RISK: Risk can be defined in different ways;

1. The probability of something happening multiplied by the resulting cost or benefit if it does.
2. The probability or threat of quantifiable damage, injury, liability, loss, or any other negative occurrence that is caused
by external or internal vulnerabilities, and that may be avoided through pre-emptive action.
UNCERTAINTY VS RISK:
1. Uncertainty is at the very core of the concept of risk itself.
2. It is uncertainty about the outcome in a given situation.
3. A measurable uncertainty is a risk.
RISK VS PROBABILITY:
1. While some definitions of risk focus only on the probability of an event occurring, more comprehensive definitions
incorporate both the probability of the event occurring and the consequences of the event.
2. Thus, the probability of a severe earthquake may be very small but the consequences are so catastrophic that it
would be categorized as a high-risk event.
RISK VS THREAT:
1. A threat is a low probability event with very large negative consequences, where analysts may be unable to assess
the probability.
2. A risk, on the other hand, is defined to be a higher probability event, where there is enough information to make
assessments of both the probability and the consequences.
ALL OUTCOMES VS NEGATIVE OUTCOMES: Some definitions of risk tend to focus only on the downside
scenarios, whereas others are more expansive and consider all variability as risk. The engineering definition of risk is
defined as the product of the probability of an event occurring, that is viewed as undesirable, and an assessment of the
expected harm from the event occurring.
Risk = Probability of an accident * Consequence in lost money/deaths
1. In contrast, risk in finance is defined in terms of variability of actual returns on an investment around an expected
return, even when those returns represent positive outcomes.
2. Building on the last distinction, we should consider broader definitions of risk that capture both the positive and
negative outcomes
3. Peril
4. Peril is defined as the cause of loss.
5. Thus, if a house burns because of a fire, the peril, or cause of, loss, is the fire. If a car is totally destroyed in an
accident with another motorist, accident (collision) is the peril, or cause of loss. Some common perils that result in
the loss or destruction of property include fire, cyclone, storm, landslide, lightning, earthquakes, theft, and
burglary.
6. We can see this if we think back to the two houses on the river bank and the risk of flood. The risk of flood does
not really make sense, what we mean is the risk of flood damage. Flood is the cause of the loss and the fact that one
of the houses was right on the bank of the river influences the outcome.
7. Flood is the peril and the proximity of the house to the river is the hazard. The peril is the prime cause; it is what
will give rise to the loss. Often it is beyond the control of anyone who may be involved. In this way we can say that
storm, fire, theft, motor accident and explosion are all perils.
HAZARD
1. Factors, which may influence the outcome, are referred to as hazards.
2. These hazards are not themselves the cause of the loss, but they can increase or decrease the effect should a peril
operate.
3. The consideration of hazard is important when an insurance company is deciding whether or not it should insure
some risk and what premium to charge.
4. So a hazard is a condition that creates or increases the chance of loss.
5. There are three major types of hazards: Hazard can be physical or moral or Morale.
6. Physical hazard
7. Physical hazard relates to the physical characteristics of the risk, such as the nature of construction of a building,
security protection at a shop or factory, or the proximity of houses to a riverbank.
8. Therefore a physical hazard is a physical condition that increases the chances of loss.
9. Thus, if a person owns an older building with defective wiring, the defective wiring is a physical hazard that
increases the chance of a fire.
10. Another example of physical hazard is a slippery road after the rains. If a motorist loses control of his car on a
slippery road and collides with another motorist, the slippery road is a physical hazard while collision is the peril,
or cause of loss.
MORAL HAZARD
1. Moral hazard concerns the human aspects which may influence the outcome.
2. Moral hazard is dishonesty or character defects in an individual that increase the chance of loss. For example, a
business firm may be overstocked with inventories because of a severe business recession. If the inventory is
insured, the owner of the firm may deliberately burn the warehouse to collect money from the insurer. In effect,
the unsold inventory has been sold to the insurer by the deliberate loss. A large number of fires are due to arson,
which is a clear example of moral hazard.
3. Moral hazard is present in all forms of insurance, and it is difficult to control. Dishonest insured persons often
rationalise their actions on the grounds that "the insurer has plenty of money". This is incorrect since the company
can pay claims only by collecting premiums from other policy owners. Because of moral hazard, premiums are
higher for all insured, including the honest. Although an individual may believe that it is morally wrong to steal
