Cms 200 Insurance Risk Management Module

CMS 200: INSURANCE AND RISK MANAGEMENT



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form is allowed.


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About this STUDY MANUAL

CMS 200, Insurance and Risk Management has been produced by

KCA Universtiy. All Modules produced by KCA University are

structured in the same way, as outlined below.

How this STUDY MANUAL is structured

The course overview

The course overview gives you a general introduction to the course.

Information contained in the course overview will help you

determine:

If the course is suitable for you.

What you will already need to know.

What you can expect from the course.

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The overview also provides guidance on:

Study skills.

Where to get help.

Course assignments and assessments.

Activity icons.

CHAPTERs.

We strongly recommend that you read the overview carefully

before starting your study.

The course content

The course is broken down into CHAPTERs. Each CHAPTER

comprises:


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An introduction to the CHAPTER content.

CHAPTER outcomes.

New terminology.

Core content of the CHAPTER with a variety of learning

activities.

A CHAPTER summary.

Assignments and/or assessments, as applicable.

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For those interested in learning more on this subject, we provide

you with a list of additional resources at the end of this STUDY

MANUAL; these may be books, articles or web sites.

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this course.


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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


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Lecture 2: Response to risk

2.0 Introduction

2.1 Lecture Outline

2.1.2 It wont happen to me syndrome

2.1.3 The risk schooling

2.1.4 Sector response; Personal, Organizational, National response to risk

2.1.5 The cost and Burden of risk.




2.4 Summary


Lecture 3: Risk Management

3.0 Introduction

3.1 Lecture Outline

3.1.2 Definition of risk management.

3.1.3 Nature of risk management

3.1.4 Principles of risk management

3.1.5 Risk management policy



3.4 Summary


Lecture 4: Risk management strategies

4.0 Introduction

4.1 Lecture Outline

4.1.2 Risk Control

4.1.3 Risk Financing

4.1.4 Risk Transfer

4.1.5 Rules in Risk management


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Lecture 5: Risk Management process

5.0 Introduction

5.1 Lecture Outline

5.1.2 Determination of Objectives

5.1.3 Identifying risks

5.1.4 Evaluating risks and considering alternatives

5.1.5 Implementation, evaluation and review

5.1.6 Risk management Problems

Lecture 6: Insurance development

6.0 Introduction

6.1 Lecture Outline

6.1.2 Historical development of insurance

6.1.3 Insurance Mechanism

6.1.4 Requisite of Insurability

6.1.5 Factors Limiting insurability of risks.

6.1.6 Functions and Benefits of insurance

Lecture 7: Classes of Insurance

7.0 Introduction

Lecture Outline

7.1.2 Life and Health

7.1.3 Liability Insurance

7.1.4 Property insurance

7.1.5 Transport insurance

7.1.6 Pensions and annuities

Lecture 8: Principles of Insurance

8.0 Introduction

8.1. Lecture Outline

8.1.2 Special Insurance contracts.


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8.1.3 Principle of Insurable Interest

8.1.4 Principle of Utmost good faith

8.1.5 Principle of Proximate cause

8.1.6 Principle of Indemnity

8.1.7 Principle of Subrogation and contribution.

Lecture 9: Insurance documentation and Regulation

9.0 Introduction

9.1 Lecture Outline

9.1.2 Proposal Forms

9.1.3 Policy Document

9.1.4 Premiums, claims and disputes

9.1.5 Underwriting and Policy writing.

9.1.6 Pre and Post Independence regulation

9.1.7 Objectives of regulating Insurance services

Lecture 10: Reinsurance and Insurance marketing

10. Introduction

10.1 Lecture Outline

10.1.2 Definition of Reinsurance

10.1.3 Forms of Reinsurance

10.1.4 Reasons and Functions of reinsurance

10.1.5 Buyers and sellers of Insurance

10.1.6 Competitive challenges associated with marketing insurance


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LECTURE 1: THE CONCEPT OF RISK

1.1 Introduction

Welcome to the first lecture on the definition of risk and related terms. We shall begin the

lecture by highlighting meaning of risk. We will further explain the other related terms;

perils and hazard, and classification of risk.

