RISK MANAGEMENT AND INSURANCE

CONCEPTS AND PRACTICE

BY

MIDIKIRA CHURCHIL KIBISU

SENIOR LECTURER, DEPARTMENT OF BUSINESS
ADMINISTRATION
UNIVERSITY OF NAIROBI
 TABLE OF CONTENT
ITEM PAGE
Overview ................................................................................................................. 1
objectives of the course ………………………………………………………….. 1-5
Lecture 1: Conceptual Framework and significance of Risk………………… 6
1.0 Introduction………………………………………………………………. 6
1.1. Objective ………………………………………………………………… 6
1.2. Definitions ………………………………………………………………. 6
1.3. Economic (cost) significance of risk…………………………………….. 7-10
1.4. Necessity of teaching Risk Management ……………………………….. 10-11
1.5. Summary ……………………………………………………………… 11
1.6. Activities ……………………………………………………………….. 12
Lecture 2: Concepts of Risk…………………………………………………. 13
2.1 Objective ……………………………………………………………….. 13
2.2. Relation of Risk to Insurance……………………………………………… 13
2.3. Types of Risks …………………………………………………………. 13-16
2.4. Terms Related to Risk………………………………………………….. 16-18
2.5. How Risk may Affect Business ……………………………………….. 18-20
2.6. Summary ………………………………………………………………. 20
2.7. Activities……. ………………………………………………………… 20
Lecture 3: Classification of Risk ……………………………………………. 21
3.0 Introduction…………………………………………………………… 21
3.1. Objectives ………………………………............................................... 21
3.2. Classifications …………………………………………………………. 21-25
3.3. Summary ………………………………………………………………. 25
3.4. Activity………………………………………………………………… 25
3.5 Enterprise Burden of Risks…………………………………………….. 26-36
Lecture 4: Risk Management Historical and Definitions and Application.. 37
4.0 Introduction…………………………………………………………… 26
4.1. Objectives …………………………………………………………. 26
4.2. Definition of Risk Management ………………………………………. 27
4.3. Historical Development.………………………………………………. 27-30
4.4. Nature of Risk Management ………………………………………….. 29-31
4.5. Risk Management in Practice………………………………………….. 31
4.6. Summary ………………………………………………………………. 32
4.7. Activity ………………………………………………………………… 32
Lecture 5: Risk Management Programme………………………………….. 34
5.0 Introduction…………………………………………………………… 34
5.1. Objectives ……………………………………………………………... 34
5.2. Risk Management Programme Objectives……………………………. 34-40
5.3. Summary ……………………………………………………………… 40
5.4. Activities ……………………………………………………………… 40
Lecture 6: Risk Management Programme
(Identification and Measurement of Risk) …………………….. 41
6.0 Introduction………………………………………………………….. 41
6.1. Objectives …………………………………………………………….. 41
6.2. Risk Identification and Evaluation ……………………………………. 41-43
6.3. Identification Tools …………………………………………………… 44-46
6.4. Measurement …………………………………………………………. 47
6.5. Ways of dealing with Risk …………………………………………… 48-49
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6.6. Summary……………………………………………………………… 49
6.7. Activities …………………………………………………………………. 49
Lecture 7: Risk Handling Techniques……………………………………… 50
7.0 Introduction……………………………………………………………… 50
7.1. Objectives………………………………………………………………… 50
7.2. Risk Handling Techniques……………………………………………….. 50-53
7.3. Risk Treatment…………………………………………………………… 54-55
7.4. Implementation and Review…………………………………………….. 55-56
7.5. Review and Evaluation of Risk Management Programme……………… 56-57
7.6 Summary………………………………………………………………… 57
7.7 Activity………………………………………………………………….. 57
Lecture 8: The Insurance Device……………………………………………… 58
8.0. Introduction ……………………………………………………………… 58
8.1. Objectives……………………………………………………………….. 58
8.2. Definition………………………………………………………………... 58
8.3. Interpretation of Probabilities…………………………………………… 58-60
8.4. Law of Large Numbers and its Application…………………………….. 60
8.5. Measurement of Risk using probabilities……………………………….. 61-62
8.6. Summary………………………………………………………………… 62
8.7 Activity………………………………………………………………….. 63
Lecture 9: The Insurance Device……………………………………………….. 64
9.0 Introduction……………………………………………………………… 64
9.1. Objectives………………………………………………………………... 64
9.2. Definition………………………………………………………………… 64-65
9.3. Requisites of Insurability………………………………………………… 65-68
9.4. Summary…………………………………………………………………. 68
9.5 Activity…………………………………………………………………… 68-69
Lecture 10: Development of Insurance……………………………………….. 71
10.0. Introduction………………………………………………………………. 71
10.1. Objectives………………………………………………………………… 70
10.2. Development of Various Insurance lines………………………………… 72
10.3. Origins, growth and control of organized Insurance in Kenya…………… 72-74
10.4. Socio-Economic Transformation ………………………………………… 74-75
10.5. Growth after Independence……………………………………………….. 76-79
10.6. Regulations and Control………………………………………………….. 79-80
10.7. Registration of Insurance ………………………………………………… 80-81
10.8. Stimulated Accountability………………………………………………… 81
10.9. Insurance Advisory Board of Kenya……………………………………… 82
10.10. Development of Insurance in Kenya…………………………………….. 82-83
10.11. Summary………………………………………………………………… 84
10.12 Activity…………………………………………………………………… 85
Lecture 11: Principles and legal Aspects of Insurance………………………… 86
11.0. Introduction……………………………………………………………….. 86
11.1. Objectives ………………………………………………………………… 86
11.2. Insurance Contracts……………………………………………………….. 86-87
11.3. Construction of contract….…………………………………………. 87
11.4. Legal Aspects of Insurance….. …………………………………….. 87-90
11.5. Policy Construction……………………………………………………….. 90
11.6 Principles Governing Insurance…………………………………………… 91-106
11.7 Summary…………………………………………………………………... 107
11.8 Activity……………………………………………………………………. 107
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Lecture 12: Types of Insurance………………………………………………… 108
12.0. Introduction……………………………………………………………….. 108
12.1. Objectives………………………………………………………………….. 108
12.2. Insurance of the Person………………………………………………….. 108-110
12.3. Traditional Life Policies………………………………………………….. 110-116
12.4. Health Insurance………………………………………………………….. 117-119
12.5. Health Maintenance of Organizations……………………………………. 119
12.6. Summary………………………………………………………………….. 119
12.7 Activity……………………………………………………………………. 120
Lecture 13: Life Assurance…………………………………………………….. 121
13.0. Introduction……………………………………………………………….. 121
13.1. Objectives ………………………………………………………………… 121
13.2. Mortality…………………………………………………………………. 121-123
13.3. Mortality Table…………………………………………………………... 123-127
13.4. Factors to consider in calculation of premium…………………………… 128-130
13.5 Summary………………………………………………………………….. 130
13.6 Activity……………………………………………………………………. 131
Lecture 14: Types of Insurance………………………………………………... 132
14.0. Introduction………………………………………………………………. 132
14.1. Objectives………………………………………………………………… 132
14.2. Property Insurance..………………………………………………………. 132-136
14.3 Summary…………………………………………………………………… 137
14.4 Activity…………………………………………………………………….. 137
Lecture 15: Type of Insurance (Liability, Motor, Marine, Aviation)………. 138
15.0. Introduction………………………………………………………………. 138
15.1. Objective …………………………………………………………………. 138
15.2. Liability Insurance……………………………………………………….. 138-143
15.3. Motor Insurance ………………………………………………………….. 143-148
15.4. Social Insurance ………………………………………………………….. 149-150
15.5 Marine Insurance………………………………………………………….. 150-151
15.6 Application of Principles of Insurance……………………………………. 151
15.7 Summary…………………………………………………………………... 152
15.8 Activity……………………………………………………………………. 152
Lecture 16: Underwriting and Claims…………………………………………. 153
16.0. Introduction……………………………………………………………….. 153
16.1. Objective …………………………………………………………………. 153
16.2. Underwriting ……………………………………………………………… 153-157
16.3. Policy document ………………………………………………………….. 157-159
16.4. Claims Administration ……………………………………………………. 159-161
16.5. Premium Computation ……………………………………………………. 161-162
16.6. Summary ………………………………………………………………….. 162-163
16.7. Activity …………………………………………………………………… 163
Lecture 17: Reinsurance ……………………………………………………….. 164
17.0. Introduction ……………………………………………………………….. 164
17.1. Objectives ………………………………………………………………..... 164
17.2. Definition of terms ……………………………………………………… 164-165
17.3. Historical Background ……………………………………………………. 165
17.4. Terminologies used in Reinsurance ………………………………………. 165-166
17.5. Types and methods of Reinsurance ………………………………………. 166-173
17.6. Bases of reinsurance cover………………………………………………….173
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17.7. Reinsurance Markets ……………………………………………………… 174
17.8. Premium Payments ………………………………………………………... 174 -176
17.9. Inflation …………………………………………………………………… 176- 177
17.10. Applications of Reinsurance. ……………………………………………… 177-179
17.11. The functions of Reinsurance …………………………………………….. 179-182
17.12. Coinsurance. ……………………………………………………………… 182
17.13. Commissions ……………………………………………………………... 182
17.14. Record-keeping and payment of a claim…………………………………. 182
17.15. Reinsurance Companies in Kenya ………………………………………. 183
17.16. Summary …………………………………………………………………. 184
Lecture 18: Marketing of Insurance ………………………………………... 185
18.0. Introduction ……………………………………………………………… 186
18.1. Objectives ……………………………………………………………….. 186
18.2. Dynamism of Marketing ………………………………………………… 186
18.3. What is marketing ……………………………………………………….. 187
18.4. Principles comprising Marketing of Insurance………………………….. 187
18.5. What does marketing do ………………………………………………... 188
18.6. Approaches to Marketing Business..……………………………………. 188-190
18.7. Development of Insurance Market ……………………………………… 190
18.8. Types of Insurance Companies ………………………………………….. 191-192
18.9. Intermediaries ……………………………………………………………. 192-195
18.10. Premium Payments ………………………………………………………. 195
18.11. Cooperation in the Insurance Industry …………………………………… 195-196
18.12. Summary …………………………………………………………………. 196-198

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OVERVIEW OF THE COURSE

RISK MANAGEMENT AND INSURANCE:

(AN ESSENTIAL PART OF THE COMMON BODY OF KNOWLEDGE
FOR BUSINESS).
Today’s managers must function in increasingly complex environments that generate many
risks (uncertainties). Some situations, such as those involving strategic decision-making,
have the prospect for either gain or loss. In contrast, other forms of uncertainty involve only
the potential for loss. The effects of such losses can threaten not only operational goals such
as profitability and growth but also the organization’s very survival. As the variety and
severity of potential losses escalate, it is increasingly important that organizations make
effective and efficient arrangements for managing their uncertainties and the associated
consequences of losses should they occur.

Knowledge of the methods for analyzing and effectively dealing with exposures to risk is
essential for those who hope to be competent organizational leaders, both now and in the
future. Yet, thousands of business school students are graduated each year from accredited
institutions, without formal instructions in this area. Arguably, such students are not fully
prepared for their future management roles. They, their employers, and society as a whole
all suffer from this deficiency. This course presents details regarding this problem and
concludes with suggested solutions.

OBJECTIVES OF THE COURSE

The objectives of this course are to:
 To impart the student with the intricate and important concepts of risk
 To give the students an overview of managing both personal and business
risks and skills which they can use in their personal lives as well as in the
management of businesses.
 To introduce the students to the theory and principles of insurance and
their utilization in risk management.
 Provide the student with an overview of the key insurance lines available
in the market including social insurance and reinsurance.
 To introduce the student to the general practice and marketing of
insurance

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 LECTURE 1

CONCEPTUAL FRAMEWORK AND SIGNIFICANCE OF RISK

1.0 Introduction
Exposure to risk and its management is a daily life undertaking. In both personal and
business lives we are faced by various risks, which pose financial losses to us. When
we walk on the streets we are faced with numerous risks such as being run over by a
car or being robbed .As we walk we are taking precautions that nothing bad happens
to us. Our obligation is therefore to try and minimize such losses and their negative
financial impact. Many people have suffered financial losses and companies have
gone under because of their inability to manage risks or their poor way of handling
the risks to which they are exposed.

1.1 Objectives:
At the end of this lecture the student should be able to:
1) Define risk
2) Have an overview of the nature of risk
3) Appreciate the necessity of teaching Risk Management
4) Understand the economic significance of risk both at micro and
macro levels

1.2 Definitions of Risk

To start us off let us understand what risk is. There are several definitions used by
those who manage risks. Five of these are stated below:

1.2.1 Risk is the chance of a loss

This definition implies that one is exposed to some loss at any time in his or her life.
The loss may take place or never take place, but there is always a chance that the loss
may take place.

1.2.2 Risk is a possibility of a loss

When we talk about the possibility of something happening, we are not very certain
that the event will take place, but from experience we know that the event could take

6
 place. If we have experienced a loss in the past, then there is a possibility that a similar
loss could take place again.

1.2.3 Risk is the dispersion of actual from expected results

In business especially, we undertake certain business decisions and expect certain
results. When we do not realize the expected results, there is a dispersion from the
actual that is the result is different from what was expected. This dispersion is the
risk and can be measured in absolute terms or using percentages.

1.2.4 Risk is the Probability of any outcome different from the one Expected
Probabilities are measured from 0 to 1(or. 0% to 100%). We can therefore assign a
probability of a certain event happening based on past occurrences or experiences.
The higher the probability the higher the chance of that event occurring. Therefore
the risk is measured by the probability assigned to it.

1.2.5 Recommended Definition

As you can see, all the above definitions reflect an aspect of uncertainty. Risk is
therefore defined as:
“Risk is a condition in which there is a possibility of an adverse deviation from
a desired outcome that is expected or hoped for”

1.3 Economic (cost) Significance of Risk.

The concept of the cost of risk can be examined from both a microeconomic and a
macroeconomic perspective. The microeconomic perspective considers how
individual organizations deal with risk, whereas the macroeconomic perspective
considers the cost of risk to society.

1.3.1 Microeconomic Perspective

Each year organizations spend hundreds of billions of shillings in connection with
“pure risk” exposures, i.e. those that present only the possibility of loss should they
occur. Some of this money is spent wisely, as part of formal management programs
that analyze alternative ways to deal with a particular organization’s loss exposure.
In other cases, management is less aware of alternative methods for handling pure

7
 risk exposures. Consequently, the entity’s operational goals can be adversely
impacted by less than optimal decisions. For example: -
i) Excessive time is spent by managers and boards in dealing with unanticipated
losses, thus detracting the firm from strategic concerns;
ii) Credit ratings of the firm and firm’s costs of capital are adversely affected;
iii) Cash flows, profitability, and growth are reduced due to sub-optimal pricing
structures necessitated by concerns over risk;
iv) Public images are tarnished and customers are lost as a result of actions that
offend societal norms;
v) Inadequate allowance is made for funding post-retirement health and welfare
plans;
vi) Qualified persons sometimes are reluctant to serve on boards of directors because
of concerns about personal liability; and
vii) Strategically desirable projects are not implemented due to inadequate abilities to
manage associated loss exposures.

At worst, the very survival of an organization may be placed at risk due to management’s
none recognition or underestimation of significant exposures to loss. One example in
USA is A.H. Robins, Inc., which was forced into bankruptcy in 1985 due to liability
losses arising out of one of its products, the Dalkon Shield. In Kenya (2006), the Uchumi
Super Market chain went under due to inability to manage unplanned expansion, thus
exposing shareholders to billions of shillings in losses.

The possible consequences and costs of risk are difficult to quantify completely.
Certainly, the actual shilling amount currently expended to manage costs due to pure risk
exposures is quite large. Counting potential property losses alone, many corporations
have several billions of shillings worth of exposures, and it is no longer rare when losses
arising out of a single incident exceed Kshs. 1 billion. Recent examples of such
spectacular property losses include the terrorist bomb attacks that damaged the American
Embassy in Nairobi (1998) and the tourist hotel in Mombasa (2003) or the explosion of
a petrochemical complex owned by Philips Petroleum Company and the 1988 Piper
Alpha oil platform explosion in the North Sea. In 1990 alone, U.S., companies spent
nearly $150 billion in premiums for insurance to protect against property and liability

8
losses. In addition, these same corporations spent almost $100 billion on risk-handling
techniques that are alternatives to commercial insurance.

Most recently is the Tsunami disaster that visited the South East Asia (2004) and caused
havoc to property and death to thousands of people, and the recent typhoons that brought
damage to property and caused the death of over 10,000 people in New Orleans (2005)
in U.S.A. or the constant damage to property and spread of disease caused by floods in
Budalangi Busia District (Kenya).

To these figures can be added the un-reimbursed costs and non-quantifiable elements of
property losses and adverse liability judgments for which organizations were not
prepared, as well as the rapidly increasing costs for employee healthcare and worker’s
compensation benefits. The cost to all U.S. employers in 1988 for healthcare benefits
alone was estimated by the U.S Chamber of commerce to be more than $ 77 billion,
representing nearly 9% of all payroll expenses, with a growth rate of 19% over the
previous year. Even these figures fail to capture the full extent of future requirements for
the accrual of liability for post-retirement benefits.

Clearly, in this environment, knowledge not only of loss exposures and employee-related
obligations but also of the many alternatives for handling risks is essential for effective
management. Such concerns form the subject matter for the field that has become known
as risk management.

As you may have noted, many of the above examples are drawn from North America.
This is because in Kenya today it is not easy to quantify and verify some of the risk
exposures that many companies are exposed to because many companies and government
have not accorded risk management concepts the seriousness they deserve. Losses such
as the burning down of a portion of the Nairobi City Council offices (2004) could be
something that could have been envisaged or provided for. Inadequate insurance
coverage was discovered after the fire. This means that no serious valuation of the
property was done to establish the potential loss the peril of fire could cause.

9
1.3.2 Macroeconomic Perspective.
While risk management principles have traditionally been taught primarily from a
microeconomic perspective, the macroeconomic perspective has been ignored though
equally important. Risk management is inherently international and universal in its
application. Its practice knows neither economic nor political boundaries and its
importance, both absolutely and relatively, increases with economic development.

The insurance component of risk management is especially important in dealing with

national and international commercial activity. Insurance alone contributes 20%
more than banking to the United States GNP, and it has been officially recognized by
the United Nations as a necessity for economic development. In Kenya today the
contribution of insurance to the GDP is in the range of 2% to 5 %. In addition to
acknowledging the importance of insurance, however, United Nations committees
have explored how to encourage risk management on a broader scale in developing
countries. Among the codes of organization for economic cooperation and
Development (OECD), certain risk management-related provisions are among the
most complete. Further, the current round of Multi-lateral Trade Negotiations taking
place under the auspices of the General Agreement on Tariffs and Trade (GATT)
seek to develop an international agreement on trade in services, including risk
management and insurance. Given such developments, as well as the increasingly
global environment in which more and more firms function, the need for managers
at all levels to better understand basic risk management principles will undoubtedly
accelerate in the future.

1.4 The Necessity of Teaching Risk Management

Given the scope and magnitude of pure risk exposures facing businesses and other
organizations, it is essential that those who aspire to managerial positions be educated
regarding risk management principles. Students who cannot recognize potential
sources of risk are inadequately prepared to participate fully in management
processes intended to achieve basic organizational goals such as profit maximization,
earnings stability, and growth.

At best, these future managers may learn basic risk management principles in an ad
hoc manner over time as they perform their jobs. In many instances, they will
10
 implement less-than-optimal methods of handling risks, perhaps only after losses
occur, with no prior integration of risk management concerns into overall managerial
philosophies.

At worst, such individuals may endanger the very survival of the organizations they
will be attempting to manage. This way of dealing haphazardly with potentially
catastrophic risks certainly is not desirable in an environment in which management
accountability is expected and demanded.

If all business students were required to learn the basic principles of risk management
decision-making, they and the organizations they work for would be well served. The
pure risk exposures now facing most organizations have become too large in both
sizes and scope to rely on outmoded management methods that fail to integrate risk
management considerations into all aspects of their planning, organizing, leading and
controlling processes.

In prior decades, some organizations were content to concentrate primarily on the

risk financing phase of risk management and then merely to buy insurance to protect
against obvious perils and employee obligations. In the intensively competitive, ever-
changing climate of the 21st century and beyond, however, such one-dimensional
management decisions will rarely be either optimal or prudent. Business, legal, and
societal pressures are all combining to require more sophisticated, integrated
approaches. Now and even more so in future years, it is essential that quality
management education include risk management as an integral and indispensable
element

1.5 Summary
The integrity of the higher education system demands that students
who study business be given a solid grounding in those areas that are
essential for responsibility, full participation in both business and
society. Students lacking an understanding of risk management are not
fully prepared to assume leadership roles in most organizations.
Their deficiency of knowledge may serve to undermine not only the achievements of basic
organizational goals but also the survival of the organization itself. In an era of management
11
accountability, business students can no longer afford to graduate without some proficiency
in a subject so essential to themselves and others. As the economic, legal, political and social
climates are evolving, it is of even greater importance that risk management be incorporated
into updated business curricula as a vital, integral element of business school preparation for
the challenges ahead.

1.6 Activity/Exercises

1. What is the significance of cost in determining risk?

2. Give the four definitions of risk and the most desired definition.
Can you come up with a comprehensive definition of risk using
your own words?
3. Identify disasters that have occurred in Kenya recently and discuss
what possible economic impact they may have had on the country
4. Can you look at your own family and consider the risks that it may
be exposed to?
5. Why is the concept of risk management important? Explain

12
 LECTURE 2

CONCEPTS OF RISK
2.0 INTRODUCTION
The concept of risk is not a new thing in our lives. When we talk about risk
automatically we think about uncertainty about the outcome of a particular event
whether it is in business or in personal life. Even those involved in gambling are
concerned about whether they will lose their bet or win. In life we do not know what
may happen to us in the next hour, day, months or even years to come. We may have
a notion that at one time in future we shall die, but we do not know exactly when we
shall die. This creates uncertainty and anxiety in our minds. All these are risks that
we must deal with at all levels.

2.1 OBJECTIVES
At the end of this lecture you should be able to:
1. Relate risk to insurance
2. Differentiate various types of risks
3. Differentiate between risk, peril, loss and hazard
4. Be able to appreciate the burden of risk to society
5. Understanding how risk and its Management affects Business

2.2 Relation of risk to insurance

Insurance is discussed from Lecture 8 onward. As discussed in the previous chapter
risk is “the possibility of an adverse deviation from a desired outcome that is
expected or hoped for”, or simply, uncertainty about the outcome of a certain
situation. The deviation from the desired outcome from the point of view of insurance
is normally accompanied by a financial loss, and the possibility of a financial loss is
a decline in, or a disappearance of value due to a contingency.

2.3 Types of risk.

There are various types of risks, which face individuals and business. These include:-
i. Economic risks
ii. Financial risks
iii. Deaths and public injury risks
iv. Employee dishonesty risks

13
 v. Social risks
vi. Physical risks
vii. Personal risks

Numerous examples of risks and losses that a firm or an individual can face were pointed
out in the preceding chapter. These suggest therefore that there are many types of risks.
Activity
List ten practical examples of losses that a business firm, situated
in an industrial city like Nairobi, can face. We discussed some of
these in lecture 1.

2.3.1 Social Risks

Social risks are caused by people. In other words it is people who cause some of the
risks they (or others) face. Examples of socially caused risks are numerous, for
instance, theft, vandalism and accidents. Theft of items like cars, household goods,
industrial equipment and many others amount to millions of shillings worth of
prosperity loss in the country over any one period.

2.3.2 Physical Risks

Physical cause of loss are also numerous. Some originate from natural phenomena
whereas damage others result from human error. Fire, which is a major cause of
death, injury, and damage to property, is a physical cause that may result from such
natural phenomena as lightning or human failure such as defective wiring. Other
examples include the weather (too much rain that causes floods or too little rain that
causes drought), landslides and earthquakes.

2.3.3 Economic Risks

Many of the risks that face a business firm (or an individual) are of economic origin.
As any basic text in economics will point out, the general level of activity in the
economy fluctuates from time to time. These fluctuations are seen in depressions
resulting in loss of jobs and decline in property values, expansions, booms and
recessions that bring losses to certain individuals and firms.

14
 Economic risks are such that they affect the whole society. Whereas it is possible for
some of them to be dealt with by individuals or some firms; the majority of them are
so large and complex that they call for unified measures by the society.
Activity
Identify one example of a risk that is not caused socially,
physically or economically.

Economic risks are those risks that a business or an individual faces because of this
changes in economic conditions. Such changes maybe caused by droughts, floods,
wars, overpopulation, coupdetat, inflation, etc. these changes can cause businesses to
close down or individuals to suffer hardships.

The basic challenge here is to reduce such risks while retaining the flexibility and
dynamic growth of the system.

2.3.4 Financial risks

These are risks of loss of income through investments or through destruction of
property. Examples would include loss of the principal investment in bonds plus
interest due to insolvency of the borrower, or loss of profits due to the destruction of
a factory by fire.

2.3.5 Death and accident risks.

These are the risks, which can also cause loss to both the business and an individual
either financially or morally. Death to a key employee or a director of a business can
cause the business to suffer financially. Accidents on the business premises of a
worker can also cause the business enormous financial losses. For an individual, the
death or impairment of the breadwinner, places the dependant in difficult financial
problems.

2.3.6 Personal and public risks.

These are risks, which face an individual or a business because of his or its actions
towards the public. These include things like injury to third parties and their property,
libel, nuisance, etc. again these can have far reaching financial losses to the
individuals or to the business through court cases.
15
2.3.7 Employee dishonesty risks
These are to do with fidelity or trustworthiness of a person As the owner of the
business cannot do everything by himself, he be trusted. Embezzlement of cash and
other dishonest practice can also lead to large financial loss to the business.
It is these numerous risks that individuals and business must guard themselves
against, because most of them have an implication of financial loss.
Having covered the concept of risk, we can now proceed to differentiate it from other
related terms.

2.4. Terms Related to Risk

Some students in discussing risk confuse it with a peril.

2.4.1 Peril
A peril is the loss-causing thing. Examples of perils will depend on the risk and how
it may be managed. They include:
 Death
 Fire
 Earthquake
 Sickness
 Negligence
 Accident

2.4.2 Loss
This is a term that we use in our day to day life. Can you define it? Check your
dictionary to verify the definition below as it relates to risk and insurance.

Definition:
When we talk about loss we mean the actual negative financial impact on an
individual or an organization as a result of a certain condition or happening of a peril.

16
 We can now look at some factors that may enhance risk and loss
2.4.3 Hazards
A hazard is defined as “a condition which affects both the frequency and size of a
loss. The hazards may be physical, moral or morale.

2.4.3.1 Physical Hazards

What are physical things? Can you name some?

Physical hazards are therefore “tangible physical things or conditions whose

properties or nature may lead to loss or enhance the extent of loss”.

Examples:
a) Flammable materials left unattended or stored in a place where fire is imminent.
b) Accumulation of rubbish which may result into diseases, injuries, fire, foul smell
etc.
c) A weakened timber or steel in a construction which may lead to loss in future e.g
the building collapsing and causing death or damage to other properties
d) Use of substandard materials in construction or equipment. These may lead to
nonperformance or collapsing of the construction and hence a loss
e) Defective or worn out tyres of a vehicle. This may lead to accidents.
f) A condition that may lead to heart diseases e.g. obesity.
g) Age. As we grow old our health deteriorates and may lead to death or increased
health care.
h) Exposed electrical gadgets. These may lead to electrical fires or may pose a danger
to children who come in contact with them.
i) Lack of exits in a building. When there is a stampede due fire or other disasters, lack
of sufficient exits may lead to high injuries or even death as people try to flee the
disaster.
j) Unqualified staff. These are a hazard because they may cause injuries to their fellow
workers or visitors. They may also cause other losses to the organization for lack of
experience.

2.4.3.2 Moral Hazard

17
 When we talk of moral hazard we mean behavioural practices, usually intentional,
which lead to a loss.
Examples include:
a) Criminal behaviour such as corruption or theft.
b) Lying and misinformation
c) Carelessness

2.4.3.3 Morale Hazard

Morale is to do with the mental state or attitudes of a person, which usually are not
intentional.
They include:
a) Psychological breakdown which lead to an individual acting in a manner likely to
cause accidents or harm.
b) Stress which may be due to exhaustion and carelessness and hence resulting in losses
c) Constant nagging of employees leading to fear and hence making costly mistakes

Can you think of the effects of the hazards we have just covered?

Hazards may or may not cause loss per se, but may increase the probability of a loss
occurring i.e. increasing the risk.
When underwriting insurance cover, insurers in the proposal form usually demand
full disclosure of hazards. Where circumstances warrant verification of hazards, the
underwriter, through some appointed agent would physically verify the hazards in
order to determine the quality of the risk to be insured. This can be achieved by visits
to properties, hiring assessors, physical examinations by doctors etc.

If the assessment is acceptable in accordance with the company’s policy, then they
will apply an appropriate rate in accordance with how they have rated the risk.

2.5 How Risk may affect Business

The overall objective of risk management is to maximize the value of the
organization. This goal is equivalent to minimizing the cost of pure risk, since such
cost reduces the value of an organization’s productive activities. The definition of
pure risk will come in the next chapter that follows. The cost of pure risk includes the
18
discounted expected value of cash outflows from losses, the cost of direct
expenditures to control risk, the value of foregone activity, and the cost of risk bearing
and risk-financing.

A firm’s exposure to pure risk affects its shareholders and bondholders its managers
and its employees, and its customers and suppliers. In any instances, it also affects
parties without direct contractual relationship to the firm. An important fact of risk
management is the analysis of the extent to which reduction in the variance of firm’s
cash flows through insurance or other pooling arrangements can increase firm value.
A large theoretical literature deals with the benefits of insurance and risk reduction
to risk a verse agent. This theory has less applicability to large firms with widely held
common stock, because shareholders of such firms can significantly reduce the
impact of non-systematic (non-market) fluctuations in cash flows associated with
pure risk through individual portfolio diversification.

It should be noted, however, that this ability of shareholders to diversify their

portfolios does not entirely eliminate the benefits of risk reduction activities by firms.
While diversifiable risks do not cause shareholders to increase the interest rates they
use in discounting a firm’s expected cash flows, such risk may significantly lessen
the size if the future cash flows that are anticipated13. Thus, shareholders can still
benefit from firm’s reduction activities. Examples include the effects of risk reduction
on a firm’s investment decision and on contractual relations with bondholders,
managers and other employees, and customers and suppliers.

More specifically, by reducing the probability of financial distress and by mitigating

potential post-loss conflicts between shareholders and bondholders, appropriate use
of risk reduction methods can reduce the likelihood that valuable investment
opportunities are foregone, thus affecting the level of expected cash flows. Risk
reduction also reduces the probability that reorganization or re-liquidation costs will
be incurred, enhance the employment security of managers and other employees, and
increase the likelihood that the firm will be able to honor commitments to customers
and suppliers. In each of these instances, risk reduction has the potential to increase
firm value and shareholders wealth by affecting the terms of contracts between
shareholders and other parties to the firm’s activities.
19
 A significant public policy issue in risk management is the extent to which a firm’s
private cost of pure risk may diverge from the cost of the risk to society. Firm value
maximization in the presence of limited liability rules can produce negative
externalities in some instances. The role of the tort system and government regulation
in mitigating attendant efficiency losses and the optimal responses of firms to judicial
and statutory constraints are important issues in risk management.

2.6 SUMMARY
In this chapter we were able to look at the various terms related to risk.
We were able to learn that there is a relationship between risk and
insurance in that risk is accompanied by a loss and insurance is used
as one of the ways of managing the risk and therefore reducing the
loss.
We were also able to identify and differentiate various types of risks which affect
individuals and business. Some of the risks we looked at included: economic,
financial, social, death, personal and public, employee dishonesty etc. These risks
affect us in different ways and we must be aware of them. The chapter also looked at
and defined other terms that tend to bring confusion to many students. These included
peril, which is the loss causing agent, loss which is the actual negative impact of a
peril, hazard which is a condition that enhances a risk. We also learnt that risk can
have a far reaching impact on business. The shareholders can lose money through an
operation of a risk which has not been properly managed. Both business and public
policy is necessary if we have to reduce the negative impact of risk.
2.7 Activity/Exercise
1) Identify personal and business risks that we may be exposed to
2) Differentiate between physical, moral and morale hazards
3) For the risks identified in (1) can you classify them for insurance
purposes
Reference
Vaughan, Emmett, J. Fundamentals of Risk and Insurance (chapter 1)

LECTURE 3
CLASSIFICATION OF RISKS

20
3.0 INTRODUCTION
In the preceding lecture, we discussed the concept of “risk” its pervasive nature, and
distinguished it from the concepts of “peril” and “hazard”. In this lecture, we intend
to focus on the various dichotomies of risk. These will help us later in determining
what tool to use in handling a specified risk.

3.1 OBJECTIVES
At the end of this lecture, you should be able to;-
1. Identify, and distinguish between, the various ways of
classifying risks:
2. Use the characteristics of a specified risk to classify it under
one of the various categories (types) of risks.

3.2 CLASSIFICATION OF RISKS

Numerous examples of risks and losses that a firm or an individual can face were
pointed out in the preceding chapter. These suggested therefore that there are many
types of risks, which can affect individuals and business in different ways. It requires
therefore that we understand their characteristics and sources.

Activity
List ten practical examples of losses that a business firm, situated
in an industrial city like Nairobi, can face. We discussed some of
these in lecture 1.

To date, there is no universally agreed method of classifying risks. Inspite of this, it

is generally accepted that when classified according to their sources practically all
risks can be identified. Drawing from the sources, it is possible for us to classify risks
in six ways, namely, objective and subjective, financial and non-financial, static and
dynamic; fundamental and particular, pure and speculative and personal and business
risks.

3.2.1 Objective and Subjective Risks

Subjective risk refers to the psychological uncertainty which stems from the
individual’s mental attitude or state of mind. Two individuals may have the same
21
 exposure to loss, for instance losing their property by fire, but one individual may
feel more uncertain about the event than the other. He may as a result insure his
property. He is said to have a greater subjective risk than the other person.

Objective risk refers to a state of nature that is the actual risk as measured by the
chance of loss. A situation may pose little or no objective risk for an individual; yet
instill in Him a big subjective risk. Phobias are typical examples of this.

On the other hand, an individual may entertain no subjective risk about a certain
possibility (for instance being hit by a falling meteorite) yet there is a small objective
risk bout such occurrence.

3.2.2. Financial and Non-financial Risks

In its broadcast context, the term “risk” includes all those situations in which there is
an exposure to adversity. In some cases, this adversity involves financial loss (that is,
it can be quantified in monetary terms), whereas in others it does not.
An example is loss of property (say a house) by fire; this is financial- as opposed to
the death of a loved one, (which is non-financial). Our emphasis will be with those
risks that involve losses that can be quantified in monetary terms (financial risks).

3.2.3. Static and Dynamic Risks

Dynamic risk result from changes in the economy, for instance, changes in the price
level, consumer taste, income and output, or technological changes may cause
financial loss to some in the economy. Dynamic risks are the results of adjustments
to mis-location of resources, and because of this, they will benefit the society in the
long run. Static risks are those that involve losses, which would occur whether or not
there were changes in the economy. Examples of these include losses from such
causes as perils of nature and the dishonesty of other individuals. They involve either
a destruction of an asset or any change in it’s possession. They are therefore not a
source of gain to the society.

NOTE:
Static risks are generally predictable because they tend to occur over
the time with a degree of regularity. Dynamic risk occur without any
22
 precise degree of regularity, and are therefore less predictable than
static risks.

3.2.4 Fundamental and Particular Risks.

A fundamental risk is impersonal in both origin and consequence. It is not caused by
one individual, and its impact generally falls on a wide range of people. Examples
include war, inflation, changing customs, typhoons, hurricanes and earthquakes.

A risk of particular nature has its origin in individual events and its impact is felt
locally. Examples of this would include accidental damage to personal effects, theft
of property, explosion of a boiler and death of a person.

NOTE:
It is their scope that distinguishes fundamental risks from ks. The
former are wider in scope (both in origin and consequence) than the
latter.

3.2.5 Pure and Speculative Risks

Pure Risks refer to that situation that may result in one of two likely outcomes – either
there is a loss, or there is no loss. For example, damage to one’s car by an accident.
Either there is damage (that is, the accident occurs) or there is no damage (the
accident does not occur).

NOTE: No benefit can emanate from an exposure to a pure risk. That is one
remains in the same position he was if the risk is not experienced
and a loss does not occur, or he loses if the risk is experienced and
a loss occurs.

23
 Examples of pure risks in the business world:
 A factory may burn down causing loss of investment
 Customers may be lost and hence loss of profits following a fire
 Stock may be stolen
 There may be loss of production due to labour strike should they occur
Should all the above not occur, the firm will not lose (neither will it profit from the
mere fact that they haven’t occurred) except for the fact that the properties are still
intact as they were and business can continue.
Speculative risk on the other hand, refers to that situation that may result in one of
three possible outcomes- either there is a loss, or there is no loss, or there is a gain.
Typical examples of a speculative risk is buying shares on the stock Exchange. If
after one year the shares have fallen in price, there is a loss. If there is no change in
their values, there is no gain. If they appreciate in value, they can be sold at a profit
hence the buyer gains.
Just like pure risks, speculative risks are numerous in the business world. They
include:
 Launching a new product
 Fixing retail prices
 Exporting to a new market etc
The firm can make a profit, or just break-even or make a loss.

Other examples of speculative risks include:

 Placing a bet on a particular horse to win
 Placing a bet on a football team to win
 Playing a card game
 Playing a game on slot machine at a casino
3.2.6 Personal and Business Risks
Personal risks relate to an individual, for instance premature death, dependant old
age, sickness or disability, unemployment, and loss of one’s property through fire or
theft etc. All of them have financial implications that are undesirable to the
individuals.
Business risks relate to the business firm. They include the factory burning down,
stock being stolen, strikes hampering production, and death of a key person. They,
too, are undesirable to the firm.
24
 We have gone through this protracted exercise of classifying risks because, as we
shall see later, risks may be handled differently depending on how they have been
classified. As a word of caution, however, we need to note that classifications are not
conclusive. A certain risk can assume characteristics failing under more than one
category of risks.

For instance, loss of property by fire is an objective risk. In addition, it is financial.

Static, particular and pure in nature. Furthermore, it could be personal or business!

LECTURE 3 CONTINUED: BURDEN OF RISKS

Outline of the lecture

 Introduction
 Objectives
25
  Costs of Risks
 Property
 Personnel Risks
 Marketing Risks
 Buying and Selling Risks
 Transportation Risks
 Storage
 Information and Standardization
 Finance Risks
 Production Risks
 Environmental Risks
 Political Risks

Administration of Risk Management Function

 Overview
 Policy Formulation
 Decision Flow Chart

3.5.1 Introduction
Businesses and individuals are faced by numerous risks that may lead to financial losses.
It costs some businesses a colossal of money in militating against these risks. They
therefore become a burden to these organizations and individuals.

3.5.2 Objectives
At the end of this lecture the student should be able to:
 Highlight the risk bearing activities in an organization
 Understand the types of costs that an organization faces
 Estimate the possible cost the organization faces
 Be able to formulate policies and make decisions based on available options

3.5.3 PERVASIVENESS OF RISKS IN THE ENTERPRISE

Risks are felt or exist in every aspect of life. We have discussed some the identifiable risks
and the definition of a risk. We have seen that risks are quite pervasive. If we can briefly
look at each area we can be able to appreciate the pervasive nature of risks.

3.5.4 Property
Enterprises own properties of various types and values. These enterprises invest substantial
amount of money in these properties. Their values may be completely lost or partially
lost depending on the cause of the loss. These causes of loss may be:
 Damage by fire
 Loss due to theft
 Damage by natural phenomena such as weather, earthquake,
 Depreciation or wasting as a result of age or poor maintenance
 Devaluation of the price due economic downturns
 Etc.
The loss may be direct or indirect. Direct losses are those that may be caused by the perils
mentioned above, while indirect losses may be felt later after the major loss, for example
loss of profitability, loss of customers or increased costs of production that may come in
26
form of finding alternative means of production, borrowing in order to continue, building
new clientele etc. i.e. consequential loss.

3.5.5 Personnel
Enterprises also hire workers who are exposed to various risks, or themselves are risks to
the enterprise. Some of the risks facing personnel include:
 Death
 Injury
 Disabilities
 Unemployment
 Premature retirement
 Old age
 etc.
 Dishonesty
 Delayed benefits

Employees may also cause losses to enterprises through their actions or inaction that may
lead to loss to the enterprise or third parties.

3.5.6 Marketing
The process of marketing involves moving goods and services from the producer to the
consumer. Activities such as:
 Standardization,
 Supply market information and research,
 Pricing
 Distribution
 Competition
 Changes in consumer taste
 Legal Changes (local and international)
 Dishonesty by sale force
 Inability to meet consumer needs
 Bad debts
 Poor roads

All these are important functions of marketing activities among others. Risks permeate all
these areas that may lead to less than optimal performance by the enterprises..

3.5.7 Transportation
Risks related to transportation are many. These will include among others
 Goods may be stolen or damaged in transit.
 Goods may be confiscated by governments and agents
 Legal disputes over salvage may cause unexpected losses to the shipper
 The seller may become liable for freight charges even though goods are not
delivered
 Delays in shipping may cause loss through spoilage or because of reduction
in prices before delivery
 Unexpected losses because of actions by foreign governments prohibiting
the importation of goods already shipped
 Etc.

3.5.8 Storage
27
Storage may pose various risks that can lead to substantial losses.
 Unexpected delays in removing goods from storage may cause loss from unusual
storage charges
 Forgery of warehouse receipts representing goods in storage may result in
unexpected crime loss
 Owners of storage facilities may suffer unexpected loss due to the nature of goods
stored
 Goods may be damaged due to poor construction of the storage (sweating,
uncontrolled temperature, leakage, infestation etc.)
 Theft by employees or intruders
 Etc.

3.5.9 Information
Information is important for decision making and planning. Losses may be experienced
due to:
 Poor storage of information
 Delayed or lack of information
 Wrong or substandard information
 Manipulated information

3.5.10 Standardization
Lack of standardization may lead to increased costs, especially in manufacturing and may
lead to costly mistakes of mixing up goods or services. Standard sizing greatly facilitates
mass production .and distribution. However, standardization may just have the opposite
effect especially if consumer tastes change, or technology changes.

3.5.11 Finance
Financial risks faced by an enterprise are many and diverse. They may arise among others
from:
 Enterprise dependency on credit both received and extended
 Insolvency of the customers
 Investment in various securities and investment decisions
 The nature of and methods of capitalization

3.5.12 Production
Risks related to production are also many and diverse, ranging from technological
deficiency to human error. They may include:
 Deciding to build a plant with too little capacity or very large capacity for
the size of expected market
 Inadequate inventory control that may lead to stock-outs for both finished
and raw materials, increased burden of storage resulting from unplanned
production and diminished market, loss of customer for non-delivery of
orders or late deliveries etc.
 Use of outdated technology that does not meet demand or standards
 Increased cost of maintenance
 Obsolescence due to overstocking or lack of foresight
 Injuries sustained by employees for lack of safety
 Existence of hazards
 Failure to plan proper plant layout or to construct plants initially with built-
in loss prevention mechanisms
28
  Failure to provide standby measures for power, water in cases of shortages
 Etc.

3.5.13 Environmental
Environmental risks have assumed great importance for most businesses. It should be
appreciated that international and state agencies have been mandated to ensure safe
environment. Businesses also would wish to operate in safe environment in order to reduce
costs in production and provision of services and to avoid any liabilities that might arise
from contamination.

Those enterprises that operate in international markets would like to be assured that there is
adequate and potable water for their manufacturing and the location of their business is in
an environmentally friendly location. Inability to realize this by business, they may end up
incurring unnecessary costs to improve the environment. Use of certain energy such as
nuclear energy may be prohibited by certain states or may require special treatment before
its waste is released into the environment. Negligent release may lead to contamination and
the enterprise may be faced with innumerable lawsuits.

3.5.14 The Cost of Risks

We can look at the costs of risks from various perspectives. For example: nature of the
types of risk costs and the distribution of the costs between individuals and groups in
society.

Total direct and

Indirect costs of risk

Nature Costs incurred Costs of Costs due to

of the In handling losses that existence
risks: risks occur of risk

The distribution Private Social

of the risks: Costs costs

The Risk Handling Costs

After a decision has been made to identify, evaluate and handle the risk, certain costs will
be incurred. For example:
 Insurance premiums,
When we transfer risk to an insurer it costs the organization in terms of premiums
paid periodically or at the beginning of the insurance contract.

 Charges for loss prevention

29
 Loss prevention involves incurring costs to prevent any losses from
occurring. Most of the risks retained may be financed with either internal
resources or through borrowing.

 Fees for consultancy

More often businesses and even governments hire consultancy to either
investigate the existence of risks or provide solutions to a problem that
exists in the organization. The fees paid is a cost to the organization.

 Management and staff time spent on dealing with the risks

Time is usually spent by staff in investigating a problem and advising on the
solution to the problem. Sometimes the organization may require the staff to
work overtime in carrying out this investigation. Time costs money and
therefore the allowances or overtime paid to the staff becomes a cost to the
firm. Such cost may not have been envisaged but it became necessary to
carry out an activity to alleviate any future losses.

 Cost of avoiding the risks

Sometimes mere avoiding a risk comes with a cost. The cost may be in
terms of unused capacity of both human and physical capital, time taken to
make a decision, any investigations carried out in order to arrive at some
decision etc.

 Opportunity costs
Opportunity cost is the cost incurred for being unable to take advantage of
an existing opportunity. When we forego a particular activity for the
purpose of reducing, avoiding or transferring risk, we may not quite realize
the maximum benefit from the methods employed in handling the risk.

Loss Costs
Loss producing events frequently results in both direct and indirect costs.

Direct costs include among others:

 Liability costs of accidents to employees and the public
 Loss of production directly linked to accidents
 Accident investigating costs
 Cost of unfit products
 Costs of delayed operations or service (goods) delivery
 Etc.
Indirect Loss Costs
 Lowered morale as a result of accidents leading to costs
 Stoppage of work costs, delays costs because a demoralized worker is not fast
enough in doing his work where others depend on him.
 Increase in spoilage of materials as a result one demoralized individual.

Cost Attributable to Existence of Risks:

Various people have certain attitudes towards risk. Mere exposure to a risk leads to a
welfare loss. This situation may be illustrated by the concept of utility (that is satisfaction)
and the expected value:

30
Expected value may be calculated as follows:

EV = Sum(pj xj)

Where pj is the probability of jth outcome

xj is the jth outcome

These can be used to compare two or more events when we know their probabilities and
values. We can also use this method to establish the optimum loss or benefits we expect in
the future.

For example: If a business is introducing a new product that will require initial outlays that
may not realize profit in the next three years and estimates that a probability of achieving a
desired volume of sales in the next three years is 70%. If the expected sales in the third year
are Kshs. 40,000,000/-, then using the formula the Expected Value will be:

EV = Sum (0.7 x 40,000,000)

= 28,000,000/-
At least the manager can expect to realize not the full potential of Kshs. 40,000,000/-, but a
lower value of Kshs. 28,000,000/- This is because there is an existence of a risk that may
hinder the realization of full potential. The risks in this case could be stiff competition,
untrained sales people, changes in consumer taste etc.

Private and Social Costs

Private risks are those that will affect an individual or a private firm. It is easy to determine
such risks because they may be specific to the individual or firm. The individual or the firm
must bear such risks either by borrowing or using internal resources to manage them.

Social risks are those that affect the entire society. They are sometimes very large and
difficult to measure. It may require the government to intervene in such risks. Sometimes
the risks may be ignored because of the magnitude of the risk, especially when they are
natural in nature. However, government has many ways of intervening in such social risks
and they incur a cost in militating against them. For example: Carrying out inoculations for
outbreaks of diseases, providing public toilets in cities, providing cattle deeps, various
campaigns to eliminate certain occurrences etc.

3.5.14.1 Property Risks

There are numerous property risks that lead to certain costs to be incurred. We can start by
looking at the direct costs

3.5.14.2 Direct Handling Costs and Loss Costs

Handling:
These include among others
Cost of preventing possible losses such as:
 Hiring of security guards
 Burglar proofing
 Installation of fire equipment, sprinklers etc.
 Cost of removing any hazards surrounding or in the premises
31
  Cost of hiring a property manager
 Cost of maintenance
Premiums paid to insurers to cover any possible damage to the property

Loss Costs
 Destruction of property
 Survey costs after destruction
 Consequential Losses
 Litigation costs
 Liability costs to third parties
 Repair costs after a damage

3..5.14.3 Indirect Cost

Opportunity cost foregone for carrying out the risk management activities
Loss of reputation for wrong use of the building
Inability for clients to access the building

Examination of Direct/Indirect Handling and Loss Costs:

3.6 Personnel Risk Costs
Personnel costs include costs incurred for providing protection against loss and imparting
skills to the staff for efficient performance.

3.6.1 Direct Handling and Loss Costs

Handling costs
Preventive costs such as:
 Provision of safety gear to staff
 Time taken for breaks to remove boredom and exhaustion
 Cost of regular medical checks
 Time taken by management to give pep talk and motivate staff
 Cost of retraining
 Cost of providing safe environment such as lighting, machine guards, ventilation,
exits for emergencies etc.
Cost of providing insurance covers for staff
Cost of communication to employees on safety matters

Loss Costs
Cost incurred in treating an injured staff
Liability cost for negligence of staff
Cost of replacing, repairing damaged property by staff

3.6.2 Indirect Costs

Cost of damaged image as a result of the actions of staff
Cost of demoralized staff in meeting their targets
Personal problems that affect performance

3.7 Marketing Risks Costs

Marketing deals mostly with selling and promotion. There are numerous risks that may
exist in marketing.

32
3.7.1 Direct Handling and Loss Costs
Handling Costs
Cost of training and retraining of staff
Cost of insurance
Cost of research for example and development in positioning, pricing and other
competition issues
Cost of advertising and promotion for improvement of sales
Cost of improving customer relations

Loss Costs
Liability costs for injuries, non-performing goods and services etc.
Damage to goods for sale
Injuries to sales staff
Cost of loss of customers (sales)

Indirect Costs
Costs due to damaged image
Cost of demoralized staff that may hinder efficiency
Cost of corrupt staff that collude with competitors or customers
Senior management behavior that may lead to lost trust

3.8 Buying Risks

These are costs related to organizations ordering of goods and services. These costs may
include both local and foreign purchases.

3.8.1 Direct Handling and Loss Costs

Handling Costs
Cost of insurance for protecting purchases
Cost of delayed delivery
Cost of wrong deliveries in terms of quantity and quality
Cost of loss/damage to third parties
Cost of evaluating suppliers

Loss Costs
Damage costs of purchased goods in transit
Damage caused by the goods to other goods and personnel
Loss incurred by unfit goods supplied
Cost of loss of customers
Cost of repairing damaged goods
Cost of loss of production

Indirect Costs
Cost of untrustworthy suppliers
Cost of inability to satisfy own customers
Cost incurred because of demotivated staff

3.9 Finance

33
Any organization tries as much as possible to alleviate finance cost or incurring losses in its
financial dealings with other organizations. These costs may range from loss of income to
high rates of interest among others.

3.9.1 Direct Handling and Loss Costs

Handling Costs
Cost of investigation/research of financial markets
Cost of hiring consultants
Cost of audits of both accounts and systems
Cost training and retraining
Cost of insurance
Cost of installing technology
Cost of floating financial instruments for funding expected risk

Loss cost
Penalties imposed for nonconformity to laws and regulations
Increased cost of money due to inflation or new conditions
Cost of liabilities incurred
Damage to property under a loan
Loss of value due to obsolescence because of age or outdated technology
Accelerated depreciation due to lack of maintenance
Loss due to negligence of staff
Lost investments
Depreciation of invested funds due to inflation, economic downturns etc
Loss due to changes in foreign exchange for foreign currency held

Indirect Cost
Inability to secure funding for operations due to poor credit rating
Inability to perform optimally
Lost sales
Opportunity costs for money tied in less earning investments

3.10 Production Risks

These are risks related to production of either goods or services. The risks will vary
depending on the type of goods services and the systems put in place to produce these
goods and services.

3.10.1 Handling and Loss Costs

Handling Costs
Cost of insurance against both liability risks and damage to production facilities
Cost of time spent on designing new systems to improve performance
Cost of acquiring new technology to alleviate any losses and improve efficiency
Cost of maintenance of systems and equipment etc.
Cost of providing security to materials, equipment and staff
Cost of training and retraining of staff to improve efficiency
Cost of consultants
Cost of research

Loss Cost
34
Cost of replacing damaged equipment and materials
Cost of repairs
Liability compensation costs to third parties
Death of key production personnel
Cost of penalties for violations of policy and laws
Cost of rejected and returned goods
Cost of poor quality materials

Indirect Costs
Loss of goodwill and image resulting in dropping of sales
Demoralized staff that do not put in maximum effort

3.11 SUMMARY
We have seen that the category under which we place a certain risk
will be dictated by its source. It may be social, physical or economic
in origin.
In addition, the risk may be objective or subjective, financial or non-financial, static
or dynamic, fundamental or particular, pure or speculative and personal or business
in nature. Finally, these classifications are not mutually exclusive – a risk can assume
certain characteristics that place it under more than one classification.
We have also examined the various burdens of risk by looking at various operations.
There are handling costs and loss costs which are direct and indirect.

3.4 Activity/Exercise
Attempt the following questions: You are advised to go back to the relevant section
of this lecture, wherever you are in doubt.

1) Can you think of any risk that does not have its origin in social, physical or economic phenomena?
2) Is gambling a pure or speculative risk? Explain
3) Go back to those ten business losses you identified earlier:
a. List down the risk that resulted in these losses.
b. What type(s) is each of these risks. How can each of these risks be classified?
4) Identify risks that may affect a manufacturing entity and classify the risks

Reference:
Insurance texts are expensive and difficult to get. Very few tittles are
available
locally.You don’t need to supplement these notes with any text.
However, these two titles may concretize what you have covered.
(i) Vaughan E.J, Fundamental of Risks and Insurance
(ii) Greene M.R. Risk and Insurance

LECTURE 4
35
 RISK MANAGEMENT: HISTORICAL DEVELOPMENT AND
APPLICATION.
4.0 Introduction
In the preceding lecture, we discussed the concept or risk, explored its pervasive
nature and looked at the ways in which risks may be classified. In this lecture, we
discuss risk management and explain how it is used in handling risks that face the
business firm. In doing this, we focus on three basic issues, namely: the definition of
risk management, risk management in practice and the historical development or risk
management.

4.1 Objectives
At the end of this lecture you should be able to:
1. Define “Risk Management”.
2. Describe the historical development of risk
management;
3. Describe the process of Risk Management
4. Recognize and explain the use of risk management in
practice.

4.2 Definition of Risk Management

4.2.1 What is Risk management?

Activity
Look up the definition of “risk” in lecture 1. Also look up the
definition of “management” in a standard dictionary and list down
the functions of management.
What do you think risk management is?
(Planning, Organizing, Directing, Staffing, Controlling,
Monitoring and Evaluation)
Several authorities in this discipline have advanced a number of definitions for risk
management. We will only consider three of these definitions.

1. Dorfman calls it, “the scientific methods of planning to deal with losses”.
2. Vaughan says it is “the scientific approach to the problem of dealing with the pure
risks faced by individuals and businesses”.

36
 3. Williams, Head and Glendenning define it as “a process that uses physical and
human resources to accomplish certain objectives concerning most pure loss
exposure.
The basic idea running through these (and indeed, all other) definitions is that risk
management is a systematic method (approach) of handling risks. For our purposes
therefore, we will take risk management to be that approach that seeks to solve the
problem a firm faces because it is exposed to the possibility of loss.
In essence therefore, risk management is a managerial orientation that provides an
answer to the question, “ how does a firm in modern times handle the risks it faces?”

Although the emphasis in this unit is on managing business risks, it should be noted
that risk management can equally be applied to possibilities of loses faced by
individual communities and the state.

4.3 Historical Development of Risk Management

The issues we now have to address ourselves to are: the origins of risks management
and, the important landmarks on the development of risk management. From a
tradition point of view, various systems existed that relate to the concepts of risk
management. For example each tribe or community put in place security systems to
ward off intruders and against any loss of property. This could not have been
undertaken by one individual.

Risk management as a profession is fairly new. In the late 19th century (1874), the
American businessmen realized that they were paying very high insurance premiums
for risks, which they could have managed themselves. They decided to come together
and review ways and means of minimizing the cost of insurance. It was realized that
insurance is just one way of dealing with risk and that other means of dealing with
risk were available to the businessmen.

The origins of risk management as we know it today can be traced to the French
authority on General Management –Henri Fayol, who as early as 1916, identified it
as one of the six basic activities of an industrial undertaking. He called it the
“Security Activity”.

37
Fayol stated that the goal of the Security Activity was ‘to safeguard property and
persons against theft, fire and flood; to ward off strikes and felonies and broadly all
social or natural disturbances liable to endanger the progress and even the life of the
business. He referred to it as:
“the master’s eye, the watchdog of the one-man business, the police or the army in
the case of the state. It is, generally speaking, all measures conferring security upon
the undertaking and the requisite peace of mind upon the personnel”
The terms “Security Activity” did not, however, pick up and become universally
accepted. In spite of this, we must note that risk management today does what Fayol’s
security Activity set out to do in 1916.

The usage of the terms “Risk management”, in the sense in which we know it today,
began in the early 1950’s. Its first appearance in the literature is credited to one
Russell Gallagher who used it in his article “Risk Management: A new phase of cost
control” that appeared in the Harvard Business Review of September-October 1956.
Its usage picked up and it became increasingly acceptable over the next two decades.
Activity
Copies of the journal “Harvard Business Review” are available in the
Periodicals section of the Jomo Kenyatta Memorial Library,
University of Nairobi. Look up Gallagher’s article.

Another important landmark in this development occurred in 1974 when two

professors, Mehr and Hedges propounded the objectives of risk management. This
marked the coming of age of this concept.

Thereafter, its spread and acceptance was more rapid than before. Today, quite a
number of professional associations and practitioners have the words risk
management in their titles (names). In Britain, these are the AIRMIC (Association of
Insurance and Risk Managers in Industry). In the U.S., the American Society of
Insurance Management (ASIM0 changed its name in 1975 to Risk and Insurance
Management Society (RIMS)

In Kenya, although popularly accepted, Risk Management has not developed as fast
as in the western world. Practicing risk managers are yet to be a common sight in the
38
 business world. Nevertheless, Risk Management services are provided by
management consultants (and even then, not as very strong sidelines). In spite of this,
the term Risk Management, and what it entails, is widely accepted and used in the
insurance and finance circles.

Following the bomb blast in Nairobi and Mombasa, Kenya is contemplating enacting
a law that deals with the menace of terrorism. Also a disaster management section
has been created in the Office of the President to deal with all kinds of disasters. The
most crucial aspects of disaster management i.e. “Early Detection and Response”
mechanisms is what lacks. This is risk management on a national level.

4.4 The Nature of Risk Management

Risk management involves the financial, legal, and social responsibilities of
companies, not-for-profit organizations, and public entities. It is a systematic means
for managing an organization’s pure and other risk exposures to achieve its objectives
in a manner consistent with public interest, human safety, environmental factors, and
the law. Because risk management is a managerial process, it involves the usual
functions of planning, organizing, leading, coordinating, and controlling. Such
activities are undertaken with the overall objective of minimizing the cost of risk to
organizations. Achieving this goal in practice requires an efficient pre-loss plan that
minimizes the adverse impact of losses on the achievement of an entity’s operational
goals. A more detailed explanation of the conceptual foundation for risk management
in the context of economic and financial theory is provided throughout this course.

Just as finance and marketing are applications of management processes and

techniques to specialized problems and, in fact, evolved from the general field of
management, risk management likewise involves adapting and revisiting general
management processes and techniques to the specialized problems of risk control and
risk financing.

The risk management process involves three interrelated functions:-

1. The systematic and continuous identification of risk loss exposures, together with an
evaluation of their nature, frequency, severity and potential impact on the
organization.
39
 2. The planning and organizing of appropriate risk control and risk financing
techniques to minimize the cost of risk for the organizations, insurers and other risk
finance specialists.
3. The implementation of such techniques, both internally at the departmental and top
management levels and externally with loss control organizations, insurers, and other
risk finance specialists.
The risk management functions, including employees benefit design and administration,
is today formalized in one or more specialized departments in the vast majority of
medium to large enterprises, although the locus of responsibility for many exposures
actually resides within all departments. Since accidents, injuries, fires, thefts, defective
products, violations of employees rights and the like usually occur at the department
level, they usually can best be prevented or reduced there.

Whatever definition one prefers, it is generally agreed that risk management is a process
that involves a series of several distinct steps. We can identify six of them, namely:
1. Determination of risk management programme objectives.
2. Identification of risks.
3. Measurement (analysis) of the risk.
4. Selection of the techniques to handle the risks.
5. Implementation of the techniques.
6. Control and review of the decisions made.
Some authorities combine two or more of these steps thus ending up with fewer than
six steps. Others split some of these steps and end up with more than six. Be it as it
may, this orientation encourages a firm to approach risks from a broad perspective in
which insurance is just one of the several possible solutions.

After the foregoing background, we are now in the position to discuss the application
of risk management to the risks that a business faces.

4.5 Risk Management in Practice.

Basically, a firm’s risk management programme (or process) is dependent on how
the firm’s management wants to see the business performs after a loss, i.e. does
management simply want the business to survive and plod on, or is it management’s
desire that the loss should not interfere with the overall aims of the business? Should
40
 the firm continue expanding or should it cut down its scale of operations? These
questions make it imperative that the firm should set out objectives for its risk
management programme.
Thereafter, the next phase in the risk management process, commences when
management asks: (1) What occurrences can damage the business? The answer to
this question will entail the management identifying the loss exposures (risks) that
the firm faces.

Activity.
Consider an organization that you are familiar with. What possible losses
do you think it faces? List them adown and compare them with the list you
developed in lecture 2. Are they similar?
The next logical question is,(2) “How much damage can the business suffer?” This
requires that the risks that were identified and analyzed be measured in terms of their
magnitude and frequency. The answers to the following questions must be provided
for each risk identified.
(i) How big will the resultant loss be? (magnitude/size of loss)
(ii) How many times can such a loss occur over a given period? (frequency of loss)
After all these, yet another question comes to the fore, (3) “What should the firm do
in order to take care of these possible losses?” The firm has to choose from among
the various available risk-handling techniques (tools). Thereafter, management will
ask, “How do we implement it (them)” and make arrangements to effect the choices
that were made.

The final questions management has to address are,(4) “Did we make the right
decision? Did our choice(s) prove too expensive? Have circumstances changed in
such a manner as to render past decisions unsuitable?” If answers to these are “Yes”
then management has to take remedial action. Each of these questions (or set of
questions) constitutes one distinct step in the risk management process.

Activity
Go back to the beginning of this lecture. List the various steps in the
risk management process, and against each step, indicate the
41
 corresponding question or set of questions from among those
mentioned above.
From the foregoing, we can now appreciate the fact that risk management is an
orientation that attempts to deal with the risks that face the firm. It must be pointed
out here, however, that only pure risks can be handled using this approach.
Speculative risks, by their nature, cannot be handled in this manner.

