Risk and Risk Management

Meaning & Concept of Risk

Life is full of risk. Risk implies unfortunate situation and hence risk has been the concern of
mankind. We hear a car accident, risk of loosing a job, risk of inflation

Some of the definitions are given below.

 Risk is the possibility of unfortunate occurrence
 Risk is combination of hazards
 Risk is uncertainty of loss
 Risk is possibility of loss

 Risk is both unfortunate and lost opportunities

In the above definitions the underlying ideas fall into three categories:

1) Uncertainty: Risk implies uncertainty about unfortunate outcome unlike chance which
implies an outcome which if favorable. If we are sure that the unfortunate will happen, then it is
not a risk exists whether we recognize it or not. It should be outside the control of individual
involved. Further, it refers to present and future events that are uncertain.

2) Frequency and Severity: Even if we know there is a high probability of materialization of

risk, we don’t know how frequent and how severe it could be. Some risks such as shoplifting are
frequent but less severe. Accidents involving ships and planes are less frequent but too severe.

3) Peril and hazard: Cause of eventual loss is one of the components of risk. Peril is a prime
cause that gives rise to a loss and is usually beyond the control of any one who may be involved.
Hazard is not by itself a cause but it can increase or decrease the effect should a peril operate.
An example of peril could be fire and an example of hazard could be the type of construction
material such as thatched roof.

Hazard could be physical or moral. Physical hazard refers to the physical or tangible aspects of
risk which are likely to influence the occurrence and/or severity of loss e.g. type of construction
in fire risk.

Moral hazard is concerned with the attitudes and conduct of people. This is primarily the
conduct of the person insured. Examples of moral hazard include carelessness, dishonesty of
insured and an insured who considers claims as kind of investment.

Risk Management

Risk management refers to the identification, analysis and economic control of those factors that
can threaten the assets and earning capacity of an enterprise. Generally, the risk management
process includes three major processes: identification, analysis, and control.
1.1 Process of Risk management
Risk management process involves the following steps.
 Clarify and brief the context
 Understand/identify threats-Understand the potential with those threats for damage to the
company and its stakeholders
 Understand the likely frequency of risk damage
 Decide what risk levels are acceptable and identify those unacceptable ones
 Take action on risk deemed unacceptable by using different mechanisms
( likelihood and or frequency)
 Reduce the impact whether it be human, operational or financial
 Transfer the risk to another organization
 Prepare an incident/contingency planning
 Update and maintain the agreed risk levels as organization evolves and changes
 Communicate information on risk to all who have interest

Organizational Steps in Risk management

Develop a risk management philosophy

 To enable individual risk to be done within a framework of longer term

organization wide philosophy
 For effective benchmarking

Write basic policy statement –Objectives, risk processes and prioritization

 Decide on levels of impact to be retained

 Establish responsibility in lines of authority
 Have a reporting system-upward through the board
 Have methods of monitoring

 Identify risks-formal and structural: The risk identification activity starts with the
question ‘how the assets and earning capacity of an enterprise is threatened’. Risk
identification must be recognized as important within an enterprise and as a
responsibility of every department of an organization.

 Analyze risks –understand the relevance of individual operation and to the

organization as a whole and see the potential severity and frequency- In measuring
a risk, we gather data, analyze past information, and study the frequency and/or
severity of a risk in which an enterprise is exposed. The data collected should be
relevant and accurate because any risk control decision is made based on such data.

Risk and impact control-what are the choices available for

prioritizing- refers to physical and economic control of a risk. Physical control of a
risk refers to steps that can be taken in order to control risk whereas economic
 control refers to financial mechanisms used to control the risk. (E.g. there is no
point in spending of ten Birr to control a risk which can ever cost seven Birr)

Some of the major risk control mechanisms are:

a) Risk Reduction Mechanisms:

Risk reduction can be made either by post or pre-risk loss reduction mechanisms. These are
mainly a physical risk control mechanisms.

Pre-loss physical control- the effects of a loss are anticipated and certain steps are taken to ensure
that they are kept minimum. Such as fire protection, health and safety measures, security
controls, duplication of offsite computers, create independent risks by minimizing risk exposure.
Such mechanisms attract premium reduction.

Post loss physical control- this form of risk control imagines that a risk has occurred and steps
are taken to minimize a loss after its occurrence. e.g. fire sprinklers to put off fire damage, alarm
systems.

Non-physical risk control-effective staff recruitment, employee awareness and training and
related activities

b) Risk Retention Mechanisms:

Advise smaller units and subsidiaries that losses be retained

Once a risk has been identified and controlled in some physical way, we can consider the
effect of financing the risk. It includes:-

Risk Retention - It means that the firm has to pay the cost of risk itself. In certain situations,
it may be wise to retain the risk rather than seek another form of protection such as insurance.
Risk retention is justified where;
 The risk has been properly identified and evaluated.
 The amount retained per incident and in aggregate per year is within the
financial capabilities of the firm
The cost of insurance for the amount retained would be more than the cost of retention and
hence becoming uneconomical.

