Insurance

All business persons have to take some risks, but they try to avoid any

which are unnecessary. One way of reducing risks is to take out insurance

to cover any losses.

Insurance is an agreement in which an insurance company protects

the insured against losses associated with specified risks in return for a fee

called the premium payment. Insurance policies are written, legal con-

tracts that specify all of the terms of the agreement, including the types

of risks covered, the types of actions by the insured that will void the

236

policy, the maximum amount the insured can collect for losses, and how

the premiums are to be paid. In the event of a loss, the insurer will pay for

the loss up to the amount specified in the insurance policy.

All insurance policies share several characteristics that distinguish in-

surance from other risk management techniques. These characteristics

include (1) pooling of losses, (2) the law of large numbers, (3) payment

of fortuitous losses, (4) risk transfer, and (5) indemnification.

The pooling of losses is one of the central characteristics of insurance.

Pooling is the spreading of losses incurred by a few parties over the many

parties who have purchased insurance. Thus, the party suffering the loss

is compensated in full from the fund created from premium payments

made by all policyholders.

The law of large numbers states that the larger the number of expo-

sures (policyholders), the more predictable the occurrences of perils on

which the insurance premiums are based. Such predictions are called

probabilities and are calculated using statistical principles. But making

such calculations depends on having a large number of insureds, or poli-

cyholders. By calculating the expected number and amount of losses,

the insurance company can determine the amount of premium payment

it must collect from the insureds.

Another characteristic of insurance is the payment of fortuitous loss-

es. A fortuitous loss is a loss that is unforeseen and occurs as a result

of chance. This may seem inconsistent with the calculation of expected

losses among all policyholders (the law of large numbers), but it is not.

Rather, it means only that any individual loss is unforeseen and results

from chance events. This very fact of accidental loss is what makes the

law of large numbers work. Thus, if a policyholder intentionally starts a

fire in his or her warehouse, the insurer will not cover the loss.

Risk Transfer means that the loss associated with pure risk is trans-

ferred to the insurer, who is in a better financial position (due to pre-

mium collections) to pay the loss than the insured is. Pure risks that

can be transferred to an insurer include risks of premature death, loss of

property, liability, and poor health.

A final characteristic of insurance is indemnification for losses. This

means the insured is restored to his or her approximate financial status

prior to the loss. Thus, if a company’s warehouse bums to the ground,

the insurer will indemnify the company, or restore it to its previous posi-

tion. The company will recover sufficient funds from the insurer to re-

build the warehouse.

Many types of insurance are available to protect against a wide

variety of perils and risks. The most important types of insurance for

business include liability insurance, property insurance, fidelity bonds,

surety bonds, criminal insurance, and employee benefit insurance.

Liability insurance protects against claims caused by injuries to oth-

ers or damage to their property. Unlike other types of insurance, liability

insurance pays nothing to the insured when loss occurs. Rather it pays

third parties for injuries caused by actions of the insured. Liability insur-

ance includes four types: premises, operations, contingent liability, and

product liability insurance.

Premises Insurance, sometimes called owners’, landlords’, and ten-

ants’ insurance, covers the insured when people trip on the sidewalk and

fall into a hole in the lawn, walk into the glass patio door, or fall down

the stairs. For example, a grocery store can be sued by a parent whose

child fell out of a grocery cart. Premises insurance would cover this peril.

Most businesses are required to maintain safe premises. For example,

sidewalks must be cleared during a snowstorm, and customers must be

alerted to dangerous conditions such as a recently waxed floor.

Operations Insurance. Many everyday business operations create li-

ability exposure for the company. If the business uses forklifts, trucks, or

automobiles in its operations, special liabilities exist. Both customers and

employees may be exposed to hazard from these operations. Employees

will likely be covered by public insurance programs, such as workers’

compensation. However, customers and the general public must be cov-

ered by special liability insurance. A common example of this type of

liability policy is seen in typical automobile insurance policies. These

policies cover third parties who are injured by the insured’s car and pro-

tect the owner from financial loss as a result of those injuries.

Product Liability Insurance. As many manufacturers can tell you,

their liabilities do not stop when the product leaves the door. Liability for

injuries caused by faulty products may continue throughout the prod-

ucts’ useful lives.