4.6 Summary
This lecture served as our launching pad into the realm of Risk
Management- a managerial orientation that provides an explanation to
the question, “How do firms in modern times handle the risks they
face?”
We were able to define Risk Management by looking at definitions advanced by
Dorfman, Vaughan and Williams. Their definitions suggested one common feature,
that Risk Management is a systematic approach of handling risks.
The lecture also looked at the historical development of risk management and
established that Henri Fayol, the Frenchman, was the first man to recognize the
importance of risk management under his :Security Activity” theory. There were
others such as Russel Gallagher, Mehr and Hedges who also propounded the
objectives of Risk Management.
Today we have a number of professional associations in risk management which
bring together practicing managers to enhance and stimulate the profession. As we
have seen, risk management practice is dependant on the operations and the risk each
business is exposed to and the likely loss.
4.7 Activity/Exercise
1. Define Risk Management in your own words
2. List and briefly discuss the six steps in the risk
Management process.
3. What reasons can you advance to explain the fact that
risk Management is not widely practiced in Kenya as
it is in, say, the U.S.?

42
Reference:
1. Vaghan E.J. Fundamentals of Risk Management and Insurance
Chapter 3.
2. Williams C.W., Head G.L., and Glendenning G.W. Principles of
Risk Management and Insurance Volume 1, Chapter 1 and 2.
(Available in the commerce Library, University of Nairobi, Lower
Kabete Campus).

43
 LECTURE 5
RISK MANAGEMENT PROGRAMME
(PROGRAMME OBJECTIVES )

5.0 INTRODUCTION
The preceding lecture introduced us to the realm of risk management. We mentioned,
in passing, that in essence, risk management is a process. In this lecture, we consider
the preliminaries to this process and discuss the first step of the risk management
process.

5.1 OBJECTIVES
By the end of the lecture you should be able to:
1. Identify the level of management that is charged with the risk
management task;
2. Distinguish between the various objectives of the Risk
Management programme.

5.2 The Risk Management Programme

The risk management process can be viewed as the application of traditional
management techniques to a particular problem. The following discussion highlights
the key aspects of the process.

In defining risk management we pointed out that it is a systematic approach that

addresses the problems that a firm faces. This implies two things:-
1. It is a function that has to be performed just like any other managerial
functions.
2. It is articulated in a formal programme that provides guidance to the firm
about the performance of this function.

Who, in management, is charged with the duty of overseeing the performance of the
risk management function? The answer to this question will invariably depend on the
size and complexity of the firm, and the orientation of its management cadre.

44
 Most large, modern firms have a Risk Manager (at par with other departmental heads
like the Personnel Manager in the firm’s hierarchy) reporting to the Chief Executive.
The Risk Manager heads the department that performs the risk management function.
He liaises with other units of the firm to ensure the efficient performance of this
function.
Medium-sized firms might not have a formal risk manager’s position in their
hierarchy. Instead the function may constitute one of the responsibilities of the
Finance Manager/ Controller. There may be a number of subordinates under him
performing the routine tasks involved in this function.
Small firms rarely have a formal Risk Management Programme. They might not even
have subordinates working full time on risk management activities. In spite of this,
risk management must be done, and the responsibility for this is usually rested in the
chief Executive’s office.
In the following discussion, we assume that the firm has a Risk Manager charged
with risk management responsibilities. This is in recognition of the fact that despite
the size of the loss or its complexity, a firm must perform risk management duties.
Remember that it is all measures of risk management duties that confer security upon
the firm. Look up Fayol’s definition of the security Activity again.

5.2.1 How is the risk management function articulated in the firm?

The risk management function is manifested in a formal programme that is expressed
by a policy statement and manuals.
What is meant by policy statement?
A risk management policy statement is a statement promulgated by top management,
specifying the firm’s risk management programme objectives. In other words, it is a
statement expressing the firm’s expectations regarding its risk management
programme.
We will shortly discuss these objectives.
A risk management manual is a comprehensive document prepared by the Risk
Management Department (in consultation with top management), specifying what
should be done, when, how and by whom it should be done in order to combat the
risks that face the firm. It is a document providing guidance to the whole firm
regarding the execution of risk management duties.

45
 The risk management manual specified such things as what to do in order to avoid
the outbreak of fire, or what should be done in the event of a fire outbreak;
safeguarding against theft, accidents, injury or loss of property; the insurance
coverage’s available, what they cover, the insurance companies providing cover, the
safe ways of doing things, etc. Put in other words, the manual sets out the ABC of
the risk management back to the policy statement.

5.2.2 Risk Management Programme Objective

As explained earlier a risk management policy statement articulates the firm’s risk
management programme objectives.
In the preceding lecture we pointed out that risk management came of age in 1974,
when two professors, Mehr and Hedges, propounded what has popularly come to be
accepted as the objectives of Risk Management. These are broadly divided into two
categories- pre-loss objectives and post-loss objectives as discussed here below:

(i) Pre—Loss Objectives

Pre-loss objectives try to pre-empt the occurrence of losses to the firm. They therefore
focus the firm’s attention to the situation before a loss occurs. In essence they make
the firm carry out activities that will prevent the loss from occurring; or if it occurs,
outlines how firms will deal with it. Four distinct objective can be identified
hereunder.
(a) Economy
Under this objective, the firm seeks to prepare for what may occur in the most
economical way possible that is consistent with its post-loss objectives. Preparing for
losses that may or may not occur will mean that the firm incurs such costs as safety
programme expenses, insurance premiums and expansion ways in which these losses
might be handled.

(b) Reduction in anxiety

This objective has also been called “ a quiet night’s sleep”. It attempts to reduce
anxiety, fear or worry in the minds of people (owners, managers, family heads, etc)
as regards possible losses to the firm. It recognizes that the possibility of loss to the
firm creates anxiety. These objectives therefore are achieved by making provision for

46
 all possible adverse happenings, and letting the people likely to suffer anxiety know
that “everything has been taken care of”.

Activity
Think of the possible losses to the firm that may raise anxiety
in the groups of people mentioned above. Suggest ways in
which such “possibilities” can be taken care of. Also think
of the possible losses that may face an individual which may
cause anxiety.

(c) Meeting externally imposed obligations.

Just like other managerial functions, risk management must meet certain obligations
imposed by interest groups from without the firm. This objective ensures that these
are met. In Kenya, the Factories Act and other Government regulations establish
safety standards that a firm has to adhere to. For instance, moving parts of machinery
have to be fenced, first aid kits must be maintained, the factory place has to be cleaned
periodically, etc. Other obligations that risk management has to satisfy include the
requirements by a secured creditor that property used as collateral be insured.

(d) Social Responsibility

This objective recognizes that family members, employees, customers, suppliers, and
the general public will be worried by the threat that losses may occur.
Consequently, measures taken to handle losses prior to their happening contribute to
the security and peace of mind of these interest groups. Further, rationale for this
objective includes concern for the firm’s image and social consciousness.

Activity
Pick up a dictionary or any book on management and look
up the definition of social responsibility.

(ii) Post-Loss Objective

Post-loss objectives, focus on the position of the firm after a loss has occurred. They
set out what the firm should achieve.
47
(a) Survival
Survival is the most important and basic post-loss objective of risk Management. The
firm wants to resume at least part of its operations after the loss, with, understandably,
much diminished assets.

The firm with such an objective will need to define what constitutes the essential
elements of survival, a very complex exercise. In the process of defining these
essential elements the business firm has to determine such things as ‘minimum” scale
of operations desired, and bare-bones in terms of capital, machinery, personnel and
other inputs.

Activity
Imaging that your nearest retail trader suffers a terrible loss, for
instance, his store (plus merchandise) burn down. Determine what
you think he needs in order to resume operations at the lowest
possible scale. Discuss your answer in tutorial or group sessions.

(b) Continuation of operations.

This is a slightly more ambitious objective that the survival one. The goal here may
not be full resumption of operations immediately, but rather, resumption of
operations after a period of interruption not exceeding a specified duration. For some
firms, continuation of operations may be necessary rather than optional. A case in
point are state corporations (parastatals like Kenya Railways, Post Offices, Airlines,
Water supplies and electricity), who have a duty to provide services (products) to the
public.
To some extent the same obligations apply to private firms if they do not resume
operations soon after a devastating loss, they may discover that their clients will start
dealing with other firms (products), never to return.

48
(c) Earning Stability
This objective can be achieved by continuing operations at the same cost, or by
providing funds to replace earnings lost due to some interruptions in operations, or
by a combination of both. Earnings stability as a goal is rarely achieved. Most firms
will settle for some variations of this within a predetermined range.

(d) Continuing Growth

This objective requires much more than mere continuation of operations or earnings
stability. To achieve this objective, the firm needs a strong liquidity position or the
ability to spend a great deal of money on research, development and promotion.
These are in recognition of the fact that a firm can grow through several approaches
either product and market development, or acquisitions and merger, or both.

Activity
Find out what these concepts mean.
1. Research and Development (R&D)
2. Product and Market Development
3. Acquisition
4. Merger

Any basic text on marketing will explain them.

(e) Social Responsibility
This is a repetition of the last pre-loss objective except that the focus here is on the
situation after the loss. This objective recognizes that accidental loss affects other
people apart from owners of the firm, managers or family heads. Employees,
customers, suppliers, tax payers, relatives, members of the public, and other interest
groups may also be affected.
The intention of this objective is to minimize the impact of the firm’s losses on these
groups. It is achieved by avoiding lay-offs, continuing with production, providing
relief, and other similar activities.
NOTE: Pursuit of all these objectives simultaneously will lead to conflicts.
Whereas attainment of all post loss objectives is possible, they will
however clash with the Economy objective, which seeks to keep costs
at minimum.
49
 The more ambitious the economy objective, the bigger this conflict will be. Trade
offs and compromises between objectives are therefore necessary.
The business firm therefore needs to determine, from the very beginning, what its
risk management objective will be. This will necessitate choosing from among those
objectives outlined above, rather than pursuing all of them. Either way, these
objectives will have a big influence on the subsequent steps in the firm’s risk
management process.
5.3 Summary
 The risk management functions in the firm is articulated in the
Risk Management programme.
 The Risk management programme is expressed in the risk
management policy statement, and manual. These give the
objectives of the programme and specify what is to be done to
achieve them.
 There are four pre-loss objectives and fives post-loss objectives. The firm has to
choose what objectives to pursue from among these.
 Sometimes, conflicts among objectives are seen. Trade-offs and compromises are
therefore necessary.

5.4 Activity/Exercises
1. Identify an organization that you are familiar with and describe
and explain its Risk Management Programme.
2. What is the basic difference between pre-loss and post-loss
objectives?
3. Do you think the other pre-loss objectives (except the economy one). Conflict
with the post-loss objectives? Explain
4. How can the second pre-loss objective (reduction in anxiety) be achieved?.

Further Reading
Williams V.A., Head G.L., and Glendenning G.W., Principles of Risk
Management and Insurance Vol.2, Chapter 1.

50
 LECTURE 6
RISK MANAGEMENT PROGRAMME:
IDENTIFICATION AND MEASUREMENT OF RISK

6.0 INTRODUCTION
In lecture 5, we discussed the Risk Management Programme and what it entails. We
pointed out that the firm’s management needs to determine objectives for its risk
management programme. These objectives are expressed in the risk management
policy statement. The firm’s risk manager thereafter develops a manual that gives
guidance to the whole firm in respect of what needs to be done in order to achieve
the risk management programme objectives.

In this lecture we focus on what comes next in the risk management process after
these preliminaries have been disposed of, namely, the identification and
measurement of risk that the firm has to contend with. These are the second and third
steps in the risk management process.

6.1 OBJECTIVES
By the end of this lecture, you should be able to:-
1. Logically explain the importance of the identification and
measurement steps in the risk management process.
2. Discuss the usage, merits and demerits of the various
identification tools.
3. Discuss the measurement and basis for ranking risks that have
been identified.

6.2 Risk Identification Process

It is obvious that before the risk manager can be in a position to handle the risk that the firm
faces, he must first be aware of these risks by looking at the operations of the firm. This is
what identification is all about.

After determining the objectives discussed in the preceding lecture, the second step in the
risk management process is the identification of risk exposure that affects an organization. It

51
also includes analysis and evaluation of the frequency and severity of losses associated with
each risk identified. Potential losses are sometimes classified as to whether they arise from
property, liability or personnel related exposures.

Nearly all business and other organizations have property that is susceptible to loss. When
such loss occurs, not only is there a cost to repair or replace the damaged property, but there
may also be income losses while operations are disrupted. Even a brief interruption of normal
operations can threaten the survival of some organizations. The disruption of operations of
important suppliers, customers, or neighboring groups also must be anticipated, because such
disruptions could be significantly affecting the firm’s operations.

The possibility of adverse liability judgment is another significant exposure. Increased

awards for both compensatory and punitive damages are being levied with alarming
frequency against organizations of all types. Even when liability cannot be proven, defense
costs can be significant. Examples of liability exposure include:
 The ownership, use, or acquisition of property
 Operations that pollute the environments
 The manufacture, distribution, or sale of products
 The rendering of professional and other services
 Alleged or actual violation of personal rights of employees, customers, or
clients
 Decisions made by an organization’s officers or directors
 Provisions included in contracts that transfer liability to entities that otherwise
might not be held responsible
 Injuries to employees.

In addition to liability losses, organizations may incur other costs associated with illness or
injury to employees. Most employers are subject to state workers compensation laws. Also,
many millions of shillings are spent each year on various types of employee benefits, with
one survey finding the average cost to be over Kshs.150,000 per employee for health care
benefits alone.

All of the preceding and other potential loss exposures must be evaluated in terms of their
expected frequency and severity of occurrence. This measurement and evaluation phase
52
involves the application of probability theory, statistical analyses, and a variety of loss
forecasting methodologies.

The operations of and conditions in which the firm is, will obviously give rise to a variety
of different risks. Some of these risks may be fairly obvious whereas others are just the exact
opposite. This makes the task of risk identification both important and difficult or
complicated.

It is important in the sense that the risk manager can only handle those risks he is aware of.
If some risks are not identified, it will mean that the firm may have to shoulder the resultant
loss. The fact that some overlooked risks may result in catastrophic losses underlines the
importance of the risk identification task.

It is difficult task because it is extremely easy to overlook certain risks. This difficulty is
even enhanced by the ever-changing nature of certain risks
The foregoing revelations imply, therefore, that for the risk manager to be successful in this
task, he must carry out risk identification on systematic and continuing basis.
The term “Risk Manager” is used in this unit to refer to that person who is charged with the
responsibility of overseeing the Risk Management function.

He may go by a different title, for instance, Insurance Manager, or alternatively the firm
may not have such a position in its hierarchy. Since this function must be performed, we
will apply the title to whoever does it.

6.2.1 How is risk identification systematic?

To systematize this task; the manager uses a variety of different tools. The basic aim here is
to ensure that the risks manager “digs” into the operations of the firm in order to “discover”
all the pure risks that the firm is exposed to. These tools include checklists, risk analysis
questionnaires, financial statements, flow-process charts and physical inspections. Let us
discuss them one by one.

53
6.3 Identification Tools

6.3.1 What Checklists?

Checklist may be of two types, namely, risk checklists and insurance policy checklists. As
their names imply, they are lists of risks and insurance policies, respectively that apply to the
firm.
The former are lists of all types of pure risks that might exist for a firm. Such checklists are
available from professional insurance associations, insurance companies, and commercial
publishers. The risk manager simply applies such a list to his firm.
He systematically reviews all the properties; activities and personnel of the firm to determine
which of the potential losses in the checklist apply to his firm.
Some risk managers may prefer to develop their own checklists because of certain
shortcomings in lists described above.

First, these checklists confine themselves to those pure risks that are insurable. The risk
manager’s task is broad as he needs to identify all potential losses to the business whether
insurable or uninsurable.
Secondly, most published checklists tend to organize the risks according to the types of
insurance available, for instance, fire risks, transportation risks, boiler and machinery risks,
public liability risks etc. The risk manager may prefer to organize the risks on a different
basis for instance, risks associated with:
Property and its usage.
i) Legal obligations.
ii) Personal capacity; or
iii) Earnings capacity.

Just like the checklists, insurance policy checklists contain a catalogue of the possible
policies or types of insurance coverages that a firm may require. Such checklists are available
from insurance companies and publishers specializing in insurance matters.

54
Here also, the risk manager only needs to scrutinize such a catalogue, picking out the
positions that are suitable for his firm. Again, just like the risk checklist, insurance policy
checklists consider only loss exposures for which insurance is available, and do not include
uninsurable risks.

From the foregoing, checklists form a useful tool for the risk manager since they provide
pointers as to what kinds of risks the firm faces.

ACTIVITY
A number of insurance companies in this country have developed
several kinds of these checklists. Contact your nearest insurance
company for a copy of this and outline what is contained therein.

6.3.2 Analysis Questionnaires

These are questionnaires designed to lead the risk managers to the discovery of risks through
a series of detailed and penetrating questions. They have also been called “fast-finders”

Like the checklists, these questionnaires are available from insurers and professional
associations. Answers to the questionnaires highlight the risks the firm faces. The chief
positive features if this “tool” is that it is normally designed to identity both insurable and
uninsurable risks. In some instances, the questionnaire can be exhaustive – covering almost
all faces of the firms operations.
The chief drawbacks of these questionnaires is that they are intended for a wide range of
business and may not therefore identify these risks that may be unique to a given firm. They
therefore need to be supplemented by other “tools”

6.3.3 The Firm’s Financial Statements

The firm’s balance sheets, income statements, budgets, and other financial statements have
been known to alert the risk manager of the existence of certain risks that may otherwise be
overlooked.
An item on the income statement for insurance may alert the risks manager of an activity that
portents loss to the firm. Similarly, the firm’s balance sheet may indicate to the risk manager
the existence of an asset that may be subject to loss brought about by a number of perils.

55
The role-played by financial statements in the risk identification exercise though not the most
important, it is however too significant to be ignored.
(a) Asset Inventories
List of assets their ownership, location, description and values e.g. from Plant and Property
Register
(b) Liabilities and Capital Reserves
(c) Budgetary Statements
i. Capital Budgets
ii. Sales and Production Budgets
iii. Cash Budgets
(c) Cash-flow Budgets
i. Cash movements
(d) Income Statement
ii. Revenues
iii. Expenditures

6.3.4 Flow Charts

The use of flow charts was first explained by one A.J. Ingley. When an analysis of a flow
chart of the firm’s operations is done that gives rise to special risks. Flow charts familiarize
the risk manager with the technical aspects of the business, thus increasing the likelihood of
identifying special risks. Flow process charts indicate the range of procedure of generating
output from the firm. It helps identify potential loss producing events from detailed analysis
of activity points in the firm.

Types of Flow Charts:

(a) Production Flow Charts:
Show the services required for production and the INPUT of those services as well as the
GENERAL FLOW OF MATERIALS through the transformation process. It can be depicted
as:
INPUTS PROCESS OUTPUT

The risks that are identified through analysis of production are mainly engineering risks.
These include among others: technical production related risks – breakdowns, dangerous
materials, malfunctioning of machines and critical value of each production process.
56
(b) Supply and Marketing Flow Charts:
The production flow charts do not reveal all potential risks. A supply and marketing flow
charts help fill in some of the gaps in the information revealed in the production flow charts.
The chart shows the flows of production and the value added at each stage as well as the
degree of interdependence between various parts of the business. It thus helps reveal:
 If one supplier is responsible for the deliver of an important material
 If all supplies of raw materials and components pass through the INCOMING
STORES
 If all output go to the FINISHED GOODS STORES
 If ONE CUSTOMER takes a large product or service output ratio
Analysis of the supply and marketing flow chart will help reveal many risks facing the
enterprise

(c) Input-Output Analysis

This shows inter-company dependencies. The logic of this technique is that each single
transaction can at the same time represent an OUTPUT (SALE) of one party and an INPUT
(PURCHASE) to another party.

Activity
Find out what flow charts are. They are extensively used in
management information systems and computers. What are their
shortcomings?

6.3.5 Physical inspections.

Risk managers have also been known to discover hitherto undetected risks by simply
inspecting the firm’s various operations sites and through discussions with managers and
workers.
We need to note in conclusion that the sources of risks that face firm are many and varied,
none of the tools specified above can alone, be sufficient. Above all, however, the success of
the whole identification process will depend on how diligently and imaginatively the risk
manager uses the various tools at his disposal.
57
A modern firm is dynamic in nature. This quality is “bequeathed” to the risks the firm faces.
Over time, risks change. Some risks disappear and new ones appear. Because of this, the risk
identification task is not a “one and for all” affair. The firm needs a wide-reaching
information system that is capable of providing a continual flow of information about the
risk that it faces. Indeed, the firm’s very survival may be dependent on this.
Inspection may include search in the following areas:
Premises
Processes in the organization
Goods/Services produced
Operations outside the premises
Key Employees
Transport
Security Arrangements
Research and Development Activities
Loss Prevention Arrangements

6.3.6 Information from Contracts

These provide useful information on the nature and scope of an organization’s activities but
also often contain clauses dealing with responsibilities for losses arising from the particular
activity.

6.3.7 Use of Injury and Non-Injury Accidents

This involves injury accidents records and damage accidents records. The aim here is to
identify such accidents and be able to implement DAMAGE CONTROL measures.
Reporting these accidents is regulated under the Health and Safety Act.

A record of the accidents is kept in Damage Control log book- listing date of accidents, extent
of damage, causes of the damage, causes of the accidents, estimated cost, control action taken
and the date of action.

Incident recall is used is used for non-injury accidents (near miss accidents). A record is kept
in Accident Report Form. It uses the Critical Incident Approach to discriminate among such
occurrences. Cooperation of Employees is essential for this technique to be effective.
58
6.3.8 Organizational Charts
The objectives and corporate management philosophy are reflected by its organizational
structure.
The organizational chart reveals key information which facilitates risk identification. These
include among others:
 How far control is centralized or decentralized
 The amount of autonomy given to managers at different levels of authority
 The interrelationships and interdependencies among parts of the organization
 The diversities in operations
 Geographical distribution

The chart helps in risk identification by revealing:

Activities carried out in the enterprise e.g. functional units
Products or service range i.e. variety of output in terms of products and services
The level of control and regulation of activities from a central point in the enterprise
The overreliance of the firm on a single geographical area – customer or service or even
department which exposes its VULNERABILITY to loss should that area be affected

6.4 VULNERABILITY ANALYSIS

6.1 Introduction
Risks are said to be very pervasive. That is they are found in every aspect of the
organization. Failure to identify such risks whether small or large may lead to a
catastrophe. Various identification techniques are available to a risk manager as seen in the
59
preceding lecture. In addition it is also important to understand areas of vulnerability which
may lead to losses, harm or disruption of business.

6.2 Objectives
By the end of the lecture the student should be able to:
 To appreciate the various techniques of vulnerability analysis
 Make decisions in circumstances of risk

6.3 VULNERABILITY ANALYSIS

The diagram below shows the various sources of information that would help a risk
manager to carry out a vulnerability analysis. The sources of information must be from
both internal and external sources including from various data banks.

Data Available to assist with vulnerability Analysis

External Data
Internal Data
Objective Data

60
 Risk Exposure Data

Organization Charts
Data banks Legal Documents
Consultants Personnel data
(Pooled loss
Data) Financial data Statistics
-official
Physical inspections
Trade journals

Vulnerability Analysis Data

Insurance Claims
Internal Loss records

(Published information)
Insurer data
Insurance Claims
Loss
data
Internal loss data

Subjective Data

Department:
Legal
Finance
Employee
judgment
Production
Personnel
Sales

Consultants/Trade journals

6.3.3 Fault Tree Analysis

In using fault tree analysis we ask the question “What must occur before the loss causing
event?”
The answer to this question tells us the sequence of events before a loss occurs and exposes
the vulnerability to a loss. Let’s use an example where a vehicle painting booth is exposed
to a risk of fire explosion.

61
 EXPLOSION OF AN OPEN
PLANT SPRAYING BOOTH

FLAMABLE PLANT SOURCE OF IGNITION

IN EXPLOSIVE
CONCENTRATION

FAILURE OF CONTINUING ELECTRICAL FLAMES NEAR CIGARETTE IN OR

EXTRACTION FLOW OF PAINT SPARK THE BOOTH NEAR THE BOOTH
FAN

BREAK DOWN FAILURE OF FAILURE OF INTRODUCED INTRODUCED

OF EQUIPMENT ELECTRICITY EARTHING BY OPERATIVE BY ANOTHER
SUPPLY SYSTEM PERSON

6.3.4 EVENT ANALYSIS

This technique is used when considering likely events which could cause problems and
then investigating causes and effects. This is illustrated in the diagram below.

62
CAUSE EFFECT

NATURAL LIABILITY
PHENOMENA DAMAGES

LOSS
BREACH OF PRODUCING PROPERTY
NATURAL LAWS EVENT DAMAGES

BODILY
MAN’S ACTIVITIES INJURY

LOSS OF
EARNINGS

6.3.5 HAZARD LOGIC TREE

These are the various hazards which may precipitate the operation of the peril which is the
cause of the loss producing event. It is an exposure analysis process in a methodical and
logical manner.
The figure below illustrates this phenomenon.

LOSS PRODUCING EVENT

63
 (e.g. Loss of Storage Facility)

PERILS Fire /Explosion Water Damage Other Forms of Denial of

Damage Access
H Arson Flood Aircraft Flooding
Smoking Storm Vehicle impact Subsidence of
A roads
Electrical Burst Pipes or Malicious Closure of
Z other apparatus damage e.g. roads
riots or strikes
A Heating Burst water Epidemic
mains outbreak
R Spontaneous Earthquake Government
Combustion order
D Spillage or leakage Hurricane
of flammable
S liquids
Chemical
interaction
Boiler Explosion
Spreading of fire
from adjacent
buildings
Explosion in
adjacent premises

We have looked at risk identification tools and vulnerability analysis in risk

identification. This can be summarized in the diagram below:

1. Data collected

2. Flow Charts constructed

(a) Production flow charts
(b) Supply, marketing and
distribution flow charts
3. Input/output analysis
64
 4. Hazard indices calculated

Areas of significant
vulnerability identified

Detailed Hazard identification

1. Form hazard identification team

2. Documentation on the process/plant
Collected and accumulated
3. Comparative hazard identification
4. Fundamental hazard identification
5. Findings report

Operative causes and perils identified

and feedback phase

6. Feedback/monitor to ensure
doubts raised by hazards identification
team are acted upon
7. Continue to monitor as changes occur

Review risk proportion of interested parties

6.5 Summary
 The identification of risks is a critical step in risk management
process. If not carried out systematically, it is possible for some
risks to be overlooked.
 There are several tools that are used by risk managers in the risk
identification function. These include checklists, questionnaires,
financial statements, flow-charts, physical inspections and others.

65
 After identification, the risks are categorized into critical, important and unimportant
risks. This will determine the priorities with which a risk will be handled.
 Risks can be managed in various ways: retention, transfer, avoidance and reduction. The
method may depend on the severity and frequency of the risk.
 Risk financing involves retention and transfer while risk control involves reduction and
prevention. However, all methods may involve some degree of financing.

6.5 Activity/Exercise
 Imagine that you are the risk manager of the University of Nairobi.
What types of risks do you think will come up using the tools at
your disposal?
 What is the rationale behind systemizing the risk identification
function?
 Why would it not be good sense to list risks in the order of their
importance as 1,2,3,4,5, and handle them in that order.

FURTHER READING
Vaughan E.J. Foundation of Risk and Insurance 5th Edition Chapter 3

66
 LECTURE 7
RISK MANAGEMENT: RISK HANDLING TECHNIQUES
CONTINUED: IMPLEMENTATION AND REVIEW
7.0 Introduction:
In the proceeding lecture we looked at the risk identification and measurement. We
discussed the rationale behind systemizing the identification function and the tools
that can be used in performing it. We also discussed the importance of measuring
and grouping risks into different categories that will dictate the priority with which
they are to be handled.
In this lecture, we still focus on the last three steps in the risk management process;
namely consideration and selection of the risk handling techniques implementation
of the technique(s), and review and control of the risk management programme.

7.1 Objectives
By the end of this lecture, you should be able to do the following:
1. Distinguish between the various risk-handling techniques and
categorize them under either Risk Control or Risk Financing;
2. Discuss the considerations that are borne in mind when
selection of a particular risk handling technique;
3. Describe what is entailed by the implementation of the risk-handling decision;
4. Discuss the mechanisms of reviewing the risk management.
5. Have the basic understanding of probabilities in measurement of risks
7.2 Risk Handling Techniques
After the risk manager has classified (or grouped) the risks with certain priority
consideration in mind, he then has to handle, or deal with them.
Basically, there are two broad approaches to dealing with risks, namely risk control
and risk financing.

7.2.1 What is Risk Control?

Risk control is an approach that concentrates on minimizing the risk or loss that the
firm faces. Risk control involves the techniques of avoidance and reduction.
67
 Avoidance focuses on two elements of risk – times subject to loss and focuses on
what may cause loss – and attempts to avoid either or both. Whereas risk avoidance
may not be possible in certain circumstances, it can however be effectively applied
in a myriad of situations. For instance, it may mean not introducing new product; or
ceasing some operations that have been carried our in the past; or selecting a business
side where a particular peril is absent, to mention but a few.

In essence, avoidance is a technique that is aimed at having nothing whatsoever to do

with the risk. Avoiding a risk means avoiding the consequences of the risk also.
Risk reduction is used where we cannot avoid certain risks that we must bear. There
are certain risks which cannot be avoided completely. Examples of these include the
risk of premature death, the risk of bankruptcy or the risk of liability suit. These and
a few others are always looming somewhere on the horizon. In order to handle them,
one may have to resort to techniques that will reduce their severity and frequency.

As pure risk exposures are identified and quantified, appropriate means for managing
each exposure must be selected, in order to minimize the cost of risk. The theoretical
underpinnings for this decision-making have been discussed in the conceptual
foundations of risk management. Some risks may be avoided entirely by management
decisions not engaged in certain activities. In cases where risks cannot be eliminated
entirely, control measures may be utilized to reduce the frequency and/or severity of
some possible losses. Effective control requires both technical knowledge of the
exposure and solid communications on the part of managers charged with
implementing the control measures.

They include “NO Smoking “ signs which are aimed at preventing an inadvertent
outbreak of fire; automatic sprinkler system and other fire-fighting equipment are
aimed at minimizing the damaged caused by fire when it occurs. A firm’s internal
control measures are meant to eliminate losses from theft and pilferage. In fact most
rules and regulations of a firm are addressed at reducing one risk or another.

7.2.2 What is Risk Financing?

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Risk financing involves devices that focus on arranging the availability of funds to
meet the losses that arise from risks that remain after control measures have been
taken. Risk financing, therefore, includes the techniques of retention and transfer.

Risk transfer involves the actual transfer; to entity, of either all elements of a specific
risk or the potential financial impact of the risk.
For many pure risk exposures, the appropriate means of financing the risk involves
retention. This includes those risks that are never identified and are retained by
default. It is, of course, preferable to retain risks only when careful economic and
financial analyses indicate that a particular retention method is optimal. In this sense,
risk retention techniques include decisions to pay losses from current revenues as
incurred; advance provisions for credit that may be needed if losses occur; and pre-
funding arrangements such as self-insurance and the formation of captive insurance
companies. Due to their nature, risk retention decisions should be coordinated with
other capital budgeting priorities within the organizations.

When analysis indicates that a risk cannot be adequately retained or controlled, it

should be financed by transferring it to another party capable of bearing the risk at a
lower cost. On transfer method involves hold harmless and indemnity agreements
included in leases and other contracts. Perhaps the best known examples of the risk
transfer techniques in insurance. Rather than being the primary method for handling
risks, however, insurance arrangements should be used only when other risk
management techniques are inadequate.

The techniques of risk reduction complements avoidance. It involves activities aimed

at preventing or minimizing the severity of losses when they occur. Examples of
risk reduction measures are numerous in everyday life.

Can you name a few of them?

