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COURSE OVERVIEW
Introduction
This course introduce the learners to the concepts of risk, risk management and
insurances, and attempts to delve into various aspects of insurance and risk management,
with a view to help the learner(s) have a greater understanding of the risk surrounding an
entity and several ways to manage such risks with more emphasis on risk transfer
strategy, specifically insurance as the core strategy.
Learning Outcomes
By the end of this unit the learner should be able to:
i) Explain the concept of risk, risk management and Insurance and their application
in business.
ii) Critically appraise the factors risk managers need to take into account in order to
prevent or restrict the extent of loss
iii) Analyze and evaluate the insurance concepts and frameworks available to the risk
manager in dealing with various risks.
TABLE OF CONTENTS
Lecture 1: the concept of Risk
1.1 Introduction
1.2 Lecture Outline
1.2.1 Introduction
1.2.2 Meaning of risk
1.2.3 Perils and Hazards
1.2.4 Classification of risk
1.3 Lecture Objectives
Reflection questions, activity, exercises/quizzes
1.4 End of lecture activities (self tests)
1.5 Summary
1.6 Suggestion for further reading
1.2.2 3)
Meaning
to of risk
1.2.3 Perils and Hazards
1.2.4 Classification of risk.
Introduction
The word risk is certainly used frequently in everyday conversation and seems to be well
understood. Risk implies some form of uncertainty about an outcome in a given situation.
An event might occur and if it does, the outcome is not favourable to us. Risk can be
contrasted with the word chance which implies some doubt about the outcome in a given
situation; the difference is that the outcome may also be favourable e.g. risk of an
accident, chance of winning a bet etc.
However in common business conversations the word risk is used to mean different
things:
i.
ii.
Risk as likelihood e.g. the risk of something happening, leaving keys in a car results
in high risk etc.
Risk as the object e.g. factory, plane, machine or ship might be referred to as the
iii.
risk.
Risk as verb It is not only used as a noun but also as a verb e.g. risk of crossing the
iv.
road.
All the above illustrate how the use of the word goes far beyond its technical meaning.
Meaning of risk
Various scholars have advanced different definitions of risk as follows:i.
ii.
iii.
Risk is unpredictability the tendency that actual results may differ from
predicted results.
iv.
v.
Rather than try to ascertain the best definition of risk, the underlying commonality in all
the definitions should be of interest and they include;
i) Uncertainty
Uncertainty implies doubt about the future based on a lack of knowledge or imperfection
in knowledge. If we always knew what was going to happen, there would be no risk.
ii) Levels of Risk
Risk is thus a combination of the likelihood of an event and the severity of damage
should the event occur. If an event occurs a great deal, then our knowledge about
the future begins to increase and an element of certainty begins to creep in e.g.
shoplifting, combining frequency and severity we find two relationships
iii) Peril and Hazard (Cause(s)
Peril is the prime cause, it is what will give rise to the loss e.g. storm, fire etc. Factors
which may influence the outcome are referred to as hazards. Hazards are not themselves
10
the cause of the loss but they can increase or decrease the effect should a peril operate.
Hazard can be physical or moral. Physical hazard relates to the physical characteristics of
risk e.g. grass thatched house while moral hazard concerns human aspects which may
influence the outcome. It usually relates to the attitude of the person e.g. conman.
Classification of Risk
Risks could be classified as follows:
i.
Financial and non-financial risks- a financial risk is one where the outcome can be
measured in monetary terms and where it is possible to place some value on the
outcome. Measurement in personal injury may be done by a court when damages are
awarded or negotiation among lawyers and insurers. There are cases where
measurement is not possible e.g. choice of a new car, selection from a restaurant
menu, selection of a career, choice of a marriage partner etc. all these are nonfinancial risks. Generally in business we are concerned with financial risks.
ii.
Pure and speculative risks- pure risks involve a loss or at best a break even situation.
The outcome can only be unfavourable to us or leave us in the same position as we
enjoyed before the event occurred e.g. motor accident, fire, theft etc. speculative risk
is where there is a chance of gain e.g. investing money in shares (the investment may
result in a loss or possibly a break-even but the reason it was made was the prospect
of gain), pricing of products, marketing decisions, decisions on diversification,
expansion or acquisition, providing credit to customers among others. Generally pure
risks are normally insurable while speculative risks are generally not insurable though
the trend is changing and hence dynamic.
iii.
Fundamental and particular risks- fundamental risks are those which arise from
causes outside the control of any one individual or even a group of individuals. In
addition the effect of fundamental risks is felt by large numbers of people e.g.
earthquakes, floods, famine, volcanoes, war etc. Particular risks are much more
personal both in their cause and effect e.g. fire, theft etc. Al these risks arise from
individual causes and affect individuals in their consequences. Risks however change
classification, mostly from particular to fundamental e.g. unemployment. In the main,
particular risks are insurable while fundamental risks are not.
11
1.5 Activities
1. Enumerate the various types of hazards that exist in the Kenyan business
environment.
2. Provide a theoretical definition of risk.
3. Distinguish between frequency and severity of risk in risk measurement?
1.6 Self Test Questions
1.6 Summary
12
2.3.3
The
6) to
risk schooling
2.3.4 Sector response; Personal, Organizational, National response to risk
2.3.5 The cost and Burden of risk.
It wont happen to me syndrome
For a long time, general management suffered from it wont happen to me syndrome
and many would go through the school system without sensitization on risk. The trend
has been changing however with more positive attitude to risk developing and today we
have individuals designated as risk managers. At personal level individuals could be risk
takers-jumping on any bandwagon, risk neutral- fence seaters and risk averse-those
avoiding it at all costs.
The risk schooling
Organizations undergo tremendous changes within a very short span of time, in the
process a lot of things such as bankruptcy, job losses, and restructuring and hostile take-
13
over occur. In view of the rapidly changing business environment, managers must be
schooled in the perspectives of such changes which denote that the business environment
is very fluid and risky. The orientation of managers should be to expect the unimaginable
to happen. The most successful companies of yester years like unilever and Eveready
batteries are todays underdogs, while the yesterdays underdogs are todays most
successful companies to envy and reckon with.
Sector response; Personal, Organizational, National response to risk
At personal level, there are situation that require that we adequately respond, for instance
in this current times where effects of globalization may adversely affect a firm that is not
proactive in its risk management plans, an individual may find himself retrenched at a
very young age, due to economic pressures an individual may also not reach their
economic potential may be because they were unable to respond appropriately to their
situations and risks that if they had overcame they would be in a better position. For
example a young graduate joining the labor market in the current times, the mantra could
be exit the organization mentally the very day you join it. The implication of this is that
prepare for your smooth exit in the organization so as to have less acrimonious separation
with the employer in your retirement. Also have in mind that there are no permanent jobs
these days, even when they call it permanent, because your organization is not permanent
as well, it all depend on how it responds to its risks.
At the organizational level, response to risk is very critical to remain afloat, innovation,
creativity and proactiveness is the hallmark of surviving the dynamisms of current
business environment. It is not a guarantee that you will remain a giant in the business
environment, your position as a market leader can only be assured if you are innovative,
creative and proactive. Some of the dominant market players in the corporate scene today
like Equity Bank and Safaricom were not their say 10-15 years ago and may not be sure
if they will be there in the coming 10-15 years ahead if they do not innovate and manage
the risks facing them proactively. Hence managers of such organizations have a duty to
constantly respond to risks surrounding their business operations to be guaranteed of their
continued existence and performance.