1.3 Lecture Outline

1.2.1 Introduction

1.2.2 Meaning 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. Risk as cause e.g. fire as a risk, Personal injury as a risk etc.

1.2 Specific objectives:

At the end of the lecture you should be able:

i) Define risk and enumerate its various meaning.

ii) Discuss the different types of risks that organizations face.

iii) Distinguish between Hazard and Perils.

iv) Classify the risks in its various forms.

1) to 2) to 3) to


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ii. Risk as likelihood e.g. the risk of something happening, leaving keys in a car results

in high risk etc.

iii. Risk as the object e.g. factory, plane, machine or ship might be referred to as the

risk.

iv. Risk as verb It is not only used as a noun but also as a verb e.g. risk of crossing the

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. Risk is the possibility of an unfortunate occurrence.

ii. Risk is a combination of hazards.

iii. Risk is unpredictability the tendency that actual results may differ from

predicted results.

iv. Risk is uncertainty of loss.

v. Risk is the possibility of loss.

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


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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 non-

financial 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.


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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 Summary

In this lecture you have learnt that:

1.Risk implies some form of uncertainty about an outcome in a given situation.

2. In common business conversations the word risk is used to mean different

things; cause, likelihood, object and verb.

3. The underlying commonality in all the definitions should be of interest and

they include; Uncertainty, level of risk and perils and hazard.

4. Risk can be classified as financial and non-financial, pure and speculative,

fundamental and particular risks, personal and business, dynamic and static e.t.c

1.6 Self Test Questions

To analyze the impact of risks on the social-economic development of a country

like Kenya.


Dickson, G.C. (1997) Risk Management the Chartered Insurance Institute

Vaughan, E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th

Edition, Wiley

Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th

Edition, Prentice Hall


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LECTURE 2: RESPONSE TO RISK

2.1 Introduction

Welcome to the second lecture on the response to risk. We shall begin the lecture by

highlighting the various sectorial responses to risks, the risk schooling and the cost and

burden of risk to a society.

2.3 Lecture Outline

2.3.2 It wont happen to me syndrome

2.3.3 The 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-



i) Explain the syndrome it wont happen to me

ii) Discuss the different sector responses to risk, such as personal, organizational

and National.

iii) Critically review the cost and burden of risks.

4) to 5) to 6) to


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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.


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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


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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. Such investors therefore make the cost of

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.


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6. 7. 8.

9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22.

23. 24. 25. 26. 27. 28.

2.3 Activities

1. Provide 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.

2.5 Summary


1. The It wont happen to me syndrome is away in which people only believe

certain things happen to others and not them, it could be because they feel they

are well endowed, well resourced and may not feel like taking precautions

because whatever is being managed is far from them.E.g University graduates

who graduated in the 90s and or earlier 2000 given that they got jobs

immediately after clearing their studies may not feel the risk of unemployment as

something major.

2. Risk schooling is a very important aspect in risk management, 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.

3. The sector response to risk can be categorized into personal, organizational and

National. Personal is individual specific and details our responses on the personal

risk facing the individual.




Edition, Wiley

Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th Edition,

Prentice Hall


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LECTURE 3: RISK MANAGEMENT

3.1 Introduction

We have throughout portrayed risk as having a negative effect e.g. great steps in medical

fields have been achieved at the personal risk of those researchers prepared to test drugs

and treatment; risk is also at the very heart of any free market economy i.e. it enables

wealth to be created. In summary therefore risk can be negative or positive and the

challenge to us is to manage the risk to which a business is exposed. This has led to the

evolution of the discipline of risk management which is the identification analysis and

economic control of those risks which threaten the assets or earning capacity of an

enterprise.

3.3 Lecture Outline

3.3.1 Definition of risk management.

3.3.2 Nature of risk management

3.3.3 Principles of risk management

3.3.4 Risk management policy




3.4 Summary


Definition of Risk management

It has also been defined as the logical development and carrying out of a plan to deal with

potential losses. It can also be defined as the human activity which integrates recognition



i) Define risk management

ii) Explain the main functions of a risk manager

iii) Discuss the benefits of a risk policy framework to an organization.

