Chapter 2 Risk Management and insurance marketing department

Chapter 2 risk management

1. Chapter 2 Risk Management By: Alemayehu M 1 12/13/2021

2. Discussion Questions What is risk management? How can we manage risk of different type? 12/13/2021 2 By: AM

3. 2.1. Definition of Risk Management It involves the application of general management concepts to a specialized area (risk…) Risk management is defined as a systematic process for the identification and evaluation of pure loss exposures faced by an organization or individual, and for the selection and implementation of the most appropriate techniques for treating such exposures. It is a scientific approach to dealing with pure risks ( not speculative risks) by anticipating possible accidental losses and designing and implementing procedures that minimize or avoid the occurrence of loss or the financial impact of the losses that do occur. It helps a business handle its exposures to accidental and ordinary losses in most economic and effective way . Risk management is not an option. 12/13/2021 3 By: AM

4. 2.2. Objectives of Risk Management Ensuring survival of the firm Provides Peace of mind Lowers risk management/handling costs and thus higher profits Avoiding or minimizing the interruption of the firms operation, enabling fairly stable earnings . Maintaining (developing) good will . Satisfying the firm’s sense of social responsibility . Satisfaction of externally imposed legal and other obligations 12/13/2021 4 By: AM

5. Pre-loss Objectives

6. - Economy goal - Reduction of anxiety - Meet any legal obligations

7. Post-loss Objectives:

8. Survival of the firm Continued operation Stability of earnings Continued growth Social responsibility

9. 2.3. Process of risk management 2.3.1. Risk Identification 2.3.2. Risk measurement 2.3.3. Risk Administration 2.3.4. Risk handling tools 12/13/2021 9 By: AM

10. 2.3.1. Risk Identification Definition : Risk identification is the process by which a business systematically and continually identifies property, liability, and personnel exposures as soon as or before they emerge. Probe : Risk identification is not a one time task. Why?   12/13/2021 10 By: AM

11. 1. Sources of risk In risk identification, the first step is to identify the sources of risk which can be classified in various ways. 12/13/2021 By: AM 11

12. Source of risk Physical Environment Social environment Political environment legal environment Operational environment Economic environment 12/13/2021 By: AM 12

13. 2. Categories of Risk /Loss exposure In the risk identification process, the following three types of pure losses mainly considered by the risk managers. property losses third party liability losses and personal losses 12/13/2021 13 By: AM

14. i. Property losses Property loss is a type of pure risk that arises simply because some one owns/posses a property . Property exposure to risk can be classified in four ways; according to: the class of property affected the causes of the gain or loss whether the outcome is direct, indirect, or time element in nature, and the nature of the organization’s interest in the property Reading assignment (Williams and Heins page 89---) 12/13/2021 14 By: AM

15. Cont’d…. Major property risks include the following: Physical damage to personal property because of a fire, windstorm, flood or other cause Theft of personal property Physical damage or theft of a property 12/13/2021 By: AM 15

16. Valuation of Potential physical Asset Losses Once the risk manager identified the organization’s exposures to property losses, the task of valuing the amount at risk is the next activity. Several alternative methods are recognized by appraisers. Original cost Original cost less depreciation Tax appraisal value Market Value The economic or use value Reproduction value Replacement cost for new Replacement cost for new less depreciation …… there is no one best method of valuing a property exposure 12/13/2021 16 By: AM

17. ii. Liability losses Liability risk refers to injuries caused to other people or damages caused to their property, because of their operating activities. The following are some of the factors leading to liability losses. 1. Product Liability: is associated with the manufacture and sell of a particular product. Quality problems, breach of warranty, misleading advertisement, etc are some of the factors that lead to liability losses. 2. Motor Vehicles: Operation of motor vehicles could lead to killing of people or injuries and damages of property of other people due to accidents such as collisions, fire, crash, etc. 3. Industrial Accidents: factory employees are likely to suffer physical injuries at work sites or they may be exposed to job related diseases due to dust inhalation and pungent chemical smell that can cause occupational diseases. 12/13/2021 17 By: AM

