This document discusses different methods of financial risk control, including internal and external risk financing. Internal risk financing involves funding losses from regular earnings, creating a fund to cover large losses, or self-insuring. External risk financing primarily uses insurance. The document outlines different types of insurance policies, including liability insurance, employer's liability, professional indemnity, products liability, and personal accident insurance. It provides details on how each policy covers losses and exceptions to the coverage.

1. FINANCING RISK
In this chapter financial risk control will be discussed. Like the other steps in the risk
management process financial risk control and physical risk control should be used
together. Reliance should not be placed on providing finance once the loss has
physical risk control should be part of the overall strategy of the individual or
organisation.
Financial risk control is the method used to provide for financial losses which may
following an untoward event. There are two different methods of carrying out
financial risk control and these can be entitled internal and external risk control. The
former can be divided into three separate actions. The first is to provide for losses out
of the normal earnings of the organisation. This means that your income is decreased
by the amount of losses that can occur. It also implies that the losses must be
budgeted for by the organisation. Large retail shops finance their losses for shop
lifting in this manner. It is too expensive to insure and it is comparatively easy to
calculate what the losses will be during the course of the year. Small losses that occur
regularly can easily be calculated and should be funded in this manner.
In order to calculate premium insurers use the concept of the expected loss over a
period of time. Very simply put the expected loss is calculated for a particular risk and
used as a premium. Insurers are profit making organisations so in addition to the
expected loss they will add something to cover their costs and profit for their
shareholders. When it comes to small regular losses a firm can easily calculate the
expected loss themselves and budget for the possible losses that could occur out of

2. earnings. This will avoid paying insurers costs and profits and thus decrease the cost
of financing risk.
If an organisation decides to provide for small losses it must ensure that it can meet
the cost that will be incurred. Losses that could cause the firm to become insolvent or
cannot be met by regular earnings must be dealt with another way. An example of this
could be the development of a fund to cover large losses. Again the organisation will
have to be in a position firstly to calculate the possible losses and, secondly, be able to
afford to pay in the event of something going wrong. The fund could be built up over
a period of time or a lump sum could be put aside out of the organisation’s financial
assets. However this is done a lump sum must be immediately available if a loss
occurs.
The problem with the second method is that a large sum of money is put to one side
that cannot be used by the organisation in the course of its normal business. Secondly
the money will be seen by management to be unproductive and would be an obvious
target if cash is needed for expansion or other purposes. The money could be invested
but as it is needed quickly the investments will have to be liquid in addition they
should be virtually risk free as the organisation must have enough money available to
recover should things go wrong.
A further problem with funding losses, especially larger ones, is that if a fund is being
built up by regular payments this could mean that, if a loss occurs early, not enough
money is available to cover the loss. If for example a fund is commenced in year one
and it is decided that the full amount will be built up over five years and a loss occurs

3. in year two then the fund is 3/5th short. The organisation will not be able to meet the
losses incurred. These two methods can be used together, that is small losses could be
dealt with out of regular earnings and at the same time an organisation can develop a
fund. It is really only large organisations that can develop there own full self funding
programme.
The idea of providing financing can be extended still further by large firms or trade
organisations. Large organisations may decide that it would be cheaper to form their
own insurance company as part of their conglomerate. This is known as a captive
insurer. Many large organisations, such as BMW and Mobil, have their own insurance
company as a member of their group. In this case funds from the main organisation
are diverted to another company which is registered as an insurer in the country of
choice. Captives are often strategically placed in countries where the maximum tax
advantage can be obtained. Examples of such havens are Dublin, Luxembourg and the
Isle of Man.
Internal risk financing ensures that each organisation using this method does not have
to pay a premium, all they meet is their own expenses. This means that the better their
risk control the less losses they will have to pay. If they were insured their premium
would be calculated using the experiences of other organisations which form part of
the same risk group. They could mean that the company concerned, if it is
implementing good risk control measures, is subsidising organisations who do not use
such methods. A captive organisation is able to calculate premiums based on the
company’s own experience so that, by carrying out physical loss control measures
they are able to control the financial cost.

4. This type of financing is often called self-insurance. As insurance is a means of
spreading risk among a number of individuals or organisations this is a misnomer.
Despite this it is a common term used in the insurance industry.
EXTERNAL RISK FINANCING
The main means of externally financing risk is by means of insurance. Insurers are
large organisations that have substantial amounts of capital available to them to meet
large losses. Insurance companies are usually joint stock companies owned by
shareholders but some are mutuals owned by their policy holders.
The providers of insurance are divided into two main industries called life and non-
life insurance. Organisations are required to register either as a life or a non life
company in terms of European legislation. The same company cannot be registered to
trade in both classes.. There are a number of older companies, mainly of English
origin, who do sell both types of insurance, an example being the Norwich Union, but
no new companies of this type may be formed. Although insurance can be purchased
directly from an insurance company many industrial organisations purchase their
insurance through brokers. These are intermediaries who act on behalf of their clients
to place their insurance. They hold themselves out as experts in insurance. They are
able to place insurance with one of many companies with whom they hold agencies to
sell insurance. They also advise on the best means of providing financial protection
for possible losses.
There are two other types of insurance intermediaries, one is the tied agent who only
deals with one company and acts on the insurers behalf. The second is an agent who

5. deals with less than five companies and does not hold themselves out as experts in
insurance. An example is the local accountant who sells some life insurance or the
garage that provides motor insurance.
Insurance is a means of spreading the financial consequences of risk among many
people. Premiums are calculated based on losses of a particular group. The premium
is used to pay claims resulting from a specified loss. There are many different types of
policies and these will be dealt with below.
Insurance can be used in combination with internal financing to provide a means of
financing risk. For example the organisation may decide to take a deductible (also
known as an excess). This is the first amount payable in the event of a claim. Thus if
an organisation has stock valued at £1,000,000 they may decide to pay for the first
£10,000 of any loss themselves. If there is a loss amounting to £100,000 they are only
paid £90,000. The deductible normally results in a reduction of premium. Small losses
can be carried by a deductible and funded out of an organisation’s regular earnings.
A third member of the insurance industry is the reinsurer. This is the insurer of the
insurers. The reinsurance industry expands the financial strength of the insurance
industry by providing a way for insurers to lay off risks that may be in excess of their
capacity.
TYPES OF INSURANCE
In the previous section the insurance industry was briefly explained. In this section the
various classes of insurance will be considered. Insurance can be divided into a
number of different sections, These will be discussed in the following section.

6. LIABILITYINSURANCE
The aim of liability insurance is to cover the legal liability of the insured arising out of
accidental loss or damage to property or personal injury of an individual. There are a
number of important points to notice here. The first it is the legal liability of the
insured that is covered. The insured is defined in the policy and generally extends to
include the liability of employees and directors. If anybody other than these parties
requires cover then they should be named in the policy. An example of this
eventuality is when a principal is carrying out contract works and wishes to cover his
or her contractors.
The second point to notice is that it is legal liability that is covered. This is most
important as the insurer will only provide cover in the event of legal liability being
alleged. This is not a policy that pays just because an accident has occurred. Therefore
somebody who is injured by the actions of the insured must show that the latter was in
breach of his or her duty of care. The insurer normally takes over the handling of any
claim made against their insured and will consequently make decisions concerning
liability on information they collect or evidence they obtain from the insured. The
insured must provide all reasonable assistance to the insurer in obtaining such
information. If there is no legal liability the insurer will take over the defence of the
action on behalf of the insured.
You will also note that it is accidental damage to property or personal injury that is
covered. Deliberate actions are not included in terms of the policy. The incident must
be accidental to the insured in the sense that it is not inevitable. Accidental also
implies a one off incident rather than a continual action such as the continuous

7. emission of toxic waste from a chimney stack. In this case the damage is not
accidental, it is inevitable.
A limit of liability is provided in the policy. This should be set sufficiently high to
cover all possible losses as once this is exceeded no further payments will be made
during the course of the policy’s existence although, once it is renewed at the end of
the insurance period the limit of liability recommences.
The policy only covers property not belonging to the insured or in their custody
control. This excluded property is more effectively covered by property policies..
There is a difficulty in liability insurance as to when a policy is in force. When an
accident occurs the action may not commence for many years. Usually in UK and
Ireland there is a limitation period of three years from the time that the injured party is
aware that he or she has suffered an impairment. If no action is taken in this time then
the claim is time barred. Despite this limitation period claims may not be made to
many years after the event. An example is asbestosis claims where lung damage did
not evidence itself until many years after the exposure to the toxic substance. Thus
different policies could be in force at the time of the accident and at the time that a
claim is made time of loss. Cover can be provided for the insured either at time of the
loss or at the time of the claim. Policies are normally issued on the basis that it will
cover the accident rather than the claim. Therefore in the asbestosis cases it is the
policies which were in force at the time of the exposure which would cover the loss.
This has raised problems concerning the cover provided by these policies and the
limit of indemnity.

8. There are a number of different types of liability insurance policies. In addition
different types of policies can include liability sections. For example a comprehensive
motor insurance policy has a property section covering loss or damage to the
insured’s motor vehicle and a third party liability section covering personal injury to a
third party and loss or damage to third party property. The cover provided under
liability sections of property policies have similar terms and conditions to liability
policies.
On the whole liability insurance policies are divided into a number of classes which
will now be discussed.
Third party liability
The basic liability policy is known as a general or third party liability policy. It
provides the cover referred to above but includes a number of exceptions. The first
major exception is personal injury to employees or members of the family of the
insured. Employees are defined in the policy as persons under a contract of service
with the insured.
The second exception is liability arising out of the use of motor vehicles. As discussed
above this is included under the third party section of a motor vehicle policy. Quite
often an employee of the insured will be using a motor vehicle in the course of
employment. If this is the case, and the employee is negligent whilst acting in the
course of his employment, liability could arise. The employee should ensure that
employees have insurance cover on their motor vehicle policies if they are using them
in the course of their employment to cover this eventuality.

9. The third exception relates to providing cover for the giving of advice or designing
something. The idea behind this is to exclude professional liability. The general
liability policy will cover an accident caused by somebody doing something wrong
but not as a result of the design or advice being given. For example if advice is given
and it is not correct this is professional liability if the advice is correct but it is carried
out incorrectly this falls under the general liability policy.
The next exception relates to liability arising out of the use of a product. If a product
causes damage to third parties there is strict liability on all parties who have handled
the product. This goes all the way down the line to the initial manufacturer. This loss
will not be covered by the general liability policy. Usually there is a small amount of
products liability cover insured under this policy. This refers usually to food provided
in a canteen but not to the product manufactured by the insured.
Other exceptions common to all types of policies are actions as a result of ionising
radiation or as a result of war.
There are a number of extensions to the policy. For example cover may be provided in
the event of the insured wishing to be represented by their solicitors at a post-mortem
following a fatal accident.
Employer’s liability
Employers liability insurance cover covers personal injury to employees arising in the
course of their employment caused by the wrongdoing of the insured or their agents.
This will include the negligence of fellow employees. Thus an employee who is riding

10. home on a bicycle after work is not acting in the course of employment. If a fellow
employee, driving a truck belonging to the insured, knocks down the employee and
severely injures him the eventual claim will be under the third party section of the
motor policy. If the employee is riding his bicycle to collect a parcel belonging to
insured and is run down by the same truck then, as he is acting in the course of his
employment then the policy which will be effective will be the EL. The question of
whether the EL policy comes into force depends on whether the injured party is an
employee at the time of the incident.
All the other exceptions referred to above apply to this policy. At one stage policies
were issued without a limit of indemnity, that is to say insurer’s liability was
unlimited. This has now changed and employer’s must ensure that they have
sufficient cover to provide full protection.
This type of policy is common in the English speaking countries of Europe. In other
countries this type of loss may be dealt with under Worker’s Compensation Policies
with no reliance on legal liability.
Professional indemnity or errors and omissions
A professional indemnity and an errors and omissions policy are designed to cover
advice and design risks. It covers injury to third parties including property. Thus a
veterinarian should have professional liability cover in case, by some mishap, a horse
is injured by his or her professional activities. Again the policy is a legal liability
policy and not a guarantee of payment in the event of a loss. Causation and liability
will always have to be proved in order to obtain payment under this policy. If
individuals that are providing designs or giving advice are employed as sub-

11. contractors care should be taken that they have professional liability policies in the
case of persons who are considered members of the established professions and errors
and omissions policies in other cases.
Products liability
Products liability policies cover loss or damage caused by a defective product. It does
not cover loss or damage to the product itself. Thus if a car is damaged as a result of a
defective wheel the car is covered but not the wheel. The idea behind excluding the
product is so that the insurer does not have to pay recall costs. You will have read in
the papers about various manufacturers recalling their products when a fault is
discovered. It is this cost insurers do not wish to meet. This can be covered under a
products recall policy.
Allied to the products policy is the defective workmanship cover whereby loss or
damage caused by the work carried out by a contractor is covered. Again the damage
but not the defective work is covered.
If it is decided to hire a contractor the principal should ensure that the correct liability
policies are in existence or that the contractor is capable of meeting a liability claim.
In most cases the existence of the correct liability policies are essential. The
contractor should at least have a general liability policy and an employers liability
policy before allowing them to commence work.
PERSONNEL INSURANCE
This type of insurance refers to the personal integrity of the individual and provides
finance in the event of injury or death to the life insured

12. Personal accident
The first type of policy to be considered under this section is personal accident
insurance. This cover is purchased from the non-life market and provides a lump sum
in the event of an accident occurring causing death or injury to the insured. The
amount to be paid depends on the premium, higher amounts cost more. The basic
cover is a lump sum for death. Percentages of the lump sum are then allocated for
various injuries. For example a loss of an eye or loss of a limb may receive 75% of
the death amount. The policy contains a list of injuries which are covered.
In addition to the lump sum payments will be made in the event of the life insured
being unable to work. Weekly payments will be forthcoming in a number of different
instances. The first case is in the event of partial temporary disablement, that is to say
is able to do so form of work but is unable to do his or her own work. Total temporary
disablement occurs when the life insured is unable to work at all for a period of time.
If the insured is fully disabled and unable to work at all for the rest of his or her life or
is unable to work in his original position because of the accident then again either a
lump sum will be paid or weekly payments made. It can also be extended to provide
cover in the event of sickness. In addition medical cover is provided. The medical
expenses following the accident will be met by the policy.
This policy only operates if there is an accident that causes the injury or death.
Causation is sometimes a problem. For example if a driver has a heart attack whilst
driving a vehicle and this leads to an accident the cause of the loss is the heart attack
and therefore the policy will meet any claim.

13. The policy can be taken out by an individual or on behalf of a group. For example
some organisations provide this type of insurance for their employees so that if an
accident occurs a payment may be made.
Critical illness
The life market provides a policy which provides a lump sum in the event of the life
insured contracting a named disease. This is called critical illness and the amount is
payable usually on the diagnosis of a disease which could kill.
Income continuance plan
In the event of an insured becoming ill or having an accident a further type of policy
that provides for this event is an income continuance plan. This may be purchased on
the life market. This provides that, after a waiting period, the insurer will pay the life
insured the difference between the salary that could have been earned if the illness or
accident had not occurred and the amount that is actually earned. If the insured is
unable to work then the whole salary is payable to the insured.
Protection and investment
The life market provides a suite of polices which has two functions, to provide
protection or to act as a means of investment. These two functions are often combined
in the one policy. Protection is provided by means of life cover. This is the payment
of a lump sum on death from whatever cause. The amount of the lump sum depends
on the premium. Life cover is often sold on the basis of how much an individual can
afford on a monthly or annual basis. Despite this an individual should calculate how
much is required on death to provide for those persons left behind plus the cost of the
funeral.

14. Policies can be arranged to provide cash on the death of a partner. The lump sum
would represent the amount required to buy out the deceased partner. Similarly in a
private company life policies can be arranged on directors of the company. This can
be organised that on the death of the director a lump sum may be paid to the other
directors to buy the deceased’s shares.
Life policies are long term, that is to say they are intended to last a number of years
unlike policies sold in the general market which are renewable annually. For this
reason anybody taking out life insurance either for protection or investment purposes
should be in for the long haul.
There are a number of different types of life policy. The first is a term policy. This
provides a lump sum in the event of death during the period of the policy. The cover
only lasts for a set number of years. This is the cheapest type of cover available. Many
companies allow the policy to be extended after the initial period has expired without
further proof of good health. It is mainly suitable for young people because of its
cheapness. The cost of any life policy will vary with age. The younger a life insured
the cheaper the policy as death is less probable at a younger age than when a person
becomes older.
The term policy can be used to provide for payment of a loan on death. For example a
loan is obtained to purchase a house over 25 years. If death occurs prior to full
repayment the estate still owes the amount outstanding. A term policy can be arranged
so that on the death of the life insured the creditor is paid in full by the insurer. The

15. usual type of policy used is called a diminishing term. This is because the sum insured
diminishes together with the loan and premiums are kept as low as possible.
The converse of a term policy is a pure endowment. This provides for a payment of a
lump sum in the event of the insured surviving a pre-arranged period of time. This
could be ten, fifteen or twenty years. This type of policy can be used to provide for a
lump sum at a particular time. For example school fees may be necessary for the
children at a particular age. An endowment can provide for these. In fact insurers will
provide a special school fees policy which will provide you with a lump sum when
required. Technically a pure endowment makes no payment in the event of death.
Therefore if an individual dies during the policy period the insured receives nothing,
he or she is only paid on survival. Nearly all endowment policies provide term cover
so that payment is made both on death and on survival.
The final type of life cover is whole life. This is designed to last a life time so that the
policy remains in existence until death occurs. The policy pays out an agreed sum
insured on death.
The above mentioned policies are the main classes of protection policies. The
investment polices have similar characteristics but additional benefits are provided.
One of these is a with profits policy. This provides that an insured purchasing this
type of policy is entitled to share in the profits of the insurer. The agreed sum insured
is increase by the proportion of profits due to the insured. A with profits policy can be
a term, whole life or endowment.

16. The most common type of policy available is some times called a universal life
policy. This provides for a small amount of life cover with the majority of the
premiums being used to purchase shares. The shares earn returns which are credited to
the policy holder. Usually the insured can purchase a basket of shares, Each basket
will be based on a particular class of shares. A very popular example is the ethical
share. That is shares in companies that do not sell cigarettes or arms or otherwise
breach the ethical concerns of investors. This type of policy is usually an endowment
that matures after a period time. On maturity the insured is paid out the value of his or
her shares. Shares can increase or decrease in value therefore it is often difficult to
ascertain how much is payable at the end of the period. As the period of time before
the policy expires is quite long and economies normally grow in the long term a profit
is usually made if the policy runs its full term. If the policy is cancelled early a loss
usually occurs. During the period of the policy the insured is entitled to change their
basket of shares so that they can try to gain the maximum benefit. By taking out this
type of investment the investor is relying on the expertise of the insurers investment
manager to provide a return.
If an investment policy or endowment is cancelled before the term expires it has
acquired a surrender value. This is usually very much less than its maturity value as
the costs of taking out the policy are usually paid for in the early years. Consequently
it is always a mistake to cancel a life policy that has only been in existence for a short
period of time.
A further product available from life insurers is a pension. This provides for a regular
payment to the insured at a pre-arranged age following a period whereby the insured

17. has paid a regular premium. Basically the pension policy is an endowment for a
period of years until retirement followed by an annuity.
An annuity is the opposite of a life policy. In this case the insured pays for a regular
payment from the insurers either for the rest of the insured’s life or for a pre-arranged
period of time. Pensions can be sold to individuals or to organisations. If an insured is
an employee obtaining a pension from his employers any additional pension will have
to be bought through his or her employers.
PROPERTY INSURANCE
Property and pecuniary policies are sold in the non-life market. They cover moveable
and immovable property against different types of perils. These types of policies
cover a vast range of different losses. The main classes are fire, motor, engineering,
marine, aviation and transit, computer insurance, fidelity guarantee and plate glass.
The fire policy is the most common type of cover provided for property. Although
called a fire policy it extends to cover other types of perils as well. Without going into
full details the policy will cover loss or damage caused by fire, explosion, lightning,
storm, flood and riot, strike and malicious damage. You will have to read the
extensions in the fire policy to be aware of the full extent of the cover but the basic
cover is detailed above. The loss must be caused accidentally by the peril. This means
accidental to the insured so that if somebody sets fire to the premises this is covered
but if the insured starts the fire deliberately insurers will not meet the claim.
Property is divided into moveable and immovable and usually cover is afforded under
different policies or different sections of the same policy. Moveable property includes
the contents of the building such as plant, machinery, equipment and stock.

18. Immovable property is land and buildings. Both classes of property need to be
covered under a fire policy.
This type of policy is limited by the sum insured. This is calculated on the value of the
property at risk. The evaluation will depend whether the policy has been written on a
reinstatement or indemnity basis. In the former case the reinstatement value is the cost
of replacing the property or rebuilding it whilst an indemnity basis is the depreciated
value. The insured must make certain that the sum insured is adequate to cover the
full cost of reinstatement or indemnity in the event of a total loss. This is essential for
this type of policy because it contains the average clause. The effect of this clause is
to reduce any partial loss if the sum insured is insufficient. In the case of the sum
insured being below the value of the property at risk and a partial loss occurs the
average clause applies. This means that the ratio of the sum insured to the value at
risk is applied to the loss. For example if property is valued at £100,000 and is insured
for £75,000 a partial loss of £20,000 is reduced to £15,000 (20,000 multiplied by
75/100). For this reason it is important to ensure that the sum insured is sufficient to
cover a total loss.
The policy may be extended to cover the additional costs of rebuilding any property.
For example architects and engineers fees may have to be met or additional work
carried out because of the requirements of public authorities. These require additional
amounts to be added to the sum insured.
In order to be able to recover under the policy the insured must show insurable
interest in the property at risk at the time of the loss and that the damage was caused

19. by an insured peril. For example in order to show that damage has occurred as a result
of fire there must be ignition. Scorching is insufficient. Loss by storm must be as a
result of excessively high winds.
The second class of policy covers loss or damage caused by theft. This only refers to
moveable property as buildings cannot be stolen. The crime of theft involves the
permanent removal of the goods of another with the intention of permanently
depriving the owner of those goods. This is the cover afforded by this type of policy
except that in order for the policy to pay a claim there must be forcible and violent
entry to or exit from the premises. This means that the premises has to be broken into
by the thief. In order to cover the eventuality of someone locking themselves in the
building after closing time and then breaking out with the goods the requirement of
forcible and violent exit from the buildings is covered.
Average may be applicable in the same way as a fire policy. In the case of stock a
“first loss” policy is often provided. This does not include the average clause although
the loss is limited by the sum insured. The means of calculating the amount of cover
required in this case is to ascertain the amount that can stolen at any one time. Theft
by employees or with their connivance is also excluded from this class of policy. This
is because this type of cover can be obtained under a fidelity guarantee policy. A
small amount of money is covered under a section of the policy extending to cover all
other contents. The remainder should be covered by a money policy.
If cover is required for a private dwelling the contents and buildings are again covered
under separate policies or under separate sections of the same policy. The

20. houseowners policy provides cover for the building. The perils covered include those
on the fire policy as well as additional risk such as breakage of glass, the collapse of
television aerials or masts, escape of oil and items falling from an aircraft. The
condition of average may apply consequently one should ensure that the sum insured
is correct. This should be calculated on the basis of the cost of rebuilding the property,
plus the cost of debris removal and any additional expenses such as architect’s fees.
The value of the land should not be included.
The householders policy covers the contents against similar risks to the houseowners
policy. Again average applies consequently the sum insured must be adequate.
An all risks policy covers specified property against all risks of damage excluding a
number of perils. These are usually losses that would occur in the normal course of
time such as wear and tear, damage caused by mildew and moss. The property must
be specified with each item having a sum insured. This is generally used for
expensive items or, in the case of private insurance, items you would take out of the
house such as jewellery or cameras.
There are a number of other types of insurance designed to cover specific property.
Thus aviation policies can cover aeroplanes and satellites, marine policies covers
ships and cargo. Care should be taken when arranging insurance that all the property
is properly covered.