7) to 8) to 9) to


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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) Assists the organization identify the risk

(ii) Implement a loss prevention and control programmes

(iii) Review contracts and documents for risk prevention and management purpose

(iv) Provide training and education on safety related issues

(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) Claims management and working with legal representatives to manage

litigation risks.

(vii) Designing and co-coordinating employee benefit programmes, including

retirement packages

(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) Government lobbying Where the risk manager constantly interacts with

influential persons in an effort to ensure that government policies do not

adversely affect the company.

(x) Advice on company restructuring including acquisition and mergers even

disposals. The purpose will be to avoid diverse effects of the restructuring

from affecting the company Public relation.


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Principles of risk management

Risk Management should;

i) Create value

ii) Be tailored

iii) Take into account human factors.

iv) Be transparent and inclusive.

v) Be dynamic, iterative and responsive to change.

vi) Be capable of continual improvement and enhancement.

vii) Be transparent and inclusive.

viii) Be an integral part of organization processes.

ix) Be part of decision making.

x) Explicitly address uncertainty.

xi) Be systematic and structured.

xii) Be based on the best available information

Risk Management Policy

Is an organizations written statement that sets out its approach to risk management. Its

objective is to safeguard the organizations property, interest and certain interest of

employees during the conduct of business.

Benefits of risk management policy statement

i. It enables the organization to survive in case of emergency situation i.e. a policy

that document measures to be taken in case of fire out break may save the

organization from suffering severe losses when such occur.

ii. Reassures staff, stakeholders and governing body in business of the organization

going concern capacity. This could give the insurance a hedge over its

competitors.

iii. Support Strategic and Business Planning. A risk Management policy statement

would support an efficient development of business plan by the organization since

it avails information on how to cater for potential risks.


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iv. Enhances communication between production, sales, marketing and

Administration department.

v. Improves the organizations ability to meet objectives and achieve opportunities.

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. It leads to minimization/prevention of losses which occurs due to unstructured

procedures.

ix. Enables quick assessment and gasp of new technology.

x. Supports the effective use of resources.

xi. Promotes continuous improvement.

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. 30. 31. 32.

3.4 Activities

Arrange and visit a manufacturing firm in the industrial zone in your

neighborhood, while there

i) Identify the various functions that a risk manager executes in a

manufacturing firm like the one you have visited.

ii) Find out the risk management principles put in place by the manufacturing

firm.

iii) Find out if the firm has a risk management policy. Discuss the benefits of

such a policy to such a manufacturing firm.

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.


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33. 34. 35. 36. 37. 38. 39. 40. 41. 42.

43. 44. 45. 46. 47. 48.

3.5 Summary


i) That apart from buying insurance, risk managers executes several other functions in

the organization.

ii) The principles of risk management are applicable to service, manufacturing, public or

private sectors of the economy.

iii) That an organization must have a risk management policy which has numerous

benefits to the organization.


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.



Vaughan, E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th Edition,

Wiley


Prentice Hall


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LECTURE 4: RISK MANAGEMENT STRATEGIES

4.0 Introduction

Risk, at the general level, involves two major elements: the occurrence probability of an

adverse event and the consequences of the event. Risk estimation, consequently, is an

estimation process, starting from the occurrence probability and ending at the

consequence values. Risk evaluation is a complex process of developing acceptable

levels of risk to individuals, groups, or the society as a whole. Generally there are several

risk management strategies that can be employed to mitigate risk exposures. The

strategies can be broadly categorized into three; risk control, risk financing and risk

transfer.

4.1 Lecture Outline

4.1.2 Risk Control

4.1.3 Risk Financing

4.1.4 Risk Transfer

Rules in Risk 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.



i) Discuss the three categories of risk management strategies used in the risk

environment.

ii) Discuss the main strategies applied in controlling risks in the organizations.

iii) Discuss risk financing and risk transfer strategies that are mostly used in

organizations.

iv) Explain the rules that are applied in managing risks.

.

