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CHAPTER 2 Risk Management

Risk Management

Ways to Deal with Risk
Life is risky, and insurance is not the only way to deal with risk. There are five basic ways to 
deal with risk. 

Sharing – pooling the risk with a variety of other people who share the same risk

Transfer – such as buying insurance

Avoidance – removing the possible cause of a loss

Retention – keeping all or part of the financial risk of loss

Reduction – reducing the chance of loss with safety techniques

In order for an insurance company to be able to accept premiums and pool money to pay for 
particular types of losses, the insurance company has to have a large enough number of similar risks. 



This is called the law of large numbers. This law makes it possible to statistically 
predict the probability of loss within the group, and therefore how much premium to charge. 
Ideally, insurable risk must meet certain criteria.

• Losses to be insured must be definable

• Losses must be accidental

• Losses must be large enough to cause a hardship to the insured

• There must be a homogeneous group of risks large enough to make losses predictable 
(Law of large numbers)

• Losses must not be catastrophic to many members of the group at the same time

• The insurance company must be able to determine a reasonable cost for the insurance

• The insurance company must be able to calculate the chance of loss

In addition, insurance can only pay money to people who have an insurable interest in the 
property lost. 

Insurable interest is any interest a person has in a possible subject of 
insurance, such as a car or home, of such a nature that if that property is damaged or lost, that 
person will suffer a real financial loss. For property and casualty insurance, the insurable interest 
must exist at the time the loss occurs. 
Also, an insurance company must guard against the tendency of poorer than average risks to buy 
and maintain insurance. Adverse selection occurs when insureds select only those coverages 
that are most likely to have losses.

Legal Elements of Insurance

Elements of a Contract
As we’ve said, an insurance policy is a legally binding contract between two parties. One party 
is the insured person or organization and the other is the insurance company. An insurance 
policy describes the rights and obligations of both parties.

It is important to understand the following legal terms that relate to insurance.
Agreement. When an offer made by one party has been accepted by the other, with 
mutual understanding by both, an agreement exists. 

Legal Purpose. For a contract to be valid it must not be for an illegal subject or 
contrary to public policy. Insurance does not cover intentional loss or criminal acts for 
this reason. 

Tax of values on which a contract is based. In insurance, 
the consideration offered by the insured is usually the premium and the statements 
contained in the application. The consideration offered by the insurer is the promise to 
pay in accordance with the terms of the contract. 


This is one of the elements that must be present in order to have a legal 
contract. It relates to the fitness or ability of either of the parties to the contract. An 
example of incompetency would be a mental incapacity.

Legal Contract Principles Important to Insurance
Aleatory Contract. A contract in which the number of dollars to be given up by each party is not equal. 

Insurance contracts are of this type, as the policyholder pays a premium and may 
collect nothing from the insurer or may collect a great deal more than the amount of the 
premium if a loss occurs. 
Contract of Adhesion. 

This is a characteristic of a unilateral contract which is offered on a 
"take it or leave it" basis. Most insurance policies are contracts of "adhesion," because the terms 
are drawn up by the insurer and the insured simply "adheres." For this reason ambiguous 
provisions are often interpreted by courts in favor of the insured. 
Conditional Contract. 

There are conditions which must be met by both parties before the 
contract is legally enforceable. In an insurance contract conditions for both the insurer and 
insured are spelled out in the policy form.

Personal. A personal contract is between two specific parties and generally cannot be 
transferred to other parties, unless under conditions specified in the contract. Insurance policies 
are usually not transferable unless the insurer agrees to do so.

Unilateral Contract. A contract such as an insurance policy in which only one party to the 
contract, the insurer, makes any enforceable promise. The insured does not make a promise but 
pays a premium, which constitutes the insured's part of the consideration. 

Utmost Good Faith. Acting in fairness and equity with a sincere belief that the act is not 
unlawful or harmful to others. The insurance contract requires that each party is entitled to rely 
upon the representations of the other without attempts to conceal or deceive
Other Legal Principles Important in Insurance Law

Concealment. The failure to disclose a material fact.

Materiality. In insurance, it refers to a fact which is so important that the disclosure of it 
would change the decision of an insurance company, either with respect to writing coverage, 
settling a loss, or determining a premium. Usually, the misrepresentation of a material fact 
void a policy. 

Fraud. Deceipt, trickery or misrepresentation with the intent to induce another to part with 
something of value or surrender a legal right.
Waiver. The act of giving up or surrendering a right or privilege that is known to exist. In 
property and liability fields, it may be effected by an agent, adjuster, company, employee, or 
company official, and it can be done either orally or in writing. 

The legal principle whereby a person loses the right to deny that a certain condition 
exists by virtue of having acted in such a way as to persuade others that the condition does exist. 
For example, if an insurer allows an insured to violate one of the conditions of the policy, the 
insurer cannot at a later date void the policy because the condition was violated. insurer has 
acted in such a way as to lead the insured to believe that the violation did not void the coverage.

Warranty. A statement made on an application for most kinds of insurance that is warranted 
as true in all respects. 

If untrue in any respect, even though the untruth was not known to the 
applicant, the contract may be voided without regard to the materiality of the statement. By 
contrast, statements in life and health applications are not warranties except in cases of fraud, 
and the trend in more recent court decisions in other lines has tended to modify the doctrine of 
warranty to an application only when the statement is material to a risk or the circumstances of a 

A statement made on an application for insurance that the applicant 
represents as correct to the best of his or her knowledge and belief. 
Misrepresentation. The use of oral or written statements that do not truly reflect the facts 
either by an insured on an application for insurance or by an insurer concerning the terms or 
benefits of an insurance policy.

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