69
Risk transfer may be achieved through elements of a gift or sale. Unlike in avoidance,
here, the risk continues to exist but it now rests with another entity. Other forms of
risk transfer include hedging, leasing, and hold-harmless arrangements.
Insurance is a special form of risk transfer. It is a technique that permits firms (and
individuals) to transfer the financial consequences of losses to an insurer (Insurance
Company). What makes insurance “special” is the fact that the insurer enters into
similar arrangements with many other firms and individuals (Insurers). This pooling
of risks enables the insurer to predict, with a great degree of accuracy, what is average
loss experience will be. In return for the insurer’s undertaking to bear the financial
consequences of losses when they occur (i.e. called a premium).

Insurance plays an important role in risk management. Because of this, we shall

devote subsequent lectures to it.

If a firm cannot avoid a certain risk, reduce it, or transfer it to some other entity, it
has retained it. Retention means that the firm will bear the financial consequences of
the loss should it occur.

Retention is of two types: it can be deliberate or unintentional. It is deliberate if the

firm has explored the other alternatives and decided that retention is the best solution.
On the other hand, the firm might fail to identify certain risks. This would mean that
the firm has unwittingly retained them. Only on rare occasions would this prove to
be a wise move! This underscores, yet again, the importance of the risk-identification
exercise.
Activity:
Which of the above techniques do you think should be used by the risk
manager?

None of the techniques discussed above can effectively be used on their own to
handle all the risks that a modern firm faces.

The risk manager thus has to determine which combination of these techniques meets
the optimum mix of the firms post-loss and pre-loss objectives discussed in an earlier
lecture.
70
7.3 Risk Treatment Matrix
To a great extent, the characteristics of the risk itself, as regards frequency and
severity, will determine which techniques selected to handle it. The table below
provides a summary of the risk management techniques and their appropriate
application. It should be noted that more than one technique can be applied to any
one situation.

FREQUENCY
OF LOSS
Frequency (High) Frequency (High)
Severity (Low) Severity (High)
(Reduce, retention) (Avoid/reduce)
Frequency (Low) Frequency Low
Severity (Low) Severity High
(Retain) (Transfer)
SEVERITY OF LOSS

Each technique renders itself most suitable when certain circumstances obtain. When
both severity and frequency of the loss are low, there isn’t much at stake, and the
costs of transfer or the foregone benefits that avoidance implies, cannot be justified.
The best technique will therefore be retention. However if the benefits from
reduction are more than the value of losses that would otherwise result, them
reduction can also be applied.

Risks that are of high frequency and low severity can best be dealt with through
retention and reduction. Retention is used because the high frequency implies that
transferring them will be too costly and, in any case, they can be budgeted for.
Reduction can be applied here in order to reduce the high frequency where possible.

Risks characterized by the frequency and high severity are effectively dealt with
through insurance. Should the loss occur, the high severity implies that it would be
catastrophic impact. The low frequency implies a low expected value, thus a low cost
of transfer. Resorting to retention or avoidance would not be an optimal decision.

71
 Those risks that are of high frequency and high severity should be avoided.
Transferring them would be too costly because of the high frequency. Retention
won’t be wise because of the high severity. However, reduction whenever possible
can be applied to reduce the probability and/or severity to manageable levels. Where
this can’t work, avoidance is the only way out.

Whichever techniques are selected for a particular risk, a cost-benefit analysis needs
to be conducted. The benefits, or savings made by the techniques should always
exceed its costs before it is used. Again, a technique should only be selected if it is
the least costly method of handling the risk in question.

7.4 Implementation of a Risk Management Programme

Finally, decisions must be implemented and thereafter risk exposures closely
monitored. Implementation might involve, for example:
 Establishing an organized employee safety programme
 Earmarking of internal funds to cover certain property losses
 Purchasing insurance
 Installing a fire suppression system
 Developing a communication plan to minimize adverse public reaction to a
disaster.
 Retraining and restructuring of the organization to minimize losses

Further, since exposures to risk are constantly changing, a continual review to

identify changes in exposures or appropriate management techniques is necessary.
For example:

 Changes in state laws may affect the expected severity of certain employee
benefit of liability obligations.
 Improvements in financial condition may make some forms of risk retention
feasible where risk transfer had previously seemed optimal.
 Insurance market cycle can later change the appropriateness of the insurance
mechanism over time.
These and other possible changes make the review function essential to the risk
management process.
72
 Once the combination of techniques to be used in handling the firms has been decided
on, proper administrative procedures need to be set up to implement the decision.

If, for instance, loss reduction is decided on, past occurrences need to be analysed to
determine their causes and the best way to attack them. It may be discovered, for
example, that most firms outbreaks have been caused by carelessly thrown cigarette
butts. The firm might decide to “out-law” smoking on the premises. It may set up
“No smoking” signs and institute other measures to ensure that this requirement is
adhered to. In order to contain fires that still break out in spite of all these, the firm
may install fire alarm and fire fighting equipment on the promises and train personnel
on how to use them.
Where insurance has been decided on, a number of issues need to be received or
affected. The broker and insurance firm need to be selected, terms and conditions of
the policies need to be negotiated, premium and their mode of payment have to be
determined and funds made available, tax implications of these arrangements have
also to be considered etc.
The same logic will apply to retention and avoidance. The selection of a technique
should be followed up with certain decisions being made and executed in order to
implement the techniques. The success of the technique may hinge on the decisions.

7.5 Review and Evaluation of the Risk Management Programme

Let us now turn to the last step of the risk management programme.
Sometimes, modification of the risk management programme is called for. This
should cause a review of the programme reveals that the best technique(s) was not
selected initially or the improper implementation of the decisions was made.

It could instead be that circumstances have changed. New risks have arisen and old
ones have disappeared.
Reviewing and evaluating the programmes enables the risk manager to modify
decisions and discover mistakes before they become too costly.

What was pointed out earlier about the risk-identification function also holds true for
review and evaluation of the programme. Reviewing and evaluating the programme
73
 for purposes of better control should not be a “once and for all” exercise, but rather,
a continuous one. This ensures that snags in the programme and spotted early enough
and mistakes corrected before they get out of hand and become too costly to the firm.

7.6 Summary

We have discussed two broad techniques of handling risks. These

were risk control and risk financing. Under each, various techniques
were discussed. The two broad techniques of handling the risks were
given as Risk Control and Risk Financing. In the lecture we were
also able to discuss when and how to apply the various techniques
based on their severity and frequency in occurrence. A risk treatment
matrix was developed to show which techniques to apply in various
situations. Implementation of the programme will be determined by
the nature of the risk at hand.

The last step in the risk management process was given as Reviewing and
Evaluation. It was noted that in any programme, there must be a review of the
progress of the programme and an evaluation whether objectives are being met and
the implementation is in accordance with the plan. If not, changes can be made with
the hope of changing tactics.

7.7 Activity

1. Define what is meant by risk control. What risk management

techniques would you attribute to this term
2. Discuss the concept of risk financing as one way of managing
risks.
3. Discuss the technique(s) to be applied in the following
scenarios: severity low, frequency low; severity low, frequency
high; severity high, frequency low; severity high, frequency high

References

1. Gordon C.A Dickson M. Litt. Introduction to Insurance;

Study Course 010, The CII Tuition Services, Cambridge
(Chapter 1)
2. Vaughan Emmett J. Fundamentals of Risk and Insurance,
John Wiley & Son N.Y (chapter 3)

74
 LECTURE 8
DETERMINING RISKS USING PROBABILITIES

8.0 Introduction
As defined in the earlier chapters, risk has a relationship in probabilities. The
occurrence of certain events cannot in most cases be determined with certainty. We
must resort to probabilities in order to predict the occurrences of the events.

8.1 OBJECTIVES
The objectives of this lecture will be to:

75
 1. To expose the student to the simple theory of probabilities
2. To explain the use of probabilities
3. To show how the law of large numbers is applied in the
determination of losses
4. To show the student how to calculate probabilities of certain
events and how to interpret the results

8.2 Probability Defined

Probability is concerned with measuring the likelihood of something happening and
making predictions of this likelihood. Probability is based on the randomness of the
events whose probability is to be measured or determined. If events were regular and
known, then there would be no need to consider them as risky.
However, there are some events in life that do occur with regularity while others
appear as a matter of chance. The likelihood of an event is assigned a numerical value
of between 0 and 1, with higher values assigned to those estimated to have greater
likelihood or probability of occurring.

8.3 Interpretation of Probabilities

(a) Relative Frequency Interpretation
The probabilities assigned to an event signify the relative frequency of its occurrence
that would be expected, given a large number of separate independent trials or
appearances. Only those events that repeat themselves for a long run may be governed
by probabilities.
Examples:
Floods in Budalangi Constituency will occur every after two years
Drought in Trans Nzoia will be experienced every after seven years
The A of spades will be drawn on the 52nd trial
By tossing a coin you will get a head on the second toss
Death through clashes in Rift Valley occurs every after five years

(b) Subjective Interpretation:

The probability is based on the degree of belief that something will happen. This is
not based on repetition of events, but on circumstances or state of things.
Example:
Prediction that there will be rain by mere observation of the clouds

76
 Prediction that a team will win by looking at the composition/weakness of the
opposing team

Determining the Probability of an Event Using the Relative Frequency Interpretation:

i) Apriori Probabilities
 Examines the conditions that cause the event
 The magnitude of the events
 Observe how frequently they occur
 We have some knowledge of possible outcome or underlying probability e.g
tossing a dice, flipping a coin or drawing a specific card from a deck of cards etc.

This means that for the probability to be determined, there must be several or infinite
observable occurrences. This apriori probability may be easy to determine in the most
elementary situations.

ii) Aposteriori probability

However, in certain cases it is difficult to establish the causality of certain events and
therefore we must observe these events for a long period of time before we assign
probabilities to them. For example determining the death of a 15 year old male on
reaching age 22 is 0.00181. What this means is that the mortality of all individuals
aged 15 years has been observed for a long period of time in a particular group and
an average mortality arrived at. The probabilities computed after a long observation
are referred to as a posteriori probabilities.

Note:
1. The a priori probabilities complement the a posteriori
probabilities because it requires several trials in order to
come to the true probability of an event happening.
2. It requires a large number of events or population in order to arrive at the true
or expected probability
3. The a priori probability may not be of importance except in the process of
explaining or determining the Law of Large Numbers.

Use of Probabilities:
77
 1. They help to establish the risk we face
2. They help to establish or estimate a loss
3. They help to manage risks

8.4 The Law of Large Numbers and its Application:

The Law states that: “if “p” is the expected probability of an event happening, then
the more trials or experiments we make, the more we get to the true probability “p”.
Therefore the law of large numbers presupposes that in order to achieve the actual
probability of a certain event, there must be large numbers of population or units of
the things whose probability is to be determined. Since probabilities measure the risk
of certain events, it can only be possible to arrive at the true probabilities if we make
several observations.
Similarly, it is possible to estimate possible losses resulting from a particular risk if
we have sufficient numbers of units exposed to that risk. The Law of Large Numbers
has a dual application as indicated by Vaughan:
 To estimate the underlying probability accurately, the insurance company
must have a sufficiently large sample. The larger the sample the more accurate
will be the estimate of the probability.
 Once the estimate of the probability has been made, it must be applied to a
sufficiently large number of exposure units to permit the underlying
probability to work itself out.

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8.5 Measurement of Risks Using Probabilities:
Assume population of 1,000 houses for consideration:

Dispersion and Probability considering two scenarios:

1.
Year Houses Burning
1 7
2 11
3 10
4 9
5 13
Total 50

2.
Year Houses Burning
1 16
2 4
3 10
4 12
5 8
Total 50

Probability:
Over a period of 5 years a total of 50 houses burnt in both scenarios. Thus a average
of 10 houses burnt every year. This gives a probability of 10/1000 or 0.01.

Range:

Scenario 1.
13-7 = 6

Scenario 2.
16-4 = 12

Standard Deviation:

Year Average Loss Actual Loss Difference Diff. Sq

1 10 7 3 9
2 10 11 1 1
3 10 10 0 0
4 10 9 1 1
5 10 13 3 9
Total 50 50 20

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 Year Average Actual Difference Diff. Sq
1 10 16 6 36
2 10 4 6 36
3 10 10 0 0
4 10 12 2 4
5 10 8 2 4
Total 50 50 80

Deviation/Variance:

Scenario 1: 20/5 = 4

Scenario 2: 80/5 = 16

The standard deviation is the square root of the variance. In scenario 1 the standard
deviation is therefore 2 and in scenario 2 the standard deviation is 4.

What do we learn from these two scenarios?

It should be noted that we are looking at two sets of houses exposed to the peril of
fire and the cumulative number of losses are the same although each year has different
losses. In order to understand fully the probabilities of these samples and the risk
exposure, we need to look at their standard deviations. The higher the standard
deviation the more risky it is and the lower the standard deviation the less risky it is.
The insurers take into consideration these dispersions in categorizing or determining
the rates for various risks.

8.6 SUMMARY
There are two broad approaches to handling risks, namely, risk
finance and risk control out these arise the four basic techniques of
dealing with risks – avoidance, reduction, transfer and retention.
 The characteristics of the risk will determine the technique to be used in handling it.
 To handle the risks that the firm faces the risk manager needs a combination of
techniques that is the least costly and the one that best attains the firms objectives.
 After selection of the technique, the firms has to set up proper administrative
measures to implement the decision.

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  A continuous review and evaluation exercise need to be conducted to monitor and
control the risk management programme.
 Probabilities are important in the measurement or prediction of risks and it is useful
to determine the probabilities of certain events. Insurers also use probabilities to
estimate their future losses.
 The Law of Large Numbers indicates that in order to make accurate estimates of risks
and losses there must be sufficiently large populations or samples.
 Each sample must be looked at differently in order to establish its loss or risk
experience. The standard deviation should be used to explain such variations.

8.7 Activity/Exercise
1. What step in the risk management process is the most critical? Why?
2. Insurance is the most important risk-handling technique. Why then can’t
it be applied to all risks?
3. Explain the importance of setting up proper implementation measures
when handling risks.
4. What is the purpose of reviewing the risk management programme?
5. What is the basic differences between risk control and risk finance
6. Do you think it is wise to retain any risk?
7. Define “The Law of large Numbers” What is its application?
8. Can you state why properties exposed to similar perils may have different loss
exposures?

Further Reading
1. William C.A. et al Principles of Risk Management and
Insurance, Malvern Pennsylvanian, 1978.
2. Vaughan E.J. Fundamentals of Risk and Insurance. New
York, John Wiley & Sons 4th Ed

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 LECTURE 9

THE INSURANCE DEVICE

9.0 Introduction
We have seen in previous lectures that Insurance is just one of the concepts that is
under the wider discipline of risk Management. We mentioned that insurance plays
the most crucial role among all the available risk handling techniques. In this lecture,
we intend to look at the Insurance mechanism in detail. We will specifically define
it, explain how it works and discuss the prerequisites of insurability. The insurance
device operates on the principles of receiving risks and sharing them on some
equitable basis. The insurance device must be capable of predicting losses and
planning for such losses.

9.1 Objectives
By the end of this lecture, you should be able to:
1. Define insurance and describe its role as a risk transfer mechanism
from both the individual and society’s viewpoint.
2. Discuss the requisites of insurability and explain the rationale
behind them.
3. Discuss the legal principles underlying the insurance mechanism
4. Appreciate the historical development of insurance and its impact
on social/economic environment

9.2 Definition of Insurance

As already discussed many definitions of risk exist. It is not our duty, however, to
consider all of them here. As pointed out earlier, insurance is simply one of the tools
of risk management. It is basically a risk transfer mechanism where an individual or
firm can shift some of the uncertainties of life to the shoulders of others. This is done
in return for a specified premium (price) i.e. a very small amount compared with the
potential loss. The cost of the loss is then transferred to an insurer.
Insurance therefore, is “a social device, which provides compensation for the effects
of misfortunes suffered by insureds” Each of the insureds contributes to the
insurance firm by paying the premiums, and out of the pool that is created, the insurer
compensates the unfortunate few who suffer loss.

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 The primary aim of insurance therefore is to provide financial security to individuals
or firms by spreading the financial consequences of losses suffered by the predictable
few members of the insuring public with similar risks to the whole insuring
community.
Contrary to common misconception insurance does not prevent losses from
happening. It only spreads the burden of such losses. Insurance provides certainty
for the individual members of the group by averaging loss costs. The premiums
(contribution) paid by the individual to the group is assumed, on the basis of
predictions, to be the individual’s share of average losses. In return for this
contribution, he is assured that the group will assume any losses that involve him.

In effect therefore, he has transferred his risk to the group and averaged his loss
costs – substituting uncertainty for certainty. The individual pays a certain
premium instead of facing the uncertainty of the chance of a large loss.

We mentioned the word “prediction” in explaining the purpose of insurance. The

question arising from this is how are these predictions done? These predictions are
done on the basis of probability and the law of large numbers.

ACTIVITY
The level of this unit does not allow us to delve into probability and
the law of large numbers to any great detail. To ensure that you
understand what these two concepts mean, look them up in any basic
text of statistics or mathematics of finance. Be sure to note the
difference between deduction and inductive estimates in probability.
9.3 Requisites of Insurability
Insurers have a greater ability to predict losses, than does an individual. In spite of
this, the insurer will not be able to establish, before hand, who, among his insureds
will suffer loss. The insurer is only able to ascertain, to some great degree of
accuracy, how many insureds will suffer loss.

Given this “accuracy” in predictions, why then can’t insurance be applied to all the
possible risks that face an individual or firm? The answer to this was partly broached
earlier when we pointed out that the nature of a risk determines how it will be handled.
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 In addition, the nature of insurance renders it useful only in certain situations. Certain
requirements must be fulfilled before a risk can be insured. These requirements are
commonly referred to as requisites of insurability. They include the following:

9.3.1 Large Number of Homogeneous Units

Insurance relies heavily on probability and statistics in its predictions. These
concepts depend on there being a reasonable experience of past events and a
sufficient number of present units (risks) for this experience to be applied on. If this
is not fulfilled, then prediction becomes extremely subjective rather than scientific.
A large number of risks, therefore, must be involved and these risks must be
homogenous, that is, similar to one another. Very few risks will mean high premium
if losses are to be met from these contributions.
9.3.2 Loss must be Fortuitous or accidental
This means the loss must be purely a matter of chance. This means that the frequency
and severity of the loss must be beyond the control of insured.
In this respect then, the risk must be pure. Speculative risks cannot be insured
because here, the risk is created by “speculative” means, i.e by man. Pure risks are
not “created” by man! If you gamble, you create the risk of loosing your money
(although there is a “remote” possibility that you will again instead) if you do not
gamble. If you do not gamble your money is not at risk at all!

9.3.3 Losses must be Definite in Time and Place

The insurance contract promises that the insurer will pay for the loss if it occurs
within a specified period and territory. For example, the contract may cover
accidental damage to a vehicle if it occurs within Kenya over the period July 1st 2005
to June 30th 2006. In order for this contract to be effective, it must be possible to
ascertain when and where such loss occur.

This implies that the time and place of the loss must be definite. If this cannot be
ascertained, then it is impossible to establish whether the loss is covered or not.
However,
- The loss must not be catastrophic ie it must be unlikely to produce a loss to a
large percentage of the exposure units
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 - The risk must be pure risk and not speculative

9.3.4 The Risk should involve Losses Capable of Measurement

The loss must be financially measurable or be capable of financial measurement.
Insurance is concerned with those situations where monetary compensation is given
following a loss. Examples include damage to property where the loss is equated to
the cost of repairs, theft of property where the loss is equated to the value of the
property by accident where the court can decide how much the injured party should
receive in compensation etc.

9.3.5 The Possible Loss must be Financially Significant

The operation of insurance costs money, and this requires that the risk insured against
must be financially feasible, that is, the possible loss must be relatively large
compared to with the premium paid.

Insurance cannot be utilized if the losses that the insurer pays for plus the cost of
operations are such that they are equal to or any slightly higher than the premium the
insured pays. In such cases, the insured would be better of budgeting for the risk
rather than insuring it, e.g. loss of a pencil.

The possible loss should be significant enough to warrant the loss of your pencil.
You can meet this loss without resorting to insurance.

As for the insurer, the premium should also be reasonable. It should be large enough
to cover the insurer’s costs of operating the scheme.

9.3.6 The risk must not be against Public Policy

As we shall see later, a contract of insurance must be based on a legal object. The
risk under insurance therefore must not be an illegality. For example we cannot
insure a thief’s loot knowing that such loot is ill gotten.

9.3.7 Catastrophe Hazard

Insurance is based on the premise that only a few members of the insured group will
suffer loss during a given time period. If, instead the majority suffers loss, the
mechanism will crumble because to compensate the victim will require unreasonably
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 high premium from the insured. Hence the requirement that there should be no
catastrophic hazard. (catastrophic hazards mean that insurers will not be able to
ascertain how many or how big the losses will be, rendering it impossible to build
reserves)
. This implies that there must be limits beyond which the insurers know losses will
not go. This allows insurers to build up reserves to meet the losses that will occur.

9.3.8 Insurable Interest

The principle of insurable interest is discussed in detail in the lectures that follow.
However for the purposes of requisites for insurability it will suffice to mention it
here. This therefore means that for a risk to be insured, the insured must have a
financial relationship with the subject matter of insurance that he stands to lose if
peril insured against takes place.

9.4 SUMMARY
 Insurance is a social device that spreads the consequences of a loss
onto members of Insuring group – It transfer the risk from the
individual to the insurer.
 Insurance cannot be applied to each and every risk. Certain
requirements have to be fulfilled. These requirements are known
as the requisites of insurability.
9.5 Activity/Exercise
1. What is the significance of grouping in insurance?
2. What requirements must be met if a risk is to be
insurable?
3. How do the principles of subrogation and contribution
complement indemnity?
4. What is the significance of the law of large numbers in
the operation of insurance?

Further Reading:
1. Vaghan E.J. Fundamentals of Risk and Insurance. New
York, John Wiley & Sons 4th Ed

86
2. Colin Smith, Insurances of Liability, Study Course No. 070;
The CII Tuition Service Cambridge (Chapter 8)

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 LECTURE 10

DEVELOPMENT OF INSURANCE

10.0 INTRODUCTION
From the previous lectures we have seen that there are various ways of dealing with
various types of risks. The insurance device is just but one of the many ways of
handling risks. We shall now turn to insurance as one of the most common methods
of handling risk. If you remember in the previous lecture we talked about risk transfer
and risk sharing. The insurance device operates on the principles of receiving risks
and sharing it on some equitable basis. The insurance device must be capable of
predicting losses and planning for such losses.

The role insurance plays in the economy is quite important, therefore its historical
development in the world and in Kenya in particular would be of interest to any
student of insurance. As we know, the insurance concepts and practices as we know
them today owe their origins to maritime practices. The growth and control of the
insurance industry is intrinsically intertwined with the social economic development
of any country. In this lecture we shall give a brief development of insurance in
general, but concentrate on the situation in Kenya.

10.1 OBJECTIVES
At the end of this lecture you should be able to:
 Understand the origins of insurance.

 Relate insurance growth to foreign occupation of Kenya

and inherent problems.

 Understand the social, political and economic influence on the development

of insurance.

 Understand the role and the reasons for the establishment of the office of
Commissioner of Insurance.
 Understand the factors that governed the development of insurance.
 Understand the structure of insurance in Kenya.
 Appreciate the economic impact of the industry in Kenya

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10.2 Development of Various Types of Insurance Lines
Insurance owes its development to marine practices. This is can be traced to the early
maritime traders such as the Lombards of London of early 14th century. From the
table shown below we can see that marine insurance was the first developed type of
insurance around 1550 AD. Although it took time since the Lombard merchants
were involved in international trade (almost 100 years), the first form of policy came
much later.

TYPE 1550 1600 1650 1700 1750 1800 1850 1900 1950 2000

Marine ==================================================

Ordinary Life ===============================================

Fire ======================================

Personal Accident ===================

Industrial Life ==================

Engineering =================

Liability ===============

Theft ===============

Permanent Health ==============

Loss of Profits ==============

Motor =============

Contractors All Risk =============

10.2.1 Examples of Early Insurance:

10.2.1.1 Code of Hammurabi:

The first form of insurance was illustrated in the Hammurabi Code which was an extreme
written law. For example a debtor did not have to pay a debt if he was affected by some
personal catastrophe such as death, disability or any natural calamity that made him unable
to pay the debt. In this time if one killed another, he was also killed to appease the relatives
of the deceased.

3000 BC China: Reimbursement of lost or destroyed vessels through sharing of losses

between financiers and owners.

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10.2.1.2 The Guilds Systems of Medieval Ages:
Most craftsmen were trained through the Guilds System. Apprentices spent their
childhoods working for their masters for little or no pay. When they became their own
masters, they then paid. If their premises, which were basically wooden hovels, were
destroyed, the guilds would rebuild using money from their coffers. If a master was robbed,
the guilds would cover his obligation until money started to flow in again. If the a master
was killed or became disabled, the guilds would support him or his widow and/or his
family.

10.2.1.3 Robert Hayman (17th November 1628)

The English colonialist Robert Hayman mentioned policies taken by the Diocesan
Chancellor of London for life and for safe arrival of the Hayman Ship in Guyana.

10.2.1.4 Blaise Pascal and Pierre de Fermat1654:

These Frenchmen expounded on use of probabilities as a measure of risk and on this basis
developed the first mortality tables that were used and still being used in calculating
insurance rates and hence assisting in underwriting of insurance. By 1693, mortality tables
were fully developed and life insurance developed.

10.2.1.5 London Fire 16666

The great fire destroyed around 14,000 buildings just when London was recovering from a
ravaging plague a year earlier. Many survivors found themselves without homes. Because
of this, most underwriters who had been only doing marine insurance and armed with
Pascal’s triangle tables, ventured into underwriting fire insurance.

10.2.1.6 Industrial Revolution in Europe;

This sparked the development of insurance with the various risks that came with the
revolution.

10.2.1.7 Development in USA

The insurance developed slowly in America.
1732 – The first insurance company formed in Charles town (now Charleston) South
Carolina.

Franklin’s Insurance 1752

Benjamin Franklin founded the Philadelphia for the insurance of houses from loss by fire.
It did not cover wooden houses because of the high risk.

1787-1873 –
More than twenty four life insurance companies are started. Less than six survive

Slave insurance 1861:

Some insurance companies in deep south insure the lives of slaves for the benefit of
owners. Slaves were treated as property by slavers.

10.2.1.8 Employees Insurance: (1897)

The first workmen compensation was first mooted in German and by 1897 the first
Workmen Compensation was passed in England requiring employers to insure their
employees against industrial mishaps.

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10.3 Origins, Growth and Control of Organized Insurance in Kenya.

10.3.1 Perspective and Scope.

Origins, growth and control of the insurance industry are intrinsically intertwined
with the social economic development of the economy.
(a) Need for Regulation of the Industry:
On 19/10/84, the Insurance Bill, 1984 was gazetted for introduction into the National
assembly. The stated objective of this bill was (1) to consolidate the law relating to
insurance (2) regulate the business of insurance, and (3) provisions for purposes
incidental thereto and connected therewith.

The need to regulate the insurance industry stems from the huge sums of money
controlled by insurance enterprises. Since the Government would like to spearhead
the directions of National Development, it follows logically that it would want to see
some of the huge insurance funds channeled into priority development projects.
Additionally, the insurance cover itself stimulates and accelerates economic activity
by providing security against certain risks so that individuals and enterprises can go
about their economic undertakings without being overly afraid of loosing their
valuable assets. Moreover, the Government has to regulate and control the
“economic game”.

In an economy whose Gross Domestic Product was estimated to be K£ 2,950.62

million in 1982, the insurance industry, (life and non-life insurance) was estimated to
possess K£ 183,233 million in productive assets. (Statistical Abstract, 1983).
Obviously, the construction of those assets to the National GDP is highly significant.
In this discussion, we shall survey the beginnings, growth and governmental control
of the modern and formally organized insurance industry to its present state that the
Insurance Bill, 1984, intended to regulate.
Note: This Bill came into law in 1985 and has since been amended to create the office
of Insurance Regulatory Authority (2002).

(b) The Pre – Colonial Era:

Formal organized insurance, whereby the relationship between the insured and the
insurer is documented in a contract (policy) is relatively new in Kenya. However,
the phenomenon of insurance whereby the loss of one or few is shared by many has
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 always existed in nearly all the ethic societies that now constitute the Kenyan Nation.
During pre-colonial and colonial era, many of the risks that people were exposed to
were catered for by one form or another of social insurance. Infact, well developed
institutions of social insurance existed. For example, among the Akamba, if by
accident, a man killed another, the family and clan of the killer would compensate
the family of the deceased. No matter how wealthy the killer was, it was not
permissible to make the payment alone. This practice is in essence a form of “liability
insurance”. A study of the traditional cultures of most of Kenya’s ethnic societies
would reveal many practices of insurance, including life assurance.
(c) Colonial Era
Security for Economic Activity:
As the demand for the services offered by the formally organized insurance industry
in Kenya is a function of economic development and security, there was very little
“development of either” during colonial era in Kenya. This is mainly because the
colonial powers did not get involved in any sizable economic development projects
that would in turn have created demand for insurance services. The limited demand
that there may have been was met by the foreign companies that operated branches
in Kenya. The services were rendered through agents that had power of attorney. As
such, they would underwrite and settle claims on behalf of their principals in United
Kingdom, France, India or wherever the companies may have originated from.

Post-Colonial Era
10.4 Socio – Economic Transformation
10.4.1 Colonialism to Nationalism:
To counter the colonial practices of non-development condition which prevailed
throughout all the colonies, many African National Governments nationalized the
insurance companies operating in their countries immediately they attained political
independence. However, Kenya did not do this because the Kenya Government
recognized the enormous and lasting benefits which can come from sensible
partnership between the public and the private enterprise. Nevertheless, some direct
government involvement in the insurance market was needed. Consequently, the
government acquired controlling interest in what was known as the Kenya National

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 Assurance Company (now under receivership-2006) and, later on established the
Kenya Reinsurance Corporation.

At the dawn of political independence (1963) the National Government was faced
with the enormous task of transforming the country from a colony into an
independent nation. This task required the formulation of appropriate plans and the
creation of the necessary infrastructure, institutions and mechanism that would
facilitate the transformation. These institutions included National insurance
companies. Hitherto, all insurance businesses were owned and managed by foreign
companies usually headquartered abroad.

10.4.2 National Development Objectives:

The infrastructure, institutions and mechanisms would embody the National
Development Objectives. The first National Development Plan (1964-1970)
delineated the objectives as “greater welfare for all its citizens”. Which can only
be attained through “rapid economic growth”.

For the attainment of such goals, it was necessary “to establish new economic
institutions (which included financial institutions – banks and insurance) and modify
old ones, freely choosing our models from the successful economies of the world,
adapting them to suit Kenya’s conditions and, in the process, developing new
concepts of economic organization. Ideological labels are of no concern to us; the
only criterion will be the effectiveness of the institution in achieving greater welfare
for all our people. (p. I).

10.4.3 Sessional Paper No. 10 of 1965:

Whereas “ideological labels are of no concern to us,” the guiding principles are
embodied in Sessional Paper no. 10 of 1965 on African Socialism and its Application
to Planning in Kenya.” This philosophy derived from the then ruling party KANU
manifesto, which declared at independence that the country would develop on the
basis of the concepts and philosophy of Democratic African Socialism. The approach
is dominated by the desire to ensure that the economy is Kenyanized.

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 The term “African Socialism”… was meant to convey the African roots of a system
that was itself African in its characteristics… describing an African political and
economic system that is positively African… capable of incorporating useful and
compatible techniques form whatever source.” (p. 2-3). Adoption and use of such
economic techniques for economic purposes required appropriate facilities and
infrastructure. Hence, the establishment and acquisition of such parastatals as the
Kenya National Assurance Company and Kenya Reinsurance Corporation.

“Parastatals” is a “coined term” meant to designate enterprises that are state owned
and controlled. It is less exact that “ they are state-owned-enterprises” but it connotes
that the entity referred to is either directly or indirectly controlled or supported by the
state.