10) to 11) to 12) to


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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. Reduction of severity of impact of loss. These can be done or demonstrated by

installing sprinkler or five extinguished or separation and dispersions of the company

assets to different location in an effort to salvage company assets in case of loss.

iii. Engineering approach to loss prevention. This approach focuses on removal of

hazard. It focuses on system analysis and mechanical unavoidable e.g air bugs can

boost safety belts in vehicles.

iv. Human behavior approach on loss prevention. This approach focuses on the

elimination of unsafe acts by the person. This approach is based on the fact that most

accidents are as a result of human failure e.g. alcohol and drug consumption fatigue

among others.

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:


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Training of personnel measures before

Measures during five; five:

Fastening seat belts

Measures after the event may be:

Rush victim to hospital

Offer first aid

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

RETENTION/ SELF INSURANCE

This is the most common method of dealing with risks whereby organization and

individual face unlimited number of risks most of which nothing can be done about.

Risk retention can either be conscious (intentional) or unconscious (unintentional). It can

also be voluntary or involuntary and even be funded or unfounded. When nothing can be

done about the particular exposure then the risk is retained. It is in last resort on risk

management strategy whereby the risk cannot be avoided, reduced or transferred. The

self-assumption of risk consists of waiting for the event to happen with no effort to any

financial provision in advance for the occurrence of risk. In some instances the individual

subjected to the risk may provide some amount in advance to cover for the anticipated

financial consequences of the risk normally referred to as self-insurance.

The major disadvantage of using insurance reserve is that:

(i) 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


26

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

(i) Unintentional risk It occurs when a risk is not recognized so that an individual

or organization may unknowingly or unwillingly retain the risk of loss.

(ii) Voluntary retention Results from a decision to retain risk rather than avoid or

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

risks of loss e.g. death or earthquake.

(iv) 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) Unfunded retention Is a case where there are no budgeted allocations to meet

uninsured losses.

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.

Encourage loss prevention-Since the exposure is retained; there may be greater

incentives for loss prevention.

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.

Possible higher expense- Expenses may actually be higher


27

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.


28

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.

49. 50. 51. 52. 53. 54.

4.3 Activities;

Take time and visit any three professional management firms in your nearest town,

while there find out the various business ventures they do, secondly find out the

strategies they put in place to manage the various risks that faces them and if they

employ different strategies to manage the same set of risks they encounter.


With many catastrophes such as drought, floods, hunger, insecurity affecting many parts of

Kenya. Discuss the various risk management strategies that can be used to manage such risk.


29

55. 56. 57. 58. 59. 60.

61. 62. 63.

4.5 Summary


i) Risk control is a strategy that focuses on minimizing the risk of loss to which an

organization is exposed; it can be done using risk reduction and risk avoidance.

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

risk, secondly consider the odds and lastly do not risk a lot for a little.



Vaughan, E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th Edition, Wiley

Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th Edition, Prentice

Hall


30

LECTURE 5: RISK MANAGEMENT PROCESS AND RISK MANAGEMENT

PROBLEMS

5.0 Introduction

Risk management process refers to a series of steps that must be accomplished in

managing risks. They includes; Determination of objectives, Identification of risks,

Evaluation of risks, considering alternatives and selecting the risk treatment device,

implementing decisions, evaluation and Review

5.1 Lecture Outline







The objectives of a risk management program must be determined initially i.e. deciding

precisely what the organization would like the risk management to do.

Risk management has a variety of objectives that can be classified into two;

i) Pre-loss objectives

ii) Post-loss objectives



i) Discuss the risk management process that can be universally adopted by

organizations in Kenya.

ii) Enumerate the various tools that can be used to identify risks that affect

organizations.

iii) Enumerate the various risk management problems faced by companies today

.

13) to 14) to 15) to


31

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. Other scholars have advocated that the objective of risk

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 non-

governmental 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.


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


32

not limited to insurable or those experienced in the past. For risk identification to be

successful there must be two essentials;

(i) The task of risk identification must be someones job. This is because

everybodys responsibility is nobodys responsibility e.g. having a risk manager

or someones job description includes risk identification. Good management on

its own is not enough to identify risk, it must be someones job.