18. Liability risk…… 4. Industrial Waste: industrial wastes released into air or thrown into rivers and lakes are major sources of environmental pollution. ….there is then a potential liability loss if the firm's activities pollute the environment and a law suit is filed against its activities. 5. Professional Activities: in the filed of consultancy, medicine, construction, and other professional activities, liability losses are likely to emerge because of the deficiencies inherent in the services rendered due to negligence, errors, intentional concealment and the like. 6. Ownership of immovable: this refers to building, land and machinery owned. The use of such immovable by people may bring liability losses for injuries might be caused by accidents . 12/13/2021 18 By: AM

19. iii. Personal losses Death of key personnel (loss of reputation, customers, …) 12/13/2021 19 By: AM

20. 3. Risk identification techniques The risk analysis questionnaire Financial statement method 3. Flow-chart method 4. On-site inspections 5. Interactions with other departments 6. Statistical Records of losses 7. Analysis of the environment 8. Checklist (property checklist, personnel checklist) 9. Others (organizational chart, ) 12/13/2021 20 By: AM

21. Cont’d… None of them are best, the best depends on: Availability of resources Size of the firm The nature of the organization 12/13/2021 21 By: AM

22. 2.3.2. Risk Measurement 22 After the risk manager has identified the various types of potential losses faced by his or her firm, these exposures must be measured in order to determine their relative importance and to obtain information that will help the risk manager to decide upon most desirable combination of risk management tools . By: AM 12/13/2021

23. Dimensions to be measured Information is needed concerning two dimensions of each exposure/loss: The loss frequency or the number of losses that will occur and The loss severity (amount of loss) Two commonly used measure of loss severity are: the maximum possible loss ( worst loss that could possibly happen ) , and the maximum probable loss (worst loss that is likely to happen) 12/13/2021 23 By: AM

24. Risk Management and Probability Distribution Using the probability distribution, it is possible to measure the various aspects of a risk; such as: the total birr losses per year the number of occurrences per year the birr losses per occurrence 12/13/2021 24 By: AM

25. Example : A hypothetical probability distribution Total birr Losses per Year (In Birr) Probability 0.606 500 0.273 1,000 0.100 2,000 0.015 5,000 0.003 10,000 0.002 20,000 0.001 1.000 12/13/2021 25 By: AM

26. Cont’d…. If the risk manager can estimate accurately the probability distribution of the total birr losses per year, he or she can obtain useful information concerning:   the probability that the business will incur some birr loss, the probability that " severe " losses will occur, the average loss per year, and The risk or variation in the possible results 12/13/2021 26 By: AM

27. Discussion questions based on the above example What is the probability of suffering no loss ? What is the probability of loss exceeding Br. 5000? How much is the expected loss? How can you measure the risk of the firm? 12/13/2021 27 By: AM

28. Computation of Standard deviation (STD) (1) Value (x i ) (2) Value -average (3) ( Value-average) 2 (4) Probability 3 x 4 $ 0 500 1000 2000 5000 10,000 20,000 0 – 321 500 – 321 1000 – 321 2000 – 321 5000 – 321 10,000 – 321 20,000 – 321 Br. (-321) 2 (179) 2 (679) 2 (1679) 2 (4679) 2 (9679) 2 (19679) 2 0.606 0.273 0.100 0.015 0.003 0.002 0.001 62,443 8,747 46,104 42,286 65,679 187,366 387,263 799,888 12/13/2021 28 By: AM

29. Cont’d… STD= √(x-x~)p √ 799,888 = 894 Note: When there is much doubt about what will happen because there are many outcomes with some reasonable chance of occurrence, the standard deviation will be large and vice versa. 12/13/2021 29 By: AM

30. Probability distributions The three most commonly used theoretical probability distributions are: Poisson distribution method Binomial distribution method, and Normal distribution method 12/13/2021 30 By: AM

31. 1. Poisson Distribution The Poisson probability distribution can be used for the analysis of risk measurement. The Poisson distribution works well when: there are at least 50 units exposed independently to loss, and The probability that any particular unit will suffer a loss is the same for all units and is less than 0.1 ( 1 / 10 ). These conditions can be satisfied in two ways. First, the business can have at least 50 persons, properties, or activities each of which can suffer at most one occurrence per year, and the probability being less than 0.1 (1/10) that any particular unit will have an occurrence. Second, the number of persons, properties, or activities may be less than 50, but each unit can have more than one occurrence during the exposure period. The only information that is crucial in constructing a Poisson probability distribution is the expected number of accidents (the mean ). 12/13/2021 31 By: AM

32. Cont’d…. The probability of any number of accidents can be easily calculated using the following formula : Where: M = Expected number of accidents r = number of occurrences (example: accidents) r! = r(r -1) (r-2) (r -3)… (2) (1), with 0! =1 e = a constant, a base of natural logarithms (e= 2.71828)   12/13/2021 32 By: AM

33. Example 1 . Assume that there are 5 cars and each has experiencing about one collision every two years . 1. What is the probability of facing no risk? 2. What is the probability of 1, 2, 3… accidents? 3. What is the probability of facing more than 3 accidents ? Note: First construct the probability distribution of possible outcomes. P=1/2 = 0.5 12/13/2021 33 By: AM

34. Cont’d… Number of collusions Probability Cumulative 0.6065 0.6065 1 0.3033 0.9098 2 0.0758 0.9856 3 0.0126 0.9982 4 0.0016 0.9998 5 0.0002 1 Sum 1 12/13/2021 34 By: AM Answer the Following: Probability of no accident…. Prob of 1 accident=______ Prob of 2 accident=______ Prob of 3 accident=______ Prob of more than 3 accident=____

35. Example 2: Refer the handout distributed in advance and answer the following questions: 12/13/2021 35 By: AM

36. Construct a probability distribution for the number of accidents using a assuming a poison distribution . What is the probability of facing three or more than three accidents? What is the probability of at least three accidents? What is the probability of accidents exceeding 12? What is the probability of accidents facing at least 3 and at most 13? How much is the expected number of accidents? Calculate the expected amount of loss associated with the accidents? How much is the expected monetary loss per accident? Calculate the standard deviation of number of accidents. Calculate the standard deviation of the total monetary loss. Calculate risk measures ( Rm and Rn ) 12/13/2021 36 By: AM

37. B) Using Binomial Distribution Assumptions to use the distribution: 1. The objects are independently exposed to loss; 2. Each exposed unit suffered (experience) only one loss in a year (or other budget period). Thus, the probability that the firm will suffer r occurrences during the year is calculated using the formula: P(r) = n! p r (1 – p) n-r n! (n-r)! Where : n = number of exposures r = number of accidents (occurrences) p = probability of occurrence 12/13/2021 37 By: AM

38. Example : Refer the handout and answer the following questions: Construct a binomial probability distribution Calculate risk measures (STD, Rm and Rn ) 12/13/2021 38 By: AM

39. Risk Measures m = n*p STD = √ npq or √ np (1-p) Rm = STD/mean Rn = STD/n 12/13/2021 By: AM 39

40. C) Using Normal probability distributions Assumptions : 68.27% of the observations fall within the range of one standard deviation of the mean (  1). 95.45% of the observations fall within the range of two standard deviation of the mean (  2). 99.73% of the observations fall within the range of three standard deviations of the mean (  3). 12/13/2021 40 By: AM

41. Example : Assume that a mean monetary loss of an accident due to fire is Br.100 and standard deviation of the potential loss is Br.20. Required: What is the probability of facing monetary loss between the men and Br. 120? What is the probability of facing monetary loss greater than Br. 160? What is the probability of facing ML between Br. 80 and Br.140? 12/13/2021 41 By: AM

42. Risk and Law of Large Number Law of large number states that as the number of exposure units increases, risk decreases. That means risk and numbers of exposure units are inversely related but not proportional. How can you prove this? ------------------------------------------------------------------------------------------------------------------------------------------------------- 12/13/2021 42 By: AM

43. Law of large number … n M STD Rm Rn 40 6 2.4495 0.408 0.06124 50 7.5 2.7386 0.365 0.05478 100 15 3.8730 0.258 0.03873 12/13/2021 By: AM 43