Property insurance. Property losses may arise from a variety of perils,

such as fire, explosion, lightning, wind, vandalism, and theft. Property

losses can be classified into two groups: direct and indirect losses. Direct

losses are those incurred on the property itself. For instance, if a ware-

house is damaged by a hailstorm, the costs of repair are direct losses.

Indirect property losses involve incidental losses associated with a direct

loss. For example, it may take several days for repair-people to finish

repairs on a damaged warehouse. The warehouse cannot be used during

this time, and the company may suffer losses in sales revenue. Losses

of revenue are sometimes called business interruption losses. When an

office building is damaged, businesses may have to relocate their opera-

tions for a period of time. Costs of moving, setting up, and preparing the

new premises are indirect losses.

Text 7

Read the text. Write down 15 statements (both true and false) and let the class identify

them and correct the false ones.

Risks

According to The Oxford Dictionary for the Business World, risk is a

chance or possibility of danger, loss, injury, etc. What types of risks do

you know? What risks do businesses face?

Risk tolerance is the amount of risk with which you are comfortable

when selecting your investment options. It is a key factor in building

the investment portfolio that is right for you. Often an investor’s ability

to meet their current financial responsibilities regardless of the results

of their investment will influence their tolerance for risk. If you have a

high net worth (and can therefore afford to lose some of your invested

money), you may feel comfortable speculating in potentially risky in-

vestments such as currencies, options, futures and forward contracts.

Conversely, if you have a low tolerance for risk (or few dollars to spare) it

may be wise to stick to more conservative investments.

Yet, to understand risk as it relates to investments, it is important

to have a concrete understanding of what investment risk is. Essential-

ly, investment risk is the chance of loss due to the uncertainty of future

events. Many factors can affect the value of your investments. For ex-

ample, there are risks in political systems that can reduce the value of an

investment. A company you invest in may undergo unforeseen changes

in management. Investor emotions may be unpredictable. Uncertain-

ties in exchanges, rates of currencies, and in interest rates also affect

investments. Usually, investors deal with risk in two ways: one is to sim-

ply guess at it, and the other is to study as many factors as possible and

choose the most promising course of action. This latter option is called

calculated risk.

Personal risks. This category of risk deals with the personal level of

investing. The investor is likely to have more control over this type of risk

compared to others. Timing risk is the risk of buying the right security

at the wrong time. It also refers to selling the right security at the wrong

time. For example, there is the chance that a few days after you sell a

stock it will go up several dollars in value. There is no surefire way to time

the market. Tenure risk is the risk of losing money while holding onto a

security. During the period of holding, markets may go down, inflation

may worsen, or a company may go bankrupt.

Company risks. There are two common risks on the company-wide

level. The first, financial risk, is the danger that a corporation will not be

able to repay its debts. This has a great effect on its bonds, which finance

239

the company’s assets. The more assets are financed by debts (i.e., bonds

and money market instruments), the greater the risk. Studying financial

risk involves looking at a company’s management, its leadership style,

and its credit history. Management risk is the risk that a company’s man-

agement may run the company so poorly that it is unable to grow in value

or pay dividends to its shareholders. This greatly affects the value of its

stock and the attractiveness of all the securities it issues to investors.

Fluctuation in the market as a whole may be caused by the following

risks. Market risk is the chance that the entire market will decline, thus

affecting the prices and values of securities. Market risk, in turn, is in-

fluenced by outside factors such as embargoes and interest rate changes.

Liquidity risk is the risk that an investment, when converted to cash, will

experience loss in its value. Interest rate risk is the risk that interest rates

will rise, resulting in a current investment’s loss of value. A bondholder,

for example, may hold a bond earning 6% interest and then see rates on

that type of bond climb to 7%. Inflation risk is the danger that the dollars

one invests will buy less in the future because prices of consumer goods

rise. When the rate of inflation rises, investments have less purchasing

power. This is especially true with investments that earn fixed rates of

return. As long as they are held at constant rates, they are threatened by

inflation. Inflation risk is tied to interest rate risk, because interest rates

often rise to compensate for inflation. Exchange rate risk is the chance

that a nation’s currency will lose value when exchanged for foreign cur-

rencies. Reinvestment risk is the danger that reinvested money will fetch

returns lower than those earned before reinvestment