Self Insurance as one of the risk retention mechanism

Self-insurance is one form of risk retention. When an organization is large enough financially to
carry on losses and because the cost by way of transfer (insurance) is higher than the cost of
retaining it could be advantageous to establish a fund than transferring risks to insurer. Self
insurance is a conscious decision to create a fund out of which losses will eventually be met
unlike non-insurance where there is no conscious decision made at all (either by way transfer or
self-insurance fund)

Advantages and disadvantages of self insurance are given below:

Advantages of Self-Insurance

The advantages of such a scheme may be summarized a follows:

 Premiums should be lower as there are no costs in respect of broker’s commission,

insurers’ administration and profit margins;
 Interest of the investment of the fund belongs to the insured. This can be used to increase
the fund or to reduce future premium contributions;
 The insured’s premium costs are not increased due to the adverse claims experience of
other firms;
 There is a direct incentive to reduce and control the risk of loss;
no disputes will arise with insurers over claims;
 As the decision to self-insure is likely to be limited to large organizations, they will
already have qualified insurance personnel on their staff to administer the fund;
 The profits from the fund accrue to the insured.

Disadvantages of Self-Insurance

The advantages of such a scheme may be summarized as follows:

 a catastrophic loss, however remote, could occur, wiping out the fund and perhaps
forcing the organization into liquidation;
 while the organization may be able to pay for any individual loss, the aggregate effect of
several losses in one year could have the same effect as one catastrophic loss, particularly
in the early years after formation of the fund;
 capital has to be tied up in short-term, easily realizable investments which may not
provide as good a yield as the better spread of investments available to an insurance
company;
 It may be necessary to increase the number of insurance staff employed at an extra cost;
 The technical advice of insurers on risk prevention would be lost. The insurers’
surveyors would have a wider experience over many firms different trades and this
knowledge could be advantageous to the insured;
 The claims statistics of the organization will be derived from too narrow a base for
predictions to be made with confidence as to future claims costs;
 There may be criticism from share-holders and other departments:
 At the transfer of large amount of capital to create the fund and at the cost of dividends
that year, and at the low yield on the investment of the fund compared with the yield
obtainable if that amount of capital were invested in the production side of the
organization;
  In time of financial pressure, there may be a temptation to borrow from the fund, thus
defeating the security which it had created;
 Pressure may be brought to bear on the managers of the fund, to pay losses, which are out
1 side the cover (i.e. make ex-gratia payments), with the resultant depletion of the fund
for its legitimate purposes, and thus making statistical analysis more difficult.
 The basic principle of insurance, that of spreading the risk, is defeated;
 The contributions made to the fund do not qualify as a charge against corporation tax,
whereas premium payments are allowable.

Care to be taken not to retain over exposure in self insurance

 Transfer those risks that are beyond the organization by way of Insurance or any other
mechanism
 Create a fund establish by way of captive
 Transfer by way of contract
 Contingency planning (anticipate an incident and prepare to thee incident could not
destroy vital organs of the organization) e.g. computer

Risk Transfer – The most common form of risk transfer is insurance. When one is
uncertain about the possible outcome of a loss or the risk is highly severe, it is wise to transfer
the risk. Through insurance we can remove the uncertainty by transferring unknown frequency
and/or severity of loss to insurer by way of known premium.

Sources of information for Risk identification

1) Internal information includes: Audit Manager, compliance manager, design engineer,

facilities manger, legal officer, product development manager and company secretary, existing
documents such as proposal forms, auditor reports
materials produced within the risk management

2) Sources of external information: Formal sources: such as police crime prevention

department, traffic police reports, National Bank of Ethiopia, professional magazine,
Environmental protection reports, etc

 Consultants as one source of information source

 Informal sources such as newspapers and magazines, Company reports,
association and institutes, interments

Risk identification Techniques:

1. Where do risks lie?

 Organization chart –To demonstrate the organizations activities and organizational

structure. It helps to see risk s at a glance
 Flow chart:- pictures the route, taken by all of the crucial ingredients of the final
product, through the completion of final delivery
 2. What are those risks?

 Check lists and questionnaires – Commonly used tools as aide memoir to gather risk
information.

 Physical inspection – It is a means of getting clear picture of the risk environment

through risk surveyors.

 Brains forming - an information gathering with people having a wealth of

knowledge, experience and understanding within the organizations own employees.

 Risk committee: group of people meeting to share experiences and concerns about a
particular risk environment.

3. How can we shape risk information for decision making?

 Fault trees: to look into chain of events, which brought together a wide range of
materials and resource to create, and deliver the finished product. The flow reveals
the source of critical parts.

 Hazard and operability studies: originated in the chemical industry it involves four
key questions.
What is the part intended to achieve?
What deviations are possible away from the usually expected?
What could be causes of these variations?
What could be the consequences of those variations?

2.1 Characteristics of Insurable Risks:

Classification of Risk
There are three major classification of risk for the purpose of insurance:

1) Financial and Non-Financial Risk:

This classification is based on effect of a risk as to its measurability.

A financial risk is one where an outcome can be measured in monetary terms, or an event where
it is possible to place some monetary value on the outcome. For example; we can give fire
damage to property and accident of a vehicle.

A non-financial risk, however, relates to situations where outcome is not measurable financially
(e.g. Career choice.)

2) Pure and Speculative Risks:-

This classification is based on outcome of the loss. Pure risks involve an outcome of a loss or at
best a break-even situation i.e. the outcome could be unfavorable or would leave us in the same
situation. Example of pure risks includes: motor accident or ire damage; and Speculative risks is
where there is a chance of gain break-even or a loss e.g. gambling. Other examples of
speculative risks include investment decisions of various kinds such as inflation risk, or
marketing new product.