44. What can you learn from the above table? ---------------------------------------------------------------------------------------------------------------------- 12/13/2021 By: AM 44

45. Calculating number of exposure units Given Rm or Rn we can find out the number of exposure units that enable the firm limit the level of risk. Poison ii. Binomial RM= iii. Normal RM= z   12/13/2021 45 By: AM

46. Example : 1. Suppose the risk manager wants to have Rm of 20 %, and to achieve the level of variation he wants to know the number of exposure units. From the historical data the manager has determined that the probability of accident is equal to 0.4. Answer=37.5 (assuming binomial distribution) 2. Suppose that the risk manager wants to have Rn of 10% with a probability of 0.6827. what should be the number of exposure units to satisfy the requirements of the risk manager? Answer: n= 24 (assuming binomial distribution) 12/13/2021 By: AM 46

47. Note the following .… Suppose p= 0, Rm and Rn =___________ Suppose p= 1, Rm and Rn = ___________ Suppose P= 0.5, Rm and Rn = __________ NB: Rn reaches its max when p = 0.5 , where as RM reaches its max when p approaches . 12/13/2021 By: AM 47

48. 2.3.3. Selecting the appropriate Risk Handling Tools After the risks facing the firm are identified and measured , the risk manager must decide how to handle/manage them. Risk can be handled in several ways . However, we can classify them into two broad measures/approaches. They are risk control tools and risk financing tools 12/13/2021 48 By: AM

49. A. Risk Control Tools Risk control approaches are designed to reduce the firm’s expected losses and to make the annual loss experience more predictable . Helps to avoid a risk , prevent loss, lessen the amount of damage if a loss occurs, or reduce undesirable effects of risk on an organization. The application of risk control techniques to achieve these ends may range from simple and low cost to complex and costly approaches The activities that constitute one organization’s risk control efforts may vary from organization to organization as a consequence of creativity and innovation. Regardless of such difference, a typology of risk control tools and methods still exist, which includes: 12/13/2021 49 By: AM

50. 1. Avoidance Avoidance of risk exists when the individual or the firm frees itself from the exposure through (1) abandonment, or (2) refusal to accept the risk from the very beginning (proactive avoidance). In a simple term, to avoid the risk the individual or the firm need to avoid the property, person or activity with which the exposure is associated. Avoidance is an effective approach to the handling of risk. By avoiding a risk, the company can avoid the uncertainty that the company experiences. However, the company losses the benefit that might have been derived from that risk. In some cases it would be impossible to use avoidance: The production of some products and the provision of some service may provide rewards whose expected value far exceeds potential loss pr costs at the margin. It is impossible to avoid all the properties The context of the decision also may make avoidance impossible. A decision to avoid a risk might actually create a new risk else ware or enhance some existing risk. The risk may be so fundamental to the organization’s reason for being that avoidance cannot be contemplated. Ex. mining firm may not avoid the risk of tunnel collapse. 12/13/2021 50 By: AM

51. 2. Loss Control Measures Loss control measures attack risk by lowering the chance a loss that will occur (loss frequencies) or by reducing the amount of damage when the loss does occur (loss severity). Loss control tools can be classified as: loss prevention and loss reduction measures . a) Loss Prevention (LP) Loss prevention programs seek to reduce the number of losses or to eliminate them entirely. Loss prevention activities are focused on: Altering or modifying the hazard Altering or the modifying the environment in which the hazard exists Intervening in the process whereby hazard and environment interacts. 12/13/2021 51 By: AM

52. Cont’d… b) Loss Reduction Measures Loss reduction activities on the other hand are designed to reduce the potential severity of a loss once the peril happened. Such a system does not reduce the probability of loss, instead, they reduce the amount of damage if a peril occurs. Loss reduction activities are post loss measures . Examples of LR measures are: employing fire extinguishers using active and trained guards installing automatic sprinkler 12/13/2021 52 By: AM