(ii) The tools of risk identification must be available to the person to identify risk.

The techniques and tools of risk identification include;

a) Gaining thorough knowledge of the organization and its operations by way of

interviews and outside the organization as well as examining the internal records and

documents.

b) Analysis of documents

The purpose of this is to discover trends. The documents to be analyzed include;

financial statements, contracts, inventory records, valuation reports e.t.c.

c) The flow charts

The flow chart of an organizations internal operations will view the organization as a

process and therefore seek to discover all contingencies (Unexpected liabilities) that

could interrupt the processes involved e.g. damage to key assets of the organization,

loss of key staff through death, incapacitation or resignation.

d) Risk Analysis questionnaires

These are also referred to risk tact tenders and assist in identifying risks by pausing a

series of questions whose answers will indicate whether hazardous conditions exist

e.g. does KSPS have flammable substances within the premises, does the college

have fire extinguishers that are in operational order etc.

e) Exposure Check list

This refers to a list of common exposures where aim is to reduce chances of

commissions and oversight some of which can be serious.

f) Insurance Policy checklists

These are checklists available from insurance companies and publishers of insurance

material that indicate the variety of policies that exist to cover risks.


33

g) Export computer systems

Such systems incorporate the features of risks analyze questionnaires, exposure

checklists and insurance policy checklists in one system.

h) Other Internal Records:

In addition to the Financial Statements there are other internal documents that can be

used to identify loss. These include; corporate laws, annual reports, minutes of board

and directors meetings, organization chart, policy manual, contracts such as leases

and rental agreement, purchase orders etc.

i) On Site Inspection:

Involves visiting various locations and departments where assets are located. Just as

one picture is worth a thousand words, one inspection tour may be worth a thousand

checklists.

j) Contract analysis:

This specifies who bears the loss in case it happens e.g. in sales contract, you may be

given a warrant.

k) Statistical Analysis of Past Losses:

This is done by simulating the chance of occurring using data generated by a

computer based on past events. Example; In motor vehicle industry (Matatu)

accidents occurs mostly during holidays (Easter, Xmas etc.) due to either overloading

or over speeding.

l) Studying organizational chart: Studying organizational chart could help the company

identify exposure to pure loss through loss of key personnel. Example is the case of a

very expensive machine critical to a manufacturing process which can only be

operated by one employee. This unfortunate state of affair could be identified through

scrutiny of the organizational chart.

m) Forecasting :The organization can identify its pure loss exposure through forecasting

of expected income under normal circumstances and an estimation of post loss

income .The difference is the loss


34

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.


Once risks have been identified, the risk manager must evaluate them by ranking them in

terms of importance (prioritization).

There is need to consider the approaches that might be used to deal with risk and then

select the technique appropriate to deal with the identified risk. During this stage, the

risk manager is primarily concerned with deciding on which of the techniques available is

appropriate.

In deciding which of the available techniques should be used, the risk manager should

consider:

1. The size of potential loss.

2. The probability of potential loss

3. Resources available to meet the loss should it occur.

4. The cost and benefits of each of the techniques to be adopted.


At this stage of the risk management process, a decision is made and implemented in the

organization such that if the decision is loss prevention, then a loss prevention program

must be designed and executed. If the decision is risk transfer through insurance, then

the selection of the insurer negotiation and placement is made. If the decision is to retain

risk, reserve funds must be accumulated in order to meet losses should they occur.

5.1.6 Evaluations and Review

There is need to evaluate and review the whole process due to the new changes that may

occur and new risks that arise. Hence, the technique that was appropriate in previous

periods may no longer be applicable in the current year.

Evaluation and review is important as it enables the risk manager to review decisions

made and detect mistakes before they become costly. Review can be done by repeating


35

the steps of the risk management process to determine whether past decisions were

proper in the light of existing conditions.


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) Measurement of costs and benefits

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) Measuring costs and benefits

A good feature of a successful RM is where theres absence of unpleasant surprises.

