Insurance

Accounting and
Finance
Lecture#2
By
Dr. Muhammad Usman
 The Element of Risk
Risk is the possibility that a loss or injury will occur. It is impossible to escape all
types of risk in today’s world. For individuals, driving an automobile, investing in
stocks or bonds, and even jogging along a country road are situations that involve
some risk.

For businesses, risk is a part of every decision. In fact, the essence of business
decision making is weighing the potential risks and gains involved in various
courses of action.

There is obviously a difference between, say, the risk of losing money one has
invested and the risk of being hit by a car while jogging. This difference leads to
the classification of risks as either speculative or pure risks.

Speculative risk:

A speculative risk is a risk that accompanies the possibility of earning a profit.

Most business decisions, such as the decision to market a new product, involve
speculative risks. If the new product succeeds in the marketplace, there are profits;
if it fails, there are losses. For example, PepsiCo repeatedly gambles on the
introduction of new products to compete with Coca-Cola and reach the elusive top
spot. But the gamble does not pay off when the product fizzles.
Pure risk:

A pure risk is a risk that involves only the possibility of loss, with no potential for
gain. The possibility of damage due to hurricane, fire, or automobile accident is a
pure risk because there is no gain if such damage does not occur. Another pure risk
is the risk of large medical bills resulting from a serious illness. Again, if there is
no illness, there is no monetary gain.

Let us now look at the various techniques available for managing risk.

Risk Management
Risk management is the process of evaluating the risks faced by a firm or an
individual and then minimizing the costs involved with those risks. Any risk entails
two types of costs. The first is the cost that will be incurred if a potential loss
becomes an actual loss. An example is the cost of rebuilding and reequipping an
assembly plant that burns to the ground. The second type consists of the costs of
reducing or eliminating the risk of potential loss. Here we would include the cost
of purchasing insurance against loss by fire or the cost of not building the plant at
all (this cost is equal to the profit that the plant might have earned). These two
types of costs must be balanced, one against the other, if risk management is to be
effective.

Most people think of risk management as simply buying insurance. However,

insurance, although an important part of risk management, is not the only means of
dealing with risk. Other methods may be less costly in specific situations. And
some kinds of risks are uninsurable—not even an insurance company will issue a
policy to protect against them. In this section we examine the four general risk-
management techniques. Then, in the following sections, we look more closely at
insurance.

Risk Avoidance:

An individual can avoid the risk of an automobile accident by not riding in a car. A
manufacturer can avoid the risk of product failure by refusing to introduce new
products. Both would be practicing risk avoidance—but at a very high cost. The
person who avoids automobile accidents by foregoing cars may have to give up his
or her job to do so. The business that does not take a chance on new products
probably will fail when the product life cycle catches up with existing products.

There are, however, situations in which risk avoidance is a practical technique. At

the personal level, individuals who stop smoking or refuse to walk through a dark
city park late at night are avoiding risks. Jewelry stores lock their merchandise in
vaults at the end of the business day to avoid losses through robbery. And to avoid
the risk of a holdup, many gasoline stations accept only credit cards or the exact
amount of the purchase for sales made after dark.

Obviously, no person or business can eliminate all risks. By the same token,
however, no one should assume that all risks are unavoidable.

Risk Reduction:

If a risk cannot be avoided, perhaps it can be reduced. An automobile passenger

can reduce the risk of injury in an automobile accident by wearing a seat belt. A
manufacturer can reduce the risk of product failure through careful product
planning and market testing. In both situations, the cost of reducing risk seems to
be well worth the potential saving.
Businesses face risks as a result of their operating procedures and management
decision making. An analysis of operating procedures—by company personnel or
outside consultants—often can point out areas in which risk can be reduced.
Among the techniques that can be used are:

● The establishment of an employee safety program to encourage employees’

awareness of safety

● The purchase and use of proper safety equipment, from hand guards on
machinery to goggles and safety shoes for individuals

● Burglar alarms, security guards, and even guard dogs to protect warehouses from
burglary

● Fire alarms, smoke alarms, and sprinkler systems to reduce the risk of fire and
the losses due to fire

● Accurate and effective accounting and financial controls to protect a firm’s

inventories and cash from pilfering

The risks involved in management decisions can be reduced only through effective
decision making. These risks increase when a decision is made hastily or is based
on less than sufficient information. However, the cost of reducing these risks goes
up when managers take too long to make decisions. Costs also increase when
managers require an overabundance of information before they are willing to
decide.
Risk Assumption:

An individual or firm will—and probably must—take on certain risks as part of

living or doing business. Individuals who drive to work assume the risk of having
an accident, but they wear a seat belt to reduce the risk of injury in the event of an
accident.

The firm that markets a new product assumes the risk of product failure—after first
reducing that risk through market testing. Risk assumption, then, is the act of
taking responsibility for the loss or injury that may result from a risk. Generally, it
makes sense to assume a risk when one or more of the following conditions exist:

1. The potential loss is too small to worry about.

2. Effective risk management has reduced the risk.

3. Insurance coverage, if available, is too expensive.

4. There is no other way of protecting against the loss.

Large firms with many facilities often find a particular kind of risk assumption,
called self-insurance, a practical way to avoid high insurance costs. Self-insurance
is the process of establishing a monetary fund that can be used to cover the cost of
a loss.

For instance, suppose that approximately 16,000 ABC convenience stores, each
worth $400,000, are scattered around the country. A logical approach to self-
insurance against fire losses would be to collect a certain sum—say, $600—from
each store every year. The funds are placed in an interest-bearing reserve fund and
used as necessary to repair any fire damage that occurs to ABC stores. Money not
used remains the property of the firm. Eventually, if the fund grows, the yearly
contribution from each store can be reduced.

Self-insurance does not eliminate risks; it merely provides a means for covering
losses. And it is, itself, a risky practice—at least in the beginning. For example,
ABC would suffer a considerable financial loss if more than twenty-four stores
were destroyed by fire in the first year the self-insurance program was in effect.

Shifting Risks:

Perhaps the most common method of dealing with risk is to shift, or transfer, the
risk to an insurance company. An insurer (or insurance company) is a firm that
agrees, for a fee, to assume financial responsibility for losses that may result from
a specific risk. The fee charged by an insurance company is called a premium. A
contract between an insurer and the person or firm whose risk is assumed is known
as an insurance policy.

Generally, an insurance policy is written for a period of one year. Then, if both
parties are willing, it is renewed each year. It specifies exactly which risks are
covered by the agreement, the dollar amounts the insurer will pay in case of a loss,
and the amount of the premium. Insurance is thus the protection against loss that
the purchase of an insurance policy affords. Insurance companies will not,
however, assume every kind of risk. A risk that insurance companies will assume
is called an insurable risk. Insurable risks include the risk of loss by fire and theft,
the risk of loss by automobile accident, and the risks of sickness and death. A risk
that insurance companies will not assume is called an uninsurable risk.
In general, pure risks are insurable, whereas speculative risks are uninsurable (see
Figure 1). An insurance company will protect a Ford Motor Company assembly
plant against losses due to fire or tornadoes. It will not, however, protect Ford
against losses resulting from a lack of sales orders for automobiles.

Figure 1: