Risk Analysis

RISK ANALYSIS (GLOBAL) Approved courseware for the Certified Financial Planner CM certification education programme in India\" Published by 'International College of Financial Planning Ltd.' \"Every effort has been made to avoid any errors or omission in this book. Inspite of these errors may creep in. Any mistake, error or discrepancy noted may be brought to our notice, which, shall be taken care of in the next printing. It is notified that neither the publisher nor the author or seller will be responsible for any damage or loss of action to anyone of any kind, in any manner, there from. No part of this book may be reproduced or copied in any form or by any means or reproduced on any disc, tape, perforated media or other information storage device, etc. without the written permission of the publisher. Breach of this condition is liable for legal action. All disputes are subject to Delhi jurisdiction only.\" Risk Analysis – Global & India Published by the International College of Financial Planning Ltd. © International College of Financial Planning Limited 2002

This subject material is issued by the International College of Financial Planning Ltd. on the understanding that: 1. International College of Financial Planning Ltd., its directors, author(s), or any other persons involved in the preparation of this publication expressly disclaim all and any contractual, tortuous, or other form of liability to any person (purchaser of this publication or not) in respect of the publication and any consequences arising from its use, including any omission made, by any person in reliance upon the whole or any part of the contents of this publication. 2. The International College of Financial Planning Ltd. expressly disclaims all and any liability to any person in respect of anything and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or partial, upon the whole or any part of the contents of this subject material. 3. No person should act on the basis of the material contained in the publication without considering and taking professional advice. 4. No correspondence will be entered into in relation to this publication by the distributors, publisher, editor(s) or author(s) or any other person on their behalf or otherwise. Author Sanjiv Bajaj CFPCM, MBA (Finance), International Certificate for Financial Advisors (CII – London) Revised By: Dinesh Gupta CFPCM from FPSB, IRDA and AMFI Certified. Associate in Insurance from Insurance Institute of India. \"Unless otherwise stated, copyright and all intellectual property rights in all course material(s) provided, is the property of the College. Any copying, duplication of the course material either directly, and or indirectly for use other than for the purpose provided shall tantamount to infringement and shall be strongly defended and pursued, to the fullest extent permitted by law.\"

TABLE OF CONTENT (1 - 184) RISK ANALYSIS - GLOBAL (3 - 15) Chapter 1: Principles of Risk Management 1 2 1.1 Purpose and Need of Insurance 6 1.2 Insurance as a Tool to Manage Risk 6 2.1 Adverse Selection 11 2.2 Insurable Risk 11 Insurance and Risk 12 3.1 Meaning of Risk 14 3.2 Types of Pure Risk 15 3.3 Other Types of Risk 16 3.4 The Principle of Pooling of Risk 19 3.5 Methods of Handling Risk 25 3.6 Reinsurance 25 3.7 Fundamental Principles of Insurance 28 4.1 Indemnity 30 4.2 Insurable Interest 34 4.3 Utmost Good Faith 35 4.4 Subrogation 36 4.5 Contribution 4.6 Proximate Cause (48 - 55) Chapter 2: Risk Exposures 48 50 2.1 Financial Obligations: Existing and Potential 2.2 Analysis and Evaluation of Risk Exposures (56 - 142) Chapter 3: General Insurance 72 72 1.1 Intentional Torts 74 1.2 Absolute Liability 77 1.3 Law of Negligence 78 2.0 Professional Liability 94 2.1 Malpractice and Errors and Omissions 2.2 Loans Against Life Insurance Policies

2.3 Exclusions and Restrictions 95 2.4 Suicide Clause 97 2.5 Life Insurance Policy Riders 99 2.6 Economic Value of Human Life 105 3.1 Replacement of Future Income of the Insured 109 3.2 Case Study 111 3.4 Common Features of LTC Insurance Policies 118 3.5 Disability: Personal 125 3.5.1 Common Features of Disability Insurance 126 3.5.2 Definition of Disability 130 3.5.3 Common Continuation Provisions 135 3.6 Business-related 136 3.6.1 Key person 137 3.6.2 Disability: Business 138 3.6.3 Business Overhead Expense 139 3.6.3 Business Liability and Board Member Cover 140 Chapter 4: Insurance Company and Advisor Selection (143 - 162) 4.1 Company and Advisor (Agent) Selection and Due Diligence 144 4.1.1 Company Evaluation and Selection 144 4.1.2 Intermediary Selection and Responsibilities 149 4.1.3 Choosing an Insurance Policy 152 4.2 Legal and Financial Characteristics of Insurance Parties Involved in an Insurance Contract 156 4.2.1 Insurance company 156 4.2.2 Policy owner 158 4.2.3 Beneficiary 159 4.2.4 Insured 159 4.2.5 Regulation and Compliance 160 Chapter 5: Strategic Solutions (167 - 184) 5.1. Risk Review and Evaluation: Property and Liability 167 5.1.2 Risk Review and Evaluation: Life 169 5.2 Risk Management Tools Being Used to Address Risk Exposures 174 5.3 Risk Management Needs 176 5.4 Risk Management Optimization 179 5.4.1 Risk Management Audit 179 5.4.2 Implement the Chosen Approaches 181 5.4.3 The Road Map 183

RISK ANALYSIS – INDIA (185 - 342) Chapter 1: Introduction to Insurance (187 - 197) 1.1 Overview of Insurance Sector in India 187 1.2 Re-Insurance 191 1.3 Laws governing insurance business in India 192 1.3.1 The Insurance Act, 1938 192 1.3.2 The Insurance Laws (Amendment) Act, 2015 193 1.3.3 Law relating to Agency under the Indian Contract Act, 1872 193 1.3.4 The Consumer Protection Act, 2019 194 1.3.5 Doctrines of Waiver and Estoppels 195 Chapter 2: Regulatory Infrastructure around Insurance (198 - 206 ) 2.0 Insurance Councils and General Insurance Council 201 2.1 Constitution and Powers 201 2.2 Self- Regulatory Mechanism 202 2.0 Insurance Information Bureau of India (IIB) 202 2.4 Insurance Ombudsman 203 2.4.1 Establishment and Objectives 203 2.4.2 Appointment, Tenure and Jurisdiction 204 2.4.3 Rights and Powers 204 2.4 Insurance Institute of India (III) 205 2.5.1 Authority and Functions 206 2.5.2 Education and Training 206 Chapter 3: Insurance Intermediation in India (207 – 222) Licensing of Insurance Brokers 212 Role of an Insurance Broker 213 3.1 Medical Examiners 215 3.2 Insurance Marketing Firms 217

Chapter 4: Life Insurance (223 - 299) Insurance Underwriting 223 Premium Calculation 229 Modified Products 245 3.4.1 Maturity of Policy 265 3.4.2 Death Claim 269 3.5.3 Lapse, Non-forfeiture Provision, Surrender and Revival 288 4.1 Preamble 296 4.2 Operative Clause 297 4.3 Proviso 297 4.4 Schedule 297 4.5 Attestation 298 4.6 Conditions and Privileges 299 Chapter 5: General Insurance (300 - 342) 1.0 Government and Private Insurance Companies 300 1.1 Individual Health Insurance 304 1.2 Family Floater Policy 307 1.3 Critical Illness Policy 308 1.4 Group Health Insurance Policies 308 1.5 Pre-Existing Disease Clause and Other Provisions 309 1.6 Personal and Group Accident Insurance 314 2.0 Public Liability 324 2.1 The Public Liability Insurance Act, 1991 325 2.2 Environmental Impairment Liability (EIL) 326 2.3 Product Liability 327 2.4 Professional Indemnities 327 2.5 Employer’s Liability Insurance 328 3.0 The Workmen’s Compensation Act, 1923 329 3.1 The Maternity Benefit Act, 1961 331 3.2 Motor Insurance - No Claim Bonus and Claims 335 3.3 Proposal Form 337 4.0 Policy Component 338 4.1 Heading 338 4.2 Preamble 338 4.3 Operative Clause 339 4.4 Policy Schedule 339 4.5 Signatures 339 4.6 Exceptions 340 4.7 Conditions 340

Chapter 1: Principles of Risk Management 1.1 Purpose and Need of Insurance Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium. Insurance allows individuals, businesses and other entities to protect themselves against significant potential losses and financial hardship at a reasonably affordable rate. We say \"significant\" because if the potential loss is small, then it doesn't make sense to pay a premium to protect against the loss. After all, you would not pay a monthly premium to protect against a ₹2000 loss because this would not be considered a financial hardship for most. Insurance is appropriate when you want to protect against a significant monetary loss. Take life insurance as an example. If you are the primary breadwinner in your home, the loss of income that your family would experience as a result of our premature death is considered a significant loss and hardship that you should protect them against. It would be very difficult for your family to replace your income, so the monthly premiums ensure that if you die, your income will be replaced by the insured amount. The same principle applies to many other forms of insurance. If the potential loss will have a detrimental effect on the person or entity, insurance makes sense. Everyone that wants to protect themselves or someone else against financial hardship should consider insurance. This may include:  Protecting family after one's death from loss of income Page 1  Ensuring debt repayment after death CFP Level 3: Module 1 – Risk Analysis - Global

 Covering contingent liabilities  Protecting against the death of a key employee or person in your business  Buying out a partner or co-shareholder after his or her death  Protecting your business from business interruption and loss of income  Protecting yourself against unforeseeable health expenses  Protecting your home against theft, fire, flood and other hazards  Protecting yourself against lawsuits  Protecting yourself in the event of disability  Protecting your car against theft or losses incurred because of accidents  And many more 1.2 Insurance as a Tool to Manage Risk Life is a constant process of taking risks. If a person commutes to work by bus, he runs the risk of being involved in a traffic accident. If he chooses to walk to work, he risks being knocked down by a car during the journey. If he chooses to dine outside, he runs the risk of food poisoning. Although some of the risks mentioned may be farfetched, they can never be totally eliminated. Most activities undertaken by people normally entail risks of some sort. Risk mainly refers to a condition where there is a chance that the risk - taker may suffer or enjoy a gain or maintain status quo. Insurance is an only instrument to help a sufferer to do so. If Jayesh kumar purchases a lottery ticket, he runs the risk of either losing the money used to buy the ticket or striking the top prize of ₹1 Crore. This is Gambling. When a share broker put sum of money into certain shares, he can make profit, suffer a loss or meet the break even. He undertakes the result of gambling. Though it is a risk no insurance tax available to compensate the loss out of gambling. A condition where the risk taker either suffers a loss or avoids losses without enjoying any gain. For example, if Jayesh kumar owns a property, there is a risk that it may be decimated by an accidental fire. The loss out of damage due to fire can be compensated through insurance. Thus insurance is a protection against financial loss due to pure risk but the loss out of speculation is gambling for which is tools to compensate the losses. CFP Level 3: Module 1 – Risk Analysis - Global Page 2

Definition of Risk Analysis It is an estimation of the possibility of suffering loss. In other words, it is the process of assessing identified risks to estimate their impact and probability of occurrence (likelihood) Perils named in the policy as Insured e.g. Fire, Theft, Accident, Lighting etc. CFP Level 3: Module 1 – Risk Analysis - Global Page 3

QUESTIONS Q1. The concept of Fire Insurance was born the Great fire of ___________ in 1666. (a) America (b) London (c) Germany Q2. A fund that is used for expenses immediately incurred upon a person's death. By having sufficient funds, existing assets belonging to the estate need not be liquidated on unfavorable terms to pay for such expenses is a _______________. (a) emergency fund (b) education fund (c) final expenses Q3. The very nature of insurance is to provide ____________________________. (a) protection for events that don't happen frequently (b) service at a right time (c) none of the above 1B Answers 3A 2B CFP Level 3: Module 1 – Risk Analysis - Global Page 4

Perils and Hazards A peril is an immediate, specific event causing a loss. In other words, a peril is something that can cause a loss. Examples include falling, crashing ones car, fire, wind, hail, lightning, water, volcanic eruptions, choking, falling objects etc. On the other hand a hazard is the condition which increases the risk or seriousness of a loss. In other words, a hazard is any condition or situation that makes it more likely that a peril will occur. There are four types of hazards known to the insurance profession. They are as follows:  Physical hazards: These include hazards which arise from structural or operational features of the situation. For example a slippery floor or a huge tree branch in the middle of the road would be classified as a physical hazard.  Moral hazards: These include hazards which arise from a person's habits and values. The attempt to create a loss for the purpose of collecting from an insurance company is a moral hazard. Another moral hazard is the filing of a false claim. Also, every day someone sets themselves up to be the victim of an auto theft. In many cases this is done just to avoid having to pay anymore on the loan. This is a very common moral hazard which could easily result in prison time for the one who attempts this type of fraud.  Morale hazards: These include hazards which arise from carelessness or irresponsibility. An example of a morale hazard is when some driver flies into oncoming traffic while trying to reach their dropped cell phone.  Legal hazards: These include hazards which arise from court actions that increase the likelihood or amount of loss. Legal hazards will continue to increase as more people file lawsuits for large rewards. Law of Large Numbers No one can predict the losses that a specific person will experience. We do not know when a specific person will die, become disabled, or need hospitalization. It is possible, however, to predict with a fairly high degree of accuracy the number of people in a given large group who will die or become disabled or need hospitalization during a given period of time. These predictions of future losses are based on the concept that, even though individual events - such as the death of a particular person - occur randomly, we can use observations of past events to determine the likelihood that a given event will occur in the future. This likelihood is called probability of event. An important concept that is used to determine the probability of an event occurring is the law of large numbers. CFP Level 3: Module 1 – Risk Analysis - Global Page 5

Probability: The likelihood that a given event will occur in the future Law of Large numbers states that, typically, more times we observe a particular event, the more likely it is that our observed results will approximate the \"true\" probability that an event will Occur. For example, if you toss an ordinary coin, there is a 50-50 probability that it will land with the heads side up; this is a calculable probability. Four, or even a dozen, tosses might not give the result of an equal or approximately equal number of heads and tails. If you tossed the coin 1,000 times, though, you could expect a result of approximately 50 percent heads and 50 percent tails to occur. The more often you toss the coin, the more likely it is that you will observe an approximately equal proportion of heads and tails, and thus, the more likely it is that your findings will approximate the \"true\" probability. 2.1 Adverse Selection Some insured’s do not reveal knowledge that would affect their underwriting classification. This failure to reveal relevant information may be because the insurer did not ask the right questions or because of applicant forgetfulness or misreprentation. This leads to adverse selection. An important purpose of underwriting is to deter adverse selection. 2.2 Insurable Risk Insurance products are designed in accordance with some basic principles that define which risks are insurable. In order for a risk - a potential loss - to be considered insurable, it must have certain characteristics. 1. The loss must occur by chance. 2. The loss must be definite. 3. The loss must be significant. 4. The loss rate must be predictable. 5. The loss must not be catastrophic to the insurer. These five basic characteristics used to define an insurable risk form the foundation of the business of insurance. A potential loss that does not have these characteristics generally is not considered to be an insurable risk. CFP Level 3: Module 1 – Risk Analysis - Global Page 6

The Loss Must Occur by Chance In order for a potential loss to be insurable, the element of chance must be present. The loss should be caused either by an unexpected event or by an event that is not intentionally caused by the person covered by the insurance. For example, people cannot generally control whether they will become seriously ill; as a result, insurance companies can offer health insurance policies to provide economic protection against financial losses caused by the chance event that the person who is insured will become ill and incur medical expenses. When this principle of loss is applied in its strictest sense to life insurance, an apparent problem arises: death is certain to occur. The timing of an individual's death, however, is usually out of the individual's control. Therefore, although the event being insured against - death - is a certain event rather than a chance event, the timing of that event usually occurs by chance. The Loss Must be Definite For most types of insurance, an insurable loss must be definite in terms of time and amount. In other words, the insurer must be able to determine when to pay policy benefits and how much those benefits should be. Death, illness, disability, and old age are generally identifiable conditions. The amount of economic loss resulting from these conditions can, however, be subject to interpretation. The Loss Must be Significant As described earlier, insignificant losses, like the loss of an umbrella, are not normally insured. The administrative expense of paying benefits when a very small loss occurs would drive the cost for such insurance protection so high in relation to the amount of the potential loss that most people would find the protection unaffordable. On the other hand, some losses would cause financial hardship to most people and are considered to be insurable. For example, if a person were to be injured in an accident that resulted in a long period of disability, he/she would lose a significant amount of income. Insurance coverage is available to protect against such a potential loss. CFP Level 3: Module 1 – Risk Analysis - Global Page 7

The Loss Rate Must be Predictable In order to provide a specific type of insurance coverage, an insurer must be able to predict the probable rate of loss that the people insured by the coverage will experience. To predict the loss rate for a given group of insured's, the insurer must predict the number and timing of covered losses that will occur in that group of insured's. An insurer predicts the loss rate for a group of insured's so that it can determine the proper premium amount to charge each policy owner. Loss Rate: The rate at which covered losses are expected to occur in a specified group of insured’s. The loss should not be catastrophic It means that a large proportion of exposure units should not incur losses at the same time. Otherwise, the insurance pooling would break down and become unworkable. Self-insurance Self-insurance is a risk management method in which a calculated amount of money is set aside to compensate for the potential future loss. Self-insurance is possible for any insurable risk, meaning a risk that is predictable and measurable enough in the aggregate to be able to estimate the amount that needs to be set aside to pay for future uncertain losses. For a risk to be insurable, it must represent a future, uncertain event over which the insured has no control. Other characteristics which assist in making a risk self-insurable include the ability to price or rate the risk. Normally, catastrophic risks are not self-insured as they are highly unpredictable and high in loss-value. CFP Level 3: Module 1 – Risk Analysis - Global Page 8

QUESTIONS Q1. The ______________ states that, typically, the more times we observe a particular event, the more likely it is that our observed results will approximate the \"true\" probability that the event will occur. (a) The Law of an Individual (b) The Law of Large Numbers (c) The Law of Insurance Q2. There must be a sufficiently large number of __________ exposure units to make the losses reasonably predictable. (a) Heterogeneous (b) mixed (c) homogeneous (d) All the above Q3. To be insurable the loss produced by the risk must be __________ and __________. (a) Indefinite, measurable (b) definite, measurable (c) vague, calculable (d) none of the above Q4. An insurable loss must be ____________. Page 9 (a) certain to happen (b) fortuitous or accidental (c) indefinite (d) impossible to happen Q5. A loss to be insurable, must not be _____________. (a) Catastrophic (b) fortuitous or accidental (c) definite CFP Level 3: Module 1 – Risk Analysis - Global

(d) none of the above Q6. The insurance principle is based on ______________. (a) sharing of resources (b) sharing of losses (c) sharing of capital (d) none of the above Q7. Damage that results from enemy attack would be _____________ in nature. (a) catastrophic (b) calamity (c) provisional (d) negligible Q8. Who will share the premium (level), given the number of persons to be insured and the number of persons expected to die in the given period for the sum assured? (a) No. of persons to be insured (b) No. of persons expected to die (c) Survivors (d) None of the above Answers 1B 4B 7A 2C 5A 8A 3B 6B CFP Level 3: Module 1 – Risk Analysis - Global Page 10

Insurance and Risk 3.1 Meaning of Risk Risk is a condition where there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for; when an event is stated to be possible, it has a probability between zero and one; it is neither impossible nor definite. The degree of risk may or may not be measurable. Since our purpose is to relate risk to insurance, focus will be on risk, which entails the possibility of financial loss. Financial loss may be defined as a decline in or disappearance of value due to a contingency. This means that if the loss of value is intended or if it is certain, it is not a loss within the context of the above definition. For those who define risk as uncertainty, the greater the uncertainty, the greater is the risk. For an individual, higher the probability of loss, greater is the probability of an adverse deviation from what is hoped for and therefore, greater is the risk. The expected value of loss in a given situation, or the mathematical value of risk at any point of time, is the probability of the loss materializing multiplied by the amount of the potential or anticipated loss. Risk may be defined as \"condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for.\" Risks can be divided into two basic types, namely, speculative risk and pure risk. Speculative risk refers to a condition where there is a chance that the risk-taker may suffer a loss or enjoy a gain or maintain status quo. For example, if Jayesh purchases a lottery ticket, he runs the risk of either losing the monies used to buy the ticket or striking the top prize of ₹l crore. This would be an example of taking speculative risk. When an investor invests a sum of money into certain shares, he could end up making a profit, suffering a loss or breaking even. He has also undertaken a speculative risk. Pure risk refers to a condition where the risk taker either suffers a loss or avoids losses without enjoying any gain. For example, if Jayesh owns a property, there is a risk that an accidental fire may decimate it. This is an example of a pure risk as the best that Jayesh can hope for is to maintain status quo and ensure that the property is safe. CFP Level 3: Module 1 – Risk Analysis - Global Page 11

3.2 Types of Pure Risk In risk management a financial planner has to advise and help the client minimize or eliminate the adverse consequences of pure risks. Pure risks can be classified into four categories: (a) Personal Risks These are risks that affect the income-producing ability of the client arising from events such as employment, death, disability, illness or accident. They can also cause the client to incur additional expenses relating to his maintenance and sustenance. For example, if a client is struck by disability, then he will not only be economically unproductive, but additional expenses, e.g. medical expenses, will be incurred to look after his needs arising from the disability. (b) Property Risks The ownership of property carries with it risk, since property maybe damaged, destroyed or stolen. There are two distinct types of losses that can occur in relation to property risks. These are referred to as ₹ direct' or ₹ indirect ₹ losses. A direct loss is one in which the property in question is damaged or stolen; for example, a car crashes, a building bums down or goods are stolen. Indirect or consequential losses are those that follow on from that initial loss. If the building bums down, a manufacturer is unable to produce his product or a shop owner is unable to sell his goods. As a consequence they suffer a loss of income. In addition, in trying to get back into a position where they are earning an income, they may be involved in additional expenses. For example, the shop owner may rent temporary premises to conduct the business. The rental of these premises may be at a greater rental than was paid previously. Another example of indirect losses arises where, following a fire in the premises, the refrigeration equipment is damaged, but not the cool store that the refrigeration equipment serves. As a result, the goods in the cool store become unusable as the refrigeration equipment is not operating. To summarize, property risks can involve loss from three different areas: 1. Damage to the property itself; Page 12 2. Loss of use of the property or loss of income derived from it; and CFP Level 3: Module 1 – Risk Analysis - Global

3. Indirect losses as a result of damage to property. (c) Liability Risks These are risks that expose the client to liability to third parties. They arise as a restilt of the client's words, conduct, property or legal relationships. For example, if client is a lawyer, he owes a duty of care to his client to give proper advice. If this duty is breached and client suffers losses, he could be liable for damages. Another example is where a person negligently steers his car and causes an accident resulting in injuries inflicted on a pedestrian. The driver will be liable to the pedestrian for damages to compensate him for any pain and loss suffered. Liabilities can arise when our actions or inactions result in loss, damage or injury to other people or their property. There are three broad areas of law under which a liability risk arises:  Under statute;  At common law; and  Under contract. (d) Failure of Others These are risks that expose the client to loss due to the acts or omission by others. For example, if a person engages a contractor to renovate his home but the contractor botches up (spoil) the job, resulting in extensive damage to the home to the person will have to suffer losses due to the contractor's negligence. The situation will be exacerbated (worsened) if the contractor is impecunious (poor), as any legal action instituted against him will probably not result in any compensation for the client. CFP Level 3: Module 1 – Risk Analysis - Global Page 13

3.3 Other Types of Risk Financial and Non-Financial Risk The first distinction is between financial and non-financial risk. In its widest sense the termrisk embraces all situations in which there is exposure to adverse circumstances. In some cases, these adverse circumstances will involve financial loss. In other cases, there may be a risk of pain or inconvenience. We are concerned with only those risks with which financial loss is associated. Static and Dynamic Risks Dynamic risks are those resulting from changes in the economy. Changes in the price level, consumer tastes, income and output, and technology may cause financial loss to the members of the economy. These dynamic risks normally benefit society over the long run since they are the result of adjustments to misallocation of resources. Since these dynamic risks may affect a large number of individuals, they are generally considered less predictable than static risks, as they do not occur with any precise degree of regularity. Static risks involve those losses that occur even if there were no changes in the economy. If we could hold consumer tastes, output and income, and the level of technology constant, some individuals would still suffer financial loss. These losses arise from causes other than the changes in economy, such as perils of nature and dishonesty of other individuals. Unlike dynamic risks, static risks are not a source of gain to society. Static losses tend to occur with a degree of regularity over time and, as a result, are generally predictable. Because they are predictable, static risks are more suited to treatment by insurance than are dynamic risks. CFP Level 3: Module 1 – Risk Analysis - Global Page 14

Fundamental and Particular Risks Fundamental risks involve losses that are impersonal in origin and consequences. They are group risks, caused for the most part in economic, social and political phenomena, although they may also result from physical occurrences. They affect large segments or even all of the population. Unemployment, war, inflation, earthquakes and floods are all fundamental risks. Particular risks involve losses that arise out of individual events and are felt by individuals rather than by the entire group. They may be static or dynamic. The burning of a house and the robbery of a bank are particular risks. Since fundamental risks are caused by conditions more or less beyond the control of individuals who suffer the losses and since they are not due to the fault of any one in particular, it is held that society rather than the individual has responsibility to deal with them - social insurance should be for fundamental risks - private insurance for particular risks though some fundamental risks like earthquake are covered by private insurance. 3.4 The Principle of Pooling of Risk The biggest problem in insurance is the unpredictability of the event capable of producing a loss and the probable amount of loss. To be able to predict this for an individual is impossible. We shall try to understand this from the classic coin-tossing example. If you toss an unbiased coin either a head will come or a tail, i.e., out of the two possible outcome of head or tail has a chance of one out of two. Alternatively, we can say that each outcome has a probability of ½. A probability is a way of describing how likely (or not) \"something\" is to happen. The maximum value of any probability is 1 and an event with a probability of 1 is called a certainty. The minimum value of a probability is 0 and an event with a probability of 0 is impossibility. When talking about a risk we are concerned with probabilities, which are greater, than zero but less than one i.e. there is an element of uncertainty. Going further in the coin tossing experiment we know the probability of getting a head or not getting a head is ½. Suppose the first toss, gave a head, can we say with some degree of certainty that the second toss will give a tail? Or if the coin is tossed 10 times, can we say that there will be exactly 5 heads and 5 tails? But if we toss the coin 1,000 times, we can say with a reasonable degree of certainty that there will be 500+50 heads or tails. If the number of tosses is increased to 100,000 or more we can fairly accurately predict the number of heads and tails with very little percentage error. Similarly, as discussed in chapter one, predicting the loss for one house may be near impossible, but predicting loss for 1,000 houses is fairly practicable. If CFP Level 3: Module 1 – Risk Analysis - Global Page 15

this number is further increased, losses can be predicted fairly accurately, in terms of number of losses and also the average amount of each loss. This is law of large numbers. Probability theory can be applied to a large number of loss exposures to predict future losses and this is the basic principle on which insurance companies operate. In real life situations, probability of loss occurrence is not as simple as in the coin tossing experiment. Firstly, there can be a large number of outcomes. Secondly, the outcomes may be dependent on some other outcome and may complicate the probability calculations. For a given event, different outcomes will have different probabilities ranging between 0 and 1. Insurers are interested in knowing the probability of each outcome or a set of outcomes. This can be made available to insurers either through a table or a graph. This table or graph can be called probability distribution. It will be observed here there are large number of claims of small amounts but as the amount of loss increases the number of claims decreases fast and then tapers very slowly. Insurers frequently use these probability distributions to estimate the future losses on the risks they have accepted and to fix future price of insurance on the basis of past experience as evidenced by these distributions. 3.5 Methods of Handling Risk We are surrounded by risks. We take risks when we travel, when we engage in recreational activities, even when we breathe. Some risks are significant; others are not. When we decide to leave an umbrella at home, we take the risk that we might get caught in a rain shower. Such a risk is insignificant. But what about the risks in the following situations?  Ricky Agarwal is a 23-year-old single man who is working his way through college with part-time jobs. What if he becomes ill and requires a long hospital stay and expensive medical treatment?  Dinesh and Jaya patel are working parents of two school-aged children. What if either Dinesh or Jaya becomes disabled and cannot work to support the family?  Jagdish and Jayendra Goswami own and manage a convenience store. What if a fire damages their building?  The Wilson Software Development Company's product development process depends on the genius of two employees who are computer \"whizzes\". What happens to the company if one or both of them dies?  Kavita Waghmare is an artist who supports herself by selling her artwork. What happens when she retires and her income is no longer sufficient to meet her economic needs? CFP Level 3: Module 1 – Risk Analysis - Global Page 16

Risk management: The practice of Identifying risk, Assessing risk and Dealing with risk. In each situation, the individual, family, or business can use risk management to deal with the financial risk it faces. The practice of risk management involves identifying risk, assessing risk, and dealing with risk. In order to eliminate or reduce our exposure to financial risk, we can do at least four things: (1) avoid risk, (2) control risk, (3) accept risk, and (4) transfer risk. Avoiding Risk The first, and perhaps most obvious, method of managing risk is simply to avoid risk altogether. We can avoid the risk of personal injury that may result from an airplane crash by not riding in an airplane, and we can avoid the risk of financial loss in the stock market by not investing in it. Sometimes, however, avoiding risk is not effective or practical. Controlling Risk We can try to control risk by taking steps to prevent or reduce losses. For instance, Jagdish and Jayendra Goswami in one of our earlier examples could reduce the likelihood of a fire in their convenience store by banning smoking in their building. In addition, the Goswamis could install smoke detectors and a sprinkling system in their building to lessen the extent of damage likely to happen if there is a fire. In these ways, the Goswamis are attempting to control risk by reducing the likelihood of a loss and lessening the severity of a potential loss. Accepting Risk A third method of managing risk is to accept, or retain risk. Simply stated, to accept a risk is to assume all financial responsibility for that risk. Sometimes, as in the case of an insignificant risk - losing an umbrella - the financial loss is not great enough to warrant much concern. We assume the cost of replacing the umbrella ourselves. Some people consciously choose to accept more significant risks. For instance, a couple like Dinesh and Jaya Patel from one of the previous examples may decide not to purchase disability income insurance because they believe they can just reduce their standard of living if one of them becomes disabled. Self-Insurance: Risk-management technique by which a person or business accepts financial responsibility for losses associated with specific risks. Individuals and business sometimes decide to accept total responsibility for a given risk rather than purchasing insurance to cover the risk. In this situation, the person or business is said to CFP Level 3: Module 1 – Risk Analysis - Global Page 17

self-insure against the risk. Self- insurance is a risk-management technique by which a person or business accepts financial responsibility for losses associated with specific risks. For example, many employers provide medical expense benefits to their employees'. An employer can self-insure the benefit plan by setting aside money to pay employees' medical expenses or can pay those expenses out of its current income. Individuals and business can also decide to accept only part of a risk. For instance, an employer can partially self-insure a medical expense benefit plan by paying its employees medical expenses up to a state amount and buying insurance to cover all expenses in excess of that stated amount. Many employers now use self-insurance to fund their employees1 health insurance plans. We describe self-insurance more fully in section 3. Transferring Risk Transferring risk is a fourth method of risk management. When you transfer risk to another party, you are shifting the financial responsibility for that risk to the other party, generally in exchange for a fee. The most common way for individuals, families, and business to transfer risk is to purchase insurance coverage. When an insurance company agrees to provide a person or a business with insurance coverage, the insurer issues an insurance policy. The policy is a written document that contains the terms of the agreement between the insurance company and the owner of the policy. The agreement is a legally enforceable contract under which the insurance company agrees to pay a certain amount of money - known as the policy benefit, or the policy proceeds when a specific loss occurs, provided that the insurer has received a specified amount of money, called the premium. In general, individuals and business can purchase insurance policies, which covers three types of risks: property damage risk, liability risk, and personal risk. CFP Level 3: Module 1 – Risk Analysis - Global Page 18

3.6 Reinsurance Reinsurance is a contract made between an insurance company and a third party (Reinsurance Company) to protect the insurance company from losses. The reinsurance contract provides for the reinsurer to pay for the loss sustained by the insurer when the latter makes a payment on the original contract. A reinsurance contract is a contract of indemnity, meaning that it becomes effective only when the insurance company has made a payment to the original policyholder. Reinsurance provides a way for the insurance company to protect itself from financial disaster and ruin by passing on the risk to other companies. The reinsurance industry became more popular during the late 1990s and early 2000s because natural disasters and mass tort litigation resulted in large payouts by insurance companies. Because of the large size of the payments, some insurance companies became insolvent. Almost all insurance companies have a reinsurance program. The ultimate goal of that program is to reduce their exposure to loss by passing part of the risk of loss to a reinsurer or a group of reinsurers. CFP Level 3: Module 1 – Risk Analysis - Global Page 19

Reinsurance can help a company by providing: 1. Risk Transfer - Companies can share or transfer of specific risks with other companies 2. Arbitrage - Additional profits can be garnered by purchasing insurance elsewhere for less than the premium the company collects from policyholders. 3. Capital Management - Companies can avoid having to absorb large losses by passing risk; this frees up additional capital. 4. Solvency Margins - The purchase of surplus relief insurance allows companies to accept new clients and avoid the need to raise additional capital. 5. Expertise - The expertise of another insurer can help a company obtain a proper rating and premium. There are two basic methods of reinsurance: 1. Facultative Reinsurance which is negotiated separately for each insurance contract that is reinsured. 2. Treaty Reinsurance under which all insurance contracts are reinsured at a standard rate pre-negotiated by the reinsurer and the insurer. CFP Level 3: Module 1 – Risk Analysis - Global Page 20

QUESTIONS Q1. Industrial Risks includes ______________. (a) Residential Premises (b) Permanent amusement parks (c) Manufacturing premises Q2. Dynamic risks are those resulting from the changes in ______________. (a) The economy (b) The status (c) The sources Q3. Indemnification, Reduction of Uncertainty, funds for Investment & Loss control are the ______________ of insurance in handling risks. (a) Advantages (b) Disadvantages (c) Both Q4. Reserve management has the effect of ______________ by causing profits to be reported when the business is no longer profitable (a) Intending the cycle (b) Extending the cycle (c) Both of it Q5. Risks which involve financially quantifiable loss are termed as ______________. (a) Monetary risk (b) Speculative risk (c) Financial risk (d) Personal risk Q6. Pure risk involves ______________. (a) Gain (b) loss or no loss (c) loss and gain (d) all the above CFP Level 3: Module 1 – Risk Analysis - Global Page 21

Q7. What types of risks are insurable? (a) Speculative risk (b) pure risk (c) Gambling risk (d) All the above Q8. Speculative risk involves the possibility of ______________. (a) Loss only (b) gain only (c) loss or gain (d) none of the above Q9. What are the components of personal risks that are faced by individuals? (a) death (b) disability (c) medical (d) all the above Q10. Generally in insurance the risks are separated in following categories ______________. (a) Personal and property and liability risks (b) Private and official risks (c) all the above Q11. What is the direct advantage of insurance? (a) Indemnification for unexpected losses (b) Indemnification for expected profits (c) safety of funds (d) elimination of chance of occurrence of insured risk Q12. What are the disadvantages of insurance mechanism? (a) reduction of uncertainty (b) operating expenses & moral hazard (c) capital gain & financial risk (d) none of the above CFP Level 3: Module 1 – Risk Analysis - Global Page 22

Q13. An event with Probability 1 is called a ______________. (a) Impossibility (b) Certainty (c) Uncertainty (d) Neither of above. Q14. Which of the following is not an ideal element of an insurable risk ______________. (a) The Risk must be definite. (b) The Risk must be catastrophic (c) The risk must be fortuitous (d) The risk must be measurable. Q15. Gambling is primarily an instance of ______________. (a) Pure Risk (b) Financial Risk (c) Investment Risk (d) Speculative Risk Q16. Pure Risks that have a financial cost to them may arise in which of the following categories. (a) Personal (b) Property (c) Liability (d) All of the above Q17. Which \"characteristic\" of risks among the following is not an \"absolute must\" for a risk to be insured: (a) The loss produced by the risk must be definite and measurable. (b) The loss must be fortuitous and accidental (c) The loss must be \"reinsurable\" (d) The loss must not be catastrophic Q18. Reinsurance is ______________. Page 23 (a) an insurance company insuring other insurance companies business (b) a treaty for future insurance (c) Co-insurance (d) facultative insurance CFP Level 3: Module 1 – Risk Analysis - Global

Q19. Indian insurance company reinsures with an reinsurer whose head office is in Germany. In case of a dispute what laws will apply? (a) Indian law (b) German law (c) Both the country's law (d) International law Q20. Risk of not realizing the desired return from an investment constitutes (a) Pure risk (b) Speculative risk (c) Financial risk (d) Non - financial risk Q21. Death disability liability are ______________. (a) Pure risks (b) Financial risks (c) Both (d) None Q22. As per IRDA Regulations, a reinsurance broker must have a minimum paid-up capital of ₹ ____________ lakhs. (a) ₹250 (b) ₹200 (c) ₹50 Answers 1C9D 17 C 2 A 10 A 18 A 3 A 11 A 19 D 4 B 12 B 20 C 5 C 13 B 21 C 6 B 14 B 22 B 7 B 15 D 8 C 16 D Page 24 CFP Level 3: Module 1 – Risk Analysis - Global

3.7 Fundamental Principles of Insurance 4.1 Indemnity One of the important terms of the contractual agreement between the insurance company and the owner of an insurance policy is the amount of policy benefit that will be payable if a covered loss occurs. Depending on the way in which a policy states the amount of the policy benefit, every insurance policy can be classified as either a contract of indemnity or a valued contract. A contract of indemnity is an insurance policy under which the amount of the policy benefit payable for a covered loss is based on the actual amount of financial loss that results from the loss, as determined at the time of loss. The policy states that the amount of the benefit is equal to the amount of financial loss or the maximum amount stated in the contract, whichever is less. When the owner of such a contract submits a claim - a request for payment under the terms of the policy - the benefit paid by the insurance company will not be greater than the actual amount of the financial loss. Many types of health insurance policies pay a benefit based on the actual cost of a person's medical expenses and, as such, are contracts of indemnity. For example, assume that Bala Swami is insured by a health insurance policy that will pay any covered hospital expenses Bala incurs. The policy states the maximum amount payable to cover Bala's expenses while he is hospitalized. If he is hospitalized and his actual hospital expenses are less than that maximum amount, the insurance company will not pay the stated maximum; instead, the insurance company will pay the stated maximum; instead, the insurance company will pay a sum that is based on the actual amount of Bala's hospital bill. Property and liability insurance policies are also contracts of indemnity. CFP Level 3: Module 1 – Risk Analysis - Global Page 25

Principle of Indemnity Insurance cannot be used as a means to make profit out of it. The mechanism of insurance is meant to compensate losses. Simply put, insurance should not place the Insured in a better financial position after loss as he enjoyed before the loss. This broadly is the principle of indemnity. Indemnity and insurable interest are linked together. It is the insured's financial interest in the subject matter of insurance that is insured. Therefore, amount of compensation on claim cannot be more than the extent of insurable interest. In the case of life insurance, insurable interest in one's own life is unlimited. Therefore, the principle of indemnity is not applicable to life insurance contracts. In these contracts the sum assured is decided at the time of entering into contract. Therefore, life insurance contracts are called valued contracts. Fire insurance policy may be issued on Reinstatement Value basis. Under these policies, generally issued for covering building or machinery, the basis of indemnity is the cost of reinstatement or replacement of damaged or destroyed property by new property of the same type. In as much as the Insured gets new property in the place of old, the principle of indemnity is thus modified. However, the basic idea of indemnity is still preserved because the reinstatement of damaged property is by property in a condition equal to, but not better than, its condition when new. In other words the Insured will get new property of the same kind but not a superior property. The subject matter of motor insurance could be physical property (the vehicle), and /or legal liability for third party injury or property damage. The principle of indemnity is strictly applicable to both the subject matters. The indemnity shall not exceed. (a) For total/constructive total loss of the vehicle the Insured's Declared Value of the vehicle (including accessories thereon) as per Schedule of the policy less the value of the wreck. (b) For partial losses, costs of repair/ replacement as per depreciation limits specified in the policy. Claims for liability are indemnified as per law, subject to limits, if any, under the policy. The values of cargo are subject to constant fluctuations during transit from one country to another. Besides, the market values of ships fluctuate widely, but the market value may not reflect the true value of the ship to its owner. Therefore, almost all the marine insurance policies are issued as valued policies or agreed value policies, where under the sum Insured is CFP Level 3: Module 1 – Risk Analysis - Global Page 26

agreed between the Insurers and the Insured as the value of the Insured property. The agreed amount is payable in the event of total loss, irrespective of considerations of depreciation, etc. Once the value is agreed, it cannot be re-opened subsequently, unless the Insurer is able to prove fraud. Valued policies are recognized by law and their issue is not considered to be a violation of the principle of indemnity. Thus, in marine insurance what is provided is commercial indemnity, and not pure indemnity. Limitations on the Insurer's Liability The measure of indemnity in different classes of insurance has been dealt with above. However, the Insurer's liability is subject to several limitations, some of which are mentioned below: (i) Every policy of insurance contains a sum Insured which is the maximum limit of liability under the policy. This amount is not the agreed value of the property (except under valued policies) nor is it the amount which will be automatically paid in the event of loss or damage. The amount payable under the insurance contract is the actual loss or the sum insured whichever is less. (ii) The property insurances are generally subject to the condition of average, and if there has been under insurance, only that proportion of the loss is payable, which the sum Insured bears to the market value of Insured property at the time of loss. (iii) Some policies are subject to excess or ‘franchise' which means that under certain circumstances, a part of the loss may have to be borne by the Insured. In these circumstances, the Insurer's liability is the measure of indemnity determined as above, less the amount of ‘excess' or ‘franchise’. The difference between' excess' and ‘franchise' should be clearly understood. In either case, if the loss does not reach the limit, it is not payable at all; if it exceeds the limit, the excess only is payable under the ‘excess' clause and the entire loss is payable under the ’franchise' clause. For example, if there two insurance policies ‘A' and ‘B', policy ‘A' subject to an excess of ₹1000/- and policy ‘B' subject to a franchise of ₹1000/-, and if a loss of ₹500/- is reported under each policy, nothing will be payable under both the policies. If however, the loss under each policy was ₹1,100/- policy ‘A' will pay ₹100/- only but policy ‘B' will pay₹1,100/ (iv) Salvage is property which is partially damaged, by fire for example, and if the full loss is paid, the Insurers may take over the salvage and dispose it off. Alternatively, the salvage may be retained by the Insured and the claim is paid less the value of the salvage. Salvage also arises CFP Level 3: Module 1 – Risk Analysis - Global Page 27

in other property insurances e.g. motor burglary and fire etc. 4.2 Insurable Interest Insurable interest is a legal pre-requisite for insurance. There is no single definition of Insurable Interest universally accepted However, it can best be explained as under- The primary interest of a person in the object of insurance (such as a house, car, machinery or life) which gives him the right to take insurance and so to say, this is insurable interest. In other words, it is not the house, the car, machinery or life that is insured but it is the pecuniary interest of the person in the object of insurance. The Insurance Act 1938 does not define insurable interest. Essentials of Insurable Interest – (a) There must be some property, right, interest, life, limb or potential liability capable of being insured i.e. capable financial measurement. (b) Objects cited in (a) above must be subject matter of insurance. (c) The insured must stand in a relationship with the subject matter of insurance whereby he benefits by its safety and is prejudiced by its loss or damage. CFP Level 3: Module 1 – Risk Analysis - Global Page 28

(d) The relationship between the insured and subject matter of insurance must be recognized by law. Examples to show the presence of Insurable Interest (based on the court decisions): 1. A person has an insurable interest to an unlimited extent in his own life. 2. The husband has insurable interest in the life of his wife and vice-a-versa. 3. Other family relationships as such may not give rise to insurable interest if, however, family members are having a common business or there is some other financial relationship, it may give rise to insurable interest. 4. Legal position about assurance on the lives of children is not very clear. However, in India, it is accepted that parents have insurable interest in the lives of their children. 5. An employer has an insurable interest in the life of his employee to the extent of the value of his services. 6. An employee has an insurable interest in the life of his employer to the extent of his remuneration for the period of notice for determination of service. 7. A creditor has an insurable interest in the life of the debtor to the extent of his debt. 8. A surety has an insurable interest in the life of co-surety to the extent of debt and also on the life of principal debtor. 9. Partners have insurable interest in the life of co-partners. 10. A company has an insurable interest in the life of a valuable key person. Courts in Indian have consistently held that an insurance on the life of a person, in which the person effecting insurance has no insurable interest, is void as a wagering agreement under Section 30 of the Indian Contract Act. When should insurable interest exist?  In the case of life insurance contract, it must exist at the beginning  In the case of non-life insurance contract-  In case of Marine Insurance, it must exist at the time of claim and  In other non-life insurance contracts, it must exist both at the beginning as well as the time of claim. CFP Level 3: Module 1 – Risk Analysis - Global Page 29

Rules of Insurable Interest 4.3 Utmost Good Faith In ordinary commercial contracts, the parties are governed by the principle of caveat Emptor' i.e.’ let the buyer beware'. In most of the commercial contracts, each party to the contract can  examine subject matter of the contract; and  verify truth of the statements made by the parties. There is no need to take the statements on trust. Prof can be asked for. So long as there is no attempt to mislead and the answers are given truthfully, the question of avoiding the contract would not arise. There is no need to disclose the information, which is not asked for. However, in insurance contracts the product sold is intangible. It cannot be seen or felt. Therefore, in insurance contracts, the principle of ‘Caveat Emptor' does not apply as the contract is based on the revealing of many facts which -  are known only to the proposer, and  Insurer cannot know them, if the proposer does not disclose them. CFP Level 3: Module 1 – Risk Analysis - Global Page 30

These facts relate to the proposer's health, habits, personal history, family history, etc. Insurer cannot possibly be aware of all these details unless the proposer discloses them. It may be argued that the insurer can know about the proposer's health by getting him medically examined from approved medical examiners. Even if medically examined, a person suffering from high blood pressure (B.P.) or diabetes can evade detection of these facts. Personal history of past sicknesses, injuries, operations can also be suppressed. These facts affect the longevity of the proposer and material from underwriter's point of view. Non-disclosure of these facts may adversely affect the interest of the insurer and thereby the community of policy holders. As such the law imposes a duty on the proposer to fully disclose all material facts (whether asked for or not), which are necessary for the insurer to assess and accept the risk. It is an implied condition of all insurance contracts that each party must disclose every material fact known to him. Failure on the part of the proposer to do so may result in treating the contract, as null and void. This principle of ₹ Utmost good Faith' is called ‘uberrimae fides'. The principle applies to Insurer as well but the chances and degree of breach are more in case of a Proposer than that of an Insurer. Examples of breaches on the part of the Insurer/ Agent: Making untrue statements during sale Not informing the proposer about non-availability of loans under the plan offered or that bonus rates could be different from other plans. Withholding information that the sprinkler system entitles the proposer to a rebate in fire premium. Utmost Good Faith can be defined as - 'A positive duty to disclose, accurately and fully, all the facts material to the risk being proposed, whether asked for or not'. Material fact can be defined as - \"Every circumstance is material which would influence the judgment of a prudent insurer in arriving at the decision to accept risk and fix premiums\". Therefore, facts regarding age, height, weight, build, previous medical history, smoking/drinking habits, operations, non-disclosure of earlier insurances, hazardous occupation must be disclosed. CFP Level 3: Module 1 – Risk Analysis - Global Page 31

It is not for the proposer to decide which fact is material to the risk. Facts which need not be disclosed: 1. Facts which everyone is supposed to know i.e. facts of common knowledge 2. facts of law. 3. facts which a survey would have revealed. 4. facts which lessen the risk. 5. facts which could reasonably be discovered, by reference to previous policies, records of which are available with the insurer. In Life Insurance, The Duty to Disclose' Operates: 1. From the date of submission of proposal till the risk commences. 2. However, if the terms of the contract are sought to be altered, then there is a duty to disclose all material facts relating to alteration. 3. If a lapsed/paid-up policy is revived or a surrendered policy is reinstated there would be a fresh duty to disclose all material facts at that time since what follows is a contract Novell or new contract. The breach of utmost good faith arises due to misrepresentation or non-disclosure. Misrepresentation It can be of three types: (a) An unwarranted positive assertion of that which is not true although the person making it believes it to be true; (b) Any breach of duty without an intent to deceive, by which a person gains an advantage; and (c) Causing, however innocently, a party to commit a mistake as to the subject matter of the agreement. To constitute a breach of utmost good faith, a Misrepresentation  Should be substantially false  Must be concerned with facts which are material to the acceptance or assessment of the risk, and this must have induced the other party to enter into a contract. CFP Level 3: Module 1 – Risk Analysis - Global Page 32

Non-disclosure  Should be within the knowledge of the first party  Should not be known to the second party, and  Must be calculated to induce the other party to enter into contract on its own terms. Implications of Doctrine of Utmost Good Faith on both the Parties to Types of Breach of the Doctrine of Utmost Good Faith CFP Level 3: Module 1 – Risk Analysis - Global Page 33

4.4 Subrogation Subrogation may be defined as the transfer of rights and remedies of the Insured to the Insurer who has indemnified the Insured in respect of the loss. If the Insured has any rights of action to recover the loss from any third party, who is primarily responsible for the loss, the Insurer, having paid the loss, is entitled to avail himself of these rights to recover the loss from the third party. The effect is that the Insured does not receive more than the actual amount of his loss and any recovery affected from the third party goes to the benefit of the Insurer to reduce the amount of his loss. The principle of Subrogation arises from the principle of indemnity. To allow the Insured to collect the claim from the Insurers and then collect again from the person responsible for the loss would be contrary to the principle of indemnity. He would then, be clearly making a profit out of the misfortune, and that would defeat the principle of indemnity. Common law has, therefore, evolved the doctrines of subrogation and contribution as corollaries of indemnity. The doctrine maybe illustrated by the following examples: (a) Insured property may be destroyed by fire caused by the negligence of a third party that is at law responsible to make good the loss. The Insurer having indemnified the Insured is entitled to the Insured's right of recovery against the third party. (b) If cargo is damaged due to the negligence of a carrier (e. g. railways, truck operators, shipping companies etc.) who have an obligation to make good the loss of the Insured, the benefit of this obligation passes to the Insurer. (c) A private car may be damaged in a collision caused by the rash and negligent driving of a truck. The private car owner’s right of recovery against the truck owner CFP Level 3: Module 1 – Risk Analysis - Global Page 34

is transferred to the Insurer who has indemnified the loss. (d) Under products liability policies, if a retailer is indemnified in respect of a claim preferred against him for a defective product, the Insurer can recover from the wholesaler or manufacturer who supplied the product, if liability can be established against him. (e) Under fidelity guarantee policy, the Insurer after payment of the loss is entitled to claim reimbursement from the defaulting employee. 4.5 Contribution An Insured may have several insurances on the same subject-matter. If he recovers his loss under all these insurances, he will obviously make a profit out of the loss. This will be an infringement of the principle of indemnity. Common Law has, therefore, evolved the principle of contribution which may be defined as the right of Insurers who have paid a loss under a policy to recover a proportionate amount from other Insurers who are liable for the same loss. The Common Law principle allows the Insured to recover his full loss within the sum Insured from any Insurer he likes. Contribution under Policy Conditions The principle of contribution would lead to a situation in which the Insured would be able to recover his loss from any one Insurer, who then, will have to effect proportionate recoveries from other Insurers concerned. In order to avoid this, fire policies and a majority of accident policies contain a contribution condition, which modifies the common law position. According to this condition, whenever contribution applies, the Insured is obliged to prefer claims against all the Insurers, each of whom pays only his proportion of the loss. This can be illustrated with an example. Sum Insured with Insurer A₹5,000/- A pays ₹1,000/- Sum Insured with Insurer B ₹10,000/- B pays ₹2,000/- Sum Insured with Insurer C ₹15,000/- C pays ₹3,000/- Total Sum Insured ₹30,000/- Loss ₹6,000/- The principle of contribution does not apply to personal accident policies as these are not contracts of indemnity. However it may apply in the case of medical expenses extension, weekly benefits etc. The position, depends on the wording of the policy conditions, In any case, Insurers seek to control additional insurances through a question in the proposal form. CFP Level 3: Module 1 – Risk Analysis - Global Page 35

The application of the principle of contribution is subject to the following pre-requisites: The subject-matter must be common to all policies.  The peril which causes the loss, must be common to all policies,  The interest covered under all the policies must be the same.  The policies must be effected in favors of a common Insured.  The policies must be in force at the time of loss.  The policies must be legally enforceable. 4.6 Proximate Cause Proximate Cause Relationship The final requirement of a negligent act is that a proximate cause relationship must exist. A proximate cause is a cause unbroken by any new and independent cause, which produces an event that otherwise would not have occurred. That is there must be an unbroken chain of events between the negligent act and the infliction of damages. (For example, a drunk driver who-runs a red light and kills another motorist would meet to the proximate cause requirement.) Proximate Cause The object of insurance is to provide indemnity for such losses which are caused by Insured perils. If stocks are burnt, then the cause of loss is fire which is covered under a fire policy and hence the claim is payable. If stocks are burgled, the loss is not payable under the fire policy, as burglary is not a peril covered. If stocks are burnt by a bomb dropped by an enemy country, then the loss is caused by war which is an excluded peril and hence not payable under the standard fire policy. Thus, it is important to determine the cause of loss to decide whether the loss is payable or not. There is no liability for a loss caused by an uninsured peril or an excluded peril. If the loss is brought about only by one event, it would be no problem to decide the question of liability. But in actual situations/ the loss may be the result of two or more causes, acting simultaneously or one after the other. Then, it becomes necessary to choose the most important, the most effective, the most powerful cause which has brought about the loss. This cause is termed the proximate cause', all other causes being considered as remote. CFP Level 3: Module 1 – Risk Analysis - Global Page 36

Examples: The following examples based on English case law will illustrate the distinction between ‘proximate cause' and ‘remote cause'. (a) A person Insured under a personal accident policy went out hunting and met with an accident. Due to shock and weakness, he was unable to walk. Whilst lying on the wet ground he contracted cold which developed into pneumonia which caused his death. The Court held that the proximate cause of death was the original accident and pneumonia (a disease which is not covered under the policy) only a remote cause. Hence the daim was payable. (b) An Insured suffered accidental injuries and was taken to hospital. While undergoing treatment he contracted an infectious disease which caused his death. In this case, the court gave a contrary ruling. The ‘proximate cause' of death was the disease and the original accident only a ‘remote cause.' Hence, the daim was not payable under a personal accident policy. Types of Peril CFP Level 3: Module 1 – Risk Analysis - Global Page 37

Peril, Proximate Cause & Indemnification Case lets Insurable Interest 1. A company purchased a₹10 lakh worth life insurance policy on a senior manager who was a 20% stockholder in the company. Shortly thereafter, the manager sold his stocks and resigned. Two years later he died. The insurer paid the death proceeds to the company. The legal heirs of the deceased challenged the decision of the insurer. Is the corporation entitled to the death proceeds? Yes! The court stated that termination of insurable interest before the policy matures does not affect policyholders' right of recovery under a policy valid at the time of inception. Utmost Good Faith 2. The insured misrepresented that she had no traffic violation in the prior three year period. After an accident, a check of her records revealed that she had two over speeding chards in that period. Is the insurer in a rightful position to deny cover? Yes! Material misrepresentation made with the intent to deceive voids insurance. 3. Ratan Sinha applied for a life insurance policy on own life. Five months after the policy was issued, he was murdered. The death certificate named the deceased as Ratan Seth, his true identity. The insurer denied payment on the ground that rattan had concealed a material fact by not revealing his true identity and that that he had an extensive criminal record. Is the decision of the insurer legally correct? Yes! Intentional concealment of one's true identity is material and is a breach of good faith. CFP Level 3: Module 1 – Risk Analysis - Global Page 38