14
National response to risk calls for a thorough scrutiny of the policies that drive the
national economy. Right from say education system and how that education system
guarantees the individuals a way of life or not, risks begin to emerge. For example there
is need to have a policy that guarantees all the primary students graduating from class
eight a place in a secondary school, a vocational training centre or a polytechnic and or at
worst be absorbed for a short course at the National youth service then be deployed in the
informal sector through a government framework such as youth enterprise fund. By
picking a few to join secondary school and leaving the others to sought out themselves
because they did not meet qualify grades or points, the country creates a security disaster
in the waiting. These young minds who still needs to be transformed find themselves
helpless and hapless at a critical time in their developmental stage, they resort to join any
gang that may give them hope and a listening hear, when all other doors closes at such an
early age, anything can do, even if joining a criminal gang they will gladly join it without
a second thought. Hence policy markers need to know that failure to adequately respond
to national risk, like in the example of education above creates a big burden to the tax
payers. The innocent children are at later stage branded very dangerous criminals, and
more resources to put up police stations, recruit police officers and infrastructure to fight
crime are expensed on innocent citizen who only needed right policy intervention at the
right time in their life and would have changed the course of their lives and relieved the
tax payers the wastages it has to incur to protect themselves from such innocent students
now turned rogue criminals who kill and maim at will, while the government continue to
waste the scarce resources to react to such situations, the best they could have done is to
proactively ensure a smooth transition of all the student across the various levels of
education and link them to the various sectors of the economy where there relevant
manpower is needed.
The cost and Burden of risk
The risk surrounding potential losses creates significant economic burdens for businesses,
governments and individuals. Millions of shillings are spent every year on strategies for
15
financing potential losses, especially when losses are not planned for in advance, items
may cost even more.
Businesses may be reluctant to engage in projects that are otherwise strategically
attractive if the potential losses appear to be unmanageable, thereby depriving the society
of services judged to be too important.
The following are the cost and burden of risk to a society;
1. The greatest burden of risk is that some losses will actually occur e.g. floods will
destroy houses hence loss to the house owner. That is why individuals attempt to
avoid risk or minimize its impact.
2. Risk also has additional detriment apart from causing loss. The uncertainty as to
whether loss will occur makes individuals establish risk minimization measures
such as taking insurance cover or accumulating funds to meet such losses should
they occur. The accumulated funds are reserved in highly liquid investments so
that they are readily available to set off the losses. Such investments yield very
low returns and hence investment waste due to low return investments.
3. Without insurance as a risk minimization measure, each property will be required
to accumulate their own individual funds so that the aggregate of individual funds
will exceed the insurance funds hence another wasteful investments.
4. Existence of risk may also have different effects on economic growth and capital
accumulation which determines economic progress. Investors incur risks of a
new venture only if the returns from the venture are high enough to compensate
both static and dynamic risks.
borrowing capital expensive to new venture owners. The venture owners must in
turn charge higher prices to consumers; the economy will therefore have the cost
of living increased in order to bear the burden of risk.
5. The uncertainty caused by risks produces feelings of frustrations and unrest,
particularly in the case of pure risk more than others. Speculative risks are
attractive to many individuals because it offers a chance to make gains or profits.
16
2.3 Activities
1. Provide an outline of how you will respond to the risks you face as an
individual.
2.6.Analyze the Agricultural sector response to various risks facing them
7.
3.8.Pick an organization you are familiar with its operations and document how
they respond to risk facing them.
9.
2.5 Summary
In this10.lecture you have learnt that:
11.
1.723.
Suggestion for further reading
24.
Dickson,
G.C. (1997) Risk Management the Chartered Insurance Institute
25.
26.
Vaughan, E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th
27.
28. Wiley
Edition,
Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th Edition,
Prentice Hall
17
ii)
iii)
3.3.3 8)
Principles
of risk management
to
3.3.4 9)
Risktomanagement
policy
18
of risk, risk assessment, developing strategies to manage it, and mitigation of risk using
managerial resources. Risk Management involves:
i) Identifying and measuring potential risk.
ii) Develop and execute a plan to manage these potential losses.
iii) Continuous review of the plan after it has been put into operation.
Nature of Risk Management
Buying of insurance was the traditional role of risk management and was the key function
of risk managers. A part from purchasing insurance, other functions of a risk manager
are:
(i)
(ii)
(iii)
Review contracts and documents for risk prevention and management purpose
(iv)
(v)
To ensure compliance with laws and government regulation. This will involve
monitoring changes in the laws and implementation requirements from
various stake holders
(vi)
(vii)
(viii)
Currency hedging i.e. protects the organization from adverse effects arising
due to fluctuations of currency. The risk manager can recommend the
purchase of a stable currency or money equivalent in an effort to protect the
organization.
(ix)
(x)
19
ii.
iii.
20
iv.
Enhances
communication
between
production,
sales,
marketing
and
Administration department.
v.
vi.
It encourages organization to take activities that have a high level of risk because risk can
be identified and are well managed, so that the exposure to risk is both understood and
acceptable.
vii.
It ensures survival and growth of the business even after making losses.
viii.
ix.
x.
xi.
xii.
Well prepared risk management policy makes the company socially responsible towards
its environment, employees, suppliers, customers, and the communities in which it
Operates
xiii.
Well prepared risk management policy assures the firm of stability of earnings.
29.
3.4 Activities
30.
31.
32.
executes in a manProvide an outline of how you will respond to the risks you
face as an individual.
2. Analyze the Agricultural sector response to various risks facing them
3. Pick an organization you are familiar with its operations and document how they respond
to risk facing them.
21
1. In some sense, a risk manager must be a jack of all trades, because of the breadth of
his or her activities. Identify several areas in which a risk manager should be
knowledgeable, and explain why this would be useful. Bring out the background that a
risk manager should have to undertake his roles effectively.
2. Global competition is a reality many businesses cannot ignore. In light of this, the
business leaders have a justification to develop plans and strategy to manage these
global as well as local risks. Discuss the benefit of such a move.
33.
3.5 Summary
34.
In this 35.
lecture you have learnt that:
i) That36.
apart from buying insurance, risk managers executes several other functions in
37.
38.
the organization.
39.
ii) The40.
principles of risk management are applicable to service, manufacturing, public or
private41.
sectors of the economy.
42.
iii) That an organization must have a risk management policy which has numerous
benefits to the organization.
43.
1.7 Suggestion
for further reading
44.
Dickson,
45.G.C. (1997) Risk Management the Chartered Insurance Institute
46.
Vaughan,
E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th Edition,
47.
Wiley 48.
Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th Edition,
Prentice Hall
22
10) to
11) to
Rules12)
in Risk
to Management Risk Control
This is a strategy that focuses on minimizing the risk of loss to which an organization is
exposed. Techniques used are avoidance and risk reduction.
23
i)Risk avoidance this occurs when decisions are made that prevent risks from coming
into existence in the first place, example an organization can avoid risks by deciding not
to engage in activities which it considers high risk e.g manufacture of explosives or
poisonous substances. Risk avoidance should only be used where exposure to risk is
catastrophic and the risk cannot be transferred or reduced. Risk avoidance is a negative
approach for managing risks because the advancement of personal and economic
progress requires risk taking and if risk avoidance is used extensively the organization is
unlikely to achieve its primary objectives.
ii)Risk reduction- Risk reduction consists of all techniques that are designed to reduce
the likelihood of loss or the potential severity (impact) of such losses should they occur.
Efforts to reduce the likelihood of loss are referred to as loss prevention, while efforts to
reduce the severity of loss are referred to as loss control.
Consideration of risk reduction
i.
Reduction of like hood of loss can be done through putting up signs such as no
smoking sign on a petrol station or installing protective devices around machinery to
reduce the number of injuries to employees. This will reduce frequency of loss or
their probability.
ii.
iii.
iv.
v.
Timing of risk reduction measures Such measures may be designed for prior to the
loss event, during the loss event and after the loss events. Measures prior to loss
include:
24
RISK FINANCING
These concentrate on availing the funds to meet the losses arising from risks that remain after the
application of risk control technique of measure. Risk financing include:
Risk retention
Risk acceptance
The amount set aside may be more or less at the time when the risk occurs.
(ii)
A loss may occur before the fund is sufficient to meet the risk
(iii)
There are chances that this fund may be mismanaged or may be misused by the
firm
Self-assurance is normally possible where there is a large number of risks and more of
them have a large number of value. These objects are distributed such that the possibility
25
of the risk occurring to all of them at the same time is minimal. As a general rule, the
risks that are retained are those that need small losses.
