takaful-introduction to insurance

CHAPTER 1

INTRODUCTION TO INSURANCE

NATURE OF RISK AND MANAGEMENT

1.1 Concept of Risk1.2 Related Concept1.3 Basic Categories of Risk1.4 Methods of Handling Risk1.5 Risk Management1.6 Characteristics of Insurable Risk

1.1 Concept of Risk

RISK?‘ an uncertainty regarding loss in future ’

variation in outcomes in a given situationthe possibility of lossthe exposure to dangerthe subject matter of insurance

1.1 Concept of Risk

Measurement of RiskPROBABILITY‘ an area of study which measures the chance of

occurrence of a particular event ‘

i. Priori Probabilityii. Empirical Probabilityiii.Judgmental Probability

1.1 Concept of Riski. Priori Probability determined when the total number of possible

events are known limited practical application

ii. Empirical Probability determined on the basis of historical data it possible for empirical probability to be measured

accurately is the law of large numbers

1.1 Concept of Riskiii. Judgmental Probability determined based on the judgment of the person

predicting the outcome it is used when there is a lack of historical

data/credible statistics

in practice, actual outcomes differ from expected outcomes

depend on the availability & credibility of data

1.2 Related Concept

Peril is a cause of loss

Loss is a reduction or disappearance of economic value

Peril Losses

Fire PropertyProfit/revenue

Illness Future earningMedical expenses

Negligence Court awardsLegal expenses

1.2 Related Concept

– Direct loss• Loss that occurs resulting from a catastrophe• E.g: a factory manufacturing electrical equipment was

burned down in a fire one night

– Indirect loss• Additional loss that result from direct loss• E.g: inability of factory to operate as usual would cause

a disruption in production, sales and normal profits

1.2 Related ConceptHazard is a condition that increases the chance of loss

i. Physical Hazard a physical chance that increases the condition of loss

– E.g:• Worn-out tyres of a car• Flammable liquids kept in the cabinet• Smoking cigarettes• House located next to an electricity generator

ii. Moral Hazard a character defect in an individual that increases the chance of loss

E.g : a person who conceals important health information during the application of insurance is considered as moral hazard

1.2 Related Conceptiii. Morale Hazard

Refers to an individual’s careless or indifferent attitude that increases the severity or frequency of loss due to the presence of insurance

E.g: leaving the front door unlocked while no one at home

1.3 Basic Categories of Risk1. Fundamental & Particular Risksi. Fundamental risk affects the entire eco. or large

numbers of persons/groups Responsibility of the government & the society

ii. Particular risk affects individual & not the entire community

Responsibility of individuals

1.3 Basic Categories of Risk

FUNDAMENTAL RISK• high inflation• Unemployment• War• natural disasters such as

earthquakes, hurricanes, tornadoes, and floods.

PARTICULAR RISK• Burglary• Theft• auto accident• dwelling fires.

1.3 Basic Categories of Risk2. Pure & Speculative Risksi. Pure risk exist when there is possibility of loss or nor

loss more predictable (apply law of large numbers) can be handled by insurance technique

ii. Speculative risk exist when there is the possibility of profit, loss or no loss

not predictable can’t be handled by insurance

1.3 Basic Categories of Risk

PURE RISK• Physical damage risk to property (at the

enterprise level) such as caused by fire, flood, weather damage

• Liability risk exposure (such as products liability, premise liability, employment practice liability)

• Innovational or technical obsolescence risk• Operational risk: mistakes in process or

procedure that cause losses• Environmental risks: water, air, hazardous-

chemical, and other pollution; depletion of resources; irreversible destruction of food chains

• Natural disaster damage: floods, earthquakes, windstorms

SPECULATIVE RISK• Market risks: interest risk, foreign

exchange risk, stock market risk• Reputational risk• Brand risk• Credit risk (at the individual

enterprise level)• Product success risk• Public relation risk• Population changes• Regulatory change risk

1.4 Methods of Handling Risk

i. Risk Avoidanceii. Loss Controliii. Risk Retentioniv. Risk Transfer

1.4 Methods of Handling Riski. Risk Avoidance avoiding the property, person or activity which produces the

risk

ii. Loss Control reduce the total amount of loss influenced by the frequency & severity of losses frequency is the number of times a loss producing event will

occur over a given period of time Loss prevention; by reducing the frequency severity is the amount of loss, in money terms (RM) Loss minimisation; by reducing the severity or amount of loss


iii. Risk Retention the retaining of risks by an individual/organization loss incurred are borne by the party retaining the

risks Planned; risks are retained deliberately Unplanned; risk retention involves retaining of risks

unknowingly


iv. Risk Transfer Involves the transferring of risks to an

organization/individual Losses will be paid by the organization/individual to

whom the risk is transferred Insurance contract; insurance policy Non insurance contract; business agreement

1.5 Risk Management

a systematic approach to dealing with risks that threaten assets & earning of a business

Process:i. Identifying Loss Exposuresii. Evaluating Potential Lossesiii.Selecting Techniques of Risk Handlingiv.Implementing The Risk Mgt. Programv. Controlling The Risk Mgt. Program

1.5 Risk Managementi. Identifying Loss Exposures Loss exposure; physical damage to property, liability

lawsuits etc. Identified from various sources including questionnaires,

financial statements etc.

ii. Evaluating Potential Losses Estimation of frequency & severity of loss exposures Ranking according to their relative importance Loss exposures with high loss potential will be given priority

1.5 Risk Managementiii. Selecting Techniques of Risk Handling Risk handling techniques (refer 2.4) Based on financial criteria will consider how the choice will

affect the organization’s profitability Non-financial considerations will include humanitarian

aspects & legal requirements

iv. Implementing The Risk Mgt. Program After the selection of the most appropriate

technique/combination of techniques; implement

1.5 Risk Management

v. Controlling The Risk Mgt. Program A risk mgt. program needs to be monitored to ensure that it

is achieving the result expected Make changes to the program, if necessary

1.6 Characteristics of Insurable Risk

i. Financial Value monetary compensation following a loss losses that are capable of being financially measured

ii. Large Number of Similar Risks 2 reason:

to enable the insurer to predict losses more accurately If there are only few risks, the principle of losses of a few

to be borne by many cannot be applied


iii. Pure Risks Only pure risk situation, one will suffer a loss/no loss speculative risks; loss/B-E/ profit insured would be less inclined to put in efforts to bring about

a gain when any loss will be indemnified by the insurer

iv. No Catastrophic Losses the loss should not be so catastrophic in nature as to render

it too heavy to be borne by an insurer a catastrophic loss arises when a very large number of risks

incur losses at the same time/one risk results in a huge loss


v. Fortuitous Losses is one that is accidental and unintentional insurance cannot function properly & efficiently if losses are

intentionally/fraudulently

vi. Insurable Interest must have insurable interest in the property/life/potential

liability/etc existence of insurable interest in contract of insurance that

differentiates insurance from gambling


vii. Legal & Not Against Public policy the object/subject matter must be legal a ship engaged in smuggling is illegal/fines & penalties

imposed by law is against public policy

viii.Reasonable Premium must be reasonable in relation to potential loss insurance premium required to cover the risk of fire on a ball-

point pen worth a few cents may be quite unreasonable in relation to the potential loss in view of the insurer’s claim handling expenses

takaful-introduction to insurance

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