from a neighbour, he or she often has little hesitation about stealing from an insurer and other policy owners by
either causing a loss or by inflating the size of a claim after a loss occurs
4. This usually refers to the attitude of the insured person. Morale hazard is defined as carelessness or indifference to
a loss because of the existence of insurance. The very presence of insurance causes some insurers to be careless
about protecting their property, and the chance of loss is thereby increased. For example, many motorists know their
cars are insured and, consequently, they are not too concerned about the possibility of loss through theft. Their lack
of concern will often lead them to leave their cars unlocked. The chance of a loss by theft is thereby increased
because of the existence of insurance.
5. Morale hazard should not be confused with moral hazard. Morale hazard refers to an Insured who is simply careless
about protecting his property because the property is insured against loss.
6. Moral hazard is more serious since it involves unethical or immoral behaviour by insurers who seek their own
financial gain at the expense of insurers and other policy owners. Insurers attempt to control both moral and morale
hazards by careful underwriting and by various policy provisions, such as compulsory excess, waiting periods,
exclusions, and exceptions.
7. When used in conjunction with peril and hazard we find that risk means the likelihood that the hazard will indeed
cause the peril to operate and cause the loss. For example, if the hazard is old electrical wiring prone to shorting
and causing sparks, and the peril is fire, then the risk, is the likelihood that the wiring will indeed be a cause of fire.
RISK
1. Is the variability of return from those that are expected.
2. Refers to the possibility that actual outcome of an investment will be different from expected outcome.
3. A Treasury Bill should be a risk free security, while an equity share could be an risky security.
4. The greater the variability, riskier would be the security.
MEASUREMENT OF RISK
1. Risk measures the deviation of return from arithmetic mean.
2. Different ways to measure variability of return.
• Range of Return :Difference between highest and lowest possible rate of return . Based on two extreme values.
• Variance / Standard deviation :The appropriate measure is standard deviation. i.e. Sum of the squared deviation
of each possible rate of return from expected rate of return multiplied by the probability that the rate of return
occurs.
Variance = δ2 = ∑1n p * d2 Standard deviation = δ = √ ∑1n p * d2
BASIC CATEGORIES OF RISK: With regards insurability, there are basically two categories of risks;
1. Speculative or dynamic risk;
2. Pure or static risk
SPECULATIVE OR DYNAMIC RISK: Speculative (dynamic) risk is a situation in which either profit or loss is
possible. Examples of speculative risks are betting on a horse race, investing in stocks/bonds and real estate. In the
business level, in the daily conduct of its affairs, every business establishment faces decisions that entail an element of
risk. The decision to venture into a new market, purchase new equipments, diversify on the existing product line, expand
or contract areas of operations, commit more to advertising, borrow additional capital, etc., carry risks inherent to the
business. The outcome of such speculative risk is either beneficial (profitable) or loss. Speculative risk is uninsurable.
PURE OR STATIC RISK: Pure (static) risk is a situation in which there are only the possibilities of loss or no loss,
as oppose to loss or profit with speculative risk. The only outcome of pure risks are adverse (in a loss) or neutral (with
no loss), never beneficial. Examples of pure risks include premature death, occupational disability, catastrophic medical
expenses, and damage to property due to fire, lightning, or flood.
PURE VS SPECULATIVE RISKS: It is important to distinguish between pure and speculative risks for three reasons.
First, through the use of commercial, personal, and liability insurance policies, insurance companies in the private
sector generally insure only pure risks. Speculative risks are not considered insurable, with some exceptions.
Second, the law of large numbers can be applied more easily to pure risks than to speculative risks. The law of large
numbers is important in insurance because it enables insurers to predict loss figures in advance. It is generally more
difficult to apply the law of large numbers to speculative risks in order to predict future losses. One of the exceptions is
the speculative risk of gambling, where casinos can apply the law of large numbers in a very efficient manner.The law
of large numbers, in probability and statistics, states that as a sample size grows, its mean gets closer to the average
of the whole population. This is due to the sample being more representative of the population as the sample become
larger. Finally, society as a whole may benefit from a speculative risk even though a loss occurs, but it is harmed if a
pure risk is present and a loss occurs. For instance, a computer manufacturer's competitor develops a new technology
to produce faster computer processors more cheaply. As a result, it forces the computer manufacturer into bankruptcy.