3) Fundamental and particular Risks:

This classification is based on both cause and effect. Fundamental risks are impersonal in origin
(cause) and widespread and uncontrollable in effect.

An example of fundamental risks includes natural risks such as famine, earthquake and violent
tropical hurricanes, (typhoon) or social risks such as inflation, war and unemployment. Because
of their widespread effect and being incalculable, insurers do not usually compensate them.
They rather are the responsibility of society, not individual insurers. Particular risks have their
origin in individual causes and are controllable. They are not widespread. i.e. felt by few.
Example includes motor accident risk, theft, and fire risk.

Cost of Risk

Various statistical data are available on the possible loss or damage throughout the world.
However, such data cannot fully measure magnitude and associated losses because;
Most data are based on insurable risks

 Such data do not measure the human suffering financially

 Such data do not measure data of lost production and general economic waste attributable
to certain loss event.

There are limits of transferring a risk. Not only it is not wise, it is utterly prohibited and may
lead to criminal litigation to allow people to benefit from their own criminal action. Therefore, it
is necessary to have the knowledge of insurable risks.

The following are the major characteristics of insurable risks:

Fortuitous - the happening of a loss must be fortuitous as far as the insured is concerned. For
example, he must not deliberately damage his own property. The frequency and severity of any
risk must be completely beyond the knowledge and control of the person being insured.

Financial Value – There must be some way of measuring the loss in financial terms. Insurance
doesn’t avoid the risk, it rather provides financial compensation of the loss to reinstate the
insured to his original position or financial status.
Insurable Interest - The insured must be in a legal relationship between the insured and the
financial loss. This is to avoid people insuring the property of others and then collecting
insurance money should anything happen, through their own machination.
Homogeneous Exposures - As the name implies Homogeneous Exposure means large number
of similar risks. Given sufficient number of exposures to similar risks, there will be enough
experience to forecast the expected extent of loss. This enables insurers to estimate the possible
actual loss (less guess estimate). It doesn’t mean, however, insurers do not always insure for
large homogeneous risks.
Example: Some risks such as satellite insurance were started without having large homogeneous
risks.

Pure Risks – Insurance is primarily concerned with pure risks. If some one was allowed to
insure speculative risks this would bring little incentive for people to go for work and that is why
we usually don’t insure speculative risks. However, the pure risk consequences of speculative
risks are insurable. e.g. machinery loss of profit insurance.

Particular risks – As we have previously discussed, particular risks are not widespread and
uncontrollable unlike fundamental risks. The widespread and indiscriminate nature of
fundamental risks has resulted in them traditional being uninsurable. Insurers however, insure
some and selected natural fundamental risks based on their geographical location of the property.
Fundamental risks, which arise out of the nature of society, are not insurable including changing
customs and inflation.

Public policy – It is common principle in law that contracts must not be contrary to what society
would consider right or moral thing to do, that is to say that contracts to any criminal venture are
not acceptable. For example, a company can’t insure a chauffeur in the event of convicted drink
driving offense committed by a person who is banned from driving.

2.2 Functions of Insurance:

The major function of insurance includes;

a) Risk Transfer:

As mentioned in the above discussion, the major function of insurance is to serve as a risk
transfer mechanism. Through insurance, the insured can transfer the uncertainty of loss
with certainly known and reasonable premium. Insurance will not prevent the risks from
happening but provides some form of financial compensation and what one transfers to the
insurer is the financial consequence of the risk. The main function of risk transfer is done
through common pool and equitable premium.

b) Creation of Common Pool

 In the early days of insurance, merchants carrying marine insurance, who were having
goods carried on a ship would agree prior to voyage, to make contribution to those who
suffered a loss during voyage.
  The traditional burial society in Ethiopia (Edir) will enable us to share some burial
expenses as stipulated in its memorandum of associations.

The above examples have drawbacks because every member will contribute similar amounts
irrespective of risks he has brought to the pool. Moreover, under early marine adventures
members knew their contribution after the loss. The insurance company gathers together people
who want insurance and sets itself to operate and manage the pool. It takes the contribution in a
form of premium from many people and pay for losses to the unfortunate few from such fund.
The pool idea works because not everyone in the pool will have a loss in any one year as with the
same magnitude and severity.

c) Equitable Premium:

There can be several of the pools, one each for main type. e.g. motor risks pool, fire risks
pool, employer’s liability, risks pool, etc. The insurer is faced with differing magnitude of
hazard, and differing value at risk.

The insurer should charge what is known as equitable premium, i.e., contribution made by
each party should be fair to all parties participating. Each members of the pool will be
charged based on severity, frequency, value at risk and other factors such as competition.

2.3 Benefits of insurance

The main benefits of insurance include:

1) Peace of Mind: The knowledge that insurance exists to meet financial consequences of
certain risks provide a form of peace of mind. One can directly deal on his business matters
than thinking of possible likelihood of a loss or event of loss occurring.

2) Loss Control: Insurers do have an interest in reducing the frequency and severity of a loss,
not only to enhance their profitability but also to contribute to the general reduction in
economic waste which follows from losses. e.g. surveyors advise of pre loss control like
flood control building.

3) Social Benefits: Availability of insurance cover to recover from losses provide stimulus to
the business activity. The social benefit is that people keep jobs, their source of income are
maintained and can continue to contribute to the national economy. Major losses leading to a
closing of a business can have adverse impact on the community and to the economy as a
whole.

4) Investment of funds: There is a time gap between the receipt of premium and payment of
claim. This vast sum of money should not be kept idle. It is invested in a wide range of
different forms of investment. By making loans available for mortgages and other
businesses, buying shares in the market, investing in bonds and others, insurers have become
major institutional investors in an economy.
 5) Invisible earning: Insurance like bank and tourism is invisible trade. A substantial
amount of money is earned through service export towards improving balance of trade. This
substantial foreign exchange helps to a positive balance of trade to an economy.

2.4 How Insurance Operates

Insurance is a contract (must be a written contract, Ethiopian Civil Code Article 1723-1726) in
which one party contract with another. The proof of insurance contract is the insurance policy
(Ethiopian Commercial Code 657 No. 1) and;
Further, the Ethiopian Commercial Code Article 654 defines an Insurance policy as a “contract
whereby a person, called the insurer, undertakes against payment of one or more premiums to
pay to a person, called the beneficiary, the sum of money where a specified risk materializes."

The parties to the insurance contract are the insured and the insurer. The risk is what both are
involved in the contract. This can be depicted by the triangle below.
 At the apex of the triangle is the risk

Risk

Insurer Insured

The insured:
 Knows the nature of the risk
 Has to describe the risk to the insure
The proposer
 Looks for acceptable protection, needs special clause to be included or excluded.
 He should know what is available in the market.
 Price is the main factor considered by most insured. In fact, service & security
are also considered.

The insurer;
 Is told about the risk by the proposer
 Insurers make some inquiries, use skilled surveyors and make physical
inspections.
 Intermediaries such as brokers who will assist insureds at various stages
during the transaction. We have the reinsurers at the angle of insurers to offer
the same kind of protection to the insurer as the insurer offered risk protection
to the insured.

2.4.1 Marketing
Marketing is the logical domain to start insurance transaction. The insurer, one who has the
service to sell, wants to market it in an attractive way to consumers, and the consumers want the
product/service offered by insurers. We should know that business exists solely or and because
of the customer. Marketing contributes fully to the determination of long term strategic goals of
a business organization.

2.4.2 Proposal Forms:

The proposal form is the most common mechanism used by the insurer to seek
answers to basic and necessary facts from the proposer. It is prepared by insurers
to record information, which is necessary to the underwriter to assess the nature of
the risk being proposed. Its length and form vary depending upon the information
required by insurer. The proposal from is the basis of the contract. The proposal
from is used for most classes of business. The exception is in marine insurance (a
slip used) and fire insurance (the risk detail is much that all details cannot be
accommodated by proposal forms and hence we use survey reports & other means
of assessing risk).

Proposal forms should be simple and easy to complete. The proposal forms have
general questions, questions asked in almost all classes of insurance and specific
questions which are risk specific to certain class.

General questions in proposal forms include:

 The name and address of the proposer (business),
 For identification-to identify the physical and moral hazard, indicative for
nature of trade.
 for identifying geographical address.
 Occupation and age – may show whether there is abnormal hazard.
 Details of past claims and in some cases past and present insured.
 The period of time over which insurance is required.
The basis upon which premium is to be calculated. e.g. types and cost of stock
in fire insurance.
These risk specific questions vary from class of business to another class.
Details of driver, for example, are important for private motor insurance.
 Proposal forms should have declaration and warning. Since proposal form is
the basis of a contract, the proposer should sign what has been supplied in the
proposal form is the thus to the best of his knowledge and belief. Moreover,
there should be warning or important notes to urge the proposer to reveal facts
even when they are in doubt as to whether or not they should be revealed.

2.4.3 Policy Forms: A policy is an evidence of the contract of contract of

insurance. The formation of insurance contract follows the process of offer and
acceptance.
 After a proposal is completed, terms have been agreed and premium is
agreed or been paid, then there is a contract. Every insurer has its own form
of policy for the various classes of business.

The insurance policy, as stipulated in Ethiopian Commercial code of 1960

article shall show:

1. The place and date of contract;

2. The names and addresses of the parties;
3. The item, liability or person insured
4. The nature of risks insured;
5. The amount of the guarantee
6. The amount of the premium;
7. The term for which the contract is made.

Generally, insurance policies, commonly called scheduled policies, have the

following parts:-

a) Heading - The heading includes the name of the insurer, addresses of

the company and sometimes the company’s logo

b) Preamble (Recital clause) - The preamble contains three main parts;

i. The proposal as the basis of the contract and incorporated in it.
ii. Mentions that premium has been paid or agreed to be paid
iii. That the insurer will provide cover stated in the policy

“Whereas the Insured named in the Schedule has by a signed proposal and
declaration which proposal and declaration the Insured has agreed shall be
the basis of this Contract and be held as incorporated herein applied to the
Company named in the Schedule (hereinafter called the Company) for
insurance against the Contingencies specified herein”
c) Operative Clause - This section of the policy is the part where the actual
cover provided is outlined. It begins with the word, ‘The Company “The
Corporation will….” by stating the covers as outline.

d) Exception - Exceptions are one of the occasions on which insurance gets “bad
press”. Exceptions are the inevitable consequences of insurance i.e., all
insurers can do is to make it clear that there are exceptions and word them in
simple terms. Exceptions could be general and specific. General exceptions
refer to those which are found in almost all policies such as war, radioactive
waste, earth quake, typhoons, hurricanes and the like. Particular exceptions
refer to those which are peculiar to certain class of insurance or which is
covered by other insurance policies e.g. riot in fire policy.

e) Conditions - At the end of policy is a list of conditions. Conditions could be

implied and expressed. Implied conditions do not appear on the policy but
 are nevertheless important. In other words, implied policies are found as
legal provisions. Such conditions are implied by law to apply to all classes
of insurance. Major implied conditions include;

1. The fact that the subject matter of insurance is actually existence and is able
to be identified.
2. That the insured has insurable interest.
3. That there has been utmost good faith.

Express conditions are those, which are expressly written in the policy.
Express policies may be found as legal provision. The clauses include in
express conditions are:-

1) A conditions stating that the insured will comply with all the terms of
the policy
2) The requirement that the insured notify the insurer of any change in the
risk (notification clause)
3) What procedures should be followed in the event of claim? This will
vary from cover to cover but will include reference to the time as then
which the claim will be notified. (Notification of claims clause). This is
five days in the Ethiopian Commercial Code.
4) The effect of fraud.
5) Reference to the fact that the insured is to take all reasonable care to
minimize the risk of loss/damage or of incurring liability. (In other words,
existence of policy of insurance is not being regarded as a mandate for
carelessness).
6) The arbitration condition relates to the amount to be paid under the
claim and not liability for the claim and not liability for the claim itself
(Arbitration clause). Here there is a difference in amount regarding the
claim. Most insurers who didn’t admit the claim liability will not accept
arbitration.
6) Condition will outline what will happen if there are other policies in
force covering the same loss (Contribution Clause).
7) There may be a condition allowing the insurer and the insured to cancel
the policy and saying how it is to be done (Cancellation Clause).

8) Many premiums are based on an estimated figure and adjusted once the
actual figure is known (Declaration Clause). These are common in Stock
in (fire insurance) and Workmen’s Compensation (employer’s liability).

f) Signature - This refers to the signature of the Company’s official

who has signed to show that contract has been concluded.

g) The Policy Schedule - The schedule is the place where the policy is
made personal to the insured. Included in the policy schedule are:-
 the insured
  the address of the insured
 the nature of the business
 premiums
 the limits of liability
 policy number
 Reference made to any special exclusions, conditions and
aspects of cover.

Essentials of Underwriting

The actual process by which risks are underwritten varies from one class of business to
another and depends on an insurer’s general approach. In fire and engineering insurance it is
common to make risk survey before risk is underwritten.

The underwriting process can be generally summarized as follows:

b) Assess the risk (conduct pre-risk survey);
c) Decide whether or not to accept the risk;
d) Determine the terms, conditions & scope of cover to be offered;
e) Calculate the premium
f)Policy issuance
Premium for insurance includes
a) To cover cost of expected claims;
b) create an estimate for outstanding claims;
c) provide a reserve to meet claims at some time in the futures(contingency);
d) meet all expenses;
e) Provide for profit.

Whenever we calculate premium, we should consider the following important points:

a) Inflation
b) Interest rates
c) Competition
d) Exchange rates
4. Principles of Insurances -
The following are major principles of insurance.

INSURABLE INTEREST

Whosoever effect insurance policy for own benefit should be one who stands to suffer financial
loss if the insured event takes place. Insurable interest constitutes the legal right to insure arising
out of a financial relationship recognized at law between the insured and the subject matter of
insurance. In the absence of insurable interest requirement, if people were free to insure for their
own benefit whoever and whatever pleases them, it would have been an open invitation to the
unscrupulous to commit a host of serious crimes with the view to the realization of profit.
Situation is clearly not in the public interest or is out of Public Policy.

Insurable interest is created when one stands in relationship with some subject matter whereby
the benefits from its safety and prejudiced from its loss/destruction. One can also insure for an
amount not greater than the value of his interest.

An example of how insurable interest is created is given below:

Life Insurance - No monetary value is placed on human life. The extent of insurable interest on
ones owns life has no limit. But when one insures the life of another is different. As per
Ethiopian Commercial Code a person can insure the life of another but only with the consent of
the person to be insured both as to the assurance and amount of assurance;

- A creditor or guarantor can insure the life of debtor to the extent of loan and interest
- A partner can insure the life of his partner to the extent of the latter's financial interest.
- An employer has insurable interest in the life of his employees to the extent of possible
financial loss or legal liability.

Property Insurance - absolute owner has insurable interest to the extent of financial value of the
property.

- Mortgages - Lender has insurable interest in the property to the extent of the loan and any
interest.
- Persons holding goods in trust for others and where they are responsible for the safe keeping of
goods either by law or by contract such as carriers, hoteliers, laundries, warehouseman etc. can
insure to the extent of the value
- An agent can insure property on behalf of his principal
- A joint owner of property can insure for full value of property financial interest, as does so an
agent for the other part of joint owner
Liability Insurance - amount of liability can't usually be known in advance. Recover under the
policy is limited to the award even where the limit of policy per the policy is greater.
In majority cases, the existence of insurable interest in non-life insurance must exist at the time
of loss, not necessarily at inception. Non-Life policies are contracts of indemnity and a person
can be indemnified only if loss is incurred. Insurable interest need only exist at inception in the
case of life policy since life policy is not a contract of indemnity

If one has no insurable interest, its effect is that there was no enforceable contract at all or the
policy is void.

UTMOST GOOD FAITH

In the context of insurance, the essence of utmost good faith is one, which the law imposes on
both insured and insurer. In the process of insurance negotiation, each party must provide the
other with truthful and sufficiently complete information to enable one arrive at a decision
whether to enter into an insurance contract. The duty is reciprocal. While the propose can
examine a specimen of the policy before accepting the terms, the insurer is at disadvantage as he
cannot examine all aspects of the proposed insurance which are material to in and therefore, the
responsibility of disclosure heavily rests on the proposer. The proposer should have all facts that
he knows and which have a material bearing on the risk being proposed. On the other hand, the
insurer should state the exact terms, exceptions and conditions of insurance.

The proposer is expected to answer the questions and requests truthfully and also is responsible
to voluntarily disclose material facts on aspect of the risk not covered by the proposal form.

It should be noted that not all facts need to be disclosed. Facts to be disclosed should be material
such that it would be one that would influence the insurer in accepting or declining the risk or in
fixing the premium or terms and conditions of the contract.

Regarding duration of material fact, the duty to disclose material facts starts from the time of
negotiations for the contract and continues to the moment of contract formation. There are also
duties on the part of the insured, as per the 1960's Commercial Code article 669, to inform the
insurer any increase in the risk subsequent to the formation of the contract.

The duty discloses revives at the time of renewal as well as during the currency of the policy.

The duty of disclosure is violated where there is misrepresentation and non disclosure.
Representation refers to an oral or written statement of fact made at the time of negotiation for a
contract with the intention of inducing the other party to enter into the proposed contract.

The remedies for breach of utmost good faith are stated in the Ethiopian Commercial Code of
1960 Article No. 668

PROXIMATE CAUSE

MEANING
Obviously, when a loss does occur, it is essential to determine its cause or causes in order to
decide whether or not the loss is covered by the policy.
Where the loss is the effect of single cause, the decision as to admission of liability under a
policy is relatively simple. All that is needed is reference to the policy to see whether the
causative event is named as an insured peril. If it is so, liability will be admitted; but if it is not,
liability will be denied.

On the other hand, there are also cases where two or more events produce loss. Under such cases,
too, if all the events involved are insured perils or if all of them are expected or unnamed perils,
the matter of admission of liability is rather straightforward: admission or denial respectively.
But where the events represent combinations of insured, expected and unnamed perils, it
becomes necessary (if at all possible) to identify the loss caused by each event. Thus, each event
will be the proximate cause of the loss that it alone produces. But if such separation of cause and
effect is not possible, it becomes instrumental in bringing about the loss.

MORE THAN ONE CAUSE

These events may be either a chain/train of events or concurrent events.

In respect of a series of events, proximate cause has been defined as follows: "Proximate cause
means the active, efficient cause that set in motion a train of events which brings about a result,
without the intervention of any force started and working actively from a new and independent
source."

There is an initial Event 1 which is cause for the happening of Event 2. Event 2 in turn causes
Event 3 and so on until the chain of events stops at some point. that is, each event is the logical
or natural effect of the immediately proceeding event and the logical cause for the immediately
proceeding event and the logical cause for the immediately following event. Each event along
the chain may or may not produce a loss; what is definite is that there is some loss at the end.

Unbroken Sequence: Where the link between the first and last events in the chain is unbroken,
the proximate cause for the whole loss is the first cause.

Broken Sequence: If at some point in the chain the sequence is broken, it becomes necessary to
isolate the loss caused by each event, and thereby each event will be the proximate cause for the
loss brought about by it.

Remote Causes: the description of chain of events outlined above envisages a situation where
the time interval between the happenings of two consecutive events is too short to effect
measures for the prevention of further loss. If in fact time was too short, then the initial cause is
usually held to be the proximate cause. On the other hand, if there was sufficient time between
two consecutive events the original cause is deemed to be too remote a cause for the loss
produced by the later event. "It should be noted, however, that where damage is serious and
further loss is almost inevitable, the initial cause will be the proximate one while attempts at
removing the danger are made and until the danger is remover."
Concurrent events : These are events which are independent or unrelated to one another but
which occur simultaneously by chance to produce loss(es)

Under such a case, there is not necessarily one proximate cause but two or more. The effect of
each will have to be isolated If possible; then each event is the proximate cause for the loss
produced by it.
The Importance of Identifying the Cause of Loss

It is obvious that the cause of a loss must be reasonably established before insurers are
considered liable. A peril of some kind will have caused the loss, but not all perils are
insured. In fact, there are three basic types of peril:

a) Insured perils: These are plainly understood, such as fire under a fire policy and
burglary under a burglary policy.
b) Excepted perils: These are perils which are specifically excluded from the
insurance cover, either because it is not practicable to insure them at all or because
they cannot be insured at the premium applicable to the policy. Examples would be
suicide under a personal accident policy, or spontaneous combustion under a
standard fire policy.
c) Uninsured perils: These are perils which are not mentioned in the policy
document, but which are clearly outside the scope of cover, such as fire damage
under a burglary policy and death from natural causes under a personal accident
policy.

POLICY WORDING

The principles outlined above need to be applied in light of policy wording so as to:

 Determine the nature of perils relevant to the application of the doctrine of

proximate cause; i.e. insured, excepted and unnamed perils;
 Ascertain whether or not the policy wording modifies application of the
doctrine or there is any reference to "indirect" causes.

INDEMNITY:

MEANING

The central purpose of insurance in general is to provide to the insured compensation in money
or money's worth equal to the amount of the financial loss he might sustain if the insured event
takes place.
 This is the concept of indemnity. That is, "for the purposes of insurance contracts, indemnity
could be looked upon as the exact financial compensation sufficient to place the insured in the
same financial position after the loss as she enjoyed immediately before it occurred." (Refer also
commercial code of 1960 article 678).

The essence of the principle is that ideally compensation should be equal to the loss; neither
more nor less. If compensations is greater than the loss, the insured will have made a gain, and
this is clearly at variance with the basic purpose of insurance as noted on the chapter on insurable
interest. On the other hand, if compensation is smaller than the loss, he will not have been
indemnified.

LINK WITH INSURABLE INTEREST

In the event of a claim the insured cannot recover under a policy a sum greater that the value of
his financial interest in the subject matter of insurance.
APPLICABILITY

The principle of indemnity applies to all forms of insurance other than those on the life of
persons (notably life and personal accident insurances). The explanation is not difficult to find.
As noted in the chapter on insurable interest, the value of a human being cannot be measured in
terms of money. Therefore, it generally is meaningless to try to ascertain the financial loss
incurred by the death of a person, or as the result of the loss of limb, eyesight, etc. This is
expressed by saying that these are not contracts of indemnity. They are rather contract of
benefits.

Nevertheless, life and personal accident insurance policies can be made to be contracts of
indemnity for certain specific purposes. A creditor or a debtor may insure a debtor for no more
than the amount to the debt. A partner may also not insure another partner for an amount greater
than the sum the partnership. These are all insurances of indemnity. A personal accident policy
can also be a contract of indemnity where for example an employer effect such a policy on his
staff specifically so as to provide himself with any amount he would have to pay in wages to
disabled employees. In short, many of the policies affected on the life another person can be
viewed as contracts of indemnity.
HOW PROVIDED

Indemnity may be provided in one of four ways. The choice as to which method to apply is
usually given to the insurers by the policy.

These four methods of providing indemnity are the following:

Cash Payment
The amount of claim payable under the policy is paid to the insured in cash.
Repair
Damage to the insured object is made good by repair at the insurer's cost.
Replacement
Where the insured object is lost or destroyed beyond economic repair, the insurer undertakes to
replace is with a like object.

Reinstatement
As a method of providing indemnity, "reinstatement" refers to rebuilding or restoring a damaged
building.

MEASUREMENT OF INDEMNITY

In effect, measurement of indemnity is measurement in money terms of the loss sustained by the
insured. But is should be pointed out at this stage that settlement under the policy may be for a
different amount as shall be show later in this chapter.

Measurement of indemnity under the main forms of insurance can be summarized as follows:

Marine

Marine policies cover cargo and ship. Marine policies fall into two categories. Valued and
unvalued. The more usual marine policy is the valued policy. A valued policy is one in which
the value of the subject matter insured is mutually agreed between the insured and the insurer at
inception. The cargo policy allows the insured to i8nsure the cost price of goods, freight and the
insurance premium as well as his profit. Because the element of profit is included, a commercial
indemnity, rather than strict indemnity is provided.

In the event of total loss, the measure of indemnity is the value fixed by the policy. Where there
is a partial loss of goods, the loss will be a proportion of the total agreed value. In the case of a
partial loss of a ship, indemnity is equal to the cost of repairing the damage.

Property

There are several classes of property, the main ones being building, machinery and contents
(other that stock), and stock-in-trade. In all cases, the general rule is that where property is lost,
damaged or destroyed (in whole or in part), indemnity in respect thereof or represented not by its
cost but by its value at the date and at the place of loss excluding any element of prospective
profits but including any increase in value during the currency of the policy subject to the
application of average.

Building: Indemnity is the cost or repair or reconstruction at the time of loss less an allowance
for betterment. There will be betterment because old materials will have been replaced by new,
and some features which did not exist before the loss might have been added.

Machinery & Contents: Indemnity is the cost of repair or replacement less any allowance for
wear and tear. Where the replacement is new, allowance for wear and tear will be deducted but
where the replacement is by an identical secondhand item there is no such deduction.
Stock-in-trade: Indemnity is the cost of replacing the stock at the time and at the place of loss.

In the Case of Manufacturer's Stock:

Raw Material: replacement cost including delivery to site;

Other Stock: cost of replacement at prices ruling on the date of loss.

In the Case of wholesalers' or retailers': includes transport and handling costs to the insured's
premises.

Salvage: In all property or marine claims, the value of any salvage is deducted from the amount
of indemnity determined as above. If this is not done the insured will be more than indemnified.

Pecuniary Insurance
Under a fidelity guarantee policy, indemnity is represented by the actual monetary loss sustained
by the insured as a result of the dishonesty of an employee or employees.

In consequential loss insurance, indemnity is the prospective profit lost due to interruption of
business after a fire.

Liability Insurances
Indemnity is easily measurable. This is simply the amount awarded by a court or negotiated out
of court plus costs and expenses incurred in connection with the claim.

FACTORS LIMITING THE PAYMENT OF INDEMNITY

As noted earlier above, payment under a policy may not be equal to indemnity; it could be less
for one or more of the following reasons;

Sum Insured
The maximum amount payable under a policy is the sum insured (or limit of indemnity or limit
of liability). Thus where this amount is less than indemnity, the insured will not be fully
compensated by his policy and, therefore, will have to bear part of the loss himself.

Average
If there is under-insurance (i.e. where the sum insured is less than the full value of the subject
matter insured), the insurer's share of any loss is =
Sum insured X Loss
Value at risk
The insured bears the balance of Full Value
(See Eth. commercial Code of 1960 article 679 and 680.

Franchise//Excess/Deductible
These require that the insured himself bear the first Birr X of each claim, in which case the sum
payable under the policy is less than indemnity.
Limits of Liability
These place a maximum limit payable under a policy for any one item irrespective of its value.
Here again, the policy will pay to these limits, the insured bearing the balance, if any.

EXTENSIONS IN THE OPERATION OF INDEMNITY

There are also cases where payment under a policy will amount to more than indemnity.

Reinstatement Memorandum
An insured can request that insurance in respect of buildings and machinery be subject to the:
reinstatement memorandum". In such a case, settlement will be made without deduction for
wear, tear and depreciation.

New of Old Policies

This is for household gods are destroyed within the first three to five years of their purchase;
settlement will be for the cost of new items without deduction for wear and tear.

Agreed Additional costs

an insured can arrange for his policy to cover costs for the removal of debris, architects' and
survey9or' fees incurred for supervision of work when rebuilding after a fire.

SUBROGATION
MEANING
There arte certain cases where a third party is legally liable for the loss sustained by the insured.
Under such a case, the insured will have two sources of compensation his insurance policy and
the third party. If the sum of the compensation received from both sources exceeds the value of
the insured's loss, he will have been more than indemnified; i.e., he will have made a gain; a
situation which should not be allowed to happen. Therefore, the principle of subrogation (which
is a corollary to the principle of indemnity) is required to secure the objective of indemnity and it
requires the insured, after having been indemnified by his insurer, to account to the insurer for
any profit he might make from the insured event.

This is effected by the insured subrogating or relinquishing his rights and remedies against the
third party to the insurer who then pursues these rights and remedies in the name of the insured
and recover whatever amount is due from the third party.

APPLICATION
The principle of subrogation is needed to support the principle of indemnity. Therefore, it does
not apply to life and personal accident insurances since, as noted in earlier chapters; these are not
contracts of indemnity.

HOW SUBROGATION ARISES

Subrogation rights may arise in one of three ways as follows:
Civil Wrong
If an insured sustains a loss due to the wrongful act of another person, then the insurer, after
having indemnified the insured, is entitled to take legal action to recover his outlay from the
wrongdoer.
Contract
Where the insured has been indemnified he cannot also retain any available salvage as this would
give him more indemnity. The insurer is entitled to the salvage.

WHEN DOES SUBROGATION ARISE?

Subrogation does not normally arise until the insurer has admitted and paid it. This could,
however, give rise to some problems as the insurers would not have complete control from the
date of the loss and their eventual position could be produced by delay or other action on the
insured's part.

To ensure their position is not prejudiced, insurers place a condition on the policy giving
themselves subrogation rights before the claim is paid. The insurer cannot of course recover
from the third party before he has actually settled with his own insured but the express condition
allows the insures to hold the third party liable pending indemnity being granted to the insured
person. In marine insurance policy condition as above is not used and the claim must be met
before the underwriters have subrogation rights.

EXTENT OF SUBROGATION RIGHTS

An insured's subrogation right is limited to the amount of claim paid under the policy. In order
words, an insurer is not entitled to recover more than he had paid out and must not make any
profit by the exercise of subrogation rights. (See Commercial Code of 1960)

"Where the insured has been considered his own insurer for part of the risk, as in the case of
excess or the application of average, he is entitled to retain an amount equal to that share of the f\
risks out of any money recovered. Where the insurer makes an ex-gratia payment to an insured,
the insurer will not be entitled to subrogation rights should that insured also recover from another
source.

This follows from the fact that an ex-gratia payment is not indemnity and subrogation rights only
arise out of the need to supp-ort the concept of indemnity."

CONTRIBUTION
MEANING
The principle of contribution is another corollary to the principle of indemnity and is intended to
secure the objective of indemnity in a case where an insured has two or more policies with as
many insurers covering the same loss.

The position as similar to that discussed under the chapter on subrogation; i.e., the insured has
more than one source of compensation from which he stands to make a gain if allowed to recover
from all sources.
The principle of contribution prevents this by apportioning the claim among the insurers on some
equitable basis.

HOW CONTRIBUTION ARISES

Contribution applies where the following conditions are met:

 Two or more polices of indemnity exist;

 The policies cover a common interest;
 The policies cover a common peril which gave rise to the loss;
 The polices cover a common subject matter;
 Each policy must be liable for the loss.

THE BASIS OF CONTRIBUTION

'' The loss will be shared by the insurers in their ratable proportions''

There are two interpretations of how ''notable proportioned should be calculated. Firstly, one
could argue that each insurer should pay in proportion to the sums insured or limits of liability on
the policies.

Alternatively, one could argue that each policy should pay in proportion to its liability for the
loss, since account should be taken of restrictive terms, which might vary from policy to policy.
This approach is called the '' independent liability method''.