When a risk manager prevents or reduces losses and benefits accruing to the company,

they may not want to be faced with losses that they are not compensated. Some may

be difficult to measure, hence the need to install safety devices, to prevent such un-

contemplated risks.


36

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.

65.

66.

67.

68.

5.2Activities;

i) Plan a visit to the nearest service station in your locality, while there;

a) Find out the risk management process that is followed by the entity in operating its fuel

and gas business.

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.


37

69.

70.

71.

72.

73.

74.

75.

76.

77.

78.

5.4 Summary


i)The risk management process comprises of the following processes; Determination of

Objectives, Identifying risks, Evaluating risks and considering alternatives,

Implementation, evaluation and review.

ii) The there are various techniques and tools that are used in risk identification, among

them includes; Analysis of documents, the flow charts, Risk Analysis questionnaires,

Exposure Check list and Valuation of property among other tools.

iii) There are number of key characteristics that tend to distinguish risk management

problems from the other operational managers problems and they include the following:

time horizon, measurement of costs and benefits, credibility of data, possible

uncertainties, possible externalities, and independent exposures


1. Risk management identification tools are at best assumed to be scientific in the

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.



Vaughan, E. and Vaughan, T. (2003) Fundamentals of Risk and Insurance 9th Edition,

Wiley


Prentice Hall


38

LECTURE 6: INSURANCE DEVELOPMENT

6.0 Introduction

In this lecture we are going to learn how insurance business came to evolve with the

Chinese merchants as early as 3000BC, the transfer of risk via Great Code of

Hammurabi, to the times of Edward Lloyd coffee house. The lecture will also delve

into the African traditional societys ways of managing risk to the modern times. We

shall explore on how the insurance mechanism works, requisites of insurability,

guiding principles in establishing risk classes and lastly look at the functions and

benefits of insurance to a society.

sites

6.1 Lecture Outline

6.1.2 Historical development of insurance




6.1.6 The guiding principles in establishing risk classes


6.1.2 Historical development of insurance.

As early as 3000BC Chinese merchants utilized the techniques of sharing risks. About

500 years later, the famous Great Code of Hammurabi provided for the transfer of the

risk of loss from merchants to moneylenders. Under the provisions of the code, a trader

whose goods were lost to bandits was relieved off the debt to the moneylender who had



i) Document the historical development of insurance from the ancient times to its

present day developments.

ii) Explain how the insurance mechanism operates in an economic system like

Kenya.

iii) Discuss the functions and benefits of insurance to a country like Kenya.


39

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.

Ship-owners seeking insurance found the coffeehouses of London convenient meeting

places. One of the coffeehouses owned by Edward Lloyd, soon became the leading

meeting place. Lloyds is known to have been in existence early in 1688.

3.1.1 Traditional African society

The concept of insurance is not new to Africa. The African communities have had

traditional forms of managing risks facing them. It is still common for the old or sick to

expect material support from members of their families or clan. The family was a strong

compact unit and family meant more than just husband, wife and children. The cost

(premium) was that any good fortune was shared by all. Relics of this practice exist even

today and the famous Harambee is a spin off these traditional insurance practices.

These traditional forms of insurance are dying fast in most developing countries as a

result of economic and social developments.


40

3.1.2 Modern Insurance in Kenya

Following the scramble for Africa towards the end of the 19th

Century, various European

powers established sovereignty on the African soil. This meant that trading operations

needed certain services among them insurance. The insurance industry in Kenya owes its

beginning to foreign nationals mainly of British and Asian origin. Although the exact

date of birth of the insurance industry in East Africa is not known, there is evidence that

the first marine agency was opened in the Island of Zanzibar in 1879. It took another

twelve years before an insurance office was opened in Kenya. One British company was

represented here in 1891. But the real birth of the industry was within the first two

decades of the 20th

Century. The foreign companies in Kenya operated through agents

before establishing branches. Most of the agents were individuals or firms that transacted

other businesses and not specialized in insurance. One of the early companies to open

branches was Royal Exchange Assurance of London which opened a branch in Kenya in

1922. It was in 1930 that the first locally incorporated company was set up in the name of

Pioneer Assurance Society Limited. The others that followed are Jubilee Insurance in

1937 and Pan Africa Insurance in 1946. The insurance industry has grown since then to

the current position. There are about 200 registered insurance brokers, 193 loss assessors,

22 surveyors, 18 loss adjusters, 3 risk managers, about 3000 insurance agents, 43

insurance companies and 2 local reinsurance companies.