Despite the bankruptcy, society as a whole benefits since the competitor's computers work faster and are sold at a lower
price. On the other hand, society would not benefit when most pure risks, such as an earthquake, occur.
OTHER RISKS: Besides insurability, there are other classifications of Risks. Few of them are :
FUNDAMENTAL RISKS: Fundamental risks affect the entire economy or large numbers of people or groups within
the economy. Examples of fundamental risks are high inflation, unemployment, war, and natural disasters such as
earthquakes, hurricanes, tornadoes, and floods.
PARTICULAR RISKS: Particular risks are risks that affect only individuals and not the entire community.
Examples of particular risks are burglary, theft, auto accident, dwelling fires.
With particular risks, only individuals experience losses, and the rest of the community are left unaffected
FUNDAMENTAL VS PARTICULAR RISK: The distinction between a fundamental and a particular risk is
important, since government assistance may be necessary in order to insure fundamental risk. Social insurance,
government insurance programs, and government guarantees and subsidies are used to meet certain fundamental risks
in our country. For example, the risk of unemployment is generally not insurable by private insurance companies but
can be insured publicly by federal or state agencies. In addition, flood insurance is only available through and/or
subsidized by the federal government.
SUBJECTIVE RISK: Subjective risk is defined as uncertainty based on a person's mental condition or state of mind.
For example, assume that an individual is drinking heavily in a bar and attempts to drive home after the bar closes.
The driver may be uncertain whether he or she will arrive home safely without being arrested by the police for drunken
driving. This mental uncertainty is called subjective risk.
OBJECTIVE RISK: Objective risk is defined as the relative variation of actual loss from expected loss.
For example, assume that a fire insurer has 5,000 houses insured over a long period and, on an average, 1 percent, or
50 houses are destroyed by fire each year. However, it would be rare for exactly 50 houses to burn each year and in
some years, as few as 45 houses may burn. Thus, there is a variation of 5 houses from the expected number of 50, or a
variation of 10 percent. This relative variation of actual loss from expected loss is known as objective risk.
STATIC RISKS: Static risks are risks connected with losses caused by the irregular action of nature or by the mistakes
and misdeeds of human beings. Static risks are the same as pure risks and would, by definition, be present in an
unchanging economy.
DYNAMIC RISK: Dynamic risks are risks associated with a changing economy. Important examples of dynamic risks
include the changing tastes of consumers, technological change, new methods of production, and investments in capital
goods that are used to produce new and untried products.
STATIC VS. DYNAMIC RISKS: Static and dynamic risks have several important differences –
1. Most static risks are pure risks, but dynamic risks are always speculative risks where both profit and loss are
possible.
2. Static risks would still be present in an unchanging economy, but dynamic risks are always associated with a
changing economy.
3. Dynamic risks usually affect more individuals and have a wider impact on society than do static risks.
4. Dynamic risks may be beneficial to society but static risks are always harmful.
FINANCIAL RISK: A financial risk is one where the outcome can be measured in monetary terms. This is easy to see
in the case of material damage to property, theft of property or lost business profit following a fire. In cases of personal
injury, it can also be possible to measure financial loss in terms of a court award of damages, or as a result of
negotiations between lawyers and insurers. In any of these cases, the outcome of the risky situation can be measured
financially.
NON-FINANCIAL RISKS: There are other situations where this kind of measurement is not possible. Take the case
of the choice of a new car, or the selection of an item from a restaurant menu. These could be construed as risky
situations, not because the outcome will cause financial loss, but because the outcome could be uncomfortable or
disliked in some other way. We could even go as far as to say that the great social decisions of life are examples of non-
financial risks: the selection of a career, the choice of a marriage partner, having children. There may or may not be
financial implications, but in the main the outcome is not measurable financially but by other, more human, criteria.
However, this is a good point to stress how innovative some insurers are in that they are always looking for ways to
provide new covers, which the customers want. The difficult part is to be innovative and still make a profit.
RISK MANAGEMENT: Risk, in insurance terms, is the possibility of a loss or other adverse event that has the
potential to interfere with an organization’s ability to fulfill its mandate, and for which an insurance claim may be
submitted’.
WHAT IS RISK MANAGEMENT? Risk management ensures that an organization identifies and understands the
