Risk management is a relatively new term which is used to embrace the practice of identifying serious risks which may beset an organisation, deciding on their relative importance and advising the most advantageous ways of combatting them or mitigating their effects. At one time it was the practice to take out insurance to cover all serious eventualities, but because of the increasing cost of insurance cover many organisations now assess risks and the probability of their occurring, make an evaluation in each case of the probable loss that may be sustained, and then decide whether to insure or carry the risk themselves. A wrong judgement here, of course, could be disastrous.
Because insurance is by far the most common form of protection taken, we shall discuss this first.
1. Insurance
Primarily, insurance is an indemnity against loss. It could also be considered as the contracting out of a risk. Thus, for the payment of a certain sum of money, termed the premium, one party (the insured) may pass the monetary responsibility of any particular risk on to another party (the insurer).
In simple principle, the insurers accept premiums from the insured and form a pool of financial resource out of which to pay those insured parties who have to make claims on the funds. In practice the insurers invest a large proportion of the pool of premiums so that profit can be earned on the money, which has the effect of (a) keeping premiums to a minimun and (b) providing additional income for the insurers.
The amount of premium required by any particular insurer for any particular risk is primarily based upon the likelihood of the eventuality covered materialising and the amount of loss that is likely to be sustained. The risk element is very carefully calculated by reference to past experience. Other factors that affect the cost of insurance are the past claims behaviour of the insured and competition between insurers.
Generally speaking there are two markets for those wishing to buy insurance (a) insurance companies and (b) Lloyds underwriters.
1.1. Insurance companies
These behave in the same manner as any other company operating for a profit, with a similar management structure and philosophy. They do, however, fall into two categories: proprietary offices and mutual offices.
Proprietary offices are joint stock companies and have the usual subscribed capital. In this case the shareholders share in surplus profits.
Mutual offices are owned, technically, by their policyholders themselves and so share in surplus profits rather than these profits going to other parties.
This distinction is not important for the buyer of most forms of insurance, except, perhaps, some life assurance. In exploring the market it will be found that there is not a great deal of difference in premium costs between one company and another simply because of its capital structure.
1.2. Lloyds underwriters
These are individual persons who undertake insurance and are personally liable for the risks they buy. They are members of the Corporation of Lloyds. Curiously, Lloyds of London itself is not concerned with the selling of insurance but it is a regulating body, and its underwriting members are bound by very strict rules of conduct. The financial risks involved in underwriting insurancce have become so high that they are a burden rarely undertaken nowadays by individuals. It has thus become the practice for underwriters to act in groups or syndicates.
Lloyds underwriters may not deal with the public direct but only through insurance brokers. Insurance brokers, generally speaking, are agents of the buyers of insurance and are paid by commission levied on the premium. This commission is deducted by the broker before the premium is paid over to the underwriter.
1.3. Insuring with companies and with brokers
Opinions differ as to whether it is preferable to buy insurance from companies or from Lloyds underwriters through brokers.
In favour of the companies, it can be said that it is simple to transact business with them. Companies tend to have reasonably standard conditions, give personal attention through their representatives and in the event of a claim will normally deal direct with the insured. There is direct contact between the customer and the risk-taker at all times. On the other hand, companies are likely to quote higher premiums than Lloyds underwriters.
For the brokers it may be said that they have a very wide and expert knowledge of the insurance market and are able to place the insurance with suitable underwriters at the most economic rates. Not being tied to any particular insurer, they can explore the market, and will even place insurance with a company if it is to the advantage of their client. Against this must be set the following disadvantages:
- Very often the conditions of the policies of different underwriters vary widely and thus real comparisons can be difficult, though it must be said that an experienced broker is best able to evaluate between policies.
- The insured is not dealing with the insurer direct but through a third party. This can, and does, cause difficulties and delays in the event of claims in some cases, especially on the interpretation of policy clauses.
However, sufficient to say that both methods of buying insurance flourish and provided reputable insurers are dealt with, both methods have advantages to commend them.
1.4. Principles of insurance
There are certain basic principles appertaining to insurance which it is important to know and which, in Britain, are recognised at common law.
These are:
- Insurable interest. In order to effect an insurance legally the insured must have an insurable interest in the matter to be insured. Thus the position must be that the insured will suffer from its loss or damage, will benefit by its continued safety, or must be liable to incur a liability to a third party in respect of loss or damage. Actual ownership need not be involved. In most forms of insurance – fire, accident, marine – the insurable interest must exist at the time of the incident giving rise to a claim, but with life assurance this is not so. Life assurance is not, in fact, one of indemnity but of benefit payment. However, insurable interest must exist when the life policy is taken out, but benefit may be assigned to a third party subsequently, who would have a valid claim in the event of the death of the assured life.
