of particular risks are burglary, theft, auto accident, dwelling fires. With
particular risks, only individuals experience losses and the rest of the community are left
unaffected.
The distinction between a fundamental and a particular risk is important since
government assistance may be necessary in order to insure fundamental risk. Social
insurance, government insurance programs and government guarantees and subsidies are
used to meet certain fundamental risks in our country. For example, the risk of
unemployment is generally not insurable by private insurance companies but can be
insured publicly by federal or state agencies. In addition, flood insurance is only available
through and/or subsidized by the federal government.

5. (a) What is an Insurance Contract?

An insurance contract is a “contract under which one party (the insurer) accepts
significant insurance risk from another party (the policyholder) by agreeing to
compensate the policyholder if a specified uncertain future event (the insured event)
adversely affects then policyholder.
Also, in insurance, the policy is a contract (generally a standard form contract) between
the insurer and the insured known as the policyholder, which determines the claims

7
which the insurer is legally required to pay. In exchange for payment known as the
premium, the insurer pays for damages to the insured which are caused by covered perils
under the policy language. Insurance contracts are designed to met specific needs and
thus have many features not found in many other contracts. Since insurance policies are
standard forms, they feature boilerplate language which is similar across a wide variety of
different types of insurance policies.
The insurance policy is generally an integrated contract, meaning that it includes all
forms of supplementary writings such as letters sent after the final agreement can make
the insurance policy a non-integrated contract. One insurance textbook states that “courts
consider all prior negotiations or agreements … every contractual term in the policy at
the time of delivery, as well as those written afterwards as policy riders and
endorsements… with both parties’ consent, are part of written policy”. The textbook also
states that the policy must refer to all papers which are part of the policy. Oral
agreements are subject to the parol evidence rule and may not be considered part of the
policy. Advertising materials and circulars are typically not part of a policy. Oral
contracts pending the issuance of a written policy can occur.
A sample insurance contract document helped traders in the early 16th and 17th centuries
survive losses. See (“Appendix A”) attached herein.

(b) Five Essential Features of an Insurance Contract.

Insurance contracts are legally binding documents. All contracts, including
insurance contracts, are legal documents between two or more parties. Each person
signing a contract must be legally competent. Contracts list what each party’s
responsibility is and what each party promises to do. Insurance contracts include these
unique and essential features.
(i) Contract of Adhesion : Courts will favor the insured if the contract is ambiguous.
Insurance policies are contracts of adhesion. One party, the insurance company, creates
the contract. The insured either accepts or rejects the contract. If there is ambiguity or
vagueness in the contract, courts will favor the insured.

(ii) Aleatory Contract : The insured could receive a larger payment than the premiums
paid if a claim occurs. Aleatory contracts are based on unequal bargaining value
occurring because of a possible future event. The insured has the potential to receive a
payout larger than the total amount of premiums paid should a claim arise in the future.

(iii) Executory Contract : Insurance companies are liable only if a loss occurs. Executory
contracts are either partially or completely unfilled unless a specific action happens. In
insurance contracts, the insurer is only liable if and when a loss occurs.

(iv) Unilateral Contract : Premiums are paid in return for the promise of paying for a loss.
A unilateral contract exchanges a promise for a specific action. In an insurance contract,
the insured pays the premiums in return for the promise that any future claims will be
paid. The insured’s only responsibility is to pay the premiums; no further action is
required to keep the policy in force. Only an insurance company can be sued for breach
of contract.

8
(v) Parol Evidence Rule : Oral agreements not included in the contract cannot be used in
the court. Insurance contracts are written based on the Parol Evidence Rule, which is the
assumption that any oral agreements between the insured and the insurer have been
incorporated into the contract. Once the agreement has been signed an executed, any oral
agreements prior to signing the agreements cannot be entered in a court proceeding to
change the contract.

6. Does Insurance have any benefit to the individual and society?

• It relives those insuring from the worry and anxiety they may have about
how they would meet the cost of risk. In the case of businesses, this is a positive
stimulus to their activities and allows them to get on with their own business in
the knowledge that they are financially protected against forms of risk.
• Business people will be more inclined to risk their money by building
factories, making goods, sailing ships, flying planes, with the knowledge that they
would not lose everything should they fall victim of some risk. This is an
extremely important benefit which insurance brings – not only to the individual
insuring but to the whole country – as stimulating business makes for a healthy
economy.
• Insurance also can help in actually reducing losses. Insurance companies have
a great deal of experience in risks of all kinds and over many years, they have
found ways in which certain risks can be reduced. They employ surveyors who go
out and look at premises which people may want to insure. They can, from that
experience, often suggest ways in which the likelihood of some risk occurring
may be reduced. They might see some hazard which could injure employees, or a
host of other problems. The advice and recommendations they make on behalf of
insurance companies cannot help but reduce the likelihood of many risks
occurring.
• One further benefit derived from the transaction of insurance is the use to which
the insurance company puts the money it holds in the common pool. It does
not use immediately all the money it collects as premiums. It holds it until one of
the members of the pool suffers a loss. The money it holds is invested in a wide
range of investments which all go toward aiding government, industry, commerce
and consequently the whole country. A visible symbol of one of the uses to which
insurance funds are directed is the building work being carried out in many of our
cities. Look a little closer at the large signs surrounding these building sites and
notice how many are being funded by the insurance companies.

Appendix A

9
10