Individuals and companies (exposure units) reduce their risks by forming a pooling

arrangement. Risk averse individual and companies are persons who value lower risks

and therefore they have the incentive to participate in the risk pooling arrangement,

especially if such arrangements can be made at a lower cost.

Its not costly to operate a pooling arrangement and indeed, the cost of organizing and

operating this arrangement is the main reason for existence of insurance companies.

If for example there are 1000 vehicles in a given community, with a value of sh

1,000,000 each, the vehicle owners face the risk that they could be stolen or be involved

in serious accidents, five etc.


41

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.

Expectation gap in risk pooling arrangement

(i) Some people believe that its a waste to purchase insurance especially if a loss

does not occur and they are indemnified.

(ii) Other people believe that if they have not had a loss during the policy term, they

should be refunded their premium.

Both points constitute ignorance because:

i. 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.


42

ii. The operation of the insurance principle is based on the contribution of many

paying for loses of the unfortunate few, who have suffered. Therefore, if

premiums were to be returned to the many who did not suffer loss, there will be

no funds to cater for the few who actually incurred losses.


It is important to note that the world of businesses is not static and what may be

uninsurable risk today could very well be insurable tomorrow. A good example is recent

moves to ensure political risks through the African Trade Insurance Agency (ATIA).

However, the following would be the requisites for insurability:-

1. Fortuitous the happenings of the event must be entirely fortuitous to the insured.

These rules out inevitable events such as wear, tear and depreciation. Any damage

inflicted on purpose by the insured would be ruled out. However, purposeful events

by other persons would be covered provided they were fortuitous as far as the insured

is concerned. In life assurance, although death is certain, the timing of death is what is

fortuitous and that is the concern of life assurance.

2. Financial Value Insurance does not remove the risk but it endeavours to provide

financial protection against the consequences. Therefore, the losses must be capable

of financial measurement. In some cases the court will decide the level of

compensation due to an injured person while in property insurance it is possible to

place a value on the loss or damage. In life assurance, the level of financial

compensation is agreed at the beginning of a contract.

3. Insurable Interest Refer to principles of insurance to be discussed later

.

4. Homogenous Exposure The law of large numbers entails that given a sufficient

number of exposure to similar risks, the insurance company can forecast the expected

extent of their loss and therefore move towards accuracy in setting premium levels.

There might be a few cases where heterogeneous exposures are insurable but on the

whole insurers prefer homogenous exposures in order to benefit from the law of large

numbers.


43

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) Public Policy Contracts must no be contrary to what society would consider

right and moral e.g. contracts to kill a person, no insurance for criminal venture.


i) 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.


44

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.

6.1.6 The guiding principles in establishing risk classes

i) Separation and class homogeneity

If the insurer constructed its risk classes carefully, each class will have a

significantly different expected loss (separation). Moreover, each member of a

given class will have approximately the same chance of loss (class

homogeneity). This rule prevents combining males ages 20 and 40 in the same

life insurance pool and causes a mathematically fair insurance exchange.

ii) Reliability

If insurers decide to use a particular factor for classifying insureds, information

about the factor should be easily obtained and not subject to manipulation by the

insured. The variables of age and sex would meet this standard, but asking an

applicant kilometers are driven each year or whether drugs or alcohol are used

would not do as well because insureds can provide false information.


45

iii) Incentive value

If risk classes are crafted in a way designed to promote using societys resources

carefully, insureds should be rewarded for maintaining clean driving records or

for applying loss prevention measures. Thus, factors used for risk classification

should reward good insureds (those with below-average loss potential) with

better insurance rates.

iv) Social acceptability

This is the underwriting criterion that is the most difficult to handle. Who is to define

social acceptability? Moreover, this measure has the possibility of being at odds with

the preceding risk classification criteria. How are such conflicting outcomes to be

resolved? What do we do when the desirability of a mathematically fair insurance

exchange conflict with a socially desired outcome?