At this point it might be interesting to note the two terms ‘insurance’ and ‘assurance’. Insurance covers possibilities that may or may not happen, such as fire, accident, burglary; assurance covers an inevitable event, the only certain one being death. Hence, life assurance, not insurance.
- Uberrima fides. This means utmost good faith. In all contracts of insurance utmost good faith is essential and this means full disclosure of all relevant material facts by the insured when the policy is taken out. Failure to do this renders the contract voidable at the discretion of the insurers. Normally a policy is taken out by the completion of a proposal form, which forms the basis of the contract. It is essential, therefore, that this be fully and truthfully completed. Further, material matters appertaining to the risk must be declared even where the relevant questions do not appear on the proposal form. It is wise, therefore, to keep a copy of the proposal form for future reference in case of queries on disclosure in the event of a claim.
- Where contracts are against the happening of an uncertain event the insurer undertakes to indemnify the insured up to the amount insured – that is, to put the insured in the same position as before the event happened. Indemnity is strictly interpreted. Thus, depreciation and wear and tear will be taken into account when assessing the value of a claim even though the figure arrived at will be less than the sum insured. Moreover no claimant may make a profit on a claim, and even if premiums appropriate to a higher value have been paid only the actual loss will be reimbursed. The principle of indemnity gives rise to two corollaries, those of subrogation and contribution:
- Subrogation. This means, in effect, ‘standing in the shoes of another’. In many cases insurers will settle a policyholder’s claim where the policyholder has, in fact, a claim against a third party for all or part of the amount at issue. The insurer will then, in turn, claim on the party who caused the event. This circumstance is, of course, common in motor insurance claims.
- Contribution. This applies in cases where insurance has been taken out for the same risk with more than one insurer, at full value in each case, which in itself is perfectly legitimate. In the event of a claim only the actual amount of loss in total can be claimed. Most policies provide that in this event the policyholder must claim pro rata from all the insurers. Should no such clause appear then if so desired an insured can claim against one insurer only and leave this insurer to claim against the others.
- Proximate cause. The doctrine of proximate cause states that an insurer is liable only if the loss is due directly to the peril insured against, or is the first cause of a chain of events which leads directly to the loss without the intervention of any new cause either not covered by the policy or specifically excluded. The application of this doctrine can be very difficult, particularly where there have been a number of events leading to the final loss and it is necessary to establish the proximate cause. The principle is best illustrated by two actual cases:
- Symington v. Union Insurance of Canton (1928). A stock of cork was insured against fire. A fire started some distance away and to stop it spreading some of the cork was thrown into the sea even though it had not been burnt. It was held that the fire was the proximate cause of the loss and there was a valid claim under the fire policy.
- E. G. Gaskarth v. Law Union & Co. (1876). A fire at a building left a wall in a dangerous condition. Subsequently, during a gale, the wall was blown down and damaged the adjoining premises. It was held that the fire was a remote cause and the gale the proximate cause. The claim under the fire policy therefore failed.
2. Kinds of Insurance
Insurance can be divided into four categories
- Fire
- Accident
- Life
- Marine
Marine insurance is a highly specialised subject and does not concern us here. Life assurance, also, has only limited relevance to the normal activities of the majority of organisations though it is of extreme importance in the field of pensions for most undertakings. It is the areas of fire insurance and accident insurance that most concern the average organisation whatever its sphere of operations.
With few exceptions it is possible to insure against practically any eventuality and with such a wide availability serious consideration has to be given to the question of precisely what insurance to take. The temptation is to cover every conceivable risk, but this would prove expensive and is normally unnecessary. The following list is a suggestion for consideration:
- These are those risks which would imperil the organisation’s existence, such as the destruction of main assets (fire, flood and so on) or circumstances that would seriously impair its ability to operate effectively (such as machinery breakdown, loss of vehicles and the like).
- These consist of insurance covers that are required by law, such as employers’ liability and third-party accident in connection with motor vehicles.
- Construction and similar contracts require the contractors to take out insurance to cover such risks as public liability and fire.
- These include risks that could be costly or embarrassing; examples are burglary, export credit and accidents to key personnel.
- There are many minor risks that organisations consider worthwhile to insure against, plate-glass insurance for retail stores being an example.
3. Fire Insurance
This is an essential cover and is divided into (a) insurance of the fabric of the building and (b) insurance of its contents. In industrial and commercial undertakings contents are also divided between fixed assets such as plant and machinery and other assets such as stock, tools and cash.
Policies normally cover accidental fire and include damage by lightning, damage by water used in combatting fire, removal of goods and movable assets. They do not cover for the damage caused by spontaneous combustion (volatile liquids for example), explosions occasioned by processing and similar causes though damage by fire resulting from such incidents would be covered. Neither do normal fire policies cover for consequential loss, more popularly known as loss of profits, though this can be covered for an additional premium.
For industrial and commercial buildings there is no standard rate of premium; this is dependent upon the construction of the building, the type of activity carried on, what is stored there and the proposed insured’s past record in connection with the risk to be covered. Full details will have to be provided by the proposer. This would cover the construction of the building, its proximity to other premises subject to the same risk and other pertinent information.
It may also be thought desirable to cover other perils not normally included in the standard fire policy and this can be done by the payment of additional premiums. Such risks include fire and other damage caused by riot or civil commotion, storm, tempest and flood, explosion so far as not already covered, burst water mains, damage through impact by motor vehicles or articles dropped from aircraft. The rare possibility of damage through impact by actual aircraft and by sonic boom can also be covered.
In quoting for fire cover the insurers will almost always send a representative to inspect the premises, plant and so on, and a rate will be quoted on the assessed risk. This rate may be subject to reduction if certain circumstances obtain such as the provision of a minimum number of fire extinguishers, automatic sprinkler valves, fire-resistant construction and similar safeguards. The minimum protection against fire hazards required by law must, of course, be provided.
3.1. Value to be insured
As insurance is a contract of indemnity it follows that some thought must be given to the values of the premises, stock, plant and so on to be covered. In the event of a claim the value paid to the insured is the value after allowance has been made for fair wear and tear, provided it is not in excess of the capital sum insured. Thus, suppose a machine is insured at its new value of £6 000 and is destroyed by fire about a year after purchase. The value after allowance for fair wear and tear will probably be only £5 000 at most and this is what the insurers will settle at, despite the fact that the premium was paid on £6 000. Should the present value have exceeded £6 000 the maximum payable would be £6 000 because the premium paid would have been calculated on this figure.
Whereas this truly reinstates the insured to the situation at the time of the incident, this is not convenient to most organisations as it means replacing with secondhand goods. Therefore, it is possible to insure, at a higher premium, for the ‘reinstatement as new’ value.
Some examples of valuing for insurance are:
Premises. These are often insured at market value, but as this includes the site, which is not at risk and which may be of considerable value, this method may lead to unnecessarily high premiums. However, where the premises are old the cost of rebuilding may be more than the market value of the buildings alone, particularly as new building regulations may require a higher standard of construction. There is also the question of the cost of clearing the site of the remains of the burnt-out building. Thus insurance on a cost of rebuilding basis is recommended, this to include demolishing the remains of the old premises and clearing the site. Expert advice should be sought on this matter.
Plant and machinery. These are subject to two conditions: (a) wear and tear and(b) obsolescence. Used plant and machinery is obtainable but it is usual to insure for replacement as new. However, this is taken to mean a comparable machine and so most policies stipulate that new machines shall not be superior to the existing.
Stock and loose tools. Manufacturers’ stocks of raw materials and small tools are usually covered at replacement value, the balance sheet stock figures normally being acceptable by the insurers. Partly-finished goods should be covered at a value based on the cost to remake and finished goods at replacement value if they were to be bought in.
Wholesalers and retailers – whose stocks are, of course, goods ready for resale—should insure for the cost to them and not the prices they would obtain on sale. To insure at selling prices would run contrary to the doctrine of indemnity because a claimant would, in that case, be able to increase the stockholding on the proceeds of the claim; that is, a profit would be made. However, excise duties on goods, such as value added tax, should be covered as there is no certainty that such taxes would be the subject of remission in the event of loss.
3.2. Average
At this point it would be as well to examine the question of average. Simply, this means that a claim will be settled in the proportion to which the amount of premium actually paid relates to the premium that should have been calculated on the true value.
An example will make this clear. Suppose a manufacturer declares stock at £100 000 and pays a premium on this figure. A fire occurs that results in a total claim. If the figure declared were the true one the claim would be met in full. If, however, the value had been under-declared and the true value were £150 000 the insurers would pay only £100 000. This, of course, appears quite straightforward. However, it is often not realised that the doctrine of average applies to claims for partial loss as well so that in this case if the actual value of the loss were £100 000 the insurers would be liable for only two thirds of this – that is, £66 666 – since the declared value of £100 000 is two thirds of the true value of £150 000. This example illustrates the danger of endeavouring to reduce premium costs by under-insuring.
There are four other aspects of fire insurance which interest the office administrator.
3.3. The declaration policy
Items such as stock, loose tools and the like fluctuate in value all the time and so present a problem for valuation. This can be solved under a declaration policy, which provides for cover at the maximum value at risk at any one time and initially 75 per cent of the premium is paid. The insured then makes monthly declarations of (say) the stockholding and at the end of the year, assuming an annual policy, the declarations are totalled and divided by 12. This provides the average stockholding, which is the basis for calculating the final premium. Adjustment is then made between the initial sum paid by way of premium and the true sum due.
3.4. The floating policy
Where an organisation operates from two or more premises it is usual for the insurers to insist that the buildings are covered separately. However, so far as the contents are concerned it is often more convenient to cover them all under one policy. This averages the rate of premium to be applied and can be very useful where declarations of value have to be made. Care must be exercised in considering this type of policy, however, because if there is a proportionally high value of contents in a building that attracts a particularly high premium rate this might mean a greater premium payment than would otherwise be the case.
3.5. The blanket policy
This type of policy brings together cover for buildings, plant and machinery and contents under one document. It simplifies the problem of insurance, particularly where large organisations are concerned, a flat rate premium being charged to cover each aspect of the insurance.
3.6. Consequential loss
It was stated above that the normal fire policy does not cover for losses consequential on the fire. These include loss of profit because of curtailment in trading, rents and rates as well as salaries of permanent staff (which will continue) and also, possibly, the cost of temporary premises so that business can continue. A consequential loss policy, often known as a loss of profits policy, can be taken out to cover a business against such a catastrophe. The turnover of the preceding year is taken as a starting-point and the sum insured would be the net profit derived from this turnover plus the standing charges just mentioned (rent and rates and salaries). This total is expressed as a percentage of the turnover which can be applied for any period that the business operates at a reduced level of activity.
It is also often the case that provision is made in the policy to cover for increased working costs entailed in trying to mitigate the loss, such as taking temporary accommodation so as to continue trading.
4. Accident Insurance
Accident insurance embraces all categories of risk not covered by fire or life, excepting, of course, marine insurance.
Perhaps the most important accident insurance is public liability (or third-party) insurance. This covers the insured’s legal liability for personal injury or damage to property through negligence or defects to premises, to all third parties other than employees, that occurs on the insured’s premises or premises under the control of the insured. Among the examples of incidences that may give rise to third-party claims are injuries through defective flooring or paving, negligence of employees, unsafe fitments and the like. Damage caused to personal effects such as clothing catching on protruding spikes or to a vehicle damaged on a visit on the insured’s premises are further examples of claims that may arise. Third-party claims can be quite heavy and adequate insurance must be covered in this respect.
Two insurances that are required by law in Britain are motor insurance and employer’s liability.
4.1. Motor insurance
The law requires third-party cover only. Where vehicles are new or relatively new it is usual to take out comprehensive insurance that covers for all risks including fire and theft and damage. Where vehicles are old and their value low it may be considered preferable to insure only for fire and theft, which will attract significantly lower premiums. In all cases third-party cover is obligatory.
4.2. Employer’s liability
All employers in Britain have a statutory duty to insure their employees against accidents at work. The Employer’s Liability (Compulsory Insurance) Act, 1969, requires employers to cover their employees against bodily injury or disease arising out of the course of their employment. Related losses are not covered by this Act and claims at common law in regard to these can be quite heavy. It therefore behoves the prudent employer to extend the employer’s liability cover to include these additional risks.
There are many other risks that can be insured against, the most important of which are given below.
4.3. Products liability
A manufacturer’s or supplier’s liability for faulty goods and any injury or damage they cause has become a fact of life and claims in such cases are enforceable at law. It is prudent, therefore, for insurance to be taken out against the possibility of such claims.
4.4. Professional indemnity
Claims for damages attributable to professional negligence are on the increase and are very often successfully pursued through the courts. Further, the amounts awarded in damages can be very high indeed. It is prudent, therefore, for any member of a profession such as an accountant, architect, doctor or solicitor to take profession indemnity cover. Organisations which provide services, such as builders, laundries and so on, are also at risk for negligent work and should cover themselves against claims.
4.5. Burglary
Loss and damage through breaking and entering are insurable but larceny (theft by persons entitled to be on the premises) is not covered unless specifically required, when the premiums are relatively high. Premiums in any case, relate specifically to the extent of the risk and the value and portability of the items at risk.
4.6. Fidelity bonds
Despite larceny being a risk not welcomed by the insurance industry, employees whose duties involve handling cash can be covered against defalcations. Each such employee is the subject of a fidelity bond and the insurers seek references to ensure the worker’s honesty.
Other ways of taking out insurance against fraud and embezzlement are:
- Floating policies in which all relevant employees are named instead of having a separate bond for each worker.
- Positions policies, where the posts are named and not the employees.
- Blanket policies where employees are added and deleted as they start with the firm and leave.
Traditionally the premium for a fidelity bond is paid by the employee but this is now often paid by the employer, as are the premiums for the other types. It is worth noting that such policies also provide that all such acts insured against are discovered not later than six months after the resignation, dismissal, retirement or death of the defaulting employee or not later than three months after the termination of the policy, whichever happens first.
4.7. Cash-in-transit
Most organisations have to move money outside their premises – usually the collection of cash from the bank to pay wages. Cash-in-transit insurance covers this risk. Cash whilst in the office can also be covered.
4.8. Accident and sickness
The temporary loss of the services of key personnel through accident or sickness may be quite expensive and this expense can be mitigated by this insurance.
These are the main insurances that a prudent organisation may consider necessary, but there are others that might be advisable in appropriate situations. These include:
Forged transfer insurance in connection with transfers of shares.
Contract guarantees (bonds) which provide for damages if a contractor fails to complete a contract.
Plate-glass insurance which covers for replacement of plate-glass windows in the event of damage: mostly of interest to retail stores.
Pluvius insurance which meets some of the loss occasioned when it rains at an outdoor event.
4.9. Bad debts and credit insurance
Insurance against bad debts is a specialised form of insurance for which in Britain, there are two sources:
- The Trade Indemnity Company, formed by some of the leading insurance companies for this purpose. It accepts risks principally in the home trade. An added advantage of this insurance to the insured is that such cover is accepted by banks as providing extra security for the granting of overdrafts.
- Export Credit Guarantee. This is a department of the Department of Trade and Industry and provides insurance against bad debts to exporters. There are various schemes available depending upon the type of business involved.
5. Alternatives to Insurance
Insurance has become so expensive that ways and means are often considered whereby some risks are not put out to insurance at all. In this connection it is the task of risk management to identify possible risks, analyse them into importance and probability, and to assess their likely effect on the organisation according to cost and possible damage to the undertaking’s continuing capacity to function properly. This technique is sometimes termed risk identification and analysis. Among the actions considered are the following.
5.1. Reducing risk
Some types of risk are so severe that they are best avoided altogether, or a safer practice substituted.
5.2. Control of losses
This technique requires the examination of losses over a period of years and their classification into types, severity, frequency and cost, as well as analysis into probable causes. From this information the organisation can work out ways of controlling and reducing future losses and of remedying the causes. This may mean additional security, more effective systems, better staff training and other adjustments to current practices.
Neither risk reduction nor loss control rules out the desirability of insurance altogether: this is a decision to be made after careful consideration of all the facts. However, where insurance cover is decided upon it is very likely that the adjustments and controls instituted because of the investigations will result in significant reductions in premium costs.
5.3. Self-insurance
This term is really a misnomer but is a convenient one. In effect the organisation transfers a sufficient sum each year to a contingency fund against which losses are charged. If the risk analysis has been done effectively over the course of time it should be found that the sum of total losses is less than the insurance premiums that would have been paid. Further, the cash forming the contingency fund is a contribution to cash flow and will only be crystallised in part as an incident occurs.
5.4. Own insurance companies
Sometimes termed ‘captive’ insurance companies, this is similar to self-insurance except that a separate subsidiary company is formed to take care of the organisation’s insurance. An example is the case of a large vehicle-hire fleet operator where a subsidiary insurance company takes care of all the vehicle insurances.
Finally, ways of reducing insurance premium costs whilst being adequately insured must be considered. Among the principal ways of doing this are taking care not to overvalue the cover required and being selective in the insurances actually taken out.
Since, normally, the rule of indemnity applies the capital values insured should be examined each year to ensure that they are reduced in line with their depreciated value. This does not, of course, apply to fixed-value or reinstatement policies.
Discrimination should also be exercised in what exactly should be insured. An example will make this clear. A manufacturer may insure stores of materials and finished goods against burglary but not partly- finished goods on the grounds that the former are worth stealing but that the latter are not.
The whole area of insurance and risk management is both important and difficult, but it is one that should on no account be neglected.
Source: Eyre E. C. (1989), Office Administration, Palgrave Macmillan.
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