Chapter 16: Business Risks and Insurance
Every business operates under conditions it cannot fully predict. A trader who stocks goods for the festive season does not know whether demand will hold, whether prices will move against him, or whether a fire in the godown will destroy the stock before it is sold. The possibility of loss from such uncertain events is what business calls risk, and no enterprise is free of it. Risk is the reason profit exists as a reward, and also the reason many firms fail. Some of these risks can be shifted to someone else for a price. A firm cannot stop a fire from breaking out, but it can arrange in advance that the financial loss will be borne by an insurer in return for a regular payment. Others — a change in fashion, a fall in demand, the entry of a stronger competitor — cannot be shifted at all and must be managed by the businessman himself. This chapter explains what business risk is, which risks can be insured and which cannot, and how insurance works as a device for handling them.
Figure
Fig. 16.0-1 — Goods Stored In A Warehouse Photograph of stacked cartons and sacks in a commercial warehouse, showing the kind of stock a business stands to lose.
16.1 What Business Risk Means
Every business commits money today in the expectation of a return tomorrow. Between the commitment and the return lies a stretch of time in which conditions may change, and the outcome the businessman expected may not arrive. Business risk is the possibility of loss, or of profits falling short of what was expected, because of uncertain events that management cannot control.
The word ‘risk’ in business does not mean that a loss is certain. It means that the outcome is uncertain and that one of the possible outcomes is unfavourable. A shopkeeper who stocks umbrellas before the monsoon may sell out or may be left with unsold stock; both outcomes are open, and it is this openness that makes the venture risky.
Risk cannot be removed from business, because it arises from the very act of deciding in advance. A firm decides what to produce, how much to produce and at what price to sell, long before it knows how buyers will respond. The reward for accepting this uncertainty is profit, which is why profit is described as the reward for risk-bearing.
Losses A Businessman May Bear
Risk shows itself in three broad forms of loss, and a firm may face all three at the same time.
- Loss of assets — property such as buildings, machinery, vehicles or stock may be destroyed or damaged by fire, flood, theft or accident, and the money invested in them is lost.
- Loss of income — earning capacity may be interrupted by the death, accident or prolonged illness of the owner, by a fall in demand, or by a halt in production.
- Liability towards third parties — the firm may be legally required to compensate outsiders, such as a customer injured on its premises or a party harmed by a defective product.
Internal And External Causes
The events that create risk arise partly inside the firm and partly outside it, and the distinction matters because the two call for different responses. Internal risks arise from factors within the business, which management can usually correct. External risks arise from forces outside the firm, over which management has little or no control and to which it can only adjust. The classification is set out in FC 16.1.
Flowchart
FC 16.1 — Causes Of Business Risk Business Risk → Internal Causes, External Causes; Internal Causes → Inefficient management, Poor working conditions, Industrial unrest, Financial liability; External Causes → Natural calamities, Price fluctuations, Increased competition, Government policies, Dishonesty of customers
Because internal causes lie within the firm’s own working, they can be reduced by better planning, supervision and record-keeping. External causes cannot be prevented at all; the firm can only anticipate them, spread them, or arrange to transfer the financial loss to someone else. That last option is what insurance provides, and it is taken up later in this chapter.
16.2 Characteristics Of Business Risks
Business risk behaves in a fairly predictable way, even though the events that cause it do not. Knowing how risk behaves helps a firm judge how much of it to accept, how much to guard against, and how much to charge the customer for bearing it. The following features are common to business risk in every trade and at every scale of operation.
- Essential to business — risk cannot be separated from business activity, because a firm must commit resources before it knows the outcome. A business with no risk would be one in which every future condition was already known, and no such business exists.
- Profit is the reward of risk — the businessman is paid for accepting an uncertainty that no one else is willing to carry. Where risk is low, competition is easy to enter and margins stay thin; where risk is high, the return expected is correspondingly higher.
- Risk varies with time — the same business is riskier in some periods than in others. Political disturbance, war, economic depression or a change in the law raises the degree of risk without any change in the firm’s own conduct.
- Uncertainty is the main cause of risk — demand, prices, technology and consumer taste keep changing, and their combined effect on a firm cannot be forecast exactly. Forecasting narrows the uncertainty but never removes it.
- Degree of risk depends on the nature and size of the business — a firm dealing in perishable goods or in fashion items carries more risk than one supplying a staple item. As the volume of operations grows, the amount at stake in any single adverse event also grows.