53. 3. Risk transfer Transfer as a risk control tool refers to transferring the risk that causes a loss to some entity other than the one experiencing it to bear the burden of the loss through contractual agreement. Transfer may be accomplished in two ways: The activity or property responsible for the risk can be transferred to some other person or groups of persons.   “what makes transfer different from avoidance?” __________ 2. The risk, but not the property or activity, may be transferred. For example , a manufacturer may be able to force a retailer to assume responsibility for any damage to products that occur after the products leave the manufacturer’s premises. 12/13/2021 53 By: AM

54. 4. Separation This refers to scattering the firm’s property exposed to risk to different places. The principle is “ do not put all your eggs in one basket .” 12/13/2021 54 By: AM

55. 5. Combination some how similar to separation as it involves increasing the number of exposure units to make loss exposures more predictable. combination (pooling) increases the number of exposure units under the control of the firm. Combination follows the law of large numbers Examples: A taxi owner increasing the number of fleets Merger with other firms Use of spare parts and reserve machines 12/13/2021 55 By: AM

56. 6. Diversification U sed to handle most speculative risks Businesses diversify their product line so that a decline in profit of one product could be compensated by profits form other product lines 12/13/2021 56 By: AM

57. B. Risk Financing Tools Some losses occur in spite of the best risk control efforts. This means some measures must be used to finance losses that do occur. Risk control measures by altering the loss itself, either reduce the potential losses or make those losses more predictable. The risk financing tools, on the other hand, are ways of financing the losses that do occur . It includes: 1. Retention (Self-Insurance) The most common and easiest method of risk handling tools It is an arrangement under which the firm or an individual experiencing the loss bears the direct financial consequences. The person or the firm consciously or unconsciously, decides to assume the risk Retention may be passive or active , unconscious or conscious , unplanned or planned . The risk may be remote 12/13/2021 57 By: AM

58. Cont’d… Planned retention exist for a number of reasons. Some of these are: It is impossible to transfer the risk, ex. speculative and dynamic risks Attitudes of individuals or firms towards risk The value of the goods to be insured is lower than the insurance costs 12/13/2021 58 By: AM

59. Cont’d… The choice is between retention and insurance. The major factors to be considered in making the choice are: The maximum probable cost relative to the firm’s capacity for bearing the risk Expected loss and risk Restrictions or legal limitations applying to risk transfers Opportunity costs related to investment of funds that is going to be paid as a premium if the risk is transferred to the insurance companies Quality of service provided by the insurance companies. 12/13/2021 59 By: AM

60. Cont’d…. 2. Transfer “Risk financing transfer” is an arrangement under which some entity other than the one experiencing the loss bears the direct financial consequences. Example: I nsurance 12/13/2021 60 By: AM

61. Selections of risk management tool a risk manager should be knowledgeable enough to make analysis and select the “best” risk handling tool(s). Cost-benefit analysis is important in selecting an appropriate risk management tool(s). 12/13/2021 61 By: AM

62. Step 4:Implement and administer Develop risk Management Policy and Manual A ct according to the policy and manual 62 eeeee 12/13/2021

63. END of chapter 2 …….. Next chapter 3: Overview of Insurance 12/13/2021 By: AM 63

64. Chapter 3 Insurance: An overview

65. Chapter Objective To enable learners understand the basic concept of insurance

66. Chapter Coverage Meaning of insurance Characteristics of insurable risks Social and economic value of insurance Cost of insurance Legal principles of insurance

67. What is insurance? Article 654(1) of the commercial code of Ethiopia states insurance as follows: "A contract whereby a person called the insurer undertakes against payment of one or more premiums to pay a person, called the beneficiary , sum of money where a specified risk materializes". Insurance is defined as "a device by means of which the risks of two or more persons or firms are combined through actual or promised contributions to a fund out of which claimants are paid."

68. Cont’d… From the definitions, it can be learned that: Insurance is a system used to transfer risk of individuals or firms for payment of premium . The insured considers insurance as a transfer device whereas from the point of view of the insurer, it is regarded as retention and combination device. It is a scheme that establishes a common fund out of which financial compensation is made to those who faces accidental losses. It is a pooling of risks of many people who are exposed to the same risk. It is a device used to spread the loss suffered by an individual or firm to the members in the group. It is a method to provide security to the insured person against the probable loss.