10.5 Growth After independence.

10.5.1 National Development Plans 1 and 2:

At independence, the country inherited an elaborate framework of parastatals. In

effort to promote development, decolonize the country, increase citizen participation
in the economy and ensure more public control of the economy, the government
established more parastatals. As a result, parastatals are now found in all sectors of
the economy and employ large numbers of workers. The role and contribution of the
sector to the economy is quite significant. Let us briefly trace the developments
through the National Development Plan periods.

To facilitate Government participation in the process of transforming the country

from a colony into a National state, the policies adopted in the first National
development Plan include:-
 an investment policy designed to stimulate private capital formation and
employment opportunities for labour;
 a policy to ensure greater participation in economic affairs by the Government
and people of Kenya,
 a policy to develop new and existing institutions for promoting savings and
their productive utilization”.

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 The second National development Plan (1970 – 1974) focused more sharply on the
institutions of our interest in this discussion that is “Insurance companies”. The plan
acknowledged that “Insurance companies were the most important non-bank
financial intermediaries in Kenya. They provide a wide range of life and general
insurance facilities”.

It was noted that the local assets of insurance companies had not been growing rapidly
enough. The Government, however, continued to ensure that such assets covered the
local liabilities.

From a macro-management point of view, it should be noted that up to that time, the
use of life assurance as a savings medium was confined to non-Africans. Insurance
companies pursued conservative policies because of the lack of reliable data on
African mortality, and in many cases difficulty in obtaining satisfactory proof of age.
Underwriting standards in respect of African lives were, therefore, strict and the
choice available to the Africans had also been restricted.

10.5.2 Kenya National Assurance Company Limited (KNA):

To correct the situation, the Kenya National Assurance Company Limited (KNA),
was established in 1976 with the objectives of meeting the growing demand by
Africans for life assurance. Although the KNA initially undertook only general
business, it later provided a wide variety of life assurance and group pension
facilities. Indeed, KNA made considerable progress in attracting African savings into
life assurance although a part of its gross premiums was derived from non-life
assurance business. This company has been under receivership since 1996 due to
serious mismanagement.

10.5.3 Kenya Reinsurance Corporation (NDP 3):

By the time the Kenya society got into the third National Development Plan period
(1974 – 1978), the creation of institutions in order to achieve development policy
objectives was accepted as the thing to do. Numerous new institutions had been
created. The strategic activities of concern at that point included “reinsurance and,
to a lesser extend, general insurance. The state Reinsurance Company (Kenya Re)
95
 was responsible for all reinsurance business. The purpose was to provide reinsurance
business for the newly incorporated local companies and limit the flight of foreign
exchange in form of premiums to overseas reinsurers. Quite apart from enabling
control over strategic activities, ownership in such bodies yields substantial profits
for the Government; participation in reinsurance also saves foreign exchange.

It should be noted here that since then, reinsurance business has, however, been
liberalized and Kenya Re now competes with other reisurance firms in the market.
Such companies include among others, African Reinsurance Co., East African
Reinsurance Company, PTA Reinsurance and Swiss Reinsurance.

10.5.4 National Development Plans (4 and 5):

The fourth National Development Plan period (1979 – 1983) covers a period when
the Kenyan society was characterized by a complex network of institutions having
varied and complex relationships to each other and the international setting with
which they interact. The situation both reflects and supports the mixed economy
which has been a distinguishing characteristic of our economy since independence
and which continues into foreseeable future.

In assessing accomplishments of the fourth development plan period, the fifth

National Development Plan (1984 – 1988) has noted that the financial strength of
non-bank financial institutions (of which insurance companies are the most
important) grew faster than that of the commercial banks. “Thus the trend of relative
expansion of non-bank institutions has been accentuated in recent years. The total
liabilities of non-bank financial institutions was equivalent to 14.6 per cent of
liabilities of commercial banks in 1971 but by 1978 this figure had risen to 21.6 per
cent, and to 31.1 per cent by 1981. The growth of non-bank institutions was also
much faster than the growth of GDP at current prices”.

Starting in 1980 through 1983, non-bank financial institutions increased significantly

from 16 in 1980 to 34 by the middle of 1983. Concurrently, the financial resources
being channeled through these institutions increased significantly from (Ksh.m)
319.5 in 1980 to (Ksh.m) 537.4 in the middle of 1983.

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 “As a result of the proliferation and growth of these institutions their relative
importance in the operation of the financial systems has greatly increased.
Furthermore, the amounts of loan and advances extended to non-bank financial
institutions by commercial; banks have increased substantially reflecting a tendency
for some commercial banks to channel funds through affiliated financial institutions
for on-lending at interest rates higher than the commercial banks have been allowed
to charge. As the non-bank institutions became progressively more important and as
their operations became more closely linked with those of commercial banks, it
became increasingly clear that the regulatory framework governing such institutions
warranted review.

Finance is truly the livelihood of economic activity and growth of the financial sector
reflects the increasing role of the financial process in the economy. During the
national development plan period (1984 –1988) “Government’s policies continued to
encourage growth and diversification in the financial sector. It was recognized that
the key elements necessary for encouragement of further financial sector
development included a proper legal framework without excessive government
regulations.

10.6 Regulations and Control

10.6.1 The Organized Insurance Industry:
The Insurance Act Cap 485 the organized insurance industry that this act aims at
relating is made up of some forty one (41) insurance companies and two hundred
(200) brokerage firms (2006). The policies underwritten include (i) Accident, (ii)
Aviation, (iii) Fire, (iv) Marine, (v) Motor and (vi) Life (vii) Liability (viii)
Burglary among others. There are four (4) basic professional specializations
namely, (a) Agents, (b) Brokers, (c) Assessors, and (d) Insurers.
Organizationally, there are several institutions including, (1) Insurance Institute of
Kenya, (2) Council of Kenya Insurers, (3) Association of Kenya Insurers, and (4)
Association of Kenyan Brokers and (5) Insurance Training and Education Board.
The Act has established (6) The Commissioner of Insurance, and (7) Insurance
Advisory board.

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10.6.2 Objectives and the Commissioner of Insurance:
The Act is very comprehensive covering all phases of the industry. As stated earlier,
objectives of the Act are:-
(i) To consolidate the law relating to insurance
(ii) To regulate the business of Insurance; and
(iii) To make provision for purposes incidental to and connected with insurance.

The Act provides a good bird’s eye view as to what the future of the operating
environment of insurance business is likely to be. It starts by providing a glossary of
the term in daily use in the industry including “broker”, “agent”, “insurer”, “policy”
as well as “insurance business”.

For effective implementation of the provisions, the bill provides for the appointment
of the commissioner of Insurance. The Commissioner shall be responsible for the
general administration of the act. According to section 5, his duties shall include:-

(a) The formulation and enforcement of standards in the conduct or the business of
insurance with which a member of the insurance industry must comply.
(b) Directing insurance and reinsurance on:-

(i) The standardization of contracts of compulsory insurance.

(ii) The deletion or amendment of obscure or ambiguous terms in contracts of
insurance:
(iii) The deletion or amendment of terms and conditions in contracts of insurance
which are unfair or oppressive to policy holders;
(iv) The simplification or clarification of terms and conditions in contracts of
insurance;
(c) The approval of tariffs and rates of insurance in respect of any class or classes
of insurance.
(d) Such other duties as the Minister may assign him.

The Commissioner is also duty bound to finish to the Minister an annual report on
the working of the Act. Intern, the Minister “shall lay the report before the National
Assembly as soon as reasonably practicable thereafter”.
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10.7 Registration of Insurance
According to section 19 of the Act, “only a person registered under this Act shall…
carry insurance business:-
(a) In Kenya, whether in respect of Kenya insurance or reinsurance
business or otherwise; or
(b) Outside Kenya in respect of Kenya business, except Kenya
business which is solely reinsurance business:
To qualify for insurance, one must be “a body corporate incorporated under
the companies Act and at least one third of the controlling interest, whether
in terms of shares, paid up share capital or voting rights, as the case may be,
are held by citizens of Kenya. The capital of such a company must not be less
than two hundred million shillings of paid up shares; or in the case a body
not having share capital, assets approved by the Commissioner for the purpose
of not less than two hundred million shillings. The managing board must
contain at least one-third Kenya citizens.

10.8 Stimulated Accountability

According to section 55, it is a legal requirement to “keep such accounting records as
correctly record and explain the transactions and financial position of the insurer with
respect to his insurance business”. Section 56 provides that “The accounts of every
insurer shall be audited annually…”

Section 60 that “The balance sheet profit and loss account and revenue account…
shall be signed by two directors and the principal officer of the insurer or, if there is
only one director, by that director and by the principal officer”. The statements “shall
be printed, and four copies thereof authenticated and certified… shall be deposited
with the commissioner within six months after the end of the period to which they
relate”. (S. 61).

According to section 67, signing for false statements calls for a penalty of “a fine not
exceeding ten thousand shillings or to imprisonment for a term not exceeding twelve
months or both.” It is further providing that failure to comply with any of the
provisions dealing with Accountability (s. 52-67) calls for “a fine not exceeding fifty

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 thousand shillings; and if the offense is a continuing one, to a further fine of one
thousand shillings foe every day during which the offense continues.” (s. 67).

The Act continues to make provisions for management, Rates, Policy Terms and
Claims Settlement. Additionally, it continues to make provisions for Assignments,
Mortgages, Nominations, Claims on small life policies, Transfers, Amalgamations,
Insolvency and winding up.

10.9 The Insurance Advisory Board of Kenya

The Act empowers the Minister to appoint an Insurance Advisory board made up of
thirteen members. The board shall have a chairman, “who shall be a person not
connected with any insurer, broker or insurance agency;” with the approval of the
Minister, the board may make rules for the transaction of business at meetings of the
board. To facilitate functioning of the board, it shall have a secretary “who shall not
be a member of the board but an official working under the Commissioner.” The
board may form committees to discharge any functions which may be delegated.

According to section 165, the functions of the board shall be:-

(a) To assist the Commissioner in formulating standards in the

conduct of business with which members of the insurance industry
must comply;

(b) To advise the Commissioner and the Minister with regards to any
Matter concerning the insurance industry, including rates, terms and conditions
of policies and the operation of this Act as may be referred to the Board by the
Commissioner or the Minister for advise.

10.10 Development of Insurance Companies in Kenya

10.10. 10.5.1 National Development Plans 1 and 2:

At independence, the country inherited an elaborate framework of parastatals. In

effort to promote development, decolonize the country, increase citizen participation
in the economy and ensure more public control of the economy, the government
established more parastatals. As a result, parastatals are now found in all sectors of
the economy and employ large numbers of workers. The role and contribution of the
sector to the economy is quite significant. Let us briefly trace the developments
through the National Development Plan periods.
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 To facilitate Government participation in the process of transforming the country
from a colony into a National state, the policies adopted in the first National
development Plan include:-
 an investment policy designed to stimulate private capital formation and
employment opportunities for labour;
 a policy to ensure greater participation in economic affairs by the Government
and people of Kenya,
 a policy to develop new and existing institutions for promoting savings and
their productive utilization”.

The second National development Plan (1970 – 1974) focused more sharply on the
institutions of our interest in this discussion that is “Insurance companies”. The plan
acknowledged that “Insurance companies were the most important non-bank
financial intermediaries in Kenya. They provide a wide range of life and general
insurance facilities”.

It was noted that the local assets of insurance companies had not been growing rapidly
enough. The Government, however, continued to ensure that such assets covered the
local liabilities.

From a macro-management point of view, it should be noted that up to that time, the
use of life assurance as a savings medium was confined to non-Africans. Insurance
companies pursued conservative policies because of the lack of reliable data on
African mortality, and in many cases difficulty in obtaining satisfactory proof of age.
Underwriting standards in respect of African lives were, therefore, strict and the
choice available to the Africans had also been restricted.

10.5.5 Kenya National Assurance Company Limited (KNA):

To correct the situation, the Kenya National Assurance Company Limited (KNA),
was established in 1976 with the objectives of meeting the growing demand by
Africans for life assurance. Although the KNA initially undertook only general
business, it later provided a wide variety of life assurance and group pension
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 facilities. Indeed, KNA made considerable progress in attracting African savings into
life assurance although a part of its gross premiums was derived from non-life
assurance business. This company has been under receivership since 1996 due to
serious mismanagement.

10.5.6 Kenya Reinsurance Corporation (NDP 3):

By the time the Kenya society got into the third National Development Plan period
(1974 – 1978), the creation of institutions in order to achieve development policy
objectives was accepted as the thing to do. Numerous new institutions had been
created. The strategic activities of concern at that point included “reinsurance and,
to a lesser extend, general insurance. The state Reinsurance Company (Kenya Re)
was responsible for all reinsurance business. The purpose was to provide reinsurance
business for the newly incorporated local companies and limit the flight of foreign
exchange in form of premiums to overseas reinsurers. Quite apart from enabling
control over strategic activities, ownership in such bodies yields substantial profits
for the Government; participation in reinsurance also saves foreign exchange.

It should be noted here that since then, reinsurance business has, however, been
liberalized and Kenya Re now competes with other reisurance firms in the market.
Such companies include among others, African Reinsurance Co., East African
Reinsurance Company, PTA Reinsurance and Swiss Reinsurance.

10.5.7 National Development Plans (4 and 5):

The fourth National Development Plan period (1979 – 1983) covers a period when
the Kenyan society was characterized by a complex network of institutions having
varied and complex relationships to each other and the international setting with
which they interact. The situation both reflects and supports the mixed economy
which has been a distinguishing characteristic of our economy since independence
and which continues into foreseeable future.

In assessing accomplishments of the fourth development plan period, the fifth

National Development Plan (1984 – 1988) has noted that the financial strength of
non-bank financial institutions (of which insurance companies are the most
important) grew faster than that of the commercial banks. “Thus the trend of relative
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 expansion of non-bank institutions has been accentuated in recent years. The total
liabilities of non-bank financial institutions was equivalent to 14.6 per cent of
liabilities of commercial banks in 1971 but by 1978 this figure had risen to 21.6 per
cent, and to 31.1 per cent by 1981. The growth of non-bank institutions was also
much faster than the growth of GDP at current prices”.

Starting in 1980 through 1983, non-bank financial institutions increased significantly

from 16 in 1980 to 34 by the middle of 1983. Concurrently, the financial resources
being channeled through these institutions increased significantly from (Ksh.m)
319.5 in 1980 to (Ksh.m) 537.4 in the middle of 1983.
“As a result of the proliferation and growth of these institutions their relative
importance in the operation of the financial systems has greatly increased.
Furthermore, the amounts of loan and advances extended to non-bank financial
institutions by commercial; banks have increased substantially reflecting a tendency
for some commercial banks to channel funds through affiliated financial institutions
for on-lending at interest rates higher than the commercial banks have been allowed
to charge. As the non-bank institutions became progressively more important and as
their operations became more closely linked with those of commercial banks, it
became increasingly clear that the regulatory framework governing such institutions
warranted review.

Finance is truly the livelihood of economic activity and growth of the financial sector
reflects the increasing role of the financial process in the economy. During the
national development plan period (1984 –1988) “Government’s policies continued to
encourage growth and diversification in the financial sector. It was recognized that
the key elements necessary for encouragement of further financial sector
development included a proper legal framework without excessive government
regulations.

10.11 SUMMARY

The object of, this Act is to amend and consolidate the law relating to
insurance and to enable the Government to exercise a stricter control
and supervision over the operations of insurance companies and all
other members of the insurance industry.
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 To do so, the bill provides for the office of commissioner of Insurance and Insurance
advisory board to advise both the commissioner and the Minister on a wide range of
insurance matters. Indeed, the Commissioner is to act as the Government’s watchdog
over the industry. In cases of suspected contravention of the act by members f the
insurance industry, the Commissioner is empowered to call for information on the
affairs of the insurance enterprises, issue directions restricting dealings with their
assets, prohibit particular transactions, and, with the approval of the Minister, order
an investigation.

Regulations must be strengthened to ensure that any organization or company which

receives premiums to buy policies or properties is well managed and has adequate
capital for its purposes. The insurance industry like basic infrastructures, must
always be ahead of the requirements of the national economy otherwise economic
development would not take place at the rate it is capable of achieving.

“Insurance provides many benefits to society; stability in families and businesses,

easier completion of leading arrangements, removal of one advantage of monopolies
or large-scale business versus small-scale operations, provision of capital to business
and individuals, and active support of loss preventing research.” (Dorfman p 15).

The insurance industry provides a great number of different and challenging

employment opportunities.

Many insurance occupations require considerable technical expertise, such as that of

an actuary, lawyer, underwriter and loss adjuster. All insurance careers can provide
an individual with the greatest satisfaction of knowing that the families and
businesses and much more secure and likely to endure.
10.12 Activity/Exercise:
1. What was the Kenya Government objective(s) in its involvement
in insurance industry?
2. Can you trace the historical development of insurance in Kenya
and the world?
3. What role does the Commissioner of Insurance play in the
industry?

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 4. Can you determine the economic significance of the insurance industry in
Kenya.
5. Name chronologically some of the early private insurance companies to start
business in Kenya.
6. Of what significance was the National Development Plans 1 and 2 in the
economic reforms in Kenya. How did these plans affect the insurance
industry?

Reference:
Government of Kenya, Insurance Act Cap 485
Government of Kenya, Sessional Paper No. 10 of 1965
Government of Kenya, National Development Plans Nos 1-5

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 LECTURE 11

PRINCIPLES AND LEGAL ASPECTS OF INSURANCE

11.0. INTRODUCTION
There are basic requirements of an enforceable contract to which an insurance
contract is subjected to. It is important to note that an insurance contract is a unique
contract because from the outset, one may regard it as a gambling contract. This is
not the case, since gambling contracts are not recognized in law as binding and are
illegal. We shall look at some of the special legal issues governing the insurance
contracts.

In the previous lecture we were able to discuss the insurance device and understand
how it operates. Having appreciated the prerequisites of insurability we should now
be prepared to understand the governing principles of the insurance mechanism and
the contractual responsibilities of the insurer and the insured. Since we stated earlier
that insurable risk must bear certain characteristics and that it does not deal in
speculative risks, it is important to appreciate the legal background and the principles

11.1 OBJECTIVES
At the end of this lecture you should be able to:
1. Relate the general requirements of an enforceable contract to an
insurance contract
2. Understand the legal nature of an insurance contract
3. Understand the provisions under various types of insurance both
life and general
4. Understand the six basic principles of insurance and their effect

11.2 The Insurance Contract

The definition of insurance has touched on the uncertainty of an event happening. We
can go for further and say that if this event happens it must be accidental, although
life insurance maybe different because death is an eventual certainty, only the time is
uncertain. The insured must suffer a financial loss, which is determinable. These are
some of the general aspects of an insurance contract, which differentiates it from a

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 gambling contract or agreement where risks created by the agreement, and there is
no accident involved in the outcome of the gamble. Like any other business contracts,
the consideration for the promise of services to be rendered by the insurer is the
premium.

Also it is important to note that an insurance contract is a contract whereby the

amounts paid by the contracting parties are unequal. The insured pays the required
amount of premiums and if a loss does occur the amount of compensation paid by the
insurer far exceeds the premiums paid by the insured.

11.3 Construction of the contract.

The proposal form in fact forms part of the insurance contract as it contains the terms
of contract. The proposal form is the offer made by the insured and the insurance
company accepts the offer either by countersigning the proposal form or asking for
the premium; however, there are some intermediary steps which the insurer
undertakes before the policy is issued. Such steps have something to do with the
assessment of the risk involved as stated in the proposal form.
It is important to realize that unlike the old days where the person seeking protection
(insured) against a disaster (peril) came to the insurer and they discussed the terms of
the contract, these days, the insured has no such privileges. A contract of the
insurance is a contract of adhesion. This means that it is the insurance company
writing up the terms of the contract and asking you to accept or not to accept them. It
is therefore for the insured to make sure that the wording and intention of the contract
is understood. Some insurance contract companies have the habit of writing an
insurance contract in small print and in legal jargon, which the ordinary person cannot
easily understand. It would be advisable for the insured to seek advice before
committing himself to the contract.

11.4 Legal Aspects of Insurance

11.4.1 General Requirements:
The law of contract applies to the insurance contracts just as much as they apply to
other business contracts.
a) Offer and Acceptance
In order to have a legally binding insurance contract, there must be an offer in the
form of an application by the proposer accompanied with the first premium. The
acceptance comes in the form of a policy issued by the insurer or when the agent
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 binds the coverage and has taken the first premium under a receipt on behalf of the
insurer. That is why as we shall see later that a proposal form forms part of the
contract because through it the risk being offered is described and the form signed by
the proposer.

b) Consideration
Consideration is what really binds the parties to the contract together. It is the value
that each party surrenders to another or in exchange of something given. In case of
insurance, the insurer promises to fulfill an obligation of compensating the insured in
case the peril insured against causes a loss to the insured. In return, the insured pays
a premium for expected future loss. This premium must be paid in advance or
continuously depending on the nature of the insurance and the agreement between
the insurer and the insured. Usually the first premium binds the insurer to the contract.
However, it should be noted that the subsequent premiums are mere conditions for
the continuance of the insurance contract.

c) Legal Object
Insurance contracts are deemed to be legal contracts. That is they are not expected to
go against the public order. For example, insurance contracts should not be gambling
contracts, nor can they condone an illegality such as murder or any other criminal
activity. Therefore, contracts whose legal object is illegal are unenforceable in law.

d) Competent Parties
Competence here means that the parties to the contract must have the capacity to
enter into a contract in accordance with the law. Incompetence will include minors
and people with mental incapacity. The age of majority may vary from country to
country but the most common is 21 years. Other countries put the age of majority at
18.

e) Legal Form
The law may dictate the form in which the insurance contract may take and the
standard clauses that must be included in the contract. Also there are usually standard
wording of the conditions and terms of the contract acceptable to the law and the
nature of the insurance.

f) Void and Voidable

Sometimes we use incorrectly the two terms interchangeably. Void contracts are
unenforceable in law because they lack the legal object. A contract that engages in
criminal activity or an illegality would void. None of the parties to such a contract
can enforce it.

Avoidable contract on the other hand is a contract that may be accepted by the courts
as valid, however, it may be set apart by one of the parties for a reason acceptable by
the courts. For example, if the insured has failed to comply with one of the conditions
of the contract such as failure to disclosure of a material fact. The insurer may elect
to ignore it and continue with the contract or may elect to void the contract based on
the violation of the condition. The decision to void the contract is on the party that
has been offended.

g) Actual Cash Value

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 The doctrine of actual cash value is used to enforce the principle of indemnity. You
should refer to the principle of indemnity discussed below.

It does not matter for how much the insured party insures his property. The limit of
indemnity is the actual value of the property. For example the insured may take a
policy worth Kshs. 10,000,000/- on this property when the actual value of the
property is Kshs. 7,000,000/-. Should there be total loss, the insurer will compensate
him the actual cash value of the property.

However, it should be noted here that this doctrine may be difficult to interpret in
certain circumstances. For example in certain liability cases it is difficult to ascertain
the actual value of loss, and even in material loss, it is difficult to ascertain the actual
loss due to changing prices. For this reason, the most frequently used definition of
actual cash value is “that amount of money necessary to replace the damaged or
destroyed property with new materials at today’s prices less depreciation”

If we take the above example that the actual value of constructing the property in
1990 was Kshs. 7,000,000/- and that the current value of the property in 2006 is triple
the original value i.e. Kshs. 21,000,000/-. If we assume a depreciation of 20%, the
insurer should pay a loss of Kshs. 16,800,000/-.

h) Valued Policy
The concept of valued policies was discussed earlier as one of modifications to the
principle of indemnity. Do you remember? Where valued policies are issued both the
insurer and insured agree in advance the values to be insured and when a loss occurs
it is only the agreed values that are compensated. The application of the law for
valued policies is limited to certain types of properties and perils, and usually where
total loss has occurred. As we can see the valued policy can be in total violation of
the principle of indemnity.

i) Warranties
Warranties are promises made by the parties to the contract that certain things will be
fulfilled during the currency of the contract. A breach of a warranty may lead to the
contract being avoided, although this looks to be a very hush way of penalizing one
of the parties to the contract. The warranty may be in writing: that is it is in the body
of the contract or attached to it, or may be assumed in accordance with the practice
of business or the operation of the law.

11.4.2 Unique Characteristics

i) Insurance is a Personal Contract
The contract of insurance is between the named insured and the insurer. Therefore no
other person can claim other than the insured. When property is sold or transferred to
another party, the contract ceases immediately. The insurer may return part of the
premiums if the term had not expired.

However, the insured may assign the proceeds of the contract to another person. This
can only be done if the company consents to the assignment.

j) Insurance is a Unilateral Contract

The position is that only one party to the contract is legally bound to do anything.
Usually the insured cannot make promises that are legally enforceable. Being a
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 conditional contract, if an insured violates any of the conditions, he may be prevented
from collecting in the event of a loss, or the contract may be voidable.

k) A contract of Adhesion
A contract of Adhesion is defined as “one prepared by one of the parties (the
company) and accepted or rejected by the other party (the insured). Such contracts
are not usually drawn up through negotiations. Most business contracts are negotiated
but insurance contracts tend to be fixed in favour of the insurer.

l) The doctrine of “presumption of intent”

In this respect is important in insurance contracts. It is usually assumed by the courts
that the person accepting the contract has read and understood the terms and
conditions of the contract and therefore is bound by those terms and conditions.
However, sometimes there may be ambiguity in the wording of the terms and
conditions. In this respect, the courts will interpret the wording against the party that
created the ambiguity (the company)

m) An Aleatory Contract
The term “aleatory” means that for a small consideration by the insured, the insurer
is able to give a much higher compensation. That is the amount of money given up
by the contracting parties is unequal. This therefore give an insurance contract the
characteristics of a gambling contract.

11.5 Policy Construction

In general terms, the policy contract is divided into four major parts:

a) Declarations
These are statements made by the insured and the courts usually take them as
representations. In most cases these appear on the proposal form. At the end of the
proposal form is a declaration section which the proposer signs declaring that the
information given is true to the best of their knowledge. It binds the insured in any
future disputes.

b) Insuring Agreement
This is where the company agrees to pay a loss occurring as a result of named peril(s)
and on payment of agreed premium.

c) Exclusions
This section states what the company cannot do or limits what the company can do.
The number of exclusions has a direct relationship to the broadness or narrowness of
the insuring agreement.

d) Conditions
This section spells out in detail the duties and the rights of both the parties to the
contract. Most of the conditions found in the insurance contract are fairly standard,
that is they are common conditions for all contract of that nature in the insurance
industry. Some of these conditions come in terms of clauses acceptable
internationally. These conditions are expected to protect the insured in the event of a
loss, and also to protect the company in the event of adverse loss experience.

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11.6 Principles Governing the Contract
There are certain principles which govern the insurance contract and which must be
observed by the parties to the contract. These are: -

11.6.1 Utmost Good faith or (ubberimae fides)

Because of the nature of the insurance contract it is the duty of the parties to show
good faith in dealing with each other. As it had been stated, the insurance contract is
a contract of adhesion and therefore the insurer must prepare the contract with good
intention and has the obligation to reveal these intentions to the insured in good faith.
On the other hand, since the insurer has to rely on the information given by the insured
in rating the risk to be insured, the information should be given in good faith and
should not be misrepresented. The argument is that the insurer has no way of proving
some of the information given by the insured and has no option but to rely on the
information. Therefore all material facts related to the risk to be insured must be fully
disclosed. In practice, the burden tend to be laid on the person applying for insurance
for he knows more about the risk than the insurer who will provide cover.
The principle of utmost good faith applies in all contracts of insurance. It is more
severe than the principle of caveat emptor that applies in most simple business
contracts. It imposes a strong duty of disclosure on the parties entering the contract.

The insurers on their part are required:

 Not to accept a risk which they have reason to believe is unenforceable at law
 To issue the policy in unambiguous terms
 To make no untrue statements in the negotiations with the applicant
 Not to withhold important information e.g that the insured could obtain a discount
from his premium for certain protection on his premises.
When a person fails to disclose a material fact to the insurers, then the non-disclosure
will act against him if the insurance company discovers. The contact can be voided
or claims refused. However, it should be noted that mere failure to disclose doesn’t
automatically nullify the contact. Where non-disclosure amounts to fraud, i.e if it is
discovered that in failing to disclose the insured wanted to hide an illegality or
commit a crime, such failure will constitute grounds to void the contract.

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The insurance industry relies entirely on the information provided by the client to
decide if the client presents an acceptable risk and to determine the correct premium
that should be charged. If a client provides false or incomplete information about the
risk, this means that the actual risk differs significantly from the one that was agreed
upon. In such a case the policy would be affected and at worst may leave the client
uninsured. Information deliberately withheld in response to a direct question is
referred to as non-disclosure.

The duty of utmost good faith is to disclose all fact material to the risk. A question
may arise at this point.

“What is a material fact?”

Definition
The Marine Act 1906 gives a legal definition of material facts as:
“Every circumstance is material which would influence the judgment of a prudent
or reasonable underwriter in fixing the premium or determining whether he will
take the risk”
Facts to be disclosed
 Facts which must be disclosed include and are not limited to the following:
 Those which show that a particular risk being proposed is greater internally than
would be expected from its nature or class.
 If external factors make the risk greater than normal
 Those which would make the likely amount of loss greater than normally
expected, for example disclosure of hazards.
 Previous losses and claims under other policies.
 Previous declinature or adverse terms imposed on previous proposal by other
insurers.
 Those restricting subrogation rights due to the insured’s relieving third parties of
liabilities which they would otherwise have.
 Existence of other policies, especially covering the same risk or similar risk.
 Full facts relating to and description of the subject matter of insurance.

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For instance, an insured should disclose the fact that he or she had previously suffered
from a particular disease such as STD, pneumonia, hypertension etc when applying
for a life insurance policy.

Facts that Need Not be Disclosed

These include:
 Facts of law; Everyone is deemed to know the law.
 Those which the insurer is deemed to know, i.e. facts of common knowledge
 Those which would lessen the risk; e.g. the existence of an alarm system in
the theft risk.
 Facts covered by a policy condition.
 Those which the insurer’s survey should have noted.
 Facts about which the insurer has been put on enquiry; e.g. when the applicant
has referred the insurer to a previous claims record, or previous policy.
 Those which the applicant doesn’t know. A person cannot be expected to
disclose what is not known to him.

Duration of the Duty of Disclosure

Let’s start by asking the question at this juncture:
Is the duty of disclosure a continuous one or it ceases at some point?
The position at common law is that it starts at the commencement of negotiations
between the parties and ceases when the contract is terminated.
When the insured changes or alters the risk, say by extending a building or changing
the use of that building, or a car for that matter, it can be argued that this in fact should
enlist a new contract, and therefore the duty of disclosure revives.
In conclusion, any material fact not disclosed to the insurers at the time of making
the contract, or other intervening facts during the currency of the contract, may lead
to the contract being unenforceable before any court of law. This will give the
insurers absolute discretion to repudiate liability without any reference to a court of
law.

NOTE:

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 1. It should be noted however that the principle of utmost good
faith is not a “MUST” stipulation in making the contract, but
that not adhering to it will amount to adverse action against the
insured party.
2. It should also be noted that when an insurance company receives
information about failure to disclose a material fact and it continues to
receive premiums, the effect of their receipt of the premiums denies them the
right to repudiate the contract. The law is very clear on this.

11.6.2 Insurable Interest

Insurable interest has a backing of the law. Indeed its necessary by the law to have
insurable interest in the subject matter of insurance, otherwise the insurance contract
would be invalid without it.

The definition of insurable interest is that an individual or a group of individuals has

an interest in subject matter of the insurance if he suffers loss or is prejudiced by the
destruction of the subject matter. The individual or a group of individuals has an
insurable interest in the subject matter if benefits are derived from the continuous
existence of the subject matter. The loss or gain should be measured in financial
terms.

The Marine Act 1906 defines insurable interest as follows:

“In particular, a person is interested in a marine adventure where he stands in any
legal or equitable relationship to the adventure or to any insurable property at risk
therein, in consequence of which he may benefit by safety or due arrival of insurable
property, or may be prejudiced by its loss or damage thereto, or by the detention
thereof, or may incur liability in respect thereof.”

While this definition is given in relation to marine insurance, it can nevertheless be

used in respect of other forms of insurance by altering the subject matter of insurance
from marine adventure to the respective forms of insurance.

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Parties who have Insurable Interest
 In life insurance married couples have insurable interest in each other and
individuals have unlimited insurable interest in themselves and there is no
need for proof. This position is universally accepted and an individual can
take unlimited insurance cover.
 Business partners may have insurable interest in other partners but only to the
extent of their financial involvement in the partnership.
 People who own property have insurable interest limited to the value of the
property or their share in the property.
 Creditors can insure the life of a debtor in regard to the amount of loan
outstanding plus interest. This arrangement is evident in credit life insurance,
which especially involve mortgage business.
 Executors and Trustees need to effect insurance on property under their
administration on behalf of the beneficiaries.
 Bailees: A bailee is a person legally holding the goods of another either for
payment or gratuitously. Pawnbrokers, launderers, watch repairs, tailors are
just but a few examples of bailees. Each takes reasonable care of the goods
bailed as if they were his own.
 Agents also have insurable interest in the property they handle for their
principles in the ordinary course of business.

Thus, if an individual admires a sculpture or a piece of art situated in the middle of

the street, he cannot claim to have an insurable interest in it, although morally he is
obligated to protect it. Should anything adverse happen to the piece of art, he is not
personally prejudiced by the loss, nor does he gain financially by the continued
existence of it. But if the individual owned a piece of property, insurable interest can
be established because he is prejudiced by the destruction of the property and gains
financially by its existence. A businessman has insurable interests in the goods sold
on credit because the destruction of the goods may cause him financial loss especially
if title to the goods had not passed and he is free to insure them. The same applies to
goods in transit. Similarly, a businessman may have an insurable interests in the life
of a debtor. Also a wife and a husband have insurable interests in the life of each
other especially if one of them is the breadwinner. Thus the risk of death can deprive
the spouse a source of income. For an insurance contract to remain valid, there must
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be proof of insurable interest otherwise the contract will be a mere wager. For all
categories of property insurances insurable interests must be proved both at the time
of inception of the contract. If insurable interest is absent, then the insurance company
can refuse to insure or to compensate a loss.

Essentials of Insurable Interest

We have looked at the definition of insurable interest and through the definition we
can identify four essential features of insurable interest. Can we now name them?
 There must be some property, rights, interest, life, limb or potential liability
capable of being insured.
 Such property, rights, interest, etc must be the subject matter of insurance.
 The insured must stand in a relationship with the subject matter of insurance
whereby he benefits from its safety, well being or freedom from liability and
would be prejudiced by its damage or the existence of liability.
 The relationship between the insured and the subject matter of insurance must
be recognized at law.

When must Insurable Interest Attach?

This varies whether we are looking at life insurance or non life insurance.
In life insurance under the Legal terms, a person must have insurable interest at the
inception of the policy. However, the person need not have insurable interest at the
time of the claim. This is because at the time of claim the relationship may have been
dissolved for example husband and wife and the policy cannot be changed. Therefore
the surviving partner will make a successful claim. Also a life insurance policy is a
freely assignable policy and can in fact be transferred to another party who may have
no legal relationship with the life assured.

In general insurance, insurable interest must attach at all times. When for example a
property changes hands through sale or gift, the original owner ceases to have
insurable interest in it and the new owner acquires insurable interest in his own right.
So there is always insurable interest.

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 Enforceable at law:
The mere expectation of acquiring insurable interest in the future, however certain
the expectation is, may not be enough to create insurable interest. For example, a
promise of an inheritance or a gift is not sufficient to create an insurable interest until
such an inheritance or gift is finally given. Therefore expectancy may not create
sufficient insurable interest to be insured.

11.6.3 Indemnity
To indemnify means to bring the insured to the original position before the loss
happened. Thus if one insured has property worth sh. 160,000/= and fire destroys part
of it and the loss is estimated at shs. 30,000/= and not more. If the entire property is
destroyed, then the insurer will pay shs. 100,000/= However, indemnity or
compensation will depend on two factors:-
(i) Sum insured or face value of the policy
(ii) Market value of the property.
The sum insured or policy face value is the limit to which the insurance company can
compensate the insured. However, should the sum insured be in excess of the market
value of the property, the insurance will only pay the market value of the property
and vise versa. The insurance companies to reduce fraud have adopted this principle.
It is therefore important to ensure the property only up to its value. Insuring for
amounts in excess of its full value will not benefit the insured as only the value of the
property at the time of the loss will be compensated.
The principle of indemnity only applies to categories of property insurance; it does
not apply to life insurance. This is because one cannot place a value on life. Thus life
insurance contracts are not contracts of indemnity. The guiding figure of a life
insurance contract is the sum insured. Each individual is left to determine the value
of his life as he likes and all will be paid should he die prematurely.

There are certain modifications to the principle of indemnity, that is the insured may
not necessarily be brought back to the same position he was before the loss.

Reinstatement:
In certain cases when a property has been destroyed or damaged, the insurer may
elect to reinstate the insured. In this respect restoring the lost or damaged property
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 will be at the current prices, which may be lower or higher than the original value of
the property. For example: buying a new car or building a new building at current
cost.

Repairs
Similarly repairs of damaged property may lead to increased or reduced cost of the
original property. If for example you damaged your car in an accident, you may be
forced to order for a spare part which i9s not available in the country. The cost of
acquiring the spare part may be very high and the insurer will be compelled to meet
the cost. In certain cases repairs of damaged properties may increase the value of the
property thus making the insured gain.

Principles Applicable to Indemnity

The following principles apply to policies, which are contracts of indemnity.
1) Insurable Interest: The insured must have an interest in the subject matter of
insurance at least at the time of loss
2) The Salvage Principle: If the thing insured is not totally destroyed, but
remains wholly or in part in a deteriorated or damaged state/condition, the
insured can only claim the value of the injury or damage actually done, unless
the cost of repair is high and subject matter is surrendered to the insurer by
agreement as a total loss
3) Subrogation: This is closely analogous to the salvage principle and the
doctrine of abandonment which is normally applied in marine insurance.
Salvage is primarily a matter of salvaging physical things; subrogation is
primarily concerned with the legal rights of the insured against third parties.
By virtue of the doctrine, the insurer can also recover from the insured the
value of any benefits received by him incidental to the loss.
4) Contribution: This allows for various insurers interested in the risk insured
to contribute ratably towards the loss so that the insured does not gain through
over insurance.

These three doctrines are discussed in detail hereunder. The third and four principles
are known as “Corollaries” of indemnity

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11.6.4 Subrogation.
Definition
Subrogation means that one has to surrender his right to someone else. Insurance
practice does not allow the insured to profit from a loss. As it was stated earlier, the
insurance company tries to bring the insured to the original position before the loss.

Subrogation is a legal concept that allows someone who covers the cost of your injury
or damage to property to eventually recover those payments from the person legally
liable for your injury or property damage. For example: If your insurance company
pays your medical providers for your treatment following a vehicle accident where a
third party was negligent or at fault, your insurance company is legally entitled to be
reimbursed by the party at fault (or his insurance company).

It is to be understood that before the insurance company can claim a right to

subrogation, it must have fully compensated/indemnified the insured. If the insurance
company has not fully indemnified the insured, the it will not be entitled to the right
to subrogation. The extent of subrogation will vary from one case to another and will
depend on the extent to which the insurer has been able to fully compensate the
insured person.

Right of Action by Insured Against Third Party

Where the insured has rights both against his insurer and a third party in respect of a
loss suffered, he may recover from both an aggregate sum substantially in excess of
his loss. It is here that the doctrine of subrogation comes into operation. If, after
adequate indemnification from the insurer, the insured receives any further
compensation from the third party, he must hold it in trust for his insurers.

In this way, the principle of equity has come to the assistance of common law in
preventing the insured from profiting from his own loss. If, in such a case, the insured
declined to enforce his rights against a third party after payment by his insurers, the
insurers are allowed to sue the third party “in his shoes”, i.e. the shoes of the insured,
just as Lord Mansfield in 1782 said “Every day the insurer is put in the shoes of the
insured”

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The common law is able to apply the principles of equity in this respect, by regarding
the right of subrogation as an implied term of contact. The right of subrogation rests
upon the ground that the insurer’s contract is in nature a contract of indemnity and
that he (insurer) is therefore entitled, upon paying a sum for which others are
primarily liable to the insured, to be proportionately subrogated to the right of action
of the insured against them.

Limitations of the Doctrine

i) Insurer must first pay
No rights of subrogation accrue to the insurer until they pay under the policy.
Nor will the fact that they have paid before the trial of an action in which they
claim to be subrogated avail them, unless they have paid before the issue of
the writ

It is actual payment under a contract of indemnity that the right of subrogation

springs. There can be no right of subrogation under an honour policy, for it’s
not a contract of indemnity. But where the insurers pay under a valid policy
of indemnity, and seeks to exercise his subrogative remedies, it is no defense
to say that he was not legally bound to pay under the terms of the policy.
ii) The insured himself must have been able to bring action
The insurers can be subrogated only to actions which the insured could have
himself brought. So where the insured’s wife set fire to his house or did such
thing as to harm the life or property of the insured person, they could not
recover the insurance money as the insured had no right of action against his
wife.
iii) Benefit must be incidental to loss
The benefit to which the insurers wish to be subrogated must be incidental to
the subject matter of the loss

Extent of Subrogation Rights

Insurers are entitled to recoupment only for a loss for which they have paid, and to
the extent of their payment. The insurer is therefore entitled to damages received by

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 the insured in respect of loss to that extent, even though the sum insured or the agreed
valuation is less than the true value of the thing lost.

If the insured recovers from a third party a sum in excess of the loss, the insurer’s
right to repayment is limited to recovering from the insured any sum paid by the
insurer to the insured.

Do you remember we talked about the Principle of Salvage?

When we consider the principle of salvage under indemnity, we noted that the insurer
is entitled to any property salvage after indemnifying the insured fully. The insurer is
bound to dispose of the savage at whatever price and therefore can make profit out of
the disposal. Therefore the recovery from the insured may be more than the actual
loss suffered.

Procedure for recovering damages from a third party

It is usual for insurers to pay and then commence proceedings against the third party
in the name of the insured. If the insured upon tender of a proper indemnity as to
costs, refuses the use of his name, the insurers by proceeding in equity compel him
to give it, but they cannot insist on the insured taking any steps against the third party
until they have paid him.

Should the insured recover the damages without the assistance of the insurer, where
for instance the insurers are only entitled to a part of the damages, ,he is entitled to
deduct the reasonable expenses of recovery from the amount the insurer is entitled
to.

Modes of payment considered diminishing the loss

There are 3 modes of payments that are considered to diminish the indemnity. Due
to the operation of subrogation, they can only diminish the cost to the insurer.
i) Gift Payment
This comes in when a third party makes a voluntary gift to an insured who has
suffered loss as a result of a risk which is insured against. For insurers to claim any
such payment/gifts, they must show that they have compensated the insured in full
and not that they propose to pay.
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 ii) Payment out of Contractual Obligation
This applies to instances where the insured person might have a contractual
arrangement with a third party. The third party makes payment to him. The position
in law is that the insured will not benefit from this arrangement especially when the
insurer has fully indemnified him.

iii) Payment arising out of a Tortuous Liability

These payments arise when an injury falls into one of the many torts likely to be
committed e.g. negligence, trespass, nuisance etc. In the law of tort, which is
discussed in the chapter discussing Liability Insurance, where a tort has been
committed, the insured party can claim damages in tort against the tortfeasor (one
who occasions the tort). It so happens that a tortuous action may lead to a claim in
tort completely independent of a claim for loss under an insurance policy.
If a claim in tort succeeds, where the same person has successfully claimed for
indemnity under insurance contracts, the person will not be entitled to keep both the
benefit from the policy and the payments he may receive from the claims based on
the tortuous liability. However, we should note that most insurers may not give
coverage equal to the amounts of court awards. In this respect, and as noted above,
the insurer is only entitled to recover in subrogation an amount equal to sums insured.

If the award is less than the sum insured, the he will be entitled to the amount of the
award.

11.6.5 Contribution (Double Insurance)

Definition:
Contribution is a corollary of indemnity. It ensures that the insured does not gain
unduly from the insurance process. Contribution arises in a situation where the
insured takes more than one cover on the same subject matter of insurance. When a
loss occurs, the principle stipulates that the various insurance companies covering the
subject matter must come and contribute ratably towards the loss.

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The general rule is that any person can take out as many policies as he chooses against
the same risk, and that he is free to claim payment from his insurers in such order as
he thinks fit. There are, however, two limitations on this principle:

 In the case of insurances covered by the insurance act, insurances on property,

once he has insured to the full extent of his interest, further insurances will be
void and consequently illegal. Where the law applies, he cannot in any event
recover, in all, more than the value of his interest.

 If the contract is one of indemnity, he cannot recover more than the indemnity.
Since Life insurance is not a contract of indemnity, the principle of contribution
does not apply to it.
Although one insured cannot, by double insurance, recover more than the amount of
his loss, a number of persons interested in the same subject matter, may take out
insurances of their separate interests and recover, in all, a sum not exceeding the value
of that subject matter may be claimed. A prorated calculation of the loss will be based
on the respective sums insured.

By operation of the principle of indemnity, payment by one insurer of the full amount
of the insured’s loss will, in effect, discharge any other insurer of the same interest
against the same risk of his liability. But the insurer who has paid can nevertheless
call upon all other insurers to contribute their share of the loss on equitable principles.
This was an old principle of Marine Insurance Law, and it is now well established
that it applies generally to all contracts of indemnity.

The right of contribution amongst co-insurers, is, like the right of contribution
between co-sureties, independent of contract. It is an equitable right depending on the
maxim “equality is equity”.

For the principle of contribution to operate the following must be satisfied:

 They must be covering the same insurable interest.
It does not matter if other interests are covered by one of the policies, provided
one interest covered by both or more is identical. Thus, if a mortgagor takes out
a policy covering his interest alone, and his mortgagee takes out another covering
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 both their interests, their respective insurers will have a right of contribution as
against each other, but it is contrary where a mortgagor and a mortgagee insure
their own interests alone by separate insurances.
 The cover must be for the same period.
Policies taken at different times may not necessarily be covering the same interest
and risk. Most indemnity contracts are taken for a specified period of time, and
we cannot have policies covering the same risk for different times running
concurrently. This will amount to an illegality and fraud.
 They must be covering the same peril. The loss must be due to a peril which is
common to the respective policies. However, it is arguable that the right of
contribution does not apply if the policies differ sufficiently in their scope.
 Both Policies must be enforceable. A policy which is not legally binding cannot
give rise to a claim for contribution, nor can one which is unenforceable for
breach of condition. Both insurances must be such that the insured is entitled to
call upon them to pay in respect of the loss and both insurances must of course be
enforceable at the same time of the loss.
 The insurance must have a common subject matter.
One cannot call upon insurers covering different subject matter for contribution.
An insured may for example insure household furniture separately from the house
itself against fire. Should fire occur and destroy furniture alone, the insurer for
the house cannot be called upon to contribute for these are two different subject
matters even though the peril is the same.

11.6.6 Proximate Cause

Definition:
The principle of Proximate cause is defined as “The active efficient cause event that
sets in motion a train of events which brings about a result without the intervention
of any force started and working effectively from a new and independent source”.
This therefore means that the cause of the loss must be the peril insured against, that
is, such a peril must be the most significant cause of the loss and is easily identifiable
and not an expected peril.

According to Prof. Ivamy, every event is the effect of some cause. This implies that
the event cannot be treated as isolate or working independently of everything else.
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It’s therefore preceded and leads to a succession of events. It’s important at this point
to note the effects of Prof. Ivamy’s statement as indicated below:
 There has to be some event that leads to some cause.
 The event having commenced may be joined by other intervening events.
 In any situation in the causation circles, there may be a number of successive
events. In most cases, this goes back beyond the event that actually causes or
directly brings into effect the risk in question.
 Some of the events in the chain of causation may be irrelevant. Due to this, the
law doesn’t encourage investigations that go far back into the history of the
accident or its cause.

The law will therefore, in determining causation, look exclusively at the immediate
and most proximate cause of the risk. Any subsidiary event that may have lead to the
accident will normally be treated in law as remote, as they do not directly contribute
to the cause of the accident.

This is the basis of the “Principle of Proximate Cause”. It states that there must be
a direct nexus (connection) between the act leading to the loss (risk) and the loss that
is insured against or the actual cause of the risk. In law however, it doesn’t necessarily
mean that the last event affecting the risk will be necessarily the cause of the risk.

This principle could also be defined as “the efficient cause which brings about a
loss with no other intervening cause which breaks the chain of events”.
Example:
Firemen remove undamaged stocks from a burning building to avoid its involvement
in the fire. It is stacked in the open yard and subsequently damaged by rain. Was the
proximate cause of the damage the fire or the rain?

If the damage from the rain occurred before the insured had an opportunity to protect
it then the proximate cause of the damage would be the fire and the fire is covered
under a fire policy. However, if the stock was left unprotected for an unreasonably
long period, the rain would be a new and independent cause of damage and damage
caused by rain may not be covered under the policy.

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Pertinent Legal Issues:
Pertinent issues of causation and the linkage of causation to risk is recognized under
the Marine Act, where an insurer will only be liable for loss if that loss is
approximately caused by the peril or act that is insured against. It is this doctrine that
the principle of proximate cause determines the insurer’s liability.
The courts have not defined or put forth effective formulae for determining the
proximity of cause i.e. what exactly led to the act that the insurance company is
supposed to compensate or indemnify the insured.
The determination of proximate cause has for such a long time been aided by
resorting to decided cases as illustrated below:
Lawrence vs Accidental Insurance Co. Ltd. The defendants in this case, an insurance
company agreed with the personal representatives of the insured to issue a policy for
Pounds 1,000 in respect of the insured in case the insured suffered injury caused by
external accident or external violence. The policy covered death resulting from all
manner of diseases or fits. During the currency of the policy, the insured while
standing alone next to a railway line was seized by fits, fell on the railway line and
subsequently crushed by train to death.

The Big Question was “What was the proximate cause of death,
Accident or Fits?”

The insurers argued that the cause of death was the fits and not accident. The courts
held that death was by accidental injury and so the insurers were liable to pay.
In life insurance contracts, the proximate cause of death must be accurately
ascertained whether it was suicide, natural causes or some immediate cause. Before
any claims are settled by the insurer, the underwriter will have to truly ascertain the
proximate cause of the loss. This explains why most insurance companies take long
before they can actually settle a claim however obvious the cause may seem.
With all facts available, a prudent insurer will thus assign the right proximate cause
to the loss at hand. It is therefore important to look at all material facts surrounding
the loss to determine the proximate cause and hence whether the cause is the peril
insured against.

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11.7 SUMMARY
An insurance contract is a business contract like any other, however
there are certain unique characteristics that are not to be found in other
forms of business contracts. These include:
 an aleatory contract
 contract of adhesion
 a unilateral contract
 application of the doctrine of “presumption of intent”
For the process of insurance to be successful the six principles enumerated above
must be observed otherwise the process will be equated to a gambling process. We
have seen in the preceding lectures that insurance only covers pure risks. If the
principles were not to operate then an insurance contract would be a mere wager.
Some principles as seen may apply in some insurance lines while others don’t. It is
therefore important for the student to identify those that apply in contracts of
indemnity and those that don’t.

11.8 Activity/Exercise
1. What do you understand by the term
“corollary”?
2. Discuss six principles of insurance.
3. How do these principles apply in the various
lines of insurance?
4. Discuss the principles of equity and salvage
5. What facts are expected to be disclosed under
the principle of Utmost Good Faith?
6. What are the prerequisites of the principle of
Contribution?
7. Define “Material Facts”
8. Can you discuss the procedure for recovering
damages from a third party?
9. Enumerate both general and unique
characteristics of an insurance contract

CASE STUDY

1.
Mr. Johnstone Ngosia is a business man who owns a property in Mombasa valued at Kshs.
15,000,000/- Mr. Ngosia has taken fire insurance with a face value of Kshs 9,000,000/-
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which is the outstanding mortgage with Faulu Bank. Next to this property is a motorcycle
repair shop whose value is Kshs. 650,000/- i.e. structure and contents owned by Eddy
Mbotela. An accidental fire emanating from Ngosia’s building has destroyed the entire
building and the adjacent motorcycle repair shop and declared a total Loss. Ngosia had also
insured his shop and contents for full value. Mr.Ngosia building is supposed to be purely
residential, but he has converted one of the rooms for welding and repairing damaged
equipment in the building. He has not disclosed this although the fire did not originate in
this room. The insurers are willing to pay.

In addition, Mr. Mbotela also has insurance for contents with face value of Kshs. 750,000/-
with Kwanza Insurance. The actual market value of the contents is Kshs. 200,000/-.

Mr. Ngosia had insured as follows:

CIC Kshs. 4,000,000/-
Kenindia Kshs. 6,000,000/- (Kshs. 5,000,000/- fire, Plus Kshs. 900,000/- extension of
Liability to third party fire losses)

Mr. Ngosia has claimed from his insurers and refuses to include Mr. Mbotela in his claim
stating that it was an accident therefore he should pursue his insurers.

Required:
(a) As an expert in risk management advice the affected parties (insureds and insurers) on
the obligations they have.
(b)Using the relevant principles of insurance explain the stakes of each party to the claim
showing actual calculations.
(c) Advise Mr. Ngosia other risks he may face that he must be aware of and classify them.

2.
Aggrey Muhando is a wealthy owner of ten buildings in Eldoret Town valued at Kshs
500,000,000/-. He has insured with three insurance companies as follows:
Kenindia Insurance Company Kshs. 200,000,000/-
CIC kshs. 100,000,000/-
Imperial Insurance Kshs. 200,000,000/-
These properties are located along the main highway and adjacent to each other. There have
been frequent riots in the town leading to several losses to many properties in the last few
years. There are also a number of activities going on within the vicinity of the buildings such
as petro stations, matatu station, regular clogging of sewage and they are also located close
to the petro trunk line from Nakuru. The buildings were bought on a loan and has an
outstanding loan of Kshs. 150,000,000/- from National Housing Corporation.
The insurers have been struggling on how to rate the risk because of the environment
surrounding the risks to be covered. The properties have been covered by the three insurers
against fire with the policy starting from 1st January 2013 to 31st December 2013. On 1st
May 2013 Mr. Muhando insured the buildings individually against burglary with Britak
Insurers for Kshs 10,000,000/- each building. Britak has no knowledge of the existence of
the fire insurance by the three insurers i.e Kenindia, C.I.C and Imperial. The equipment and
furniture in the buildings was bought on loan from his bankers – KCB and they have a lean
on the movable property in the buildings. There is an outstanding loan of Kshs. 10,000,000/-
onn this loan.
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Required:
a. Assume that you are a risk assessor for the insurers discuss, explain and define the risks and
other attending environmental circumstances that the insurers must take into
consideration.
b. Supposing that a fire erupts and destroys all the buildings including contents explain and
show how Kenindia, C.I.C, Imperial and Britak would address the loss
c. What legal remedy would the financiers of Mr. Muhando have in this loss stating the
operating principle(s).
d. Assuming that the insurers have no other risks they are insuring in Eldoret, what factors
must you also consider as an advisor to the insurers?

Reference:
1. Ivamy, E.R.H, General Principles of Insurance Law
3. Holder E.A, Houseman’s Law of Life Assurance
4. C. Easton & J. Fyfe, Personal Insurance: Legal Aspects
and Underwriting
5. Vaughan, Emmett J, Fundamentals of Risk and
Insurance (chapter 11)

LECTURE 12

TYPES OF INSURANCE (1)

(LIFE AND HEALTH INSURANCES)

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12.0 INTRODUCTION
Insurance is a broad term that includes many areas touching on risk. There are
specific institutions that specialize in one or more types of risks. Life and insurance
deals in two specific risks: premature death and superannuation while health
insurance deals with the risk of sickness and disability. We shall be building on the
knowledge of risk management in the previous lectures and apply it to life and health
insurance. It is appreciated that these two topics are wide and therefore they can be
picked again in higher courses.

12.1 OBJECTIVES
At the end of this lecture the learner should be able to:
 Relate the principles of risk management to life and health
insurance.
 Understand the various types of life and health insurances
 Understand the coverage under each type of policy.
 Have a clear understanding of the legal provisions of the
policies
 Understand the application of the principles of insurance to life
and health insurance

12.2 Insurances of The Person

12.2.1 Life Insurance
The Risk
Life insurance contracts are fairly simple to understand but are some of the most
important in terms of personal risk. Some students believe that the risk involved in
life insurance is death. In reality, death is assured for each individual and therefore it
cannot be a risk anymore. The risk involved in life insurance is therefore twofold:

Premature Death.
As human beings we do not know when we shall die and therefore this situation
creates uncertainties in our minds. We must therefore prepare for the consequences
of death at any time.

Superannuation
This is a situation of living too long that you overstretch your income during your old
age. This therefore requires policies that will provide income during the old age.

12.2.1.1 Function of Life Insurance

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 The unique function of life insurance is to create an instant estate upon which the
policyholder and dependants will rely on when a financial need arises. To a greater
extent life insurance is intended for the dependants because once the policyholder
dies, the policy is no longer useful to him but to his/her dependants. What life
insurance does is to accumulate an estate for the possible contingency of premature
death.

12.2.1.2 Characteristics of Life Insurance:

a) Risk Increases with age

Life insurance follows the same concepts of risk management discussed in the earlier
lectures. Vaughan states that “the risk in life is not whether the individual is going to
die, but when and the risk increases from year to year”. This is quite correct because
as we grow old we experience deterioration in our physical state because of aging
and activities that bring stress to our bodies.

b) There is no partial Loss

In life insurance there is no partial loss like in property insurance where a fire could
destroy part of a house and leave the rest intact. Death is a total loss and therefore the
policy matures on death except if you survive the period of coverage as we shall see
shortly in the various types of insurance discussed below.

c) Life Insurance Not a Contract of Indemnity

The student should refer to lecture 10 regarding the definition of indemnity. As we
have stated above, the loss in life insurance is total. That is once an individual is dead
he/she cannot be brought back to life except by perhaps the Grace of God. Secondly,
we cannot be able to put sufficient value on the life of an individual and therefore
insurance cannot be able to compensate him enough.

d) Availability of Proceeds to Creditors

We have stated earlier that life insurance is the creation of an estate that will benefit
the dependants once the policyholder has died. The proceeds of the policy are
therefore intended for these dependants. It is therefore like a will for the dependants
and therefore the wishes of the policyholder must be fulfilled. Legally and in the
absence of assignment of the policy to a creditor, the creditors do not have an access
to the proceeds of a life insurance policy.

e) Long-term Nature
Life insurance contracts are regarded as long-term contracts. Although we can have
in certain cases short-term policies, but a majority of them are given for periods in
excess of one year. All the policies cover the individual until death.

f) Protection Element
The student should understand what we mean by protection in insurance. This simply
means protection against certain losses. Life insurance therefore protects the insured
against financial losses caused by death. This loss may include loss of the dependable
income for the dependants if the policyholder dies or loss of income as a result of old
age or as a result of loss of employment or sickness.

g) Investment Element

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 Life insurance can be used to build up resources for future use. For example to pay
school fees, to buy a property and so on. In this regard it is used as an investment for
the policyholder. Some insurers provide interest on the premiums paid or a bonus so
that by the time the policy is maturing, the face value of the policy would have
increased. Therefore it is like a property that you have invested in.

h) A property
Certain life insurance policies can be regarded as properties. In this regard, they
accumulate values with time as one pays the periodic premiums. These policies can
therefore be used as collateral at lending institutions for loans.

i) Risk transfer and sharing

Do you remember the treatment of risks? In life insurance the concept of risk transfer
and sharing and or pooling also applies. Because of the uniqueness of the risk the
pool or the insuring populations vary with age. You remember we talked about risk
increasing with age? The various age groups therefore pool together resources and
they share in the losses incurred by those dying. Each individual therefore transfers
his/her risk to the age group which the insurer manages.

12.3 Traditional Life Policies

There are three basic traditional life insurance policies. These are discussed below
and the student is expected to be conversant with their characteristics.

12.3.1 Term Life Insurance Policy

A term insurance policy is a policy taken for a specified short period. It may be for a
period of 1 year, 5 years or ten years or any other period as may be specified in the
contract.
Do you remember the protection element of life insurance? The term policy is purely
a protection policy. It does not accumulate cash values. If the policyholder dies within
the term specified the policy matures and the proceeds paid to the identified
beneficiaries. If the insured survives the term, he does not collect from the policy. So
the policyholder has to die in order for the beneficiaries to collect.

12.3.2 Whole Life Policy

The word “whole” means the entire lifetime. The whole life policy therefore covers
the policyholder as long as he/she remains alive. Premiums are therefore paid for the
period the policyholder remains alive. Sometimes this policy is referred to as “straight
life” policy. The policy has both protection and investment elements. Can you guess
why? This is because as a protection policy, if the policyholder dies the proceeds can
be used by the dependants for their needs, and as an investment because it
accumulates cash values and can use it for borrowing. Also if you survive, the
proceeds can be used for a specific purpose. Some whole life policies also earn
bonuses or interest on the premiums paid so the face values increase with time.
Ideally whole life insurance has a higher element of protection than investment
element. It is taken that if the policyholder survives up to 100 years the policy will
mature and he/she will be as good as dead.

12.3.3 Limited-Pay Whole Life

This is a form of whole life policy, but instead of paying premiums for the entire
period you are alive, you are required to pay premiums for a specified period of time.
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 For example up to age 65 or other period, or specified number of payments such as
20 payments. The premiums that are paid during this period

Under this policy the coverage is also extended up to age 100. Once you attain the
stated age you stop paying premiums but coverage continues until you die or until
age 100.

12.3.4 Endowment Life Insurance

Do you know what the word endowment means? Look it up in your dictionary. In
general terms the word endowment implies a fund or a deposit. Into this fund you
deposit money for a specific purpose. The Endowment Life Insurance does just that.
An endowment policy is taken for a specified period of time, usually between five
years to twenty years.

There are two types of endowment policies that are available on the market world
wide.

12.3.5 Pure Endowment;

This is a life insurance contract that pays the face amount only if the policyholder
survives the endowment period. Do you remember the characteristics of a Term
Policy?
The pure endowment is really the opposite of a Term Policy.

12.3.6 Endowment Life

This type of endowment policy combines both the pure endowment and a Term
Policy. That is it provides both a savings and a protection element. That is you win if
you die and you win if you survive. This is the most common type of endowment on
the market. People who take an endowment policy have at their back of their mind
saving for a particular purpose. For example saving to buy a car, house, furniture,
plot etc.

12.3.7 Participating and Nonparticipating Policies

Participating policies are those policies which allow the policyholder to participate
in the profits generated by the insurance company. That is the face value of the policy
increases with time as long as the company makes a profit. However, if the company
makes a loss, such losses are NOT transferred to the policyholder. \usually the
participation comes in form of a bonus which is added to the face value annually. The
bonus may be a fixed sum or rate or may vary with company performance.

Nonparticipating Policy are those policies that do not participate in the profits of the
company and therefore when they mature only the stated face value will be paid.

12.3.8 Special Needs Contracts

The special needs policies are geared towards fulfilling a specific need that a
policyholder may have. These needs may vary from one policyholder to another and
the policies may vary from one insurer to another and called different names though
performing the same function. The student must be able to understand the coverage
of each policy and the similarities of these coverages though the titles of the policies
may be different.
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 Advantage
The advantage for the special needs policies is that they save on administration costs
resulting from providing several benefits in one policy instead of a number of
separate contracts.
Disadvantage
A policy containing a package of benefits perceived at the issue of the policy without
due regard for the future needs may not be flexible enough to respond to changing
circumstances in the future. Individual contracts however, may be changed quickly
to respond to these changes.

Types of Special Policies.

1) Contracts for use where current insurance needs Exceed Probable Future
Insurance Needs.
(a) Level Term Coverage
In addition to the policy coverage usually whole life a level term policy is
issued in addition. It may be multiple protection policy, i.e. the death benefits
are a multiple of the face value. The benefits will be paid at the end of a stated
period say 20years or up to a certain age, say 65years. Thereafter the death
benefits reduce to the face value.

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Diagram

TERM INSURANCE

WHOLE LIFE

5 10 15 20 25 30 35 40 45………………

Some companies offer multiple protection policies whereby if death occurs during the
multiple protection period the proceeds are paid in installments for a certain period and a
lumpsum of the whole life policy at end of the multiple protection period. This type of policy
is called a family maintenance policy.

b) Decreasing Term Coverage.

This is intended to guarantee an income for those years during which there will be dependent
children and provides a decreasing term insurance for a stated number of years.
An example of this is the Family Income Policy. The term coverage is used to provide
Monthly Installments of s stated amount in the event of the assureds’ death. The installments
begin from the month of death to the end of the original term period. For examples if death
occurred at the 15th year and the term was 25years, the company will pay installments for the
rest of 10years. The whole life part is usually payable at the time of death, although some
other arrangements can be made where the proceeds are held by the company at interest up
to the end of the installment period.

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Diagram.

TERM
POLICY

WHOLE LIFE POLICY

0 5 10 15 20 25 30 35 40 45 50 (Yrs)

3.Contracts for use where current Insurance Needs are less than Probable Future Insurance
Needs.
There are various types available.

(a) Jumping Juvenile

The coverages jump from a smaller coverage to a larger coverage certain age
intervals.
For example:-
Age 0- 15 - 1,000/-
16-21 - 3,500/-
22-65 5,000/-
Premiums are usually level. In this case the premiums are usually high in element
initial coverage and low in relation to the ultimate coverage. Some companies cover
up to age 65 while others to the majority age.
(b) Guaranteed Insurability Rider.
These give option of further policies in the future without submitting now evidence
of the instability at that time.

Characteristics
(i) Options are added to policies of new insured of less than 40years.
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 (ii) Insured us permitted to purchase insurance at specific dates in the future.
(iii)The new insurance is offered at standard rates at the attained age.
(iv) Amounts taken by policyholders very from company to company, but they bear
same relationship to the face value of the base policy.
(v) Option dates can be accelerated by the happening of certain events e.g. marriage
or birth of a child.
(vi) Unexercised option may be carried forward to another date, although subsequent
options will not be lost.

4. Policies Oriented Toward Saving or Retirement

(a) Juvenile Education Endowment
This provide for a saving toward education costs of the insured’s dependent. It
matures during or before the education start or on attaining majority age of the
dependent. Sometimes the proceeds are paid in installments just to cater for the
education cost of the juvenile. There are various types available: multiple
indemnity or participating.
At small extra premium, the policy can offer accidental death and disability
coverage for the parent.
Age for insurability differs from company to company.

(b) Retirement Income Contract

This accumulates funds to provide for retirement income. It also provides a
life insurance usually term for a certain period of the term. Retirement income
starts at retirement age.

5. Contracts that minimize Initial Premium Outplay

a) Modified, step-Rate or Graded Premium Plan it is normally taken by young people
who expect to increase their income in the future.
These provide lower premium at early age. The premiums are increased after
a certain period, usually 3,5 or ID years. The period of increased varies from
one company to another.
b) High Early Cash Value Policy

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 These provides for Early Cash and loan values, sometimes in the first year.
The cash values increase higher than normal so that they are available for
loans etc. The loans can be used to pay premiums for a certain period o time.
If death occurs then the loans are deducted from the in death benefits.
Some companies use the dividends of the participating policy to purchase a
one-year term policy equal to the cash value to offset the reducing insurance
necessitated by loans.

c) Interim Term Insurance

Defers the contract date for a period of time usually less than 12months. The
Premiums will be re-evaluated at the beginning the next period.

4. Family Policy
These are offered to families including the children. The coverage of the family is on
per units basis. For examples, the husband may be covered for 5,000/-, the wife
2,500/- and each child 1,000/-, or a multiple of these.
Depending on the type of policy taken deaths benefits are received as each member
dies. Premiums are either determined on the age of the husband or separately for the
wife and husband. The number of children to be included in the policy may be limited.
When they children attain certain age, say 21, but not latter than the end of premium
paying period.

In most cases Family Policies are either Term of Endowment. At the death of the
head of the family all dependants un-expired term become fully paid up.
Waiver of Premium.
If the head of household becomes totally disabled the company will waive the
premiums and the policy will continue to be enforced.
Conversion at the expiry of the dependants term is available in certain cases.

5. Family Protection.
Specifically for family accidents.
Level of Premium Plan
Under the level premium plan, the premiums remain level during the protection
period. In the early years the cost of protection is higher than in the later years. This
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 is so because there is an increase risk of mortality in the later years of life when the
premises should be higher.

12.4 Health Insurance

The term Health Insurance combines two types of risks, namely:

 Loss of income as a result of sickness or disability

 Incurring expenses as a result of sickness or illness
These two types of risks have given rise to two types of coverage under the generic
name Health Insurance. These are explained below.

12.4.1 Disability Income Coverage

The policy covers the insured for loss of income as a result of disability caused by
sickness or accident. The sickness or accident must lead to a disability, which may
be temporary or permanent. The insurers therefore provide some income for
individuals who may lose their income when they are either at the hospital or when
they are recuperating at home and cannot work.

There is no standard disability income policy. There are variations in the coverage
and the benefits provided under a disability income policy. In most cases such
benefits are limited by a fixed amount or based on a percentage of the individuals
income.

Payment is usually made either on a weekly or monthly basis of the agreed amount.
These payments are for a specific period of time. In Kenya hardly do we find
disability income policies that will cover an individual for the rest of his life as a
result of sickness or accident. The period of payment is limited and does not exceed
52 weeks. In other countries the period may be more than 52 weeks, sometimes up
to 5 or 10 years.

12.4.2 Occupational and Non-occupational Disability

Occupational disabilities are those arising out of employment or specific
occupation. Such disabilities are covered under the Workmen’s Compensation
Policies. This is a compulsory insurance.

Non-occupational disability arise from illness/sickness or accidents which are not

work related. These provide packages from which the individual can select
depending on his/her insurance needs.

12.4.3 Definition of Disability

Most definitions fall in three categories:

 The inability of the insured to engage in his or her own occupation

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  The inability of the insured to engage in any reasonable occupation for which he
or she is or might easily become qualified.

 The inability of the insured to engage in any occupation.

In most cases, each company will define the disability they would want to cover
based on the three definitions or a combination of them.

12.4 4 Definition of Injury

Usually two definitions are common:

a) Accidental Bodily Injury: This the most common wording and is the broader term.
b) Bodily injury by accidental means: This wording is limited mostly in accident
policies. It means that the injury must have been accidental, but the cause of the
injury must have been accidental.
12.4.5 Definition of Sickness
Most disability or health insurance policies define sickness to exclude any preexisting
conditions. Insurers use two common definitions:
 Sickness or disease contracted and commencing after the policy has been in force
not less than 30 days.

A more liberal definition is:

 The company will pay the total disability benefit for total disability resulting from
sickness first manifesting itself while the policy is in force.
Can you see the difference between the two definitions?
In the first definition no preexisting condition can be covered under any
circumstances while in the next definition preexisting condition can be covered only
it manifests itself during the policy period.

12.4.6 Medical Expenses Coverage

The policy covers expenses incurred by the insured as a result of sickness/illness or
accident. The expenses may include and are not limited to:

 Hospital Expenses both in and out patient

 Surgical Expenses
 Regular medical expenses
 Major medical expenses
 Prescriptions
 On site of accident expenses
 Evacuation/Ambulance Expenses
 Consultancy Expenses
 Diagnostic Expenses

The insurer will reimburse or pay for such expenses within a stated limit. The
practice is that the insured will select amongst the various expenses he or she would
want covered. Premiums will be determined depending on selected covers.
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 The losses or expenses are covered in two ways:

a) Hospital Reimbursement Contracts

Under these the insurer pays or reimburses the cost of room and board for a daily
flat rate for a specified period of time. It also reimburses a specified amount for
expenses incurred on medication, X-rays, laboratory or theatre.

b) Hospital Service Benefits Contracts.

This plan provides for actual services of the hospital to the insured person for a
stated period. In most cases the insurer will specify to which hospitals or doctors the
insured should go for medical services.

12.5 Health Maintenance Organizations

These are new in Kenya, most of them coming on to the scene early 1990’s. The
HMO is one that provides a wide range of comprehensive healthcare services to a
group of subscribers. A group of doctors, a hospital, employer(s), or any other
group may sponsor the HMO for the purposes of providing health services to the
subscribers.

Financing of the HMO’s is through a prepayment arrangement. The HMOs may

provide various benefits to the subscribers based on types of services paid for. In
addition to inpatient services at recognized or selected hospitals, the HMOs also
provide outpatient services at their various clinics for the period of coverage.

12.6 SUMMARY
 Life Assurance is the insurance that protect the assured against
premature death and superannuation.
 There are the traditional policies such as Term Policy,
Endowment Policy and Whole Life Policy.
 The Term Policy is basically a protection policy, the
Endowment Policy having a high savings element and the
Whole Life having both savings and protection elements.
 Special Policies can be designed to meet the assured special needs or
requirements.
 Explain the coverage you would find under the Health Insurance
 Define HMO’s. What role do you think they have played in the Medical field?

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12.7 Activity/Exercise

 Differentiate between the traditional Life Assurance Policies and

the special policies.
 What advantages accrue from the special policies? Give examples.
 In your opinion, who should take: Term Policy, Endowment
Policy, Whole Life Policy?
 Discuss the concept of Level Premiums.

References:
1. Vaughan, Emmett J, : Fundamentals of Risk and
Insurance(Chapters 12-18)
2. Black, Kenneth Jr. and Harold D. Skipper Jr. : Life Insurance
12th Ed.

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 LECTURE 13

LIFE ASSURANCE
PREMIUM COMPUTATION

13.0 INTRODUCTION
Premium computation is very important in insurance. This must be based on the risk
insured and how it has been classified. There are various factors that affect the
computation of premiums. The student is expected to know them and how they
impact premium computation. It is important to realize that insurance companies are
in business to make money and therefore the manner in which they determine the
premiums for the various risks they take will also determine their sustainability in a
competitive market. Mortality is very important in life insurance and therefore it is
useful in classifying various life risks taken (usually by age) by the insurer and
assigning the appropriate rate to such classifications.
Three elements are necessary in life insurance rate making
- Mortality
- Interest
- Loading
13.1 Objectives:
At the end of this chapter the student should be able to:
1. Define mortality
2. Understand the various factors affecting mortality
3. Have the basic understand the mortality table and its uses
4. Understand the factors that affect the calculation of
premiums
5. Have the simple understanding of the various methods of
determining premiums.

13.2 Mortality
It is the probability of living or dying at any given age. Mortality is usually expressed
in a Tabular form from the chances of losing the economic value of the human life.
On the basis of past experience, and applying the theory of probability actuaries are
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 able to predict the number of deaths among a given number of people at some given
age. An arbitrary number of lives at the beginning age 0 (Radix).is determined. The
ratio of the number dying to the number living is expressed as deaths per thousand.
This ration is calculated for all ages from age O to age 100. The ration is the mortality
rate.

Assume at age 40 there are 9,241,359 people living and that 30,622 of them will die
by the end of the year. Deaths per thousand will be 3.3. Calculated as:
(30,622 / 9,241,359) x 1,000. = 3.3

If we must insure these people at shs. 1000/- each for one year, we will require Shs
(30,622x1000/-) or 30,622,000/-. But each member of the group can contribute only
a small portion towards this loss i.e. Shs. 3.53 each. So the group will contribute
(9,241,359 x3.53) = Kshs. 30,622,000

13.2.1 Factors Affecting Mortality

a) General Population versus Insured Lives
In most cases people who purchased life assurance policies are generally in the higher
economic and social status, they receive higher level of medical care and are in better
health when they take the policies. On the other hand the general public especially
those in lower economic bracket tend to have lower medical care and therefore poor
health. Mortality is therefore based on the mortality experience of the population as
a whole which would generally higher than that of insured population

b) Life insurance versus Annuity Mortality

In most cases the expectance of annuitants tends to be lower than those of the
individuals purchasing life policies. Because of these differentials mortality for
annuitants should not be the same as those purchasing life policies.

c) Standard Versus Substandard

In underwriting certain applicants may be exposed to extra mortality hazards and
therefore subject to extra premiums or even denied insurance. A mortality study with
a view of constructing mortality tables should distinguish between those who have
been insured as substandard mortality and standard mortality.
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d) Age.
It is significant factor affecting mortality. The probability of death is relatively high
at birth decreases to a low at about age 10 and rises again throughout the reminder of
life.
e) Sex
Generally men tend to have a higher mortality than women ad therefore when
constructing the tables there should be different table for different sexes.
f) Effects of Selection
Usually underwriting and selection of applicant is based on certain information,
which is obtained at the time. However, one cannot rely very much on this
information and it could not have given a true picture of insurability. It is only after
a certain period of time that the true mortality of those selected can be established.
This then calls for a review of the mortality tables. A fresh table should be constructed
(on ultimate table) to give the time experience.
g) Abnormality in Period of Observation
Because of improvement in health care, mortality can improve with time and
therefore older mortality tables have to be reviewed. By the same token abnormal
events such as war, epidemic, or economic depression may distort temporarily
mortality experience. Such distortions should be adjusted for when developing a
mortality table.

13.3 Mortality Table

It generally shows mortality rates for each age. Each mortality rate gives the
probability that a person at that exact age will die during the following year.
There are four columns to the mortality.
1. Column showing ages from 0-100
2. Column showing the number of persons living at any age.
3. Column showing the number dying at the end of a particular age.
4. Mortality rate usually expressed as a rate per thousand.
5. The expectation of life, i.e. number of years those living at each age are
expected to live

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Mortality table
(Men) Women
Age Number Number Deaths Life Age Number No. Death Life
Alive Dying per 1000 Expecta Alive Dying per 1000 Expectancy
ncy
0 10,000,000 41,800 4.18 70.83 0 10,000,00 28,900 2.89 75.83
0
1 9,958,200 10,655 1.07 70.13 1 9,971,100 8,675 0.87 75.04
2 9,9947,545 9,848 0.99 69.20 2 9,962,425 8.070 0.81 74.11
3 9,937,697 9,739 0.98 68.27 3 9,954,355 7,864 0.79 73.17
4 9,927,958 9,432 0.95 67.34 4 9,946,491 7,659 0.77 72.23
5 9,918,526 8,927 0.90 66.40 5 9,938,832 7,554 0.76 71.28
6 9,909,599 8,522 0.86 65.46 6 9,931,278 7,250 0.73 70.34
7 9,901,077 7,921 0.80 64.52 7 9,924,028 7,145 0.72 69.39
8 9,893,156 7,519 0.76 63.57 8 9,916,883 6,942 0.70 68.44
9 9,885,637 7,315 0.74 62.62 9 9,909,941 6,838 0.69 67.48
10 9,878,322 7,211 0.73 61.66 10 9,903,103 6,734 0.68 66.53
11 9,871,111 7,601 0.77 60.71 11 9,896,369 6,828 0.69 65,58
12 9,863,510 8,384 0.85 59.75 12 9,889,541 7,120 0.72 64.62
13 9,855,126 9,757 0.99 58.80 13 9,882,421 7,412 0.75 63.67
14 9,845,369 11,322 1.15 57.86 14 9,875,009 7,900 0.80 62.71
15 9,834,047 13,079 1.33 56.93 15 9,867,109 8,387 0.85 61.76
16 9,820,968 14,830 1.51 56.00 16 9,858,722 8,873 0.90 60.82
17 9,806,138 16,376 1.67 55.09 17 9,849,849 9,357 0.95 59.87
18 9,789,762 17,426 1.78 54.18 18 9,840,492 9,644 0.98 58.93
19 9,772,336 18,177 1.86 53.27 19 9,830,848 10,027 1.02 57.98
20 9,754,159 18,533 1.90 52.37 20 9,820.821 10,312 1.05 57.04
21 9,735,626 18,595 1.91 51.47 21 9,810,509 10,497 1.07 56.10
22 9,717,031 18,365 1.89 50.57 22 9,800,012 10,682 1.09 55.16

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 Age Number Number Deat Life Age Number Numbe Death Life
Alive Dying h per Expect Alive r Dying per Expectancy
1000 ancy 1000
23 9,698,666 18,040 1.86 49.66 23 9,789,330 10,866 1.11 54.22
24 9,680,626 17,619 1.82 48.75 24 9,778,464 11,147 1.14 53.28
25 9,663,007 17.104 1.77 47.84 25 9,767,317 11,330 1.16 52.34
26 9,645,903 16.687 1.73 46.93 26 9,755,987 11,610 1.19 51.40
27 9,629,216 16,466 1.71 46.01 27 9,744,377 11,888 1.22 50.46
28 9,612,750 16,342 1.70 45.09 28 9,732,489 12,263 1.26 49.52
29 9,596,408 16,410 1.71 44.16 29 9,720,226 12.636 1.30 48.59
30 9,579,998 16,573 1.73 43.24 30 9,707,590 13,105 1.35 47.65
31 9,563,425 17,023 1.78 42.31 31 9,694,485 13,572 1.40 46.71
32 9,546,402 17,470 1.83 41.38 32 9,680,913 14,037 1.45 45.78
33 9,528,932 18,200 1.91 40.46 33 9,666,976 14,500 1.50 44.84
34 9,510,732 19,021 2.00 39,54 34 9,652,376 15,251 1.58 43.91
35 9,491,711 20,028 2.11 38.61 35 9,637,125 15,901 1.65 42.98
36 9,471,683 21,217 2.24 37.69 36 9,621,224 16,933 1.76 42.05
37 9,450,466 22,681 2.40 36.78 37 9,604,291 18,152 1.89 41.12
38 9,427,785 24,324 2.58 35.87 38 9,586,139 19,556 2.04 40.20
39 9,403,461 26,236 2.79 34.96 39 9,566,583 21,238 2.22 39.28
40 9,377,225 28,319 3.02 34.05 40 9,545,345 23,100 2.42 38.36
41 9,348,906 30,758 3.29 33.16 41 9,522,245 25,139 2.64 37,46
42 9,284,975 35,933 3.87 32.26 42 9,497,106 27.257 2.87 36.55
43 9,284,975 35,933 3.87 31.38 43 9,469,849 29,262 3.09 35.66
44 9,249,042 38,753 4.19 30.50 44 9,440,587 31,343 3.32 34.77
45 9,210,289 41,907 4.55 29.62 45 9,409,244 33,497 3.56 33.88
46 9,168,382 45,108 4.92 28.76 46 9,375,747 35,628 3.80 33.00
47 9,123,274 48,536 5.32 27.90 47 9,340,119 37,827 4.05 32.12
48 9,074,738 52,089 5.74 27.04 48 9,302,292 40,279 4.33 31.25
49 9,022,649 56,031 6.21 26.20 49 9,262,013 42,883 4.63 30.39
50 8,966,618 60,166 6.71 25.36 50 9,219,130 45,727 4.96 29.53

Source: Extracted from Emmett J Vaughan p 212 and 213

NOTE: The Mortality tables are constructed up to age 100

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The student should not worry about how a mortality table is constructed. This is the work of
an actuary. The table starts with an arbitrary number of 10,000,000 lives. This figure is
referred to as the “radix”.

The mortality table can also be regarded as the chance of loss through death. We can therefore
use the mortality table to estimate life premiums at any given age. Let us consider the
mortality for males aged 20 years. Out of the initial 10,000,000, there are 9,754,159 living.
Out of this number, 18,533 will die before reaching age 21. The table shows that this
represents a death rate of 1.90 per 1,000.

Do you remember the Term Policy and the pooling mechanism?

If we assume that the entire population would like to be covered by a 1 year Term policy
with a face value of Kshs. 1,000 each, we should consider the loss that the insurers will
experience. This loss will be 18,533 deaths multiply by Kshs. 1,000 face value. This gives
us a loss of Kshs. 18,533,000. Each policyholder will therefore pay a net premium of Kshs.
1.90.

Kshs. 18,533,000 = Kshs. 1.90

9,754,159
The net premium does not take into consideration the interest, expenses and profit for the
insurer.
Can you calculate the premium for the women at the same age? Lets try.
The number of living is 9,820,821. The number that will die by year 22 is 10,312
Expected loss is: 10,312 x Kshs. 1,000 = 10,312,000
Net premium is Kshs. 10.312,000 = Ksh. 1.05
9,820,821

What can we conclude from these two examples?

Let us go back to the mortality tables for men and women. You should be able to observe the
following:

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  It is assumed that this is an insuring population not considering new births or
migration and therefore the population decreases with time through deaths.
 The number dying increases with age.
 Life expectancy reduces with increase in age for all men and women, however life
expectancy amongst women is higher than in men.
 There is a higher death rate amongst the men than the women.
 Premiums for men of the same age with women are higher

Note: Insurers collect millions of shillings in premium which they invest and earn
some interest. It is therefore possible that the premium as calculated above
may be less. Lets assume that the premiums are invested at 4%. One shilling
(Ksh.1.0) invested at 4% for one year will yield Kshs. 1.04. Therefore the
present value of Kshs. 1.00 at 4% is:
1.00 = 0.96158
1.04

If we apply this discounted value of one shilling to the above premiums it will give
you the following figures
Men: Kshs. 1.90 x 0.96158 = Ksh. 1.83
Women: Kshs. 1.05 x 0.96158 = Kshs.1.00
The insurer can therefore charge these premiums for a policy of Kshs. 1,000 from the
populations given and at the end of the year be able to pay for the losses through
death.

Remember: This is a net premium and has not considered other

expenses and the profit expectation by the insurer.

13.3.1 Uses of Mortality Table.

1. For calculating mortality the reserves necessary for a particular age.
2. For calculating various probability ratios e.g.
(i) Probability of surviving up to a certain age
(ii) Probability of dying at a certain age
(iii) Probability of dying before a certain age.

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 3. For the determination if expectation of life for an individual at any particular
age.

13.4 Factors to Consider In Calculation of Premiums

13.4.1 General Considerations
a) Adequacy
Adequacy here means the ability of the company to pay benefits and expenses from
the premiums collected. That is the premiums should determine the ultimate solvency
of the company. On deciding on the rate of gross premium long-term effects such as
inflation, increased costs etc. should be considered. The ability of the company to
remain solvent will depend partly on the adequacy of the premiums collected.

b) Equity
Theoretically each policyholders should pay premiums in commensurate with the
risks involved it should not be upon other policyholders to bear the cost of insuring a
risky life. Selection tools used for each risk must be considered in determining the
premiums for each individual and correspond to the risk and to the plan of insurance.

c) Legal Limitations
Gross premiums changed should correspond to the legal requirement of the state. For
Kenya the requirement tends to be based on subjective judgment rather than giving a
specific limit. The level of the premium may also be influenced by the legal
requirements of reserves. If additional reserves are required for certain types of
policies then the company may increase its loading for these types of policies.

d) Competition and Company Objective

Competition has an effect on the level of premiums changed by any company.
Companies cannot afford to change by competitors. To do so will mean losing the
possible policyholders and hence business.

Salient Factors To Consider (Primary Factors)

13.4.2 Salient Factors

e) Mortality
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 This is on major factor that must be considered in the calculation of premiums.
Generally there has been some improvement in mortality in certain sections of society
whereas there has been a deterioration in others. The choices of mortality tables
actuary may use experience rates based on long-term trend, but these may have an
obvious drawbacks in that they do not give the true picture of the current events and
improved mortality. Recent trends may be more correct than using long-term trends.
Mortality can also very from company to company depending on the underwriting
and marketing policies. Higher mortality rates for an individual company could have
come about due to the effects of anti-selection- a marketing problem. An astute
actuary would adjust rates for these effects in order to arrive at accurate rates.
f) Interest
The interest to be assumed by the insurance company is a matter of importance in the
calculation of gross premiums. The following rates may be considered
(a) The current rate of yield on new investments and on all investments
(b) Short-term trends in company’s rate of yield on new investments and
on all investments.
(c) Future investment policies.
(d) Income Tax effects on investment earnings.
(e) Trends in the investment yields of other companies.
The earnings from the investments of premiums will have an effect on the premiums
to be changed. If higher earnings are expected then premiums should be low,
especially for the non-participating policies.

g) Withdrawals
Withdrawals and lapse of policies are dependent on economic conditions. The rate of
withdrawals can only be based on experience and the costs involved calculated. The
rates applied should take into account the type of plans, age, sex, etc.

h) Expenses
Expenses vary from company to company, but the long-term trend of expenses is
definitely upward and calculations if premiums must take into consideration this
factor. The types of expenses that are generally encountered can be categorized as
follows:-
- Acquisition
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 - Agent Compensation
- Maintenance (Bend system or policy fee system)

i) Profit
A definition if adequacy would be that the premium collected and the investment
income earned should be in excess of benefits and expenses paid.
The excess over benefits and expenses maybe used as an addition to surplus, and in
case of a stock company the excess should be paid to the shareholders as a dividend
or an increase in the value of their stock. Profit is therefore a necessary factors in
premium calculation.

Profit objectives will vary from one company to another and from year to year. Most
actuaries would test their premiums adequacy on the first four factors living the profit
factor to be determined later. It is apparent that there us an inverse relationship
between unit profits and competitiveness (i.e. profit per unit of insurance), and
therefore the more competitive the company can create. The increased business may
result in increased profits even though unit profits are decreased.

13.4.3 Methods of Calculating Premiums

There are two methods.
Equation Method: This equates the present value of premiums to the
present value of benefits, experience, and profits.
Accumulation Method: This starts with a hypothetical premium, which is
continually accumulated and adjusted

13.5 Summary
In this lecture we were able to look at mortality as a measure of
probability of death or as a death rate of a particular population. We
also looked at the general factors affecting mortality. In the lecture
we also discussed how a mortality table is constructed and the various components
of the table. It was also seen how mortality tables are used in calculation of premiums.

The lecture further discussed both general and salient factors affecting the calculation
of premiums. Can you remember some of these factors?
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13.6 Activity Exercise
1. What are the general and salient factors affecting mortality?
2. What factors affect the determination of a premium?
4. Discuss the various methods of calculating premiums
5. Using the mortality table calculate the net premium for a men and women
aged 40 years assuming that the insurer invests premiums at 3% and that the
entire population is taking a policy worth Kshs. 2,000/- for one year.
6. Why in your own opinion do you think that women live longer than men?
7. Refer to the regulation of insurance in Kenya and discuss how such regulation
affect premium determination.
Reference:
1. Vaughan, Emmett, J : Fundamentals of Risk and Insurance

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 LECTURE 14

TYPES OF INSURANCE (2)

VARIOUS TYPES OF PROPERTY INURANCES

14.0 INTRODUCTION
The lines offered in property insurance are many and we shall also use the knowledge
acquired in the previous lectures to apply to these lines of insurance. The risk
involved in the property insurance in general is the financial loss incurred as a result
of damage to the properties insured. It is not possible to discuss in this chapter all
possible types property, but a few are selected to highlight their insurance.

14.1 Objectives
 At the end of the lecture, the learner should be able to:
 Identify the risk involved in each type of property insurance.
 Determine the coverage offered for each type of policy
identified.
 Understand the legal provision under each policy.
 Apply the principles of insurance learned in previous lectures.

14.2 Property Insurance

Historical Development:
Property and Liability Insurance developed from FOUR distinct fields of
insurance namely:

 Fire Insurance
 Marine Insurance
 Casualty Insurance
 Surety Bonding

Originally theses policies were written by two categories of insurers:

 Fire Insurance Companies wrote both Marine and Fire Insurances
 Casualty Insurers wrote Casualty Insurance and Surety Bonds

The terminology “Fire” and “Casualty” have given way to more descriptive divisions
between “Property” and “Liability” insurances. The term “property insurance” now
refers to fire insurance, marine insurance and such real and personal properties.

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 Liability which may have been as part of the certain aspects of casualty and security
bonds deals specifically with third party injuries and damages.

14.2.1 Fire Insurance

The Risk: The uncertainty of properties (real and personal) being destroyed by fire

Methods of Insuring:
As part of a more comprehensive policy such as Household Policy or Homeowners
Policy or Business Premises Policy

OR

Offered Separately as a Fire Policy

Perils Covered:

(a) Fire:
Defined as “Combustion proceeding at a rate rapid enough to generate flame,
glow or incandescence”

Note: Not all fires can be covered. Only hostile or unfriendly fires
may be covered.

Definitions of fire:

Friendly Fire:
“One that is within the confines for which it was intended, and that it was
intentionally kindled and burns where it is supposed to burn”

Hostile or Unfriendly Fire:

“One that escapes its intended confines and causes unintended damage”.

Examples of Various Scenarios of an unfriendly fire

 A cigarette inadvertently left on the edge of a table

 A cigarette thrown in a bush and ignites a fire
 A gas cooker fire igniting a cook’s apron
 A lighted matchstick thrown at spilt petrol at the gas station
 Etc.

The coverage is therefore the direct damage by the unfriendly fire.

(b) Lightning:
One may ask, why is lightning covered when in actual fact it is a natural
phenomenon?

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 Do you remember the fundamental classification of risks?

The answer is that is that lightning itself is an electrical discharge that may not
necessarily cause a fire. However, fires may at times erupt during a lightning or
thunderstorm. Insurers have mostly agreed that this is an unfriendly fire and therefore
should be covered.

(c) Scorching
During an outbreak of fire, the fire may cause damage to walls, paint work, or other
properties.

(d) Smoke
Smoke from an infernal may cause damage to certain parts of the building such as
walls, ceiling or and adjoining or neighbouring property. Such damage would be
covered under a fire policy.

(e) Fire fighting agents

In the process of fighting the fire, various agencies are used such as water, chemicals,
gases etc. These agencies may cause further damage to property.

(f) Removal
As a fire rages, some property may be saved and these may be damaged during the
removal. Such losses would be covered. Also cost of storage for saved property for a
specified period of time would be compensated.

14.2.2 Engineering Insurance

Origins:
Engineering Insurance owes its origins and development to the industrial
development and industrial revolution.

Investment of Steam Engines

The invention of the steam engine came with it the havoc of destruction to property
and cause of deaths in the workplace. This was due to high pressure connected with
steam engines which led to burst tanks, burst pipes, blowing up of buildings and
equipment and causing of deaths.

Realization of the Problem:

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 The accidents related to steam engines and boilers caused concerns to both people in
the industry and government leading to the need to both regulate and to provide
insurance cover.

Manchester Steam Users Association (1850-1859)

Early industrial concerns are illustrated in the formation of the Manchester Steam
Users Association. Purpose was to advise and share in losses experienced by
members

Examples of early Insurers for Steam Boilers:

Steam Boiler Assurance Co. 1859
National Boiler Insurance Co, 1864

Government Regulations:
The losses experienced by boilers in the early days necessitated government
intervention through legislation. Some of these legislations are enumerated below.
1. Boiler Explosions Act 1882
The purpose was to report any explosions within 24 hours to the Board of Trade
2. Factory and Workshop Act 1901
To inspect the boilers and engines every 14 months
3. Coal Mines Act 1911
To inspect boilers and engines used in coal mines every 14 months

4. Road Traffic Act 1930

Regulate and inspect motor vehicles propelled by boilers
5. Building and Docks Regulations 1931 and 1934
6. Factories Act 1937
Steam Boiler inspection on regular basis

Effecting Boiler Insurance:

The details in the Proposal Form would include among others:

(a) Full name of the proposer
(b) Full address
(c) Trade or Business
(d) Situation (status) of the plant (inspection report)
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(e) Nearest public transport station to the works and distance therefrom
(f) Schedule detailing every aspect of the plant
Item number
Maker’s number
Type of plant
Diameter of tanks
Date of manufacture
Maximum pressure on safety valves
(g) Description of all defects

Coverage:
Property itself
Third Party losses

Extensions:
Steam pipes by cracking
Explosion of feed pipes
Damage to tubes by overheating
Fuel gas explosions
Exclusions:
(a) Damage to insured property during the application of hydraulic tests caused by strikes,
lockouts, riot or civil commotion
(b) Loss of use or consequential loss

(c) Willful negligence

(d) Liability assumed by insured through agreement

(e) Any consequence of war, invasion, act of foreign enemy, civil war, rebellion, revolution,
insurrection or military or usurped power.