risks to which it is exposed. Risk management also guarantees that the organization creates and implements an
effective plan to prevent losses or reduce the impact if a loss occurs.
RISK MANAGEMENT PLAN:
1. A risk management plan includes strategies and techniques for recognizing and confronting these risks.
2. Good risk management doesn’t have to be expensive or time consuming; it may be as uncomplicated as answering
these three questions:
• What can go wrong?
• What will we do, both to prevent the harm from occurring and in response to the harm or loss?
• If something happens, how will we pay for it?
BENEFITS TO MANAGING RISK
1. Risk management provides a clear and structured approach to identifying risks.
2. Having a clear understanding of all risks allows an organization to measure and prioritize them and take the
appropriate actions to reduce losses.
BENEFITS TO MANAGING RISK: Risk management has other benefits for an organization, including:
1. Saving resources: Time, assets, income, property and people are all valuable resources that can be saved if fewer
claims occur.
2. Protecting the reputation and public image of the organization.
3. Preventing or reducing legal liability and increasing the stability of operations.
4. Protecting people from harm.
5. Protecting the environment.
6. Enhancing the ability to prepare for various circumstances.
7. Reducing liabilities.
8. Assisting in clearly defining insurance needs.
An effective risk management practice does not eliminate risks. However, having an effective and operational risk
management practice shows an insurer that your organization is committed to loss reduction or prevention. It makes
your organization a better risk to insure.
ROLE OF INSURANCE IN RISK MANAGEMENT: Insurance is a valuable risk-financing tool. Few organizations
have the reserves or funds necessary to take on the risk themselves and pay the total costs following a loss. Purchasing
insurance, however, is not risk management. A thorough and thoughtful risk management plan is the commitment to
prevent harm. Risk management also addresses many risks that are not insurable, including brand integrity, potential
loss of tax- exempt status for volunteer groups, public goodwill and continuing donor support.
Risk Management Comprises of mainly three steps
1. Risk Analysis
I. Risk Identification
 II. Risk Assessment
2. Risk Planning
3. Risk Controlling
RISK ANALYSIS: Risk Analysis is the process of identifying, analyzing and communicating the major risks. (VEN
DIAGRAM)
Once risks have been identified, they must then be assessed as to their potential severity of impact (generally a negative
impact, such as damage or loss) and to the probability of occurrence. These quantities can be either simple to measure,
in the case of the value of a lost building, or impossible to know for sure in the case of the probability of an unlikely
event occurring. This process is known as risk analysis. In the assessment process it is critical to make the best educated
decisions in order to properly prioritize the implementation of the risk management plan.
RISK PLANNING AND CONTROL: Once risk and identified and analyzed, it is important to plan and adopt a
suitable strategy for controlling the risk. Risk planning and controlling is the stage which comes after the risk analysis
process is over. There are five major methods of handling and controlling risk.
1. Risk avoidance;
2. Risk retention;
3. Risk transfer;
4. Loss control; and
5. Insurance.
RISK AVOIDANCE
1. Risk avoidance is one method of handling risk.
2. For example, you can avoid the risk of being pick pocketed in Metropolitan cities by staying out of them; you can
avoid the risk of divorce by not marrying; a career employee who is frequently transferred can avoid the risk of
selling a house in a depressed real estate market by renting instead of owning; and a business firm can avoid the
risk of being sued for a defective product by not producing the product.
3. Risk Avoidance
4. But as a practical matter, not all risks can or even should be avoided.
5. For example, you can avoid the risk of death or disability in a plane crash by refusing to fly. But is this practical
and desirable?
6. The alternatives are not appealing. You can drive or take a bus or train, all of which take considerable time and
often involve great fatigue.
7. Although the risk of a plane crash is present, the safety record of commercial airlines is excellent, and flying is a
reasonable risk to assume. Or one may wish to avoid the risk of business failure by refusing to go into business for
oneself. But a person may have the necessary skills and capital to be successful in business, and risk avoidance
may not be the best approach for him to follow in this case
RISK RETENTION: Risk retention is a second method of handling risk. An individual or a business firm may retain
all or part of a given risk. Risk retention can be either active or passive.
ACTIVE RISK RETENTION: Active risk retention means that an individual is consciously aware of the risk and
deliberately plans to retain all or part of it. For example, a motorist may wish to retain the risk of a small collision loss
by purchasing an own damage insurance policy with a Rs. 2,000 voluntary excess. A homeowner may retain a small