21. PECUNIARYCOVER
Money
The money policy covers loss of money either stolen from the premises, whilst in
transit or at the home of the owner or manager of the business. This cover is only
offered to businesses. There are various limits set under the policy depending on the
nature of the cover. Loss of money from the safe may be limited to a sum of £500,
money stolen whilst in transit could be limited to £1000 and so on. The limits are
based on the amount of money at risk at any one time. An item can be included on the
policy to automatically increase the limits at particular times of the year when the
organisation is exceptionally busy and collecting a larger sum of money than is
normal. An extension can also be included to provide personal accident cover to
employees dealing with money.
The perils insured against are on an all risks basis but excludes loss caused by
employees or the family of the insured. It also excludes accounting losses.
Fidelity Guarantee
The next type of policy is the fidelity guarantee that covers theft of money or property
by employees. This can include all those employed by the insured or to specified
classes of employees such as accountants, bookkeepers or collectors.
Business Interruption
When an organisation suffers a fire this could prevent them from continuing their
business until the property is reinstated. This leads to a loss of profit resulting from a
fire. The business must have a property policy covering the buildings, machinery and
stock that would normally earn the insured a profit. Before a business interruption

22. policy meets any claim liability must admitted under the requisite property policy.
This business interruption policy sets out the method of calculating of the loss and can
be quite difficult to apply.
There are a number of important points to remember about a business interruption
policy. The first is the necessity to provide an indemnity period. This is the period
during which the insured is involved in recovering form the fire. The policy stipulates
a maximum indemnity period that is usually one year but in some cases this will have
to be extended to cover seasonal increases in earnings or particular difficulty in
reinstating the property. The length of the indemnity period should be based on the
length of time it would take to reinstate all the property and regain the insured’s
market share.
The second point is that the policy prescribes how to calculate loss of profits. A
formula is usually stated in the policy. This is usually based on gross earnings less
variable charges or net earnings plus standing charges. Cover is required to include
standing charges as these type of costs continue even though the business is no longer
running. An example of a standing charge is interest on loans. In addition to loss of
profits additional costs that may be incurred in trying to maintain the business and this
is also covered under the policy. The sum insured must be based on the profits earned
during the indemnity period and average is applicable.
RULES OF RISK CONTROL
Both physical and financial risk control have been discussed during the last two
chapters. In this section the manner in which they are brought together will be
considered. When considering a risk control strategy one should use all the tools

23. available. Internal and external financing should be used together with physical risk
control. Insurance is essential for large losses which an organisation cannot afford to
bear whilst physical risk control reduces the probability of a loss occurring and this
will eventually reduce insurance premiums. In using the tools that are available there
are three basic tenets of risk management which should be taken into account.
The first is not to risk more than the organisation can afford. In the event of any loss
being large enough to threaten the existence of the organisation or the attainment of
its objectives insurance should be purchased to finance this occurrence. The business
should never be put at risk for the wont of an insurance policy. Most small
organisations cannot afford to be without at least fire cover on their premises. If their
buildings are destroyed it is hardly likely that the owner will be able to find enough
cash to rebuild the premises and be without earnings during the period of rebuilding.
Smaller losses may be met by the insured provided that cash can be found to pay
medical bills or replace property.
Organisations may decide to insure the larger losses over and above the amount they
can afford to pay themselves. This could imply the use of deductibles together with
insurance policies. It is difficult to calculate the amount that an organisation can
afford. Each will be different but the normal criteria to consider is the net worth of the
organisation. This is the total value of the enterprise. If this is at risk insurance should
be considered unless financing can be obtained from another source. One would also
consider the enterprise’s cash flow as this will help management decide that amount
that could be paid out of regular earning. The reserves that are easily turned into cash

24. need to be considered as well as the availability of funds form outside the
organisation.
Secondly you should always consider the odds. The person responsible for risk should
always bear in mind the probability of a loss occurring. This involves knowing the
frequency of losses from a particular source. Insurers are able to calculate the
frequency of losses from their exceptionally large database and from this work out a
premium. The more frequent the losses the easier it is for insurers to rely on their
calculations. If losses are low it is difficult to calculate with any certainty the expected
losses. In the case of more frequent losses spread across many organisations the cost
of insurance is higher than when the loss is less frequent. In the first case it may be
cheaper for the organisation to self-insure and control the risk than to purchase
insurance.
The final tenet is not to risk a lot for a little. It is pointless deciding to self insure if the
savings made are small compared with a possible loss. This criteria implies a cost
benefit approach.
The determinants of the risk management tools to be used in a particular situation will
depend on the characteristics of the risk being considered. Each loss producing event
is different and needs to be considered separately. The decision concerning which tool
to be used will depend on it’s appropriateness and it’s comparative cost Generally
speaking risk can be considered in terms of the relative frequency and severity of
possible losses. From this generalisation risk can be classified into four classes which
are depicted in diagram nineteen. The top of the matrix refers to the frequency of loss

25. whilst the side refers to severity. This provides four sections in the matrix, high
severity and frequency in the top left hand corner, low frequency and severity in the
bottom right hand corner. The top right is low frequency and high severity and the
bottom left high frequency and low severity. This matrix can be used as a starting
point for deciding which risk management tool to use. Each box will now be
considered separately to develop a basic decision matrix.
If the probability of loss is high and the severity of loss severe taking into account the
organisation’s financial position, then the activity involving this risk should be
avoided or loss control measures effected in order to reduce the risks to manageable
proportions. This risk will be costly to insure and also the firm will not be able to
retain the loss itself, thus normally this class of risk will be avoided. In the event of an
activity producing frequent losses of low severity provision should be made to retain
the financial consequences of a loss as insurance will be comparatively expensive.
The organisation will be able to reasonably accurately calculate the possible losses
and, as the severity of loss is low firm will be able to meet the losses themselves. This
can be done either out of cash flow or from a fund built up for the purpose. In order to
reduce the possible losses a physical risk control programme should be implemented.
High severity and low frequency losses should be relatively cheap to insure. As
insurers deal with a large number of risks they are able to calculate the future possible
losses with greater accuracy than the individual risk bearer therefore the amount to be
set aside to meet these losses can be calculated with greater precision. The less the
uncertainty the lower the cost of risk. This will be reflected in the insurance premium.
If frequency is low the severity of a possible loss is high and may exceed the amount
a firm can afford to bear. This is a case for purchasing insurance. Finally low

26. frequency and low severity losses can best be dealt with by self insurance. If a loss or
series of losses should occur the cost will be easily absorbed as part of the normal
operating expenses of the organisation and included in the budget.
To take the matter further we can use the idea that frequency and severity can be
measured by using a series of numbers, say one to five, five being high severity and
low severity numbered one.. Numbers two to four can be used to cover risks in
between. Each number can be defined so that five represents complete destruction of
the firm, four a failure to achieve the organisation’s objectives etc. In a similar
manner severity can be measured. This can produce a matrix as shown in diagram
twenty. Using this matrix, decisions can be made on how to handle the identified
risks. Risks that turn up in the bottom right hand corner with a score of twenty or
more need to be avoided. The lesser risks that achieve say a score of more than twelve
but less than say twenty needs to be controlled and also insured. Scores in the top left
hand corner of between one to four need to be retained and controlled. In this way the
whole of the matrix can be used to assist in decision making. This matrix is useful in
that it can be applied in all types of organisations. The numbers one to five can be
defined in such a way as to applicable to each organisation large or small provided
that care is to taken to classify the risks accurately.
Risk control strategies require to be monitored so that decisions can be made as
changes occur. In setting risk control strategies objectives should be set which are
achievable and preferably measurable. The matrix can be used to show how risks
change. As preventative measures are taken they will, hopefully, reduce either the
severity or frequency of losses or both.

27. SUMMARY
In this section a brief overview of internal and external financing has been given.
Several types of insurance were discussed and an overview of the cover afforded
provided. There are many policies on the market and in order to compare them any
discerning buyer should compare the cover offered with the premium charged. One
cannot purchase insurance on price alone as a cheaper policy may not have the cover
required.
As a final section the rules of risk control were considered. This now leaves the final
step in the risk management programme, which is monitoring. This will be considered
in the next chapter.