Classes of Risk Retention
Unintentional risk It occurs when a risk is not recognized so that an individual
(i)
(ii)
transfer that risk. Sometimes voluntary retention will occur when a risk manager
purchases insurance that does not cover fully the risk exposure.
(iii)
Involuntary retention occurs when its not possible to avoid or reduce or transfer
an exposure to an insurance company.
NB
Voluntary retention occurs when its not possible to transfer, refer or avoid
Funded Retention - This is where an organization sets side assets that are held in
liquid or semi-liquid. To cater for the risk of loss. Such risks are visually accepted
or retained by the entity.
(v)
Advantages of retention
Saves money-The firm can save money in the long run if its actual losses are less than
the loss allowance in the insurers premium.
Lower expenses- The services provided by the insurer can be provided by the firm at
a lower cost.
Increase cash flow- Cash flow may be increased, since the firm can use funds that
normally would be held by the insurer.
Disadvantages of retention
Possible higher losses-The losses retained by the firm may be greater than the loss
allowance in the insurance premium.
26
Possible higher taxes- Income taxes may also be higher as the premiums paid to the
insurer are income tax deductibles.
Risk Transfer
Is the shifting of the risk burden from one party to another. This can be done through
several ways;
a) Through risk allocation, where there is sharing of the risk burden with other parties.
This is usually based on a business decision when a client realizes that the cost of
doing a project is too large and needs to spread the economic risk with another firm.
Also, when a client lacks a specific competency that is a requirement of the contract,
e.g., design capability for a design-build project. A typical example of using a risk
allocation strategy is in the formation of a joint venture.
b) Through purchase of insurance. Whereby in consideration of a specific payment
(premium) by one party, the second party contracts to indemnity the first party against
specified loss that may or may not occur up to a certain limit
c) Subcontracting whereby if an employee accepts work which they are not fully
competent without the assistance of others, they can subcontract the extra work. Extra
work would involve specialist work which that employee lacks the knowledge to
handle; or which would involve excessive amount of work beyond the capability of
that employee.
d) Through the use of contract indemnification provisions
e) Leasing and renting
RULES IN RISK MANAGEMENT
The following are the guidelines:
(i)
Do not risk more than you can afford to risk. This does not tell us what needs to
be done about a given risk but informs the individual or the company not to risk
more than it can afford to retain.
For instance, if the risk can result in bankruptcy, then retention is not the most
appropriate method of managing the risk.
27
The ability of a company to retain a particular risk is complicated and varies from
one company to another and depends on company cash flow, liquidity position
gearing level.
The rule gives guideline as to which risks should never be retained that is those
that are catastrophic.
(ii)
Consider the odds. If the individual can determine or predict the probability that a
loss will occur then he/she is in a better position to deal with that risk than when
he did not have such information. High, medium and low probability of risk
enables the manager to determine which method of risk management to use.
(iii)
Do not risk a lot for a little. The risk should not be retained when possible risk is
large relative to the premium saved through retention and vise versa.
This rule requires that the risk manager analyses the cost benefit of the risk
when selecting the appropriate method of handing the risk.
4.3 Activities;
49.
50.
Take
time and visit any three professional management firms in your nearest town,
51.
52. there find out the various business ventures they do, secondly find out the
while
53.
strategies
they put in place to manage the various risks that faces them and if they
54.
employ different strategies to manage the same set of risks they encounter.
28
4.5 55.
Summary
56.
In this
57. lecture you have learnt that:
58. control is a strategy that focuses on minimizing the risk of loss to which an
i) Risk
59.
organization
is exposed; it can be done using risk reduction and risk avoidance.
60.
ii) Risk financing concentrate on availing the funds to meet the losses arising from risks
that remain after the application of risk control techniques. Risk financing include; Risk
retention and risk acceptance.
iii) Risk transfer is the shifting of the risk burden from one party to another. This can be
done through; risk allocation, purchase of insurance, Subcontracting, use of contract
indemnification provisions and Leasing and renting.
iv) Rules of risk management require that you do not risk more than you can afford to
61.secondly consider the odds and lastly do not risk a lot for a little.
risk,
62.
63.
29
5.1.5 Implementation,
evaluation and review
14) to
15)management
to
5.1.6 Risk
Problems
30
i)
Pre-loss objectives
ii)
Post-loss objectives
Pre-loss objectives
This will include economy, reduction of anxiety, and meeting externally imposed
obligations and social responsibility
Post-loss objectives
This will include survival, continuity of operations, earning stability, continued growth
and social responsibility.
management is similar to the ultimate goal of other functions of the business, which is to
maximize value of the organization.
The limitation to the value maximization objective is that it is only relevant to business
entities and not relevant to the organization such as the government and nongovernmental organization.
Some scholars have argued that the main objective of risk management is survival, in
order to guarantee the continued existence of the organization or preserve the operating
effectiveness of the organization.
This objective of survival will ensure that the organization is not prevented from
achieving its objectives by losses that may occur out of pure risk.
Because one cannot know those losses will occur or the amounts of such losses,
arrangements to guarantee fee survival must reflect the worst possible combination of
outputs.
5.1.3 Identifying risks
Before risk management can be done, the risks that face the organization must be
identified. This is the most difficult step because it is a continuous process as well as it is
difficult to establish when risk identification has been done completely and exhaustively.
It is difficult to generalize about the risks that face the organization hence the need for a
systematic approach to risk identification.
In risk identification we ask the question, how can the assets or earning capacity of the
enterprise be threatened? The objective being to identify all risks facing the organization
31
not limited to insurable or those experienced in the past. For risk identification to be
successful there must be two essentials;
(i)
(ii)
The tools of risk identification must be available to the person to identify risk.
32
33
n) Valuation of property: Knowledge of replacement values can help the risk manager to
estimate the exposure to pure loss. Risk managers should keep current price and
source list for their properties.
34
the steps of the risk management process to determine whether past decisions were
proper in the light of existing conditions.
5.1.7 Risk management Problems
Many of the challenges faced by risk managers are often similar to those faced by other
managers. However, a number of key characteristics will tend to distinguish risk
management problems and they include the following:
a)
Time horizon
b)
c)
Credibility of data
d)
Possible uncertainties
e)
Possible externalities
f)
Independent exposures
a)
Time horizon
The evaluation of risk control efforts usually require long term view even up to 20
years in order to evaluate companys risk management projects that require
capital investment. Also, risk financing consideration companies will require a
long-term horizon for example decisions regarding medical insurance schemes
will be adopted by a company as opposed to a company where a fixed medical
allowance is granted to all employees or where medical bills are refunded upon
production of genuine receipts.
b)
35
c)
Credibility of data
The justification of risk management efforts will often rely on the data developed from
past experience, hence environmental change and the nature of the organization can
make data obsolete for decision making purposes.
d)
Possible Uncertainties
The prediction of future outcomes in order to make current decisions is often a risky
task and can only be done by use of probabilities.
e)
Recognition of externalities
Externalities are economic costs that are not captured in the price of a product. They
represent market failure to the extent that the market pricing systems fail to capture or
predict production costs.
For example, when pricing and costing items in a factory, the pollution caused by
the factory may not be factored unless the factory is under duty to clean up such
pollution
f)
Identification of Inter-dependence:
Inter dependent exposures are present when a single peril can cause more than one
loss. Possible interdependence is of critical importance to a risk manager. For
example, a natural calamity can trigger more than one loss such as property
destruction; death etc yet such peril may not be insurable.
64.
5.2Activities;
65.
i) Plan a visit to the nearest service station in your locality, while there;
66.
a) Find out the risk management process that is followed by the entity in operating its fuel
67.
and gas business.
68.
b) Establish the tools that they use to identify the risks facing them.
ii) Determine some of the unique problems that risk manager in the energy sector face.
36
69.
organizational
risk management strategy. Point out the most commonly used tools in
organization today. Discuss how such tools can be practically applied with positive
impact to business organizations in Kenya.
2. Risk management process is a detailed plan that if well adhered to saves the
organizations many losses. Articulate in brief the risk management process that should be
in place for a manufacturing firm. What are the business consequences of not adhering to
the process?