part of the risk of damage to the house by purchasing a Householders policy with substantial voluntary excess. A
business firm may deliberately retain the risk of petty thefts by employees, shoplifting, or the spoilage of perishable
goods. Or a business firm may use risk retention in a self-insurance program, which is a special application of risk
retention. In these cases, the individual or business firm makes a conscious decision to retain part or all of a given risk.
Active risk retention is used for two major reasons. First, risk retention can save money. Insurance may not be purchased
at all, or it may be purchased with voluntary excesses; either way, there is often a substantial saving in the cost of
insurance. Second, the risk may be deliberately retained because commercial insurance is either unavailable or can be
obtained only by the payment of prohibitive premiums. Some physicians, for example, practice medicine without
professional liability insurance because they perceive the premiums to be inordinately high.
PASSIVE RISK RETENTION: Risk can also be retained passively. Certain risks may be unknowingly retained
because of ignorance, indifference, or lasiness. This is often dangerous if a risk that is retained has the potential for
destroying a person financially. For example, many persons with earned incomes are not insured against the risk of
long- term disability under either an individual or group disability income plan. However, the adverse financial
consequences of a long-term disability generally are more severe than premature death. Thus, people who are not
insured against the risk of long-term disability are using the technique of risk retention in a most dangerous and
inappropriate manner. In summary, risk retention can be an extremely useful technique for handling risk, especially in
a modern corporate risk management program. Risk retention, however, is appropriate primarily for high frequency,
low severity risks where potential losses are relatively small. Except under unusual circumstances, an individual should
not use the technique of risk retention to retain low frequency, high severity risks, such as the risk of catastrophic losses
like earthquake and floods.
RISK TRANSFER: Risk transfer is another technique for handling risk.
Risks can be transferred by several methods, among which are the following:
1. Transfer of risk by contracts;
2. Hedging price risks; and
3. Conversion to Public Limited Company.
TRANSFER OF RISK BY CONTRACTS: Unwanted risks can be transferred by contracts. For example, the risk of
a defective television or stereo set can be transferred to the retailer by purchasing a service contract, which makes the
retailer responsible for all repairs after the warranty expires. The risk of a substantial increase in rent can be transferred
to the landlord by a long-term lease. The risk of a substantial price increase in construction costs can be transferred to
the builder by having a firm price in the contract rather than a cost-plus contract.
HEDGING PRICE RISKS: Hedging price risks is another example of risk transfer. Hedging is a technique for
transferring the risk of unfavorable price fluctuations to a speculator by purchasing and selling futures contracts on an
organized exchange, such as NSE. In recent years, institutional investors have sold stock index futures contracts to
hedge against adverse price declines in the stock market. This technique is often called portfolio insurance. However,
it is not formal insurance but is a risk transfer technique that provides considerable protection against a decline in stock
prices.
CONVERSION TO PUBLIC LIMITED COMPANY: Incorporation is another example of risk transfer. If a firm is
a sole proprietorship, creditors for satisfaction of debts can attach the owner’s personal assets, as well as the assets of
the firm. If a firm incorporates, however, creditors for payment of the firm’s debts cannot attach the personal assets of
the stockholders. In essence, by incorporation, the liability of the stockholders is limited, and the risk of the firm having
insufficient assets to pay business debts is shifted to the creditors.
LOSS CONTROL: Loss control is another important method for handling risk. Loss control consists of certain
activities undertaken to reduce both the frequency and severity of losses. Thus, loss control has two major objectives:
1. Loss prevention.
2. Loss reduction.
LOSS PREVENTION: Loss prevention aims at reducing the probability of loss so that the frequency of losses is
reduced. Several examples of personal loss prevention can be given. Automobile accidents can be reduced if motorists
pass a safe driving course and drive defensively. Dropping out of college can be prevented by intensive study on a
regular basis. The number of heart attacks can be reduced if individuals watch their weight, give up smoking, and follow
good health habits. Loss prevention is also important for business firms. For example, a boiler explosion can be
prevented by periodic inspections by a safety engineer; occupational accidents can be reduced by the elimination of
unsafe working conditions and by strong enforcement of safety rules; and fire can be prevented by forbidding workers
to smoke in an area where highly flammable materials are being used. In short, the goal of loss prevention is to prevent