14.3 Summary

In this chapter we have been able to discuss two types of property

insurance, fire insurance and boiler insurance. We discussed
the definition of two types of fire, friendly and unfriendly fire. The boiler
insurance is another aspect of engineering insurance that was discussed. We looked

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 at the various aspects of both the fire and boiler insurance including coverage and
exclusions.

14.4 Activity/Exercise:
1. Discuss the perils insured in a fire policy
2. Define the two types of fire
3. Discuss the history and what led to the introduction of Engineering
Insurance
4. How can you effect a Boiler Insurance
5. What exclusions would you find in both fire and engineering
policies?

References:
1.Vaughan, Emmett J, : Fundamentals of Risk and Insurance(
2. Black, Kenneth Jr. and Harold D. Skipper Jr. : Life Insurance 12th
Ed.

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 LECTURE 15
TYPES OF INSURANCE (3)
(Liability, Motor , Marine, Aviation)

15.0 INTRODUCTION
This lecture will focus basically on insurance related to transport. This is one area of
risk management where calamities are always reported in regard to accidents leading
to loss of life and property. Motor transport has for example been a major source of
loss of lives and the introduction of the motor vehicle as a means of transport has
brought with it a risk of greater proportions than before. Civil aviation has also
brought a unique risk such as hijacking and terrorism. There has been such an
increase in air travel world wide that that the risk involved is so enormous that one
must protect oneself against such risks. Similarly, marine risks have increased since
the Tudor times and more sophisticated equipment has been developed not only
increasing the values of these equipment, but also speed and complicated
maneuverability at sea. Increase in international trade makes marine risks to be
complicated and may require international agreements and practices.

15.1 Objectives
At the end of this workshop the learner should be able to:
 Identify and describe the risks involved in each line of
insurance i.e. liability, motor, marine and social insurance
 Relate the principles of insurance to each type of
insurance.
 Understand the general coverage under each type of
policy.
 Understand some of the basic legal provisions under each
policy.
5.2 Liability Insurance
15.2.1 Sources of Legal Liability
Definitions
1. Tort: A civil wrong for which the remedy is a common Law Action for unliquidated
damages and which is not exclusively the breach of contact.

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 Tort may take the form of negligence, nuisance, trespass or defamation.

2. Contract: An agreement which creates obligations enforceable which by laws.

Essential ingredients of a valid contract are:
- There must be an agreement consisting of:-
 Offer by one party
 Acceptance by another party.
- The contract must be contained in a deed under seal.
- There must be valuable consideration given by one or both parties.
- The agreement must have been reached with the intention of creating a
legal relationship and by its character must be seen doing so
- The parties must have legal capacity to enter into the legal relationship.
 Sound mind
 Legal majority of age.
 Authority
- The parties must comply with certain formalities imposed by law.

3. Statute: These are government laws enacted by parliament. Such laws place certain
obligations on its citizens and businesses which they must observe at all times.
Included in this category are any by-laws passed by Local Authorities.
Violations of these laws may lead to injuries or damage to properties. This
creates a liability to those that violet such statutes.

Differences in Breach.
Contract: Is a violation of a right created by an agreement or promise (normally
voluntarily assumed)

Tort: Is a breach of a duty which a person owes to his fellow men in general to
regulate his actions in order that he should not cause injury to them or damage
their property.

Negligence
It is the most common form of tort.

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Definition:
1. It was defined in Blythe V. Birmingham Waterworks Co. (1856) as :-
“Omission t do something which reasonable man guided by those
considerations which ordinarily regulate the conduct of human affairs would
do, or doing something which a prudent and reasonable man would not do”.
2. In Vaughan V Taff Rly co. (1860) it was defined as:
“Negligence is the absence of care according to the circumstances.
3. Law Reform Committee (1939)
“ Failure to exercises due care in a case in which a duty to take care exists”

Requirement of the law in application of Negligence

- Application of reasonable skills based on experience
- Application of “Reasonable prudence”
- Use of common sense

The law does not expect exceptional ability to be applied in cases of negligent
acts.

4. Unfair contract terms Act 1977(English)

Defined negligence as breach:
- Of any obligation arising from the express or implied terms of a contract
skill in the performance of the contract.
- Of any common law duty to take reasonable care or exercise reasonable
skill (but not any stricter duty)
- Of the common duty of care imposed by the occupiers liability Act 1957
or the occupiers liability Act (Northern Ireland) 1957.
Proof of Negligence
- The defendant was under a duty to exercise care towards the plaintiff
- There was a breach of that duty
- The plaintiff sustained damage as a result
- The breach of duty was the proximate cause of damage

Duty to Take Care

A duty to take care must exist before there can be negligence.
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Each person has a duty to his fellow men to regulate
- His personal actions
- The conditions of his property.
- The activities of employees.

So as not to cause injury or damage to others

Failure to observe this duty renders one guilty of negligence.

Other forms of Tort include:

(a) Trespass
To Land
Defined as “an authorized entry to one’s land including premises)

To Chattel (a good)
Defined as “denying the owner of the chattel (good) immediate possession”
That is the owner cannot access it when he so wants the good.
To the Person (Battery, Assault and False Imprisonment)
Battery means unauthorized actual bodily contact that may lead to injury.
Assault is threatening another with possible harm that leaves one party in a state of fear.
False imprisonment means unlawful confinement of an individual that he/she cannot be able
move or leave. This is not necessarily mean in a prison environment. It can even be in an
open field or any enclosure.

(b) Nuisance
Nuisance refers to interference of one’s enjoyment of his property that may lead to
annoyance. There are two types of Nuisances: Private Nuisance, which affects the individual
or firm such as foul smell or loud music and action can be taken by the individual or the firm;
and Public Nuisance, which affects a larger community where a legal action is taken by the
state.

(c) Defamation
Definition: It is the communication that injures the reputation of another that this other is
looked upon by others in a lowly manner or is shunned by the common man on the street or
his/her contemporaries in business or profession.
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There are two types of defamation: Libel, which a permanent form of defamation such as
printed or written materials through print media, books or pamphlets. Slander, which is
transitory in nature that is, it is not permanent. Slander is basically spoken word.

For defamation to hold, the communication must be passed from one individual to another
or group of people. In the absence of any dissemination of the defamatory words, the person
claiming injury to his reputation will not have grounds to sue.

15.2.3 Liability Policies

Liability policies are expected to protect the insured against third party liabilities arising from
the various sources of liabilities discussed above.

These include:
1) Public Liability Policies
These cover mostly businesses against their liabilities towards the public. For
example: any bodily injuries to the public or damage to their properties.

2) Employers Liability Policies

These cover bodily injuries or diseases contracted by employees at their places of
work or during or in the course of their employment. In most countries, it is a
requirement that the employer carries a compulsory cover for any injuries sustained
by the employee in course of his employment. Such policies are usually limited in
that they do not provide full cover of the injuries. The Workmen’s Compensation is
an example of such compulsory cover.

3) Product Liability Policies

These protect the businesses, especially manufacturers and sellers of products against
injuries sustained or losses incurred by buyers and consumers of the products.

4) Professional Indemnity Policies

These are policies that are taken by the professionals to cover them against any
professional negligence or malpractices. Professionals such as doctors, accountants,

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 architects, engineers, lawyers and others may take professional policies that relate to
their specific profession.

5) Third Party Motor Insurance

The third party motor insurance covers motor vehicle owners against any injury and
or damage to property caused through negligent driving. It also covers injury to
passengers in the vehicle.
Third party Motor Insurance is a compulsory cover as provided under the Traffic Act
and the Insurance (Motor Vehicle Third Party Risks) Act Cap 405 of the Laws of
Kenya. Under these acts, you may not drive any vehicle on the roads unless you have,
at least, a valid Third Party cover.
Activity/Exercise
1. Define the following term:
o Liability
o Tort
o Negligence
o Nuisance
o Trespass
o Defamation
2. Discuss the various ways of insuring liability risks

15.3 Motor Insurance

Introduction
A motor vehicle is probably the most common asset owned by a majority of people.
When we look at the historical development of the motor vehicle, we see that it
developed out of necessity. In the early years, the railway was the most dominant
mode of transport, especially on long distance passenger transport and carriage of
goods. The railway however could not serve effectively on short distance haulage or
intra city transport. Also there emerged a class of people who required more
personalized mode of transport. As time went on, there was also the question of
economic growth and industrial revolution and development. These again required
specialized modes of transport and the vehicle of various types were therefore in
demand.

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 The increase in motor vehicles on our roads created a unique risk requiring specific
treatment. Loss of human life and property led to large claims, sometimes in millions
of shillings, which the owners of the vehicles could not pay. These losses led to the
government passing legislations that were geared towards reducing accidents on the
roads and making the drivers and owners of vehicles to be covered by a motor
insurance cover.

15.3.1 Motor Risks

The motor risks may arise in many ways:
 Through the ownership of property that is possible loss of the car though accidents,
fire or theft.
 Use of the car leading to injuries to the driver, passengers, pedestrians, and third party
property.
All these lead to economic losses of various magnitudes.

15.3.2 Effect of Motor Vehicle Accidents

1) Loss of life resulting in loss of:
- Income for the dependants
- Skills of trained people
2) Disabilities that lead to loss of income both for the dependant and the victim
3) Loss of property that may lead to: -
- Loss of production
- Loss of investments
- Loss of employment
- Loss of income and profit

Can you discuss how each one of these comes about and the effect to society?

15.3.3 Financial Implications of Motor Accidents

1) High cost of replacement of damaged property

2) Increased indirect costs
 Investments into hospitals
 Investments into law enforcement

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  Investments into production of specialized equipment
 Investments into training
3) High costs of investigations and processing of claims
4) High cost of court litigations

15.3.4 Nature of the Motor Insurance

1) A motor vehicle is apt to standardization, yet there are a wide range of factors to
consider in: -
 Assessment of value
 Decision to accept the risk
 Rating of the risk
For example: Vehicle worth the same performance characteristics and
geographical areas of operation.
Drivers with same motoring history and characteristics
.
2) The loss from one accident or one insured can easily wipe out the insured.
Foe example: a vehicle, which was left on a railway crossing may lead to the
derailment of the train and a claim for the loss put to the owner of the car.
3) The compulsory nature of the insurance especially the liability aspect of it.
4) Various classes of motor vehicles for different use pose unique characteristics
or risks.
5) The complexity in the passenger transport (PSV) industry especially the so
called “Matatu”

15.3.5 Motor Insurance Policies

Motor insurance has four specific coverage areas. These may be taken according to
the needs of the insured and the according to the law.
(a) Third Party Only Cover
This is a compulsory cover as provided under the Third Party Motor Insurance Act.
Insurers give a little wider cover of 3rd party losses than is required by the Traffic
Act. In addition to coverage under Traffic Act, they cover.
 Apply to accidents occurring within the geographical area.
 Indemnity to third party property damage.

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  Indemnity to anyone who is driving he/she be responsible for an accident
(usually given at the classification of use).
 Indemnity to a passenger should he/she be responsible for an accident.
(Usually given at the policyholders request)
 Indemnity to employer, partner or fellow employee in accordance with
the classifications of use.
 Legal costs and expenses as mentioned in Road Traffic Act. These include
those that relate to property damage claims as well as to injury claims.
 Any other expenses related to the accident living of other cars.

(b) Third Party Fire and Theft.

The cover includes all third party only indemnities plus:
 Damage caused by fire, lightening or explosion.
 Damage either during attempted theft or while it is stolen
 Stolen but not recovered.
 Accessories and spare parts kept in or on the car.
 Towing charges
 If the car through attempted theft is damaged beyond repairs.
 Repairs of the damaged car

Exceptions to Third Party and Third Party Fire and Theft
 Unlicensed drivers
 The Traffic rules require that drivers must be properly licensed. Violation
of any Traffic rules could be ground for refusal of claims.
 Violation of the terms of the policy.
 If the person claiming indemnity is entitled to indemnity under another
policy (e.g. workman’s compensation).
 Death or bodily injury to, any person arising out of and in the course of
that person’s employment policy. The employer’s liability should apply
in this respect. Reference should be made on the use of the car.
 Damage to property belonging or in the case of anyone entitled to claim
indemnity under the policy. This includes damage to the car itself whether
owned or borrowed.

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  Any accident, injury, loss or damage which occurs while the insured
vehicle is being used for a purpose outside the description of use in the
policy or certificate of insurance.
 For any consequences of war, invasion, act of foreign enemy (whether
war could be declared or not), civil war, rebellion, insurrection or military
or usurped power, except so far as is necessary to meet the requirement of
the Road Traffic Act.
 Loss or destruction of or damage to any property, or any resulting loss or
expense or any consequential loss.
 Any legal liability directly or indirectly caused by: -
Ionizing radiation or contamination by radioactivity from nuclear fuel or
nuclear waste.
Radioactive toxic, explosive or other hazardous properties of any nuclear
assembly or nuclear components of such assembly.
 For any liability, which attaches by virtue of an agreement but which
could not have attached in the absence of such agreement.
NOTE
The purpose of motor policies is to cover liabilities, which exist under
common law. Additional liabilities, which increase the risk and entered in by
the insured should be met from the insured personal resources.
Any accident, injury loss or damage arising during or consequence of earthquake,
riot or civil war commotion.

Those applying to 3rd party fire and theft only: -

 Loss of use depreciation, wear and tear mechanical or electrical
breakdowns or failures.
 Damages to tyres by braking, road punctures, cuts or bursts.
 Damage caused directly by pressure wares from aircraft and other aerial
devices raveling at sonic or supersonic speeds.
NOTE
These also apply to comprehensive policies.
Reason:

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 Because both 3rd party fire and theft and comprehensive policies maybe involved
in the repairs or reinstatement of the vehicle after loss.

(c) Comprehensive Cover

The comprehensive insurance covers the Third Party Fire and Theft risks and in
addition covers:
Damage to the vehicle after an accident
Medical Expenses for the insured/driver after an accident

(d) Windscreen Cover

This is usually taken separately, but some insurers may include it under the
comprehensive cover. The purpose of the windscreen cover is that not all accidents
may lead to total damage. Windscreens are delicate and it is possible that they may
be damaged separately without the whole car being affected. For example a stone
may be thrown at the windscreen and it breaks and no other damage to the car is
experienced.

15.3.6 Suspension of Cover

1) Some insurers may suspend cover it the vehicle is laid off for periods
exceeding one month. In this case the certificate of insurance must be returned
and proportion of premiums refunded.

2) Also suspension or termination can be effect when the vehicle is sold to

someone else. The certificate of insurance must be surrendered to the insurer
and proportionate premiums reimbursed
Activity
1. What led to the development of a motor vehicle?
2. Explain the financial benefit we derive from the motor
vehicles
3. Briefly describe the four types of motor policies available on
the market
4. Discuss the motor vehicle classifications we have in Kenya
for purposes of registration

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15.4 Social Insurance

Introduction

We have seen in the previous chapters various aspects of private/commercial

insurances. Can you name some of them?

Social insurance as the word suggests deals with the risks that affect the entire
society. It does not discriminate any member of society. On the other hand private
insurance is voluntary and only those interested in a specific protection would take
the private insurance coverage.

Definition:
Social insurance can be defined as “A device that transfers the risk from the
individual or society to the government”. Vaughan defines social insurance as “A
device for pooling of risks by their transfer to an organization, usually
governmental, that is required by law to provide pecuniary or service benefits to or
on behalf of covered persons upon the occurrence of certain predestinated losses
under specified conditions”

Social insurance is based on the notion that within the society there are individuals
who face specifically fundamental risks, which they cannot manage on their own.
These risks must therefore be managed by the entire society and the only institution
that can do this is the government.

Like the private insurance, the social insurance also uses the mechanisms of
transferring, sharing and reducing in managing risks. Transferring is achieved when
the risk is removed from the individual or society to the government. A small
contribution is made in form of a premium to finance the risk. Sharing is done when
the various members of society pool their resources together and any member
suffering a loss is compensated through the pool. Reducing the risk is done through
the various programmes that the government initiates in order to avert certain
catastrophes. For example: building dykes and trenches in floods prone areas,
moving populations from steep slopes and resettling them in the plains to avoid

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 disaster resulting from landslides and putting other disaster response mechanisms in
place to deal with any eventuality.

Characteristics of social insurance

i) The programmes are provided by the government under legal provisions
ii) Eligibility for benefits is based on contributions made by the person covered or
dependant. There is no need for the individual to demonstrate that he or she is in
a particular financial need.
iii) The formula of determining the benefits is stated by the law and therefore the
benefits are not directly related to contributions.
iv) The contributions are normally shared between the employee and the employer
in stated proportions. For most plans membership is compulsory and therefore
contribution is by automatic deduction from the salary.
v) The programme is administered and even suspended by the government.

Examples of Social Insurances in Kenya:

i) National Social Security Fund (NSSF). This provides income for retirement.
ii) National Hospital Insurance Fund (NHIF).It provides for hospitalization
expenses for contributors up to a certain maximum. This fund is in the process
of being reviewed (2006) to expand coverage.
iii) Pension Scheme provided by the government departments and parastatals for
their workers. However some private organizations may also have their own
pension schemes or gratuities.
iv) Workmen’s Compensation Insurance. This provides relief to workers injured or
contracting diseases related to their work place. This relief is usually not a
complete indemnity.

15.5 Marine Insurance

This is the oldest form of insurance dating as far back as the 15th century by the
Lombards merchants of London and through marine practices by merchants..

15.5.1 Historical Development

Marine as we know it today, was started in a coffee house named The Lloyds Coffee
House. In this coffee house, merchants carrying on international maritime trade
congregated to transact business. It brought together traders and financiers who
would cover any risks undertaken by the traders. The financiers acted as the insurers
of the adventures by writing under each business placed. This is how the term
underwriting came into place.

The policy contract came much later in mid 1800. The practices of international
maritime trade dominated and still dominate the terms and condition of the marine
insurance.

15.5.2 Perils/Risk covered

The policy covers the risks of the sea leading to the loss of the vessel and the various
liability risks attached to maritime adventures.
The perils covered include:
 All perils of the sea
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  Accidental Fires
 Pirates, rovers, and thieves
 Foreign enemies whether war is declared or not
 Jettison i.e goods thrown overboard in order to save the adventure
 Detention by foreign countries
 Negligent acts of the crew

15.5.3 Types of Policies

There are various policies available under marine insurance. These include:

(a) Time Policy:

This is a policy that is taken to cover a specific period of time. For example: covering
a period from 1st January 2008 to 30th May 2008.

(b) Voyage Policy

A voyage policy covers the insured against any losses caused by the perils insured
against for a specified voyage. The voyage must be described in the proposal or the
slip upon which the coverage is indicated. The voyage is described by stating the port
of origin, ports of call and the port of destination. That is the entire route must be
described.

(c) Floating Policy

A floating policy as the name suggests is not for a specific time or voyage. It is used
where shipment is in installments. When every shipment is done, the insured declares
it in terms value and destination and the policy will cover the shipment.

(d) Mixed Policy

This is a policy that is both time policy and voyage policy. That is, it covers the
insured for a specified period of time for a specified voyage.

15.5.4 Clauses Governing the Marine Policy

It should be appreciated that maritime trade is complex and it involves many
international agreements. Clauses that govern marine insurance therefore are based
on such international agreements. Each type of trade, cargo shipped and the type of
vessel would therefore be unique and the policy covering such adventure would
require to be governed by specific clauses. This lecture will not go into the details of
these clauses.

15.6Application of Principles of Insurance

Do you remember the principles that were discussed in lecture 11? All the six
principles discussed are applicable in all the lines of insurance referred to in this
lecture. We can say that these are contracts of indemnity unlike the life insurance
policies which are not.

15.7 Summary

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 In this lecture we have been able to discuss the basic principles and
risks to be found in liability insurance, motor insurance, marine
insurance and social insurance. We have also looked at some of the
policies available under each line of insurance. Can you remember some
of these policies? It was also established that the six principles of insurance
discussed in lecture 11 apply to all the lines of insurance referred to in this lecture.

15.8 Activity
1. Explain the perils covered under the Fire Insurance
2. Briefly discuss the development of the Engineering Insurance
3. What are the sources of legal liability? Give examples of each
source
4. Define a social insurance. Give examples of social insurance
here in Kenya
5. What are some of the characteristics of social insurance?
6. Describe the four types marine insurance. Why do you think
that the marine insurance policies are unique?

Reference:

1. Vaughan, Emmett, J: Fundamentals of Risk and Insurance

2. Symith, Colin: Insurances of Liability- Study Course 070
CII Tuition Service

LECTURE 16

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 UNDERWRITING AND CLAIMS ADMINISTRATION

16.0 INTRODUCTION
The insurance industry’s survival depends solely on effective and sound underwriting
and claims procedures. It should be noted that these two procedures come at the
opposite ends of the insurance mechanism. Whereas underwriting creates the
insurer’s obligations, claims on the other hand fulfills those obligations. Poor
underwriting may lead to selecting poor losses that may lead to high claims that may
bankrupt the company. Poor claims procedures may cause the company lose its
reputation and hence clients or even lead to high losses. These are some of the things
we shall be discussing in this chapter

16.1 Objectives
At the end of this chapter the student should be able to:
1. Define underwriting and claims administration
2. Understand the processes of underwriting and claims
administration
3. Understand the purpose for a proposal form
4. Rate making and premium determination
5. Appreciate the need for a policy for underwriting and
claims administration
6. Understand some of the basic conditions to be found in
a policy document

16.2 Underwriting
Definition:
Underwriting is defined as the process of risk selection, risk classification and rating
of the risks
16.2.1 Objectives of underwriting
Underwriting is an essential element in the operation of any insurance. An
insurance company may receive all kinds of applications for coverage some of
which may be poor risks. It is therefore upon the underwriter to select wisely those
risks that he can be able to manage. Poor risks may lead to adverse selection, which
in turn may lead to high claims when policies mature.

It is however, not possible to select all good risks. There must be some proportion
of some poor and good risks selected in the process. The intention of an underwriter

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 is to avoid as much as possible to select a bigger portion of bad risks than good
risks. The intention is to equalize the actual losses with expected losses.

The other objective of underwriting is to secure a volume of risks large enough so

as to first equalize the bad risks with the good risks. It is not always easy just to find
good risks at all times. Secondly large volumes makes it easier for the underwriter
to predict losses.

He must guard against congestion or concentration of exposures that might result in

a catastrophe. Not all high risks are automatically rejected. If they are rejected, they
may be accepted at another rate.

Can you remember the application of “The Law of Large

Numbers?”

Lastly, large volume of selected risks provides sufficient resources in the pool for
use in case of losses to be claimed.

16.2.2 Process of Underwriting

Underwriting starts by securing information. This information may be secured
through various means. Let us explore some of these means or tools.

(a) Primary Sources

(i) Proposal form
A proposal form is a document prepared by the insurer whose main function is to
obtain information regarding the applicant. The form should therefore be designed in
such a manner as to bring out the characteristics or the description of the risk to be
insured. It must also be able to bring out the details of the applicant. It is therefore
the basic document that the insurer may rely on in accepting or rejecting to insure a
risk.
Agents and brokers in the underwriting process use the proposal form, as it is the only
document available to them for receiving applications. Agents and brokers are
referred to as “Field Underwriters” That is selection and recommendation for
coverage may start with agents and brokers.
Agents specifically may give further information regarding the applicant in support
of the information given in the proposal form. It should be understood that agents are
employees of the insurer and therefore must give information regarding the applicant
to protect the interests of the insurer.

(ii) Internal valuation

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 Once the proposal form has left the field and comes to the office (insurer), the internal
officers scrutinize the proposal form further so as to classify the risk and make a
decision whether to accept the risk or not. This is referred to as “Desk
Underwriting” Very often you will find the insurer relying on the field underwriter
to do a good job of selecting risks.

(b) Secondary information

The insurer may seek further information from secondary sources when it apparent
that the information received through the primary source is not sufficient. Such
secondary source may be in the form of:
(i) Information Bureaus
(ii) Private investigators
(iii) Direct visits and investigation
(iv) Surveys
(v) Inspection –report

c) Third source of information

The underwriter may also obtain specialized information from experts or
professionals when need arises in certain circumstances. For example information
may be sought from:
- Banks -Other insurers -Fire departments
- Creditors -Law enforcement agencies - Local administrators
- Employers -Doctors and other professionals

Why must the underwriter seek for information?

This is because the information will help to:

 To describe the risk

 To guard against moral hazard
 To establish applicants with high probability of loss
 Guard against adverse selection

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 Information is sought on moral qualities such as honesty dependability and ethical
behaviour, housekeeping, living habits, physical conditions, finance and business factors.
Also information is sought so that we can look at past experience of claims, number of
times contracts have been denied or cancelled among others.

When data is received, it is the responsibility of the underwriter to evaluate the data so
as to:
- Sort out objective and subjective data.
- Establish the reliability of the source.
- Statistically analyses the objective data
- Make alternative decisions based on acceptability standards set. e.g.
Fully acceptable
Acceptable with conditions e.g.
Increase in premiums
Increase/reduction in deductions
Change of conditions and terms
Reject

16.2.3 Classification of Risks

Before accepting a risk, the underwriting decision may be based on classification of
the risks.
a) Preferred /super standard
A preferred risk is that which the insurer offers less than standard rate. For
example a person in a certain age group whose mortality is expected to be
above average, or property in an upper-market which has never made any
claim for some time, or a young non-smoking person.

b) Standard
This is a risk, which attracts a standard rate, that is, a rate without surcharges,
or conditions restricted,

c) Substandard

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 This is a risk that attracts surcharges or certain conditions imposed to
coverage. It is not rejected, but its premium will be higher than the standard
rate.

d) Uninsurable
This is a risk that will be rejected as not meeting the underwriting standards
set by the insurer.
NOTE:
The underwriting process often involves more than rejection or acceptance
of a particular risk. A risk, which may be relatively risky, may be accepted
at a higher rate. The underwriter may also want to look at the volume of the
relatively bad risks in relation to the good risks before he will reject any
risk.

16.3 Policy Document

When issued
The policy document is usually issued after the insurer is satisfied with the
information obtained regarding the risk to be covered. The proposal form must also
be duly filled and the declaration portion duly signed by the applicant. The proposal
form must be accompanied by the first installment of the premium.
The document must therefore have the following features

i) Declaration
ii) Identification of insured and the risk insured.
iii) Types of coverage
iv) Period of contract
v) Other information related to risk.
1) The Insuring Agreement
This is a formal statement detailing what the insurer promises to do in return for
the premium paid. The statement maybe fairly lengthy and detailed. And may
include:
 Perils to be insured
 Services promised
 Definitions of words used
 Limits and face values
 Legal provision governing the agreement
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 2) Exclusion and limitations
These are those coverage or losses that the insurer will not honour. They may
include:
 Risks not covered
 Perils not covered
 Properties not covered
 Actions not covered
 Limitations of coverage.
 Territorial limits

3) Conditions.
These are things that the insured must do in order to enforce his rights under
contract e.g.
o Supply of information,
o Payment of premiums .
o Not violating existing legal provisions
o Not increasing the risk.

16.3.1 Some common clauses.

The policy document may contain various clauses that govern the parties to the
contract. They are the legal arm governing the contract. The wording of these clauses
is very important because it is through the wording that obligations are created which
the parties must honour. The interpretation of the words used must be clear and
understood. One of the most important doctrine in the legal interpretation of the
wording is the “Reasonable Expectation” doctrine. This just means that ambiguity
to be interpreted against the insurer. Some examples of the clauses include:

 Entire contract clause **

 Assignment clause **
 Cancellation clause **
 Mortgage rights clause
 Notice of loss clause **
 Proof of loss clause **
 Other insurance clause
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  Validation clause
 Jurisdiction clause **
 Territorial clause **
 War Clause **
 Nuclear ionization
 Aviation clause **
 Subrogation clause
 Contribution clause
 Insurable interest clause **
 Indemnity clause
 Concealment **
 Representation and warranty **
 Waiver and estoppels **
 Renewal **
 Suicide Clause **
 Non-forfeiture Clause **

NOTE: ** Related to Life Insurance

16.4 Claims Administration

Role of the claims department
A claims department is an essential part of the insurance process. Remember we said
at the beginning of this chapter that the underwriting process creates an obligation to
be fulfilled by the insurer. At the end of the stick is the claim, which fulfills that
obligation.

Why is the claims Department important to the Insurer?

When we take an insurance cover, we deal mostly with the agent and perhaps the
broker. Once the policy has been issued we do not come in contact with the insurer
until we make a claim. The manner in which an insurer handles a claim is therefore

181
 crucial to the insured. Poor handling will mean the loss of that client and poor
publicity of the company.

The claims department deals with many other people and agencies in addition to the
insured. For example it deals with lawyers, police officers, investigators, surveyors
loss adjusters among others. These various publics may have diverse impacts on the
insurance depending the relationships created. Therefore apart from paying claims,
the claims department actually also plays the role of public relations.

16.4.1. Corporate Policy Statement

A claims department of any insurance company must develop a claims policy that
will govern the process.

(a) Level of responsibilities

This will provide for the details of which officer will deal with various types of claims
in terms of value or type of claim

(b) Processing of claims

The policy should provide guidelines as to the processing of any claim from the time
notification is received to t6he time a payment is finally made. For example there
should be a policy on each one of the following:

 Approval of payments
 Settlement of disputes
 Jurisdictions
 Time within to settle
 Subrogation procedures/ recovery procedures
 Contribution procedures
 Salvage procedures
 Sue and labour actions
 Valuation of loss procedures
 Replacement values- new market values, landed values etc
 Interest Policy
 Loss of income estimation procedures and base e.g.
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 i. Historical basis
ii. Expected future income.
iii. Mortgaged Property

16.4.2 Claims Process

The process may take the procedure described below:
(a) Receive notification
The first thing that an insured is expected to do is to notify the insurer as
soon as possible the occurrence of a loss. The policy will have stipulated the
manner in which the loss should be reported. Failure to follow the
prescribed procedure may lead to the insurer refusing to honour the claim or
surcharging the insured. In most general business, the notification must be
done within 24 hours of the occurrence of a loss. Other times may be
provided.

(b) Establish a loss

The insurer cannot just pay a claim because it has been notified. Proof must
be furnished of such a loss and the claim must be legal. The insurer will there
accomplish this by looking at various reports such as:
 Investigations and surveys by experts
 Police abstracts
 Reports from or statements made by the insured
 Reports from doctors/ fire department etc.
-
(c) Interpretation of various clauses
Remember the clauses we discussed earlier?
These help to interpret the extent liability and or whether the claim has been made in
the authorized manner, or whether the insured violated any of the clauses.

(d) Establish value of loss

The value of the loss will depend on whether the loss is partial or total. In partial
loss it may require that an assessor establishes the value of the loss. In total loss
the insurer need only look at the sums insured or try to establish the actual market
value.
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 Remember the conditions of the principle of indemnity?
(e) Establish beneficiaries under the contract
It is important that the claims department establishes who the beneficiaries under
the contract are. Sometimes we may have more than one interest in the subject
matter of insurance which need to be recognized. If it is a Life Assurance policy,.
the named beneficiaries and their categories have to be established

(f) Replacement - payments initiation.

In initiating payments, the claims department must have established that the claim
is legