RISK MANAGEMENT & INSURANCE

Topic 10 – RISK MANAGEMENT & INSURANCE
Solutions
Question 1:
What is the difference between pure and speculative risk? What are the main categories
of pure risk?
Pure risk is where is there is the possibility of loss or no loss. For example a house might
burn down or it might not. Pure risk is generally an insurable risk.
Speculative risk is where there is a chance of a loss or gain. For example investing in shares
might produce a loss or a gain. Speculative risk is a risk voluntarily undertaken by an
individual as opposed to pure risk. Speculative risk is generally not an insurable risk.
Pure risk can be categorised into personal, property and liability risk.
Question 2
(a) Potential risks to assets and income
1. Property
• Home: The risks are damages, destruction and loss from fire, water, lighting, impact
(eg. tree falling) and forced entry (from burglars). A home insurance covering up to
the market value is required.
• Home content: – same perils as above with the additional risk of the contents being
stolen.
• Equipment for office practice: – same as home content
• Cars: – the risk of collision damage, fire and theft.
2. Personal
Personal risks may arise from:
• Death
• Disability / injury
• Sickness/illness
3. Liability:
• Public liability
• Incorrect advice given to clients
(b) Life insurance coverage
There are 3 main types of life insurance policies:
• -term life
• -endowment life
• -whole of life
Because of their young ages, term life will be the cheapest and probably the most effective
for their needs. Unless they were keen to acquire a life policy with a savings component,
would advise term life
(c) Protect against litigation
• properly explain the risks to client
• detailed notes of recommendations in client file
• properly document the recommended coverage within the financial plan
• know your client and know your products
• take out professional indemnity insurance
Question 3
(i)
Owing the plane for personal use will expose John to pure risk, as the outcome can be loss or
no loss. He has some speculative risk with the charter trip. The pure risk he faces are:

i. ii. iii. iv.

Death or injury to himself (personal risk) Death or injury to passengers (public liability) Damage or loss of the plane (property risk) Loss of income from the charter business as a result of personal and property risk (consequential/commercial risk)

Each of the above risk can be covered as follows:
• Personal: life, trauma, income protection insurance
• Property: property insurance, avoiding / restricting charter business
• Public liability: public liability insurance, avoiding / restricting charter business
• Loss of income / incurring expenses: business insurances – business overheads, loss
of profits.
(ii)
In the event of under-insurance, the insurer is unlikely to pay for the full costs of repair /
replacement. Co-insurance provisions are likely to be invoked by the insurer if sum insured is
not at least 80% of replacement value. The Insurer will make a proportionate adjustment to
the payout to compensate for the under-insurance.
Question 4
(a)
Life insurance provides a lump sum in when a person has died.
TPD cover provides a lump sum amount in the event of the insured being totally disabled.
Trauma policy provides a lump sum also, this time providing for the medical and related
costs that may arise from a traumatic condition.
Income protection insurance provides an income stream in the event of illness or accident that
prevents you from working.
(b)
At their age, insurances would be very costly. They would also need to consider whether such
insurances were needed at their age. Consider the following: level of debt outstanding,
dependants, health, amount in superannuation, holding of investments etc.
Depending on the type of business they are running, it may be possible to purchase a business
insurance policy, which may include death and TPD at a reasonable cost. There would also
likely be some life, income protection and total and permanent disability insurance coverage
under their superannuation policies.
Question 5
Nina – income protection insurance. Consider impact of workers compensation insurance
Steven – probably not required: would normally rely upon sick leave and annual leave for the
short period
Alfred – probably not required: would be covered by Workers Compensation Insurance / sick
leave / annual leave for the short period
Linda – trauma insurance, life insurance and income protection insurance
Peter – income protection insurance and total and permanent disability insurance
Question 6
(a) Cost of paying for public liability
(b) Cost of property and consequential damage (loss of business)
(c) Income loss from premature death/debts outstanding/education costs/child-minding
(d) Loss of potential income and cost of medical treatment
(e) The cost of repair or replacement of property
Question 7
(a) The risks can be classified as:
1. Property
Home: – The risks are damages, destruction and loss from fire, water, lighting, impact (eg.
tree falling) and forced entry (from burglars). A home insurance covering up to the market
value is required.
Home content: – same perils as above with the additional risk of the contents being stolen.
Equipment for practice: – same as home content
Cars : – the risk of collision damage, fire and theft.
2. Personal
Personal risks may arise from:
Death
Disability / injury
Sickness/illness
3. Liability:
Public liability
Incorrect advice given to clients
(b)
1. Property
Home and contents insurance will provide the protection from financial loss as a result of the
perils described. A comprehensive motor vehicle insurance will cover for item.
2. Personal
Life insurance, trauma, and income protection insurance provides coverage for personal risks
for Mr. Client. Mrs. Client should also be protected for death and trauma. Income protection
would not be possible because she is not working.
3. Liability
Public liability protection is normally provided through home and contents policy.
Professional indemnity insurance will protect Mr Client against the liability risk of his
profession.
(c) In determining the amount of insurance to purchase, the following three (3) step process
should be considered:
1. Death expenses: funeral and burial expense, medical and probate cost
2. Debt cancellation: liability such as home mortgage, credit cards, income and other taxes &
child minding.
3. Income replacement: the amount should cover for living expenses for spouse and children,
and future expenses such as education, retirement of spouse and etc.
1st Death Needs – $4,000 consisting of funeral and medical expenses
2nd Death Needs – $580,818
• Home Mortgage – $200,000
• Credit cards – $3,000
• Loan on investment property – $240,000
• Personal loan – $20,000
• Child minding and other associated costs – $117,818 (see below)
–Calculation of PV of annual care of children:
Need to determine the present value of an ordinary annuity of $12,000 p.a. for 20 years at a
discount factor of 8% = $117,818
3rd Death Needs – $550,907
Educational fund – $60,000
Living Expenses – $490,907 (see below for calculation)
Calculation of PV of shortfall of funds required for living expenses:
Need to determine the present value of an ordinary annuity of $50,000 p.a. for 20 years at a
discount factor of 8% = $490,907
Adding the above
• 1st Death Needs – $4,000
• 2nd Death Needs – $580,818
• 3rd Death Needs – $550,907
Subtotal $1,135,725
Cash available upon Mr Client’s death:
• Bank account $40,000
• Managed fund $150,000
• Superannuation $250,000
• Investment property $290,000 *
• Equipment of practice $18,000 *
Subtotal $748,000
* Assumption made they would be disposed of upon death of Mr Client.
Amount of additional insurance required on Mr Client’s life is:
$1,135,725 – $748,000 = $387,725
Calculation of PV of annual care of children:
Present value compounding interest of an annuity formula:
Calculation of PV of shortfall of funds required for living expenses:
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