the loss from occurring.
LOSS REDUCTION: Although stringent loss prevention efforts can reduce the frequency of losses, some losses will
inevitably occur. Thus, the second objective of loss control is to reduce the severity of a loss after it occurs. For example,
a warehouse can install a sprinkler system so that a fire is promptly extinguished, thereby reducing the loss; highly
flammable materials can be stored in a separate area to confine a possible fire to that area; a plant can be constructed
with fire resistant materials to minimize a loss; and fire doors and fire walls can be used to prevent a fire from spreading.
LOSS CONTROL-IDEAL METHOD FOR HANDLING RISK: From the viewpoint of society, loss control is the
ideal method for handling risk. This is true for two reasons. First, the indirect costs of losses may be large, and in some
instances, they can easily exceed the direct costs. For example, a worker may be injured on the job. In addition to being
responsible for the worker’s medical expenses and a certain percentage of earnings (direct costs), the firm may also
incur sizeable indirect costs: a machine may be damaged and must be repaired; the assembly line may have to be shut
down; costs are incurred in training a new worker to replace the injured worker; and a contract may be cancelled
because goods are not shipped on time. By preventing the loss from occurring, both indirect costs and direct costs are
reduced. Second, the social costs of losses must also be considered. For example, assume that the worker in the preceding
example dies from the accident.
Substantial social costs are incurred because of the death. Society is deprived forever of the goods and services that the
deceased worker could have produced. The worker’s family loses its share of the worker’s earnings and may experience
considerable grief and financial insecurity. And the worker may personally experience great pain and suffering before
he or she finally dies. In short, these social costs can be reduced through an effective loss control programmed.
INSURANCE AND REINSURANCE AS A RISK TRANSFER TECHNIQUES: Insurance and reinsurance are both
forms of financial protection which are used to guard against the risk of losses. Losses are guarded against by
transferring the risk to another party through the payment of an insurance premium, as an incentive for bearing the
risk. Insurance and reinsurance are similar in concept even though they are quite different to each other in terms of how
they are used.
INSURANCE: Insurance is a more commonly known concept that describes the act of guarding against risk.
An insured is the party who will seek to obtain an insurance policy while the insurer is the party that shares the risk for
a paid price called an insurance premium. The insured can easily obtain an insurance policy for a number of risks.
The most common types of insurance policy taken out is a vehicle/auto insurance policy as this is mandated by law in
many countries. Other policies include home owner’s insurance, renter’s insurance, medical insurance, life insurance,
liability insurance, etc. The insured who takes out a vehicle insurance will specify the losses against which he wishes
to be insured. This may include repairs to the vehicle in case of an accident, damages to the party who is injured,
payment for a rented vehicle until such time the insured’s vehicle is fixed, etc. The insurance premium paid will depend
upon a number of factors such as the insured’s driving record, driver’s age, any medical complications of the driver,
etc. If the driver has had a reckless driving record he may be charged a higher premium as the probability of loss is
higher. On the other hand, if the driver has had no previous accidents then the premium will be lower since the
probability of loss is relatively low.
REINSURANCE: Re insurance is when an insurance company will guard themselves against the risk of loss.
Reinsurance in simpler terms is the insurance that is taken out by an insurance company. Since insurance companies
provide protection against the risk of loss, insurance is a very risky business, and it is important that an insurance
company has its own protection in place to avoid bankruptcy. Through a reinsurance scheme, an insurance company is
able to bring together or ‘pool’ its insurance policies and then divide up the risk among a number of insurance providers
so that in the event that a large loss occurs this will be divided up throughout a number of firms, thereby saving the
one insurance company from large losses.
INSURANCE VS REINSURANCE: Insurance and reinsurance are similar in concept in that they are both tools that
guard against large losses. Insurance, on the one hand, is a protection for the individual, whereas reinsurance is the
protection taken out by a large insurance firm to ensure that they survive large losses. The premium that is paid by an
individual will be received by the company that provides the insurance whereas the insurance premium paid for
reinsurance will be divided among all the insurance companies in the pool that bear the risk of loss.
 Essentials of Valid Contract
As given by Section 10 of Indian Contract Act, 1872. Not given by Section 10 but Indian Contract Act,
1872 are also considered essential

1. Aggrement
2. Free consent
3. Lawful consideration
4. Competency of the parties
5. Legal object
6. Not expressly declared to bevoid
7. Two parties
8. Intention to create legalrelationship
9. Fulfilment of legal formalities
10. Certainty of meaning
11. Possibility of performance

Valid Contract

According to Section 10, all agreements are contracts if

1. They are made by the free consent of the parties,

2. Competent to contract,

3. For a lawful consideration

4. With a lawful object, and

5. Not hereby expressly declared to be void.”

Valid Contract

Since section 10 is not complete and exhaustive, so there are certain others sections which also contains
requirements for an agreement to be enforceable.

Thus, in order to create a valid contract, the following elements should be present:

– 1. Two Parties

– 2. Parties must intend to create legal obligations:

– 3. Other Formalities to be complied with in certain cases:

– 4. Certainty of meaning:

– 5. Possibility of performance of an agreement:

1. Two Parties:

One cannot contract with himself.

A contract involves at least two parties- one party making the offer and the other party accepting it.

• A contract may be made by natural persons and by other persons having legal existence e.g.
companies, universities etc. It is necessary to remember that identity of the parties be ascertainable.
• Example: To constitute a contract of insurance, there must be two parties- Insurer and Insured.
The insurer and insured must be two different persons, because a person cannot buy his own goods.

• In State of Gujarat vs. Ramanlal S & Co. when on dissolution of a partnership, the assets of the
firm were divided among the partners, the sales tax officer wanted to tax this transaction. It was held
that it was not a sale. The partners being joint owner of those assets cannot be both buyer and seller.

2. Parties must intend to create legal obligations:

• There must be an intention on the part of the parties to create legal relationship between them.
• Social or domestic type of agreements are not enforceable in court of law and hence they do not
result into contracts.

• Example: A husband agreed to pay to his wife certain amount as maintenance every month while he
was abroad. Husband failed to pay the promised amount.

• Wife sued him for the recovery of the amount. Here in this case wife could not recover as it was a
social agreement and the parties did not intend to create any legal relations. (Balfour v. Balfour)

3. Other Formalities to be complied with incertain cases:

• In case of certain contracts, the contracts must be in writing,
– e.g. Contract of Insurance is not valid except as a written contract.
• Further, in case of certain contracts, registration of contract under the laws which is in force at the
time, is essential for it to be valid, e.g. in the case of immovable property.
4. Certainty of meaning:
• The agreement must be certain and not vague or indefinite.
• Example: A agrees to insure his vehicle with B Insurance company.
• There is nothing certain in order to showwhich vehicle was intended for.

5. Possibility of performance of an agreement:

• The terms of agreement should be capable of performance.