69. Your reflection Why insurance companies accept our risk?

70. Why insurance companies accept our risk? They have the knowledge and the skill to apply various risk reduction and risk control measures; Combination or pooling of similar risks will enable the insurer to predict the actual loss experience with a reasonable accuracy. They have financial capacity to assume/ take risk They are in a position to enforce loss reduction and prevention measures For losses that are beyond their capacity, insurers arrange a reinsurance mechanism.

71. INSURANCE, GAMBLING, AND SPECULATION Gambling Insurance Creates risk which did not exist previously Protects the insured against the risk There is a possibility of gain No gain for the insured The gambler accepts deliberately the risk of loss The insured accepts deliberately the certainty of a small loss in exchange for freedom from risk Gambler bears the risk Insured transfers risk Is socially unproductive (when one gains the other losses) Socially productive

72. Speculation Vs Risk Speculation Insurance Is risk transfer method Is risk transfer method individuals enter into a risk deliberately in the anticipation of profits Insured transfer s risk to the insurer and no gain at all handling risks that are typically uninsurable Handles pure risks Involves risk transfer Involves risk transfer and reduction

73. CHARACTERISTICS OF INSURABLE RISK The following are the characteristics of insurable risks: Large number of exposure units Accidental and unintentional Why should losses be accidental?  ----------------------------- Determinable and measurable Calculable chance of loss Premiums should be economically feasible The loss should not be catastrophic

74. SOCIAL AND ECONOMIC VALUES OF INSURANCE Indemnification Reduction of uncertainty 3. Encourages savings 4. Help businesses continue without interruption of operation 5. Provide funds for investment 6. Keeps families together   7. Provides a basis for credit 8. Promotes loss control systems 9. It provides financial stability to the community 10. Stimulates international trade and commerce

75. Discussion It is obvious that insurance has various socio-economic benefits. Do you think that insurance has a limitation? If yes identify them? ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

76. COSTS OF INSURANCE Disadvantages/ Costs of Insurance It encourages fraud to collect dishonest claims ( moral hazard problems ). Increases carelessness in life ( morale hazard problem Cost of Insurance : insurers incur operating expenses such as loss control costs, loss adjustment expenses, expense involved in acquiring insured, (advertisement cost), state premium taxes, and general administrative costs. In addition to these expenses, the insured is expected to cover a reasonable amount for profit and contingencies. Adverse selection

77. LEGAL PRINCIPLES OF INSURANCE CONTRACT Insurable Interest refers to the existence of financial relationship to the subject matter insured. Conditions to be fulfilled: There must be some subject matter of insurance such as physical object or potential liability; There must be risk to which the subject matter is exposed The insured must have some legally recognized relationship with the subject matter insured. The insured should stand to benefit by the safety of the subject matter and should incur loss by its destruction or damage; and The subject matter should be measurable in terms of money. When should is exist? --------------------------------------- Why insurable interest? ------------------------------------

78. 2. Utmost good-faith Insurance contracts are based upon mutual trust and confidence between the insurer and the insured. This principle requires each party to tell the other "the truth, the whole truth and nothing but the truth". Material facts are of the following types: those which affect the nature or incidence of risk; & those which affect the character of insured. Non-disclosure, concealment, innocent misrepresentation, and fraud may lead to avoidance or cancellation of the insurance contract by one of the parties to the contract.

79. 3. Indemnity states that the insured, in the event or loss, receives financial compensation equal to the amount of the loss or the face value of the policy, which ever is lower. It is the controlling principle in insurance contract that limits compensation. Indemnity implies that: There must be an actual loss The loss should have occurred through the risk insured The loss must be capable of calculation in terms of money The payment made by another person (third party) should not exceed the actual loss suffered.  Indemnity can take different forms: cash payment, replacement of property or reinstatement of the property or repair.