3.Relate the unique problems of risk management as a discipline to the normal
operational management issues faced by business managers in todays organizations.
5.4 Summary
37
38
loaned the money to buy the goods. Babylonian moneylenders loaded their interest
charges to compensate for this transfer of risk. Loans were made to ship-owners and
merchants engaged in trade, with the ship or cargo pledged as collateral. The borrower
was offered an option, for somewhat higher interest charge, the lender agreed to cancel
the loan if the ship or cargo was lost at sea. The additional interest on such loans was
called a premium and the term is still used even today. The contracts were referred to as
bottomry contracts in cases where the ship was pledged and respondentia contracts
when cargo was the security. Although these were insurance of sorts, the modern
insurance business did not begin until the commercial revolution in Europe following the
crusades.
Marine insurance the oldest of the modern branches of insurance was started in Italy
during the 13th Century. This early marine insurance was issued by individuals rather
than insurance companies. A ship-owner or merchant prepared a sheet with information
describing the ship, its cargo, its destination among others. Those who agreed to accept a
portion of the risk wrote their names under the description of the risk and the terms of the
agreement. This practice of writing under the agreement gave rise to the term underwriter.
39
40
The financial loss that will therefore occur would be 1 billion. Some vehicles may
actually incur loss, but the probability that all of them will actually suffer or incur loss is
remote. If the vehicle owners enter into an agreement to share the cost of loss as they
occur, to the extent that no single vehicle owner will be forced to incur the entire
financial loss of sh 1M, it would mean that in case a vehicle incurs a loss, all the 1000
vehicle owners should contribute to that loss.
Under this arrangement, vehicle owners who suffer financial loss will be indemnified by
those who do not suffer the accident hence owner who escape loss will be willing to pay
those who suffer loss, because by doing so, they eliminate the possibility of themselves
suffering the sh 1M loss.
The potential difficulty of this arrangement is that some group members may refuse to
pay their assessment of sh 1M at the time of loss and this problem can only be solved by
requiring advance payment of cash by each person contributing to the arrangement. The
assessment that each individual is required to pay will be calculated on the basis of past
exposure and experience.
Insurance does not decrease uncertainty of financial losses or alter the probability of
occurrence, but reduces the probability of financial loss connected to the event.
(i)
Other people believe that if they have not had a loss during the policy term, they
should be refunded their premium.
Insurance provides a valuable feature which is freedom from uncertainty and even
if a loss did not occur during the policy term the insured will have received the
benefits for the premium paid, which is the promise of indemnification if a loss
occurred.
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ii.
42
5)
Pure Risks Insurance is primarily concerned with pure risks. Speculative risks
are generally not covered because it may act as a disincentive to effort e.g.
insuring profit would mean no effort to achieve desired results. But the pure risks
consequences of speculative risks are insurable e.g. risks of a new line of business
selling or not though in itself a speculative, the risk of the factory being
damaged by fire is pure and therefore insurable.
6)
Particular risks Fundamental risks are generally not insurable e.g. war, inflation
etc. However fundamental risks arising out of physical cause e.g. earthquakes
may be insurable.
7)
Premium Loading
Risk averse people desire insurance cover but the extent to which they purchase
the insurance depends on the insurance premium loading. The premium and
insurance is equal to the total claim cost and a loading for administration and
capital costs.
If the loading is 0, the premium will be equal to the expected payments from the
insurer and therefore the risk averse will purchase full insurance cover
Unfortunately the premium loading is rarely zero because the insurer must be
compensated for their costs.
ii)
Moral Hazard
It refers to increased probability of loss that result from existence of insurance
fraud. This may result from reduced incentive of the policy holders to prevent
losses or engage in activities that cause loss for personal gain.
43
iii)
Adverse Selection
Arises when it is too costly for the insured to classify perfectly the insured on how
much they should be charged for the insurance purchased.
Different covers are charged different premiums yet due to the information given
to the insurance companies concerning the high and low risks, insurance
purchased may be charged for similar risks. Ideally, high-risk persons should be
charged a higher rate in order to generate funds compensating such persons.
However, since classification is costly, insurance companies will only classify if it
is cost effective.
iv) Subsidization
Occurs as a result of the insurers inability to classify perfectly the insured, some
insureds are wrongly classified and are made to pay more than their fair share of the risk
they face. For example classifying 20 year olds in the same class with 60 year olds. The
20 yr olds will subsidize for the 60 yr olds.
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2.
Creation of Common Pool This enables the losses of a few to be met by the
contributions of many. An insurance company operates such a pool. It takes
contributions in form of premium and is able to pay the losses to a few. The
insurer benefits from the law of large number i.e. the actual number of events
occurring will tend towards the expected where there are large similar situations.
3.
premium is charged, which reflects the hazard and value of risk brought to the
45
pool. The completive forces must also be taken into consideration in premium
rating.
Benefits of Insurance
1.
2.
Loss Control Insurers play a great role in reduction of the frequency and
severity of losses. The surveyor plays the role of risk control specialist.
Advice could be given on pre-loss control (e.g. wearing safety belts) and post
loss control (e.g. having fire extinguishers).
3.
Social Benefits The fact that insurance provides indemnity after loss means
jobs may not be lost and goods and services can still be sold.
4.
5.
46
6.2 Activities;
i) Plan79.
a visit or make a call to Jubilee insurance head office in Nairobi with a sole purpose of
84.
85.
1. Highlight
the major milestones in the development of insurance sector in Kenya up
to its present status.
2. Using local examples and illustration demonstrate how the insurance mechanism,
the law of large numbers and the principle of expectation gap operate.
3. Requisite for insurability are critical determinants in any insurance business. Discuss
the application of this concept in the present insurance business today.
6.4 Summary
86. lecture you have learnt that:
In this
87.
i)
88.
89.
ii)
90.
91.
92.
iii)
93.
94.
95.
96.
97.
98.
99.
iv)
Insurance has developed from the ancient times to its present day developments.
Insurance mechanism is a risk pooling arrangement where an individual transfer
his or her risk to the pool.
There are requisites of insurability that insurers considers vital before insuring
any risk brought to them and they includes, risk must be accidental, must
have financial value, must be a pure risk, homogenous exposure among
other requisites.
Insurance has several functions and benefits to a society key among the functions
include; risk transfer and creation of the insurance pool. The benefit includes;
the peace of mind and the social benefits it provides the members of the
society.
47
48
7.0 Introduction
Insurance offices are split into departments or sections, which deal with types of risks
which have affiliation with each other. Generally insurance companies are categorized
into the following offering the specified products or policies:
Lecture Outline
7.1.2 Life and Health
16) to
17) to
to insurance
7.1.418)
Property
49
A life insurance contract is intended to meet the needs of survivors or beneficiaries, when
the investor dies. From the life insurance contract, the beneficiaries receive a sum of
money that far exceeds the value of the premiums the investor had paid. The
beneficiaries, of course, receive this benefit if the person insured dies during the contract
period.
The contract of life insurance is different from other types of insurance in the following
respects.
i)
The event insurer against is an eventual certainty i.e nobody lives forever.
ii)
It is not the possibility of death that is insured against; rather, its the
untimely death. The risk is not whether the insured person is going to die
but when.
The risk increases as the individual ages or grows older because chances
of death are greater in later years than in initial years.
iii)
iv)
Life assurance is not a contract of indemnity, that is, the position after the
loss as before the loss. This is because it is not possible to place a value on
human life.
v)
Life assurance does not violet the principle of contribution i.e counts of
law have held that every individual has unlimited interests in their own
lives and individuals can assign insurable interests to any one therefore, if
the person taking insurance does so with many insurers all of them will
compensate the next of kin.
Ordinary life assurance, industrial life and group life would all fall under the wider
caption of life and health insurance. Under life and health, there are various types of
(assurance) as follows:
a) Term Assurance It provides for payment of the sum assured on death occurring
within a specified term. If the life assured survives to the end of the term, cover
ceases and nothing is payable by the life office.