Proximate Cause 4. A captain (ship) lost his course and took his ship in a different direction to try and pick up a light house. Due to hostilities, the lights in the light house were however put out and the ship ran aground. The Proximate Cause was bad seamanship. 5. Insured had hidden money in the fire place and later mistakenly lit up the fire place. The Proximate Cause was something accidentally falling into fire. 6. A building was left in a dangerous state due to a fire and hence it was ordered to be demolished. During the demolition process the neighbours' houses suffered damages. The Proximate Cause was fire. 7. A thief took advantage of a blackout during an air raid happening due to war. The Proximate Cause was theft. 8. The insured fell from his horse and suffered some injuries which forced him to lie in cold and damp condition so that he contracted pneumonia and eventually died. The Proximate Cause was accident 9. The insured fell from his horse and suffered some injuries which forced him to be hospitalized where he contracted pneumonia from a neighboring patient and eventually died. The Proximate Cause was disease. 10. Afire led to gathering of a mob from where riot spread and glasses of a shop were damaged. The Proximate Cause was riot. CFP Level 3: Module 1 – Risk Analysis - Global Page 39

QUESTIONS Q1. A substantial amount of information is supplied by the applicant by way of _____________. (a) Completion of a submission form (b) Completion of an application form (c) Completion of a require mental form Q2. Under the principles of insurance law, there is no limit the value of a human life and a person can take up _____________. (a) as much life coverage as he wants to (b) as much risk coverage as he wants to (c) as much insurance coverage as he wants to Q3. Which of the following is not considered as a material fact? (a) The Insured had cancelled his policy. (b) The previous Insurer had cancelled the policy. (c) The previous Insurer had rejected the proposal. (d) The previous Insurer had refused to renew the proposal. Q4. It should be noted that for a Life Insurance Policy to be valid, the owner need only show that he has an insurable interest at the time of _____________ of the policy. (a) Renewal (b) Presentation (c) Inception Q5. The common law right of subrogation only arises _____________ the insurers have admitted the insured claim and paid it. (a) Twice (b) Once (c) Thrice CFP Level 3: Module 1 – Risk Analysis - Global Page 40

Q6. The fundamental principles of Insurance are: utmost good faith, Insurable interest, Indemnity, and _____________. (a) proximate loss (b) proximate cause (c) proximate profit Q7. Proposal forms are designed to obtain all material information about _____________. (a) the subject matter of insurance (b) the legal matter of insurance (c) the fundamental matter of insurance Q8. Once the application is completed and signed by the insured, _____________. (a) It can't then be submitted to the insurer together with the premium payment (b) it can then be submitted to the insurer together with the premium payment (c) The work is completed Q9. \"Cooling off\" provision in insurance policies refers to _____________. (a) the period during which insured can elect to cancel the policy and receive refund of premium (b) the period during which insurance company cools of i.e. stops operations. (c) the period during which the insureds do not have to pay premiums. (d) None of the above. Q10. At a building site, Ramesh sustains injuries, when the building contractor's car runs over his toes and he is unable to attend work for 6 weeks. What are the options available to Ramesh? (a) Ramesh gets accident insurance, the contractor also gets accident insurance (b) Ramesh gets accident insurance, the contactor gets third party liability insurance and Ramesh can sue the contractor for damages (c) Ramesh gets disability insurance if he has one, the building contractor gets third party liability insurance and Ramesh also gets insurance for third party negligence (d) Ramesh gets disability insurance, the contractor gets accident insurance. CFP Level 3: Module 1 – Risk Analysis - Global Page 41

Q11. Uberrimaefidei refers to (b) Caveat emptor (a) Let the buyer beware (d) Principle of adhesion (c) Utmost good faith Q12. Subrogation means that (a) the insurer is entitled to any profits that the insured might make from the insurance claim (b) the insurer is entitled to a part of the claim which is unjustified (c) the insured is entitled to the sum assured (d) the insured is entitled to atleast return of premiums on survival Q13. The principle of indemnity does not (a) differentiate between different types of policies (b) apply to general insurance policies (c) recognise that it is difficult to establish the extent of insurable interest (d) have the principle of subrogation as a corollary Q14. Insurable interest refers to: (a) Interest paid by the insured to the Insurer. (b) Interest paid by the Insurer to the Insured (c) Interest taken by the Insurer in the life of the Insured. (d) Interest of the Insured in the subject matter of Insurance. Q15. Disclosure of which of the facts by the insured is not material: (a) Terms of acceptance of previous Insurance (b) Facts which diminish the risk (c) Facts which increase the risk (d) Previous record of losses and claims. Q16. There is a property worth ₹10 lakhs. An Insurance cover has been preferred by its owner for ₹6 lakhs. Claim has been lodged for a loss. The loss is valued for ₹2 lakhs. How much will the Insurer usually pay? CFP Level 3: Module 1 – Risk Analysis - Global Page 42

(a) ₹2 lacs (b) ₹6 lacs (c) ₹1.20 lacs (d) ₹1.50 lacs. Q17. Mr. Paul owns a Ford Ikon. He opted to have statutory minimum cover to avoid higher premium. One day, in trying to save a child while driving, his car hit a parked car, causing damage to it for ₹5000/- and then hit a boundary wall causing damage to it for ₹5000/-. His own car suffered a repair cost of ₹8000/-. How much claim is admissible? (a) ₹ 18,000/- (b) ₹10,000/- (c) ₹5000/- (d) None of the above Q18. Which among the following is not a part of the \"essentials\" of insurable interest: (a) There must be life or limb, property, potential liability, rights or financial interest capable of being covered. (b) Such life or limb etc in (a) above must be the subject matter of the insurance. (c) The insured must have adequate financial resources to pay the premium. (d) The insured must be in a legally recognised relationship with the subject matter of insurance. Q19. In the Indian context, which one of the following relationship does not satisfy the criteria of insurable interest principle: (a) Husband on wife's life and vice-versa. (b) Debtor on creditor's life (c) Parent on the child's life (d) Business partner on the life of the partner Q20. The Doctrine of Adhesion protects: (b) The insurer (a) The insured (d) None of the above (c) The IRDA Q21. Obligations under the principle of utmost good faith rest on the: (a) Proposer only (b) Insurer only (c) Both the proposer and the insurer (d) On neither CFP Level 3: Module 1 – Risk Analysis - Global Page 43

Q22. The principle of \"utmost good faith\" places on each party to the contract the obligation to disclose all \"material facts\" to each other. Which one of the facts referred to bellows does not fall into the category of \"material fact\": (a) Proposer's vocation hobby etc. (b) Proposer's personal medical history and profile (c) Proposer's parents' occupational status (d) Proposer's family history. Q23. The provision in the Insurance Act which deals with the incontestability of an insurance policy an grounds/ misstatement or concealment after the expiry of two years is covered by (a) Section 27 (b) Section 47 (c) Section 45 (d) Section 11 Q24. The \"principle of utmost good faith\" will be most relevant at the time of (a) Issuing the policy (b) Settling claim (c) Underwriting the risk (d) None of the above. Q25. Insurable Interest can exist between a Member of Parliament and his (unrelated) party workers. (a) True (b) False (c) Data insufficient Q26. Ram insures his home worth ₹50 lakhs for ₹30 lakhs. The house is destroyed in a fire and he suffers lossesworth₹20 lakhs. How much will he receive from the Insurance Company? (a) ₹20 lakhs (b) ₹16 lakhs (c) ₹12 lakhs CFP Level 3: Module 1 – Risk Analysis - Global Page 44