Risk Is A Matter Of Degree
Business risk is present in every enterprise, from a street vendor to a large manufacturer; what differs between them is degree, not existence. The vendor risks a day’s stock, the manufacturer risks a plant worth crores, and each must judge the risk against the return expected from it.
This is why two firms in the same trade may take opposite decisions on the same opportunity. A firm with large reserves can absorb a loss that would close down a smaller rival, so it can afford to accept a risk the smaller firm must avoid.
16.3 Insurable And Non-Insurable Risks
A firm that faces risk would naturally like to hand the loss to someone else. An insurance company, however, cannot accept every loss offered to it. It works by collecting small contributions from a large number of people exposed to a similar danger and paying the few who actually suffer, so it must be able to judge in advance how often the loss will occur and how much it will cost. Where that judgement is impossible, no insurer can quote a price.
Business risks therefore fall into two groups. Those that an insurance company is willing and able to cover are insurable; those it cannot cover must be carried by the businessman himself.
16.3.1 Insurable Risks
Insurable risks are those risks whose chance of occurrence can be estimated beforehand and whose loss can be measured in money. Past experience and statistical records make it possible to forecast how many fires, thefts or accidents will occur in a large group, even though no one can say which member of the group will suffer. Loss by fire, theft, accident, bad debts and death are the usual examples.
A risk must satisfy several conditions before an insurer will accept it. Each condition exists to protect the working of the pool from which claims are paid.
- Large exposure — a large number of persons or firms must face a similar loss, so that the contributions of the many can meet the losses of the few. A danger faced by only one or two parties cannot be spread.
- Accidental — the loss must be uncertain, not bound to happen. Depreciation of a machine through normal wear and tear is certain and cannot be insured, and a loss deliberately caused by the insured is never covered.
- Estimatable — the probability of the event must be capable of being forecast with reasonable accuracy, and the loss must be measurable in terms of money. Without this the insurer cannot fix a fair charge.
- Unexpected — an event already certain to occur, or certain to occur very soon, is not insurable, because there is no uncertainty left to share.
- Not catastrophic — the loss should not be of a kind that strikes all the insured at once. If every policyholder claims at the same moment, the pool is exhausted and no one can be paid in full.
- Not against public policy — a risk arising from an unlawful act cannot be insured, since the law will not help a person to profit from wrongdoing. Stolen or smuggled goods cannot be insured by the person who took them.
- Significant — the loss must be large enough to be worth insuring. Insuring a trifling loss costs more in administration than the protection is worth, and such losses are better borne by the firm itself.
16.3.2 Non-Insurable Risks
Non-insurable risks are those risks that cannot be covered by an insurance contract because they cannot be anticipated with reasonable accuracy. They arise from changes in market conditions rather than from physical mishap, and they affect all firms in a trade at roughly the same time, so there is no pool of the fortunate from which to compensate the unfortunate.
Four features explain why an insurer refuses them.
- They cannot be assessed easily, and how often they will occur cannot be estimated.
- No fair premium can be calculated, because there is no measurable chance on which to base it.
- They have no past statistical record of occurrence to work from.
- They are therefore not accepted for cover by insurance companies at all.
Losses arising from wrong business decisions, from fluctuations in demand and prices, from war, and from widespread calamities such as famine or earthquake fall into this group. Non-insurable risks are commonly classified as shown in FC 16.2.
Flowchart
FC 16.2 — Classification Of Non-Insurable Risks Non-Insurable Risks → Time Risks, Place Risks, Competition Risks
- Time risks — these arise from the gap between the decision to produce goods and their eventual sale. During the interval, fashion and taste may change and the goods may lose their market.
- Place risks — these arise because the price of a product differs from place to place. They are heavy in perishable and fragile goods, though better transport has reduced them considerably.
- Competition risks — these arise when a rival cuts prices and the firm is forced to follow, so that it earns less on every unit it sells.
Since these risks cannot be transferred, they have to be managed internally — by studying market trends, spreading the business over more than one product or market, holding reserves, and avoiding over-commitment to a single line.
16.3.3 Insurable And Non-Insurable Risks Compared
Both kinds of risk are unavoidable, but they are handled in entirely different ways, and a firm must be able to tell one from the other before it decides how to protect itself. The main points of difference are set out in Table 16.1.
16.4 Meaning And Definitions Of Insurance
Insurance does not prevent a loss. A fire policy does not stop a godown from catching fire; it only ensures that when the fire occurs, the money value of what was destroyed is made good. Insurance is therefore best described as a shield against the financial effect of risk rather than against the risk itself.
The whole arrangement rests on cooperation. A large number of persons exposed to the same danger each contribute a small sum into a common fund, and the few who actually suffer are compensated out of that fund. The many who escape loss lose only their contribution; the few who suffer are saved from ruin. Insurance is the contract through which this sharing is organised.
Under the contract, one party agrees to make good the loss suffered by the other on the happening of a stated uncertain event, in return for a payment. The insured hands over the burden of the loss; the insurer accepts it, having calculated that the contributions of all those insured will exceed the claims of the few.
Terms Used In Insurance
Insurance has a vocabulary of its own, and the same five terms recur throughout the subject.
- Insurer — the party who undertakes the responsibility for the risk, that is, the insurance company that promises to pay.
- Insured — the party whose risk is covered and who is entitled to claim compensation when the stated event occurs.
- Premium — the fee charged by the insurer for providing this protection, payable at agreed intervals such as half-yearly or yearly.
- Policy — the document containing the contract of insurance, in which the terms and conditions of the cover are set out.
- Sum assured — the amount for which the policy is taken, and the outer limit of what the insurer will pay.
How The Contract Works
Consider a trading firm that insures its shop against fire. It pays a premium every year for as long as it wants the cover. If no fire occurs, the insurer pays nothing and the premium is simply the price of the protection the firm enjoyed during the year.
If the shop is destroyed by fire, the insurer pays the loss actually suffered or the sum assured, whichever is lower. The firm is restored to the position it was in before the fire, but it gains nothing beyond that. This limit is what keeps insurance a device for protection and prevents it from becoming a means of earning.
16.5 Characteristics Of Insurance
Insurance is a contract, but it is a contract of a special kind. It is signed before the loss occurs, it deals with an event that may never occur at all, and it depends entirely on what each party tells the other about a risk that only one of them can see clearly. The following features follow from this and mark insurance off from an ordinary commercial agreement.
- Two parties — every insurance contract has an insurer who accepts the risk and an insured whose risk is accepted. Neither can exist without the other.
- Based on utmost good faith — the insurer prices the risk from what the insured tells him, so each party must disclose every material fact. A person taking a life policy must reveal an existing illness, and the insurer must make the terms of the policy clear.
- Based on a cooperative system — the losses of the few are met from the contributions of the many. The insurer only administers this pool; the money paid out comes from the premiums of all those exposed to the same danger.
- Coverage of expected risk — only a risk that is anticipated and named in the policy is covered. A loss from an event the policy does not mention gives rise to no claim.
- Transfer of expected loss — what passes to the insurer is the financial burden of the loss, not the risk of the event itself. The fire is no less likely for the policy having been taken.
- Payment of premium — the insurer takes on the risk only against a periodic payment. If the premium is not paid, the cover lapses and the promise falls away.
- Various types of insurance — insurance is available for a wide range of dangers, and the main division is between life and general insurance, as shown in FC 16.3.
- Compensation for actual loss — the purpose of the contract is served only when the loss actually occurs, and what is paid is measured by that loss.
- Security and investment — a general insurance policy gives security alone, while a life policy also builds up a sum payable at maturity and so carries an element of saving.
- Ownership not compulsory — the person insuring need not own the property, provided he stands to lose financially if it is damaged. A lender may insure property he has taken as security from a borrower.
Flowchart
FC 16.3 — Types Of Insurance Insurance → Life Insurance, General Insurance; General Insurance → Fire, Marine, Theft, Accident, Health
Life insurance covers the life of a person and pays either on death or on maturity of the policy. General insurance covers property and liability against dangers such as fire, theft, accident and loss at sea, and is normally taken for one year at a time.
Why Good Faith Matters Most
Of all these features, the duty of full disclosure carries the greatest weight in practice. The insured knows the condition of his godown, his health and his trade; the insurer knows none of these and must rely on what he is told.
If a material fact is concealed, the premium charged is too low for the risk actually accepted, and the whole pool is weakened. The law therefore allows the insurer to treat such a contract as void, which is why concealment usually ends in a rejected claim.
16.6 Principles Of Insurance
An insurance contract promises money on the happening of an event that has not yet occurred and may never occur. Such a promise invites two abuses — a person may insure something he has no interest in, hoping to gain by its destruction, and a person who is insured may grow careless because the loss will be met by someone else. The principles of insurance exist to close both these doors and to keep the contract a device for protection rather than for gain.
Seven principles govern insurance contracts, and they are listed in FC 16.4. The first two decide whether a contract is valid at all; the next three decide how much is payable and by whom; the last two decide whether a particular loss is covered and how the insured must behave when it occurs.
Flowchart
FC 16.4 — Principles Of Insurance Principles Of Insurance → Utmost Good Faith, Insurable Interest, Indemnity, Contribution, Subrogation, Causa Proxima, Mitigation Of Losses
16.6.1 Utmost Good Faith And Insurable Interest
Utmost Good Faith
The principle of utmost good faith, or uberrimae fidei, requires each party to disclose every material fact connected with the subject matter of the insurance and to conceal nothing relevant. A material fact is one that would affect the other party’s decision to enter into the contract or the terms on which it is entered.
The duty falls more heavily on the insured, because the facts are within his knowledge alone. A trader who does not mention that a petrol pump adjoins his godown, or a person who does not disclose an existing illness while taking a life policy, has withheld exactly the information on which the premium was calculated.
Breach of this duty makes the contract voidable, and the insurer may cancel the policy and refuse the claim. The duty is not unlimited, however. The insured need not disclose facts that the insurer has waived, facts the insurer already knows or ought to know in the ordinary course of his business, or facts that reduce rather than increase the risk.
Insurable Interest
The principle of insurable interest requires that the insured must stand to gain from the continued existence of the subject matter and to lose from its destruction. Without such an interest the contract is not insurance at all but a wager, and a wagering agreement is void.
The test is financial, not sentimental. A person may insure his own life, his own property, and property in which he has a financial stake such as goods pledged to him; he cannot insure a neighbour’s house, because its destruction causes him no economic loss.
When the interest must exist depends on the type of policy. In life insurance it must be present when the policy is taken. In fire and other general insurance it must be present both when the contract is made and at the time of the loss, which is why a policy on a warehouse gives the seller no claim once the warehouse has been sold.
16.6.2 Indemnity, Contribution And Subrogation
Indemnity
The principle of indemnity limits the claim to the actual loss suffered, subject to the sum assured. Its object is to restore the insured to the position he occupied before the loss and to take him no further, because insurance is meant to cover a risk and not to earn a profit.
Two limits therefore operate together. The insurer never pays more than the loss actually proved, and never more than the amount for which the property was insured; the claim is the lower of the two. Where property is insured for less than its value, the insured himself bears the balance of the loss.
Indemnity applies to all contracts of insurance except life insurance. Human life cannot be valued in money, so a life policy is a contract to pay an agreed sum rather than to make good a measured loss.
Contribution
The principle of contribution applies where the same property is insured with more than one insurer. The insured may claim from any of them, but he cannot recover the same loss twice over; the total received cannot exceed the actual loss.
The insurers share the burden among themselves in the proportion of the amounts for which each has insured the property. An insurer who has paid the whole claim may recover a proportionate share from the others, so that each bears only what it undertook.
Subrogation
The principle of subrogation transfers to the insurer, after it has paid the full claim, all the rights and remedies the insured had in respect of the property. In effect the insurer steps into the shoes of the insured.
The principle works in two ways. Whatever remains of the damaged property belongs to the insurer, so the scrap of a fully compensated vehicle is the insurer’s to sell. And if the insured also recovers compensation from the third party who caused the loss, he must hand that amount over, since he cannot be paid twice for one loss.
The right is exercised through the insured, as the insurer cannot sue a third party in its own name, and the insured is expected to assist it in doing so.
16.6.3 Causa Proxima And Mitigation Of Losses
Causa Proxima
A loss often has more than one cause, and only some causes are named in the policy. The principle of causa proxima, or proximate cause, directs that the claim be decided by the nearest and most effective cause of the loss, not by every circumstance that preceded it.
If that dominant cause is one of the risks covered by the policy, the insurer is liable, even though a cause outside the policy also played a part. If the dominant cause falls outside the policy, the claim fails. The principle is used most often in marine insurance, where sea perils, delay and the condition of the goods may all be present together.
Mitigation Of Losses
The principle of mitigation of losses requires the insured to take all reasonable steps to reduce the loss when the insured event occurs. He must act as a prudent person would have acted had the property not been insured at all.
The reason is behavioural. If a policy allowed the insured to stand by and watch his goods burn, the cost of insurance would rise for everyone in the pool. The insured is not expected to take heroic risks, only the ordinary precautions any owner would take.
16.7 Re-Insurance And Double Insurance
Two arrangements in insurance practice sound similar and are constantly confused, yet they answer entirely different problems. One protects the insurer, the other is chosen by the insured, and the two operate at different levels of the same contract.
Re-Insurance
An insurance company may be asked to cover a risk larger than it can comfortably carry — a factory, a ship, a fleet of vehicles. Accepting it in full would expose the company to a single claim big enough to damage it. Re-insurance is the arrangement by which the insurer passes on a part of such a risk to another insurance company, retaining the rest and paying that company a share of the premium.
The policyholder is not a party to this arrangement and is usually unaware of it. His contract remains with the original insurer alone, and on the happening of the loss he claims the whole amount from that insurer. It is then for the original insurer to recover the reinsured portion from the reinsurer.
Re-insurance thus spreads a large risk across several companies in the same way as ordinary insurance spreads a loss across many policyholders. Without it, insurers would have to refuse the very risks that most need cover.
Double Insurance
Double insurance arises when the insured himself takes more than one policy on the same subject matter with different insurers. It is his own act, and it is not forbidden by law.
Its effect depends on the kind of insurance. In life insurance the full sum assured under every policy is payable, because a life policy is a promise to pay an agreed sum and not a measure of loss. In fire and other general insurance the principle of indemnity applies, so the insured recovers only the loss actually suffered, however many policies he holds, and the insurers meet that amount between them in proportion to the sums they have insured.
For this reason double insurance of property is of limited use. Insuring the same property for a total far above its value only means paying premiums on cover that can never be claimed, since the claim can never exceed the loss.
The Two Compared
The distinction turns on who arranges the cover, who is protected by it, and how the claim is met. Table 16.2 sets out the main bases of difference.
16.8 Meaning Of Assurance
Not every event a person wants to guard against is uncertain. A godown may or may not catch fire, but a person will certainly die, and the family that depends on his earnings will certainly need money when he does. What is uncertain is only the timing.
Assurance is the contract used for events of this second kind. It is associated with life and term policies, and it provides long-term security against an event that is bound to occur sooner or later. Because the event itself is certain, the insurer knows that a payment will have to be made; only the date is unknown.
Under such a contract the sum assured is payable either on the death of the assured or on the maturity of the policy, whichever comes first. The policyholder is therefore certain of a payment, which is why assurance is treated as a means of providing for a family rather than merely of covering a loss.
Two consequences follow. Assurance policies run for long periods, often for decades, whereas a general insurance policy is usually renewed each year. And the amount payable is fixed in advance, since a human life cannot be valued as a fire-damaged godown can.
Why A Family Takes A Term Policy
Consider a household in which one member’s salary meets the school fees, the medical costs and the monthly running of the home. If that income stops suddenly, the family’s obligations do not stop with it.
Term insurance answers this situation. The policy runs for a fixed number of years and pays the agreed sum to the family if the assured dies during that term, so that the household’s needs can continue to be met. It is bought not for gain but to keep a dependent family from being left without support.
16.9 Insurance And Assurance Compared
The two words are often used as though they meant the same thing, and in ordinary speech insurance is used for both. In business the distinction is real, and it turns on a single question: is the event covered certain to happen?
Insurance covers an event that may or may not occur — a fire, a theft, a road accident. The insured must actually suffer a loss before he can claim, and if the year passes without mishap nothing is payable. Assurance covers an event that is bound to occur, so a payment will be made sooner or later whether or not any loss is suffered in the ordinary sense.
Everything else follows from that difference. Because an insurance claim measures a loss, it is governed by indemnity and can be made more than once during the life of the policy. Because an assurance claim pays a fixed sum on a certain event, it arises once and closes the contract. The main points of difference are set out in Table 16.3.
Which Of The Two A Business Needs
A firm normally needs both, because they answer different exposures. Its property, stock, vehicles and liability to outsiders are covered by general insurance, which restores what an accident destroys.
The life of a proprietor or a key partner is a different matter. His death does not damage any asset, yet it may end the earning capacity of the firm and leave dependants and creditors unprovided for. That exposure is met by assurance, and no property policy can substitute for it.
16.10 Summary
- Business risk is the possibility of loss, or of profit falling short of expectation, because of uncertain events beyond the control of management. It arises because a firm must commit resources before it knows the outcome, and profit is the reward for bearing it.
- Risk shows itself as loss of assets, loss of income, or liability towards third parties, and its causes are of two kinds:
- Internal causes — inefficient management, poor working conditions, industrial unrest and financial liability, which the firm can correct.
- External causes — natural calamities, price fluctuations, competition and government policy, which the firm can only anticipate or transfer.
- Business risk is essential to business, varies with time, is caused mainly by uncertainty, and differs in degree according to the nature and size of the firm; it is present in every enterprise, large or small.
- Insurable risks are those whose probability can be estimated and whose loss can be measured in money. To be insurable a risk must involve large exposure, be accidental, estimatable, unexpected, not catastrophic, not against public policy, and significant in amount.
- Non-insurable risks cannot be anticipated with accuracy and are borne by the businessman himself. They are classified as time risks, place risks and competition risks, and are managed through forecasting, diversification and reserves.
- Insurance is a contract by which one party agrees, for a consideration called the premium, to indemnify the other against a stated loss or to pay an agreed sum on a certain event. It rests on cooperation: the losses of the few are met from the contributions of the many.
- The essential terms of insurance are insurer, insured, premium, policy and sum assured; the main types are life insurance and general insurance.
- Insurance is a contract between two parties, based on utmost good faith and on a cooperative system, covering an expected risk against payment of a premium, compensating actual loss, and not requiring the insured to own the property.
- Seven principles govern insurance contracts:
- Utmost good faith — both parties must disclose all material facts.
- Insurable interest — the insured must stand to lose financially from the loss of the subject matter.
- Indemnity — the claim is limited to the actual loss, up to the sum assured; it does not apply to life insurance.
- Contribution — where several insurers cover the same property, they share the loss in proportion to the sums assured.
- Subrogation — after paying the full claim, the insurer takes over the insured’s rights in the property and against third parties.
- Causa proxima — the claim is decided by the nearest and most effective cause of the loss.
- Mitigation of losses — the insured must take reasonable steps to reduce the loss when it occurs.
- Re-insurance is an arrangement between insurers, by which an insurer passes part of an accepted risk to another company, while the insured continues to claim the whole loss from the original insurer.
- Double insurance is an act of the insured, who takes more than one policy on the same subject matter. In general insurance the total claim cannot exceed the actual loss, which the insurers share proportionately.
- Assurance covers an event certain to occur, so the sum assured is bound to be paid on maturity or on death, whichever is earlier. Insurance covers an event that may or may not occur, and a loss must be suffered before a claim arises.
- The chapter’s spine is summarised in FC 16.5.
Flowchart
FC 16.5 — How A Business Handles Risk Business Risk → Insurable Risks, Non-Insurable Risks; Insurable Risks → Transferred to an insurer through a contract of insurance; Non-Insurable Risks → Retained and managed by the businessman
16.11 Key Terms
- Assurance A contract under which the sum assured is bound to be paid sooner or later, on the maturity of the policy or on the death of the assured, whichever is earlier.
- Business risk The probability of loss or of inadequate profit arising from uncertain or unexpected events beyond the control of the management of the business.
- Contribution The principle under which several insurers covering the same property share the loss between them in proportion to the sums for which each has insured it.
- Double insurance The practice of insuring the same subject matter with two or more insurers at the same time.
- External risks Risks arising from forces outside the firm, such as natural calamities, price fluctuations, competition and government policy, over which management has little control.
- General insurance Insurance covering property and liability against dangers such as fire, theft, accident, loss at sea and illness, normally taken for one year at a time.
- Indemnity The principle under which the insurer makes good the actual loss suffered, up to the sum assured, so that the insured earns no profit from the loss; it does not apply to life insurance.
- Insurable interest The financial interest of the insured in the subject matter, such that he benefits from its continued existence and loses money from its destruction.
- Insurable risks Risks whose probability of occurrence can be estimated in advance and whose loss can be measured in money, and which an insurer is therefore willing to cover.
- Insurance A contract by which one party agrees, in return for a consideration called the premium, to indemnify the other against a stated loss or to pay an agreed sum on the happening of a certain event.
- Insured The party whose risk is covered and who is entitled to claim compensation when the stated event occurs.
- Insurer The party who accepts the responsibility for the risk, that is, the insurance company that promises to pay.
- Internal risks Risks arising from factors within the business, such as inefficient management, poor working conditions and industrial unrest, which management can usually correct.
- Life insurance Insurance covering the life of a person, under which the sum assured is payable on death or on maturity of the policy.
- Mitigation of losses The principle requiring the insured to take all reasonable steps to reduce the loss when the insured event occurs.
- Non-insurable risks Risks that cannot be covered by insurance because they cannot be anticipated with reasonable accuracy, and which the businessman must bear himself.
- Policy The document containing the contract of insurance, in which the terms and conditions of the cover are set out.
- Premium The fee charged by the insurer for providing insurance protection, payable at agreed intervals.
- Proximate cause The principle that a claim is decided by the nearest and most effective cause of the loss rather than by every circumstance preceding it.
- Re-insurance A contract by which an insurer transfers part of a risk it has accepted to another insurance company, while the insured continues to claim the whole loss from the original insurer.
- Subrogation The principle under which the insurer, after paying the full claim, takes over the rights and remedies the insured had in respect of the property.
- Sum assured The amount for which a policy is taken, being the maximum the insurer will pay.
- Term insurance A life policy running for a fixed number of years that pays the agreed sum only if the assured dies within that term.
- Utmost good faith The principle requiring both parties to disclose every material fact connected with the subject matter of the insurance and to conceal nothing relevant.
16.12 Points To Ponder
- If profit is the reward for bearing risk, does a business that insures most of its risks deserve a smaller profit? Consider what the firm is still bearing after the premium has been paid.
- Non-insurable risks are the ones that can end a business, yet the businessman must carry them alone. Is it fair to describe insurance as protection against the losses that matter least?
- The principle of mitigation assumes that an insured person might otherwise let a loss grow. Is that assumption a fair view of human behaviour, or a necessary safeguard for the insurance pool?
- A firm insuring its stock must disclose facts that will raise its premium. Where should the line be drawn between a material fact the insured must reveal and a fact the insurer ought to find out for itself?
- Insurance restores a firm to the position it held before the loss, but it cannot restore the customers, contracts or reputation lost while the business was closed. What does this suggest about relying on insurance as the sole answer to risk?
- Would a business be better managed if it could not insure at all? Weigh the discipline that might follow against the risks a firm would then refuse to take.
16.13 Objective Questions
- A risk can be accepted by an insurer only if the chance of its occurrence can be: [1]
- eliminated altogether
- estimated in advance
- shifted to the customer
- prevented by management
- Assertion (A): A person may insure a building that he does not own. Reason (R): Insurable interest requires only that the insured should suffer a financial loss if the building is damaged. [1]
- Both (A) and (R) are true, and (R) is the correct explanation of (A).
- Both (A) and (R) are true, but (R) is not the correct explanation of (A).
- is true, but (R) is false.
- is false, but (R) is true.
- Match the items in Column A with those in Column B. [1]
| Column A | Column B |
|---|---|
| a. Subrogation | i. Insurers share a loss in proportion to the sums assured |
| b. Contribution | ii. The event covered is certain to occur |
| c. Re-insurance | iii. An insurer passes part of an accepted risk to another insurer |
| d. Assurance | iv. The insurer takes over the rights of the insured after paying the claim |
- Fill in the blank: A loss caused by a change in consumer fashion is an example of a _______ risk. [1]
- State whether the following statement is true or false: Under a contract of general insurance, an insured who holds policies with three insurers may recover the full loss from each of them. [1]
16.14 Check Your Concepts
- Define business risk and state any one reason why it cannot be removed from business. [2]
- State any three conditions a risk must satisfy before an insurance company will agree to cover it, giving the reason for each. [3]
- Distinguish between re-insurance and double insurance on any three bases. [3]
- Why does the principle of indemnity not apply to life insurance? Explain with an example. [4]
- ‘Insurance protects a business without reducing its risk.’ Evaluate this claim, explaining the principles of insurance that support your answer. [6]
16.15 Case-Based Questions
- Harivansh Papers Ltd. insured its godown and stock against fire, taking policies from two insurers for amounts that together came to less than the value of the stock. A fire broke out one night. The night watchman, knowing the stock was insured, made no attempt to move the goods away from the flames. On investigating the claim, the insurers also found that the firm had not disclosed that inflammable chemicals were stored in an adjoining shed.
- Name the principle the firm has breached by not disclosing the storage of chemicals, and state the effect of that breach on the contract. [2]
- Explain the principle the watchman’s conduct has ignored, and state how the loss will be shared between the two insurers. [2]