• An agreement to do an act impossible in itself cannot be enforced.

• Example: A agrees with B to get his car repaired by magic. The agreement cannot be
enforced as it is not possible to be performed.
 Essential elements of a valid

Essential Elements of a Valid Contract

1. Proper offer and proper acceptance.

There must be an agreement based on a lawful offer made by person to another and lawful acceptance
of that offer made by the latter.

Section 3 to 9 of the contract act, 1872 lay down the rules for making valid acceptance

According to Section 2(e) of the Indian Contract Act, 1872, “Every promise and every set of promises,
forming consideration for each other, is an agreement” and according to Section 2(b) “A proposal when
accepted, becomes a promise”. An agreement is an outcome of offer and acceptance.

2. Free Consent:

Two or more persons are said to consent when they agree upon the same thing in the same sense.

This can also be understood as identity of minds in understanding the terms viz consensus ad idem.

Further such a consent must be free. Consent would be considered as free consent if it is not caused by
coercion, undue influence, fraud or, misrepresentation or mistake. When consent to an agreement is
caused by coercion, undue influence, fraud or misrepresentation, the agreement is a contract voidable
at the option of the party whose consent was so caused.

When consent is vitiated by mistake, the contract becomes void.

Example: A threatened to not to sanction his loan application of B if he (B) does not get himself insured
with him and B agreed to it. Here the agreement is entered into under coercion and hence voidable at
the option of B.

3. Competent to contract or capacity:

In order to make a valid contract the parties to it must be competent to be contracted.

According to section 11 of the Contract Act, a person is considered to be competent to contract if he
satisfies the following criterion:

– The person has reached the age of maturity.

– The person is of sound mind.

– The person is not disqualified from contracting by any law. Such persons are: an alien enemy,
foreign sovereigns, convicts etc. They are disqualified unless they full certain formalities required by
law.

4. Consideration

• It is referred to as ‘quid pro quo’ i.e. ‘something in return’.

An agreement to form a valid contract should be supported by consideration.

Consideration means “something in return”. It can be cash, kind, an act or abstinence.

It can be past, present or future.

• A valuable consideration in the sense of law may consist either in some right, interest, profit,
or benefit accruing to one party, or some forbearance, detriment, loss or responsibility given, suffered
or undertaken by the other.

• Example:- A agrees to sell an insurance plan to B for Rs. 10,000, B’s promise to pay Rs. 10,000
is the consideration for A’s promise to sell his insurance plan and A’s promise to sell the insurance is
the consideration for B’s promise to pay Rs. 10,000.

5. Lawful consideration and Object : Consideration should be real and lawful.

Section 23 states that consideration or object is not lawful if it is prohibited by law, or it is such as
would defeat the provisions of law, if it is fraudulent or involves injury to the person or property of
another or court regards it as immoral or opposed to public policy.

Example : ‘A’ promises to drop prosecution instituted against ‘B’ for robbery of his car and ‘B’
promises to restore the value of the car taken. The agreement is void, as its object is unlawful.

6. Not expressly declared to be void:

• The agreement entered into must not be which the law declares to be either illegal or void.

• An illegal agreement is an agreement expressly or impliedly prohibited by law.

• A void agreement is one without any legal effects.

Example: Threat to commit murder or making/publishing defamatory statements or entering into

agreements which are opposed to public policy are illegal in nature.

Similarly any agreement in restraint of trade, marriage, legal proceedings, etc. are classic examples of
void agreements.

Understanding Principles of Insurance

The business of insurance aims to protect the economic value of assets or life of a person.
Through a contract of insurance the insurer agrees to make good any loss on the insured property or
loss of life (as the case may be) that may occur in course of time in consideration for a small premium
to be paid by the insured.

Apart from the above essentials of a valid contract, insurance contracts are subject to additional
principles.

These are:

1. Principle of Utmost good faith

2. Principle of Insurable interest

3. Principle of Indemnity

4. Principle of Subrogation

5. Principle of Contribution

6. Principle of Proximate cause

7. Principle of Loss of Minimization