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Cover is
provided to assureds disabled for longer periods who due to accident or illness may
not engage in any occupation or change to a lower paid occupation. The cover usually
excludes say the first six or twelve months since many employees under such
circumstances may remain on payroll for such period before being struck off. The
maximum benefit is usually 75% of previous earnings less any other disability
benefits payable.
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52
improvement on the traditional scope of cover that was available on the market.
The policy can cover expensive items like jewellery, cameras etc. The objective of
the cover being to cover a whole range of accidental loss or damage.
d) Goods in Transit It provides compensation, if goods are damaged or lost while in
transit, this would cover modes of transport like road, railway etc. The cover can
be affected by the owner of the goods or the carrier if he is responsible for them
while in his custody.
e) Contractors All Risks When new buildings or civil engineering projects are
being constructed, a great deal of money is invested before the work is finished.
There is a risk that the building or bridge may sustain severe damage prolonging
construction time and delaying eventual completion date. This may entail the
contractor to start building again or repair the damages. The extra cost cannot be
added to the eventual charge the contractor will make to the owner. The intention
of the policy is to provide compensation to the contractor for damage to
construction works from a wide range of perils.
f) Money Insurance The policy provides compensation to the insured in the event
of money being stolen either from the business, his home or while it is being
carried to or from bank.
53
b)
Voyage Policy which is operative for the period of the voyage - for
cargo it is from ware house to warehouse.
c)
Mixed Policy Which covers the subject mater for the voyage and a
period of time thereafter e.g. while in port.
d)
e)
Floating Policy - It provides the policy holder with a large reserve of for
cargo. A large initial sum is granted and each time shipments are sent, the
insured declares the value which is deducted from the outstanding sum
insured.
f)
ii)
Aviation Insurance Most policies are issued on an all risks basis, subject to
certain restrictions. In most cases a comprehensive policy is issued covering the
aircraft itself (the hull), the liabilities to passengers and the liabilities to others.
iii)
54
Deferred
This refers to an annuity where benefits are deferred until some future date / time.
The particular time when benefits are to begin may or may not be specified ahead of
time.
2)
Temporary
This type is rarely used, it pays benefits until the expiration of a specified period of years
or until the annuitant dies, whichever comes first.
3)
55
An annuity may be issued on more than one life. It provides that annuity payments will
continue as long as either annuitant is alive. The periodic payment may be constant
during the entire period or it may be arranged so that the amount of each payment is
reduced upon the death of the first annuitant.
The size of the survivors benefit (payable when only one of the two persons is still alive)
is often stated as a % of the joint benefit (payable while both annuitants are living) using
the terminology joint and x % survivor annuity.
Thus a joint and 100% survivor annuity would pay the same benefits regardless of
whether one or two annuitants were still alive. But a joint and 50 % survivor annuity will
pay the survivor only one half of the joint benefit. Age is an important factor as J & S
annuities are more expensive at younger ages.
4)
5)
death.
6)
ii)
While the annuity pays back the total value of the investment made plus the
gains earned on it, the life insurance investment returns an amount that may be
multiple times larger than the premiums paid.
iii)
Life insurance is paid upon death or maturity and in lump sum while annuity
is paid in instalments.
iv)
Life insurance has terms and conditions to be met while annuity matures at
expiry of the stated period.
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v)
Annuity can be deferred while life insurance is upon expiry of the stated
period.
vi)
In life insurance penalties are charged if funds are accessed before maturity
while in annuity no penalties are charged.
vii)
7.2 Activities;
106.
107. to attend the annual Association of Kenya Insurers expo to be held in one of
Arrange
108.
the
47 counties in Kenya. While there;
109.
110.
i) Find out the various policies under Life and health sold by most insurance
companies.
ii) Establish which policies are sold under property and liability insurance.
iii) Find out how most insurance companies manage their annuity funds.
111.
7.3 Self
Test Questions
112.
1. Discuss how the contract of life insurance is different from other classes of insurance.
2. Discuss the various types of assurances offered by the Kenyan insurance companies
under the life and health class.
3. The classes of property insurance are not clearly demarcated. Give reasons why this
could be so. Discuss some of the classes for property insurance sold in Kenya.
4. Using suitable local illustrations explain the various types of liability insurance covers
available in the insurance market in Kenya.
5. Discuss the reasons for pension provisions in Kenya.
6. Distinguish the different kinds of annuities available in the market.
57
7.4 Summary
113.
114.There are various policies sold under Life and Health class.
i)
115.
ii)
116.There are different liability insurance policies available in the market.
117.The are various property insurance policies sold in the Kenyan market.
iii)
118.
58
59
A contract of adhesion is one prepared by one party, the insurer to be accepted or rejected
by another party. If the insured does not like the contract terms, he may choose not to
purchase the insurance. Therefore, if he purchases the insurance, he must accept the
policy the way it is. Under this doctrine, the counts of law have ruled that a person is
bound by the terms of a written contract that he signs or accepts whether or not the
person reads the contractual terms
Assurance Aleaotory Contract
aleatory means that the outcome is affected by chance and the money given by the
contractual parties will be unequal. That is the insured pays the required premiums and if
no loss is suffered, the insurer pays nothing. However, if a loss occurs, the compensation
made to the insured will outweigh the insureds premium.
Insurances as a contract of good faith (fiduciary contract)
Applicants for insurance must make full disclosures for the risk to the insurance agent or
company. The risk that the insurer assumes must be equal to the risk that is being
transferred to them by the insured.
8.1.3 Principle of Insurable Interest
An insurable contract is one whereby the insurer agrees to indemnify the insured should a
particular event occur or pay him a specified amount on the happening of some event. In
return the insured pays a premium. The subject matter of insurance under a fire policy
can be buildings, under liability policy can be legal liability for injury or damage, under
life assurance policy the life assured, in marine is the ship etc. It is important however to
note that it is not the house, ship etc that is insured. It is the financial or pecuniary interest
of the insured in the subject matter that is insured. The subject matter of the contract is
the name given to the financial interest which a person has in the subject matter of the
insurance. This is the root of insurable interest as in the case of Castellain V Preston
(1883) What is it that is insured in a fire policy? Not the bricks and materials, but the
financial interest of the insured in the subject matter of insurance.
Essential Features of Insurable Interest
a) There must be some property rights, interest, life, limbs or potential liability
capable of being insured.
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b) Such property, rights, interest etc must be the subject matter of insurance.
c) The insured must stand in a relationship with the subject matter of insurance
whereby he benefits from its safety and would be prejudiced by its damage.
d) The relationship must be recognized at law e.g. Macaura V. Northern Assurance
Company (1925). Mr. Macaura effected a fire policy on an amount of cut timber on
his estate. He later sold the timber to a one-man company of which he was the only
shareholder. A great deal of the timber was destroyed in a fire and the insurers
refused to pay the claim on the basis that Mr. Macaura had no insurable interest in
the assets of the company of which he was principal shareholder. A company is a
separate legal entity from its shareholders and the relationship between timber and
Mr. Macaura, whereby Macaura stood to loose by its destruction had to be one
recognized or enforceable at law. In this case such a relationship did not exist as
Macauras financial interest in the company as a shareholder was limited to value of
his shares and he had no insurable interest in any of the assets of the company.
Creation of Insurable Interest
Insurable interest may arise in the following circumstances:
i)
ii)
iii)
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i)
Carriers Act 1830 - A common carrier is exempted from liability for certain
valuable articles of greater value than a fixed amount, except where the value
is declared and an extra charge paid
ii)
iii)
Trustee Act 1925 - Trustees can effect fire insurance on trust property, paying
premiums from the trust income.
Life Assurance
Everyone has un-limited insurable interest in their own life and is entitled to
effect a policy for any sum assured. Also a person has unlimited insurable interest
in the life of his or her spouse. However, a blood relationship does not imply an
automatic insurable interest. But some people can assure the life of another to
whom they bear a relationship recognized at law, to the extent of a possible
financial loss. Therefore, partners can insure each others lives up to the limit of
their financial involvement. Also a creditor has insurable interest in the life of his
debtor.
2.
Property Insurance
For Property, insurable interest mostly arises out of ownership. A person with a
partial interest in some property is entitled to insure the full value of that property
rather than his partial interest. But in the event of loss, he acts as a trustee passing
over other proceeds to the other partners. Mortgagees and mortgagors have
insurable interest; the purchaser as owner and seller as creditor. A bailee is a
person legally holding the goods of another either for payment or gratuitously and
is legally responsible for property under their care and hence have insurable
interest.
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3.
Liability Insurance
A person has insurable interest to the extent of potential legal liability he may
incur by way of damages and other costs. A persons extent of interest in liability
insurance is without limit.
In Marine Insurance, insurable interest need only exist at the time of any loss.
This is because of customs of maritime trading where cargo may change
ownership while in transit and protects merchants who may assume interest in
cargo during a voyage.
2.
3.
For all other Insurances - Insurable interest must be present both at the time of
affecting the policy and when any claim is made.
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A material fact is every circumstance which would influence the judgment of a prudent
insurer in fixing the premium or determining whether he will take the risk. However, a
fact which was immaterial when the contract was made, but later became material need
not be disclosed in the absence of a policy condition requiring continuous disclosure. The
facts that must be disclosed are:i)
Facts which show that the risk being proposed is greater because of
individual, internal factors than should be expected from its nature or class.
ii)
External factors that make the risk greater than that normally expected.
iii)
Facts that would make amount of loss greater than normally expected
iv)
v)
vi)
Facts restricting subrogation rights due to the insured relieving third parties
off liabilities which they would otherwise have.
vii)
viii)
Facts of law.
ii)
iii)
iv)
v)
vi)
vii)
ix)
Facts (convictions) which are spent under the rehabilitation of offenders Act
1974.
64
law position by requiring full disclosure during the currency of the contract which the
insurer is not obligated to underwrite.
The position at renewal is that for life and permanent health insurance contracts
disclosure lasts only until completion of the contract. This is because they are long term
contracts. But in the other classes of insurance the original duty of disclosure is revived at
renewal. However, for all classes if the terms of the contract are altered e.g. increase of
sum insured, then the duty of disclosure arises.
Representations and Warranties
Representations are written or oral statements made during negotiations for a contract.
Some of the statements will be material and others not. Warranties on the other hand in
ordinary commercial contracts are promises, subsidiary to the main contract, a breach of
which would have the aggrieved party with the right to sue for damages only. However,
warranties in insurance contracts are fundamental conditions to the contract and a breach
allows the aggrieved party to repudiate the contract. Warranties are imposed to ensure
good housekeeping and also ensure certain features of higher risk are not introduced
without the insurers knowledge. Warranties can either be express or implied. Express
warranties are agreed on upfront e.g. I will not store inflammable liquids in my premises.
Implied warranties are assumed to be part of the contract even though not expressly
negotiated e.g. the vehicle is road worthy.
Breach of utmost good faith can either be innocent or accidental and deliberate or
fraudulent. There are several remedies for breach of utmost good faith and include:i)
ii)
iii)
The aggrieved party must exercise the option within a reasonable time of discovery of the
breach. However, for some insurance that are compulsory like third party cover for motor
vehicles, the Road Traffic Act prohibits the insurer from avoiding liability on grounds of
65
breach of utmost good faith. But the insurer may claim the amount paid from the insured
though this situation is faced with practical differences.
8.1.5 Principle of Proximate cause
In insurance contracts, there are two main types of perils that need consideration:i)
ii)
Excluded Perils - these are the perils not covered by the policy.
It is because of the above that the principle of proximate cause is important. Every loss is
the effect of some cause. Sometimes there is a single cause of loss but frequently there is
a chain of causation or several causes may operate concurrently, and in these
circumstances it may require considerable thought to decide whether the loss is within the
scope of the policy or not. The doctrine covering such deliberations is proximate cause.
Proximate cause means the active, efficient cause that sets in motion a train of events
which brings about a result, without the intervention of any force started and working
actively from a new and independent source. It is not necessarily the first cause nor the
last one but the dominant, efficient or operative cause.
Rules for the Application of Proximate Cause
i)
The risk insured against must actually take place e.g. mere fear of insured
peril is not loss by that peril.
ii)
iii)
Intervention of a new act is without the doctrine e.g. if during a fire onlookers
cause damage to surrounding property then fire is not the cause of the loss.
iv)
Last Straw Cases where the original peril has meant that loss was more or
less inevitable, the original peril will be the proximate cause even though the
last straw comes from another source.
Gaskarth V Law Union (1972) a fire left a wall standing but in a weakened
condition. Several days later, a gale caused the collapse of the wall onto
another property. It was held that fire was not the proximate cause but the
66
gale. The crucial factor was the delay of several days during which no steps
were taken to shore up the weakened wall. The chain had been broken.
b)
c)
ii)
67
iii)
iv)
Measurement of Indemnity
In property insurance the measure of indemnity in respect of loss of any property is
determined not by its cost but its value at the date of the loss and at the place of the loss.
If the value of the property has increased, the insured is entitled to this subject to the sum
insured or average being applied. For buildings it is the cost of repair or reconstruction
less an allowance for betterment which includes improvements or non deductions of wear
and tear. In liability insurance the measure of indemnity is the amount of any court award
or negotiated out of court settlement plus costs and expenses thereon.
Factors Limiting the Payment of Indemnity
i)
Sum Insured The limit of an insurers liability is the sum insured. The
insured cannot receive more that the sum insured even where indemnity is a
higher figure.
ii)
x loss
Full value
When average operates to reduce the amount payable, the insured receives
less than indemnity.
iii)
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iv)
v)
Limits Many policies limit the amount to be paid for certain events.
vi)
ii)
New for Old Insurer agrees to pay for reinstatement of contents if destroyed
within a specified period without deduction of wear and tear.
iii)
Agreed additional costs Insurers may pay including additional costs like
architects and surveyors fees if agreed. This may mean receipt of more than
indemnity.
69
i)
An insurer is not entitled to recover more than be has paid out. Insurers must
not make profit by exercising subrogation rights.
ii)
Where the insured retains part of the risks e.g. by an excess or application of
average, he is entitled to an amount equal to that share of the risk out of any
money recovered. Where the insurer makes ex-gratia payment to an insured
then the insurer is not entitled to subrogation rights. This is because ex-gratia
payment is not indemnity and subrogation rights arise only to support the
concept of indemnity.
b)
Right arising out of contract This can arise where a person has contractual
rights to compensation regardless of fault and where the custom of trade to
which the contract applies dictates that certain bailees are responsible e.g.
hotel proprietor. The insurer then assumes the benefits of these rights e.g.
tenants agree to make good any damage to the property they occupy. The
owner may also maintain an insurance policy and in the event of damage; if he
recovers from the insurance policy, he is not entitled to compensation from
the tenant and the insurers assume the rights to any money from the tenants.
c)
Right arising out of statute where a person sustain damage in a riot and is
indemnified, his insurers have a right to recover the outlay from the police
authority as per Rot Damage Act 1886.
d)
Rights arising out of subject Matter of insurance - where an insured has been
indemnified for a total loss, he cannot claim the salvage as it would be more
than indemnity.
70
At common law subrogation does not arise until the insurers have admitted the insured
claim and paid it. However, insurers place a condition in the policy giving themselves
subrogation rights before the claim is paid. Subrogation has the effect of ensuring
negligent persons are not let off the hook simply because there was insurance.
Modification to the Operation of Subrogation
The exercising of subrogation rights by one insurer my involve claiming money from
another insurer. For a motorist hitting property, the property insurer would exercise
subrogation against the driver who in turn passes it to motor insurer. This may mean
insurers getting involved against each other often. This is particularly true for motor
insurance and is handled in the following ways:i)
Motor insurance Some insurers waive their subrogation rights against each
other by executing knock for knock agreements.
ii)
Other insurers sign agreements whereby they contribute towards the losses by
pre-determined proportions.
iii)
Contribution
In a case where someone has a right to recover his loss from two or more insurers with
whom he has affected policies, the principle of indemnity prevents the insured from being
more than fully indemnified by each by way of contribution. Contribution ensures that
the insurers will share the loss as they have all received a premium for the risk.