1. Risk Transfer The primary function of insurance is that it is a risk transfer

mechanism which exchanges uncertainty for certainty. It exchanges the uncertain

loss for a certain premium.

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. Equitable Premiums - An insurance company maintains several pools for each

risk. This enables the insurer to tell the profitable from the unprofitable ones.

However, similar types of risks could be brought into a common pool although

they will represent different degrees of risk to the pool. This should be reflected

in the contributions to the pool. It wouldnt be equitable for private car owners to

subsidize commercial vehicle owners. The insurer has to ensure that a fair

premium is charged, which reflects the hazard and value of risk brought to the


46

pool. The completive forces must also be taken into consideration in premium

rating.

Benefits of Insurance

1. Peace of Mind The knowledge that insurance exists to indemnify provides

peace of mind for individuals, industry and commerce. Insurance encourages

entrepreneurship by way of transfer of risk. It also stimulates the business in

existence by releasing funds for investment. The recent spate of robberies to

banks in Kenya could have easily sent some closing, but because of insurance

these risks are catered for. The need of peace of mind has led the government

to make some forms of insurance compulsory e.g. third party liability cover,

workmens compensation and employers liability.

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. Investment of Funds Because of the time lapse between receipt of premium

and payment of claims, insurers are major investors of funds. By having a

spread of investments, insurance helps government in borrowing, offers loans

through mortgages, buying of shares on the stock exchange etc. They form a

part of institutional investors including banks, building societies and pension

funds. They also invest in property e.g. ICEA Building, Jubilee Insurance

House, etc. Most life funds are invested in longer term ventures as apposed to

general insurance. Insurance therefore assists in mobilizing savings.

5. Invisible Earnings Insurance is one of the invisible earning forums including

such areas as tourism, banking etc. Risks outside the country can be insured in

Kenya and money earned on these transactions represents a substantial

volume of earnings. It contributes to a favorable balance of trade i.e. exports

exceed imports.


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79.

80.

81.

82.

83.

84.

85.

86. 87. 88. 89. 90. 91. 92. 93. 94. 95. 96. 97. 98. 99.

6.2 Activities;

i) Plan a visit or make a call to Jubilee insurance head office in Nairobi with a sole purpose of

knowing its historical development in the country.

ii) Try to establish the requisites Jubilee insurance considers in order to accept a risk for

insurance.

iii) The benefits and or impact its insurance business has had in the country in the years it has

operated in the country.

6.4 Summary


i) Insurance has developed from the ancient times to its present day developments.

ii) Insurance mechanism is a risk pooling arrangement where an individual transfer

his or her risk to the pool.

iii) 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.

iv) 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.


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.


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100. 101. 102. 103. 104. 105.




Edition, Wiley

Dorfman, M.S. (2005) Introduction to Risk Management and Insurance, 9th

Edition, Prentice Hall


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LECTURE 7: CLASSES OF INSURANCE

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


7.1.3 Liability Insurance

7.1.4 Property insurance

7.1.5 Transport insurance

7.1.6 Pensions and annuities


This is a contract between the policy owner and the insurer, where the insurer agrees to

pay a sum of money upon the occurrence of the insured individuals or individuals

death. It is the risk pooling plan and economic device through which the risk of

premature death is transferred from the individual to a group In return the policy owner

or policy payer agrees to pay a stipulated amount called a premium at regular intervals or

in lump sums (so-called paid up insurance).


At the end of the lecture you should be able to:

i) Distinguish between Life and Health insurance policies.

ii) Enumerate the various categorization of Life and Health class.

iii) Discuss the different liability insurance policies available in the market.

iv) Discuss the various property insurance policies sold in the Kenyan market.

v) Explain the difference between pensions and annuities.

16) to 17) to 18) to


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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) There is no possibility of partial loss in life as in the case of property and

liability insurance. Therefore, if a loss occurs under life ass

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