80. 4. Subrogation Subrogation is the right to an insurer who has paid a claim under a policy issued by him to receive the benefit of all rights and remedies of the insured. Principle of subrogation is a supplement to the principle of indemnity. The reason behind this principle is to eliminate the profit motive of the insured. Subrogation implies that: The insurer makes payment to the insured for his actual loss The insurer after making good the loss, places himself in the position of the insured and has all the rights and remedies of the insured The insurer cannot recover anything more than he has paid to the insured

81. 5. Contribution Contribution is also corollary of /or supplement of the principle of indemnity. The doctrine of this principle preaches for an "equitable distribution" of any loss among insurers. Contribution is the right of an insurer who has paid a loss under a policy to recover a proportionate amount from other insurers who are liable for the same loss.  It is enforceable only under the following conditions: The policies must cover the same period The policies must have been in force at the time of loss They must protect the same peril The subject matter of insurance must be the same, and The insured must be the same person.

82. example Contribution= sum insured with particular insurer Total sum insured will all insurers

83. Cont’d…. Note that: Principle of indemnity, subrogation and contribution are not applicable to life insurance policies .

84. Insurance contracts Insurance contracts are agreements between the insurance companies and the insured for the purpose of transferring from the insured to the insurer part of the risk or loss arising out of contingent events. The contract serves the following functions: Define the risk to be transferred Explain the procedures for selling loss claims. State the conditions under which the contract parties should know such as premium and performance of certain acts.

85. REQUIREMENTS OF AN INSURANCE CONTRACT An insurance policy is based on the law of contracts. To be legally enforceable, an insurance contract must meet four basic requirements:   Offer and Acceptance   Consideration. Competent Parties. Legal Purpose.

86. DISTINCT LEGAL CHARACTERISTICS OF INSURANCE CONTRACTS Insurance contracts have distinct legal characteris­tics that make them different from other legal contracts. Probe: What do you think are these characteristics? ---------------------------------------------------------------------------------------------------------------------------------------------------------------------

87. 1. Aleatory Contract An aleatory contract is one in which the values exchanged are not equal . Depending on chance, one party may receive a value out of proportion to the value that is given. So an insurance contract is aleatory rather than com­mutative. In contrast, other commercial contracts are commutative. A commutative contract is one in which the values exchanged by both parties are theoreti­cally even.

88. 2. Unilateral Contract An insurance contract is a unilateral contract. A unilateral contract means that only one party makes a legally enforceable promise. In this case, only the in­surer makes a legally enforceable promise to pay a claim or provide other services to the insured. In contrast, most commercial contracts are bilat­eral in nature. Each party makes a legally enforceable promise to the other party

89. 3. Conditional Contract An insurance contract is a conditional contract. This means the insurer's obligation to pay a claim depends on whether or not the insured or the beneficiary has complied with all policy conditions. The insurer is not obligated to pay a claim if the policy conditions are not met.

90. 4. Personal Contract In property insurance, insurance is a personal con­tract. This means the contract is between the insured and the insurer. Strictly speaking, a property insurance contract does not insure property , but insures the owner of property against loss. Because of this, property insurance policy cannot be assigned to another party without the insurer's consent. If property is sold to another person, the new owner may not be acceptable to the insurer. Thus, the insurer's consent is normally required before the policy can be validly assigned to another party. In contrast, a life insurance policy is not a personal contract . Therefore, it can be freely assigned to anyone without the insurer's consent. The loss payment can, however, be freely assigned to another party without the property insurer's consent. Although the insurer's consent is not required, the contract may require that the insurer be notified of the assignment of the proceeds to another party.

91. 5. Contract of Adhesion A contract of adhesion means the insured must accept the entire contract, with all of its terms and conditions. The insurer drafts and prints the policy, and the insured generally must accept the entire document and cannot insist that certain provisions be added or deleted or the contract rewritten to suit the insured. However, to redress the imbalance that exists in such a situation, the courts have ruled that any ambiguities or uncertainties in the contract are construed against the insurer. If the policy is ambiguous, the insured gets the benefit of the doubt.

92. 6. Contracts of Uberrimae Fidei The literal meaning of " Uberrimae Fidei " is utmost good faith that can be restated as the highest standard honesty. Insurance contracts are contracts of the utmost good faith. Both parties to the contract are bound to disclose all the facts relevant to the transaction. Neither party is to take advantage of the other's lack of information.

93. End of Chapter 3 12/13/2021 93