Contribution applies only to contracts of indemnity. Contribution is the right of an insurer
to call upon others similarly but not necessarily equally liable to the sum insured to share
the cost of an indemnity payment.
At common law contribution will only apply where the following are met:-
71
i)
ii)
iii)
The policies cover the same or common peril giving rise to loss.
iv)
v)
The policies do not require to cover identical interest, perils or subject matter so long as
there is an overlap shared by them.
The leading case in contribution is North British & Mercantile V Liverpool & London
Globe (1877). It is also known as the King and Queen Granaries case. Merchants had
deposited grain in the granary owned by Barnett. The latter had a strict liability for the
grain by custom of his trade and had insured it. The owner had insured it to cover his
interest as owner. When the grain was damaged by fire the bailees insurers paid and
sought to recover from the owners insurers. As interests were different, one as bailee and
the other as owner, the court held that contributions should not apply.
When Contributions Operates
i)
At common law When an insured has more than one insurer, he can confine
his claim to one of them if he so wishes and that insurer must meet the loss to
the limit of his liability and can only call for contribution from the others after
he has paid.
ii)
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8.2Activities;
1.
Organize
an insurance contest with two teams; allow each team to randomly pick any
2.
3.
three principles of insurance from the list of the six principles.
4.
5. team to debate on the merits and demerits of each of the principles to the
Let each
insurance business.
7. The insurance and risk industry operates certain principles. Provide an outline of
1.
these principles in the Kenya business sector and analyze how these principles
have impacted on the insurance business and risk Management in general.
2. Using suitable illustrations and examples, discuss the special elements of an
insurance contract and their usage in insurance practice.
8.4 Summary
8.
8.5 Suggestion
for further reading
9.
10. G.C. (1997) Risk Management the Chartered Insurance Institute
Dickson,
11.
Vaughan,
12. E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th Edition,
13.
Wiley
14.
Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th Edition,
Prentice Hall
73
74
not necessary. This is particularly so for corporate fire or marine insurance. The details
for fire are so complex to be confined to a proposal form. In these cases, insurers use
their own risk surveyors to visit the premises to discuss the risk with the proposer.
Brokers play an important part, preparing full details for an insurer. For personal
insurance, the form carries both general and specific questions. The forms are simple to
understand and easy to complete. For business insurances the information required is
greater and is supplemented by additional information provided by the proposer or
broker. Every proposal has a declaration that the proposer confirms that the information
which has been supplied is true to the best of the proposers knowledge and belief.
9.1.3 Policy Document
Once a proposer has completed a proposal, submitted it to an insurer and is accepted,
then there is a contract of insurance. A contract of insurance is subject to all laws of
contract and it exists whether policy is issued or not. The policy is only evidence of the
contract. Components of the policy document are:
i)
ii)
Preamble This is the wording at the beginning of each of the policies. It covers
the following aspects:a)
b)
It also states that premium has been paid or agreement that the insured
will pay
c)
It states that the insurer will provide cover detailed in the policy
subject to the terms and conditions.
iii)
iv)
Operative Clause It is the part that outlines the actual cover provided. It begins
with The company will. And then states what the company promises.
v)
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vi)
Conditions they include a condition that the insured will comply with all terms
of the policy and procedure in the event of a claim etc.
vii)
Policy Schedule - This is where the policy is made personal to the insured. The
details specified include; name of the insured, address, nature of business, period
of insurance, premiums, sum insured and policy number among others.
Cover expected claims the law of large numbers does allow the
underwriter to make a reasonably accurate assessment of the likely loss
costs.
b)
Create an estimate for outstanding claims the premium must take into
account those claims still to be settled at the end of the year.
c)
d)
e)
Inflation the cost of settling claims may rise due to the fall in the value
of money.
b)
c)
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d)
Life assurance premiums are made up of four components namely:i) Mortality is the risk of death, mortality tables are used.
ii) Expenses salaries, commission etc.
iii) Investment Investments earn substantial income & are taken into account
iv) Contingencies Unexpected level of loss.
The premium charged will mostly be a level premium though the risk increases each year
as person gets older but this is taken into consideration.
Claims and Disputes
i.
Claims notification is the responsibility of the insured- The insurer will want
speedy notification of the claim. This enables the insurer for instance to take
statements from witnesses immediately after the accident. A claim is normally
intimated by completing a claim form. In life assurance, the insurer needs proper
proof of death and wills or assignments is taken into consideration.
ii.
Claims handling Small brokers may have authority to handle claims although
limits will be imposed. A majority of claims are handled in the claims department
of the insurer. The insured has to prove the amount of loss e.g. purchase receipt,
repair account or valuation. In addition to claims staff of insurance companies,
experts could be retained like loss adjusters. The adjusters report covers basic facts
about the insured and the loss.
iii.
Claims Settlement The final stage in the claims procedure is the actual
settlement. In life assurance, what is payable is a fixed sum. However for general
insurance the eventual costs of the claim will depend on the extent of loss or
damage and nature of cover afforded by the policy.
iv.
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Objectives of Underwriting
The main objective of underwriting is
i) To see that the applicant will not have a loss experience that is very different from
that assumed when the rates were formulated.
ii) To set up the standards of selection relating to physical and moral hazards
especially to help when rates are calculated.
iii) To ensure that the set standards are observed when risks are accepted.
iv) To accept risk exposures that will not make the insurer to incur losses, and at the
same time not to reject exposures just for the sake of it. I.e. ensure profitable
business to the insurer.
ii)
iii)
iv)
v)
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Policy Writing
Part of the work of underwriting department may be most concisely described as policy
writing. In property-liability insurance, the agent
i)
ii)
The underwriting department then checks the work of the agent to determine the accuracy
of the rates charged, whether a prohibited risk has been taken
In life insurance, the policy usually is written in a special department whose main task is
to issue written contracts in accordance with instructions from the underwriting
department.
The underwriting department also keeps a register of the policies underwritten.
9.1.6 Pre and Post-Independence regulation
Pre-independence legislation
Modern insurance came with colonial administration; the legislation was racist as it
demonstrated a deliberate move by the colonial government to keep Africans out of the
monetary economy. The first legislation instrument governing insurance was enacted in
1945 and was in the form of a statute. It restricted the sale of insurance to Europeans
only arguing that Africans did not appreciate the services of insurance. In 1947 a second
legislative instrument was enacted referred to as the African life control ordinance. It
stated that the Africans could only buy insurance with approval of the governor in
council.
In 1960, the first wide ranging legislation was enacted called insurance
company ordinance (Cap 487). The reasons that led to its enactment were:
(a)
(b)
It was a reproduction of the British laws governing insurance. It lacked tight control on
insurance company as compared to the British situation, although it was the first
comprehensive legislation. It did not have the interest of African at heart.
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(b)
c)
d)
In 1962, 1960 ordinance was amended, giving access to insurance facilities by all the
locals. In 1964, the Kenya Government formed the first local insurance company by the
name Kenya National Insurance Company officially closed on 13th July 1996 following a
budget proposal on June 1996. In 1970 the state re-insurance act was enacted that
brought into existence the Kenya Reinsurance Corporation. In 1973, it was revised and
called the Kenya Reinsurance Corporation Act.
Since insurance involves taking money from members public, who thereby become
policyholders in return for promise of payment, some unscrupulous persons collected
premiums and diverted them without bothering to honor their promises. This was the
situation in Kenya in the late 1970s and early 1980s as insurance companies could start
their operations after being registered by the Registrar of companies. This made the
public to loose faith in the insurance companies. In 1984, Kenya Government passed the
insurance Act (Cap.487) and came into force in 1987 with the following objectives.
9.1.7 Objectives of regulating Insurance services
1. Protecting the interest of the policyholders, the insurance company must maintain
sufficient reserves to meet their obligations.
2. Building up and developing the local insurance market by shielding the local insurer
from foreign insurance.
3. Ensuring that insurers in Kenya must be incorporated under the Companies Act and
that Kenyan citizens hold a third of the controlling interests in the company.
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4. Developing local insurance expertise. This is being achieved through training, e.g.
teaching insurance courses in the institution of higher learning and the opening of
the College of Insurance in 1991.
5. Ensuring that funds generated by insurance operations are channeled into the local
market.
6. Develop a policy framework with regard to insurance economic and social
development of the country.
The Insurance Regulatory Authority Previously referred to as the office of Commissioner
of Insurance is in charge of regulating Insurance activities in the country> The following
are the duties of a Commissioner include:
1) Enforce the provision of the insurance Act.
2) Formulate and enforce standard for conduct of the insurance business.
3) Direct insurers and re-insurers on the standardization of contracts of insurance.
4) Approve tariffs and rates of insurance in respect of any class or classes of
insurance.
5) Licenses all members of the industry annually and can revoke their licenses.
6) Ensuring that the insurers deliver the promised benefits and that the company is
being properly managed to meet its future liabilities as they fall due.
7) Ensure that an insurer invests their assets prudently and adopt a positive attitude
towards its obligation to policy holders and claimants.
8) Ensure that Insurance companies maintain deposits in government securities with
Central Bank of Kenya for certain amounts and for specific line of business. This can be
used to offset an insurers debt to policyholders if the insurer goes into liquidation.
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9.2Activities;
1.
Plan 2.
a visit to the offices of Insurance Regulatory Authority (IRA) with a view to hold
discussions
with the officials concerning;
3.
i)4. Regulatory challenges facing the insurance sector and how the Authority is trying
5.
ii)6. Find out the mandate that the authority has over the insurance business in Kenya
and their achievements so far, with regard to their outlined mandate
7. Test Questions
9.3 Self
1. Explain
using relevant examples the components of life assurance premium.
8.
2. Explain the concept of underwriting in the Kenyan context. What are the
objectives of underwriters in Kenya?
3. Discuss the regulatory framework that was in place during pre-independence era. How did
it impact on the insurance business in Kenya?
4. Discuss the post independence era regulatory framework citing the reasons for legislating
insurance during this period.
5. Insurance regulatory Authority is a recently established autonomous institution. Discuss
the functions of this authority in regulating insurance
9.4 Summary
In this lecture you have learnt that:
9.i) A proposal form is the mechanism by which the insurer receives information
10.
11.
12.
ii) A policy document a contract that is the only evidence of the contract. And has
several components.
iii) There exist several factors that determine the amount of premium one pays in an
insurance policy.
iv) The pre and post independent regulations have had a significant bearing on the
governance of insurance sector in Kenya.
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10.1.5
Buyers
and sellers of Insurance
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20,000
200,000
200,000
TOTAL
420,000
Facultative reinsurance
80,000
500,000
The arrangement under non-proportional treaties include; Excess of loss and stop loss
reinsurance.
10.1.4 Reasons and Functions of reinsurance
The reasons why insurers buy reinsurance are:a)
b)
c)
d)
e)
Macro benefits the cost of risk is spread at the market place and the
world, the impact of risk does not fall solely on one economy.
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Functions of Reinsurance
i.
Spreading of Risks
Insurance companies are able to avoid catastrophic losses by passing on a portion
of any risk too large to handle. Through excess loss reinsurance arrangements, a
company may protect itself against a single occurrence of catastrophic scope.
Smaller insurance companies are also able to insure expenses they could not
otherwise handle within the line of safety.
ii.
Financial Function
When the premium volume of an insurance company is expanding, the net
result will be a drain on the surplus of the company. With a continued
expanding premium volume, a company faces a dilemma.
iii.
Reinsurance provides a solution to the dilemma. When the direct writing company
reinsures a portion of the business it has written under a quota share or surplus line
treaty, it pays a proportional share of the premium collected to the re-insurer. The
re-insurer then establishes the unearned premium reserves or policy reserves
required and the direct writer is relieved of the obligation to maintain such
reserves.
Since the direct writer has incurred expenses in acquiring the business, the re-insurer pays
the direct writing company a commission for having put the business on the books. The
payment of the ceding commission by the re-insurer to the direct writer means that the
unearned premium reserves is reduced resulting in an increase in surplus.
iv.
The policyholder is thus spared the necessity of negotiating with many companies and
can place insurance with little delay. Using a single policy is therefore more uniform,
easier to comprehend and there is an added guarantee of the re-insurer, which makes it
safer.
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v.
Reinsurance allows the ceding company to have a stable level of profits and
underwriting losses than it is to have a higher but unstable level in the long run;
thus smoothing out fluctuations that may occur. The ceding company may procure
new business as it participates in mutual risk sharing.
vi.
For new, small companies, the requirement that a company sets aside premiums
received as unearned premium reserves for policyholders may hinder growth.
Because no allowance is made in these requirements, for expenses incurred, the
insurer must pay for producers commissions and for other expenses out of surplus.
As the premiums earned during the life of the policy, these amounts are restored to
surplus. In this case the firm may not be able to finance some of the business it is
offered. Through reinsurance the firm can accept all the business it can obtain and
then pass on to the re-insurer part of the liability for loss and with it the loss and
unearned premium reserve requirement.
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a)
b)
Lloyds Brokers carries out the functions mentioned above but only for placing
business at Lloyds. The council of Lloyds registers broking firms to act as
Lloyds brokers.
c)
Insurance Consultants - Regulations exist for those who wish to call themselves
brokers. Many of the persons acting as intermediaries without registering under
the relevant legislation (The insurance Act) may refer to themselves as
consultants.
d)
Tied Agents tied agents can only advise on products offered by their host
company.
e)
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of profit by way of dividends but in the mutual company the policy holder
owner may enjoy lower premiums or higher life assurance bonuses than
would otherwise be the case.
3) Captive Insurance companies its an arrangement where the parent company
forms a subsidiary company to underwrite certain of its insurable risks. It benefits
by the groups risk control techniques thus paying premiums based on its own
experience, avoidance of direct insurers overheads and purchasing reinsurance at
lower costs.
4) Reinsurance Companies - Reinsurance furthers the principle of spreading risk and
offers the insurer stability and protection against catastrophe and offers technical
devises.
10.1.6 Competitive challenges associated with marketing insurance
(i)
(ii)
(iii)
Other challenges;
Price By offering lower prices to products than rival companies, an insurer can reduce
premiums by cutting down on the following operation cost:
(i)
Payment of losses
(ii)
(iii)
Cost of marketing
(iv)
Administrative expenses
Quality By offering all forms of policies, or offering policies with benefit to the insured
i.e. broadening of coverage. This offers more flexible underwriting conditions.
Services By offering superior claim segment procedures, better agency represents and
loss prevention services.
Others include:
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Gifts
1.
10.2 Activities;
2.
Plan 3.
a visit or call the risk management department of Kenya Airways Ltd.
4.
In your visit find out;
5.
i)6. How they insure their aircrafts and other aviation related risks.
ii) How did their insurer handle the crash that occurred in Abidjan 3years
ago? Did there insurer rely on the reinsurer to meet their claim obligation?
Have they found it a challenge to place their risk with a single insurer in
Kenya due to capacity constraints? Has there insurer always risen to the
occasion whenever disaster strikes?
10.4 Summary
In this lecture you have learnt that:
i) There are two main forms of reinsurance namely facultative and treaty.
ii) There are several reasons why insurers buy reinsurance and which include:Security, Stability, Capacity, Catastrophes and Macro benefits.
7.
iii) The Buyers of Insurance for most insurance companies, emanates from
8.
commercial
and group insurances that form a big volume of their business.
9.
10.
iv) There exist competitive challenges associated with marketing insurance and they
include; Lack of proper training of salesmen, Ignorance on the part of the insured,
Economic level of individuals, innovation and creativity of the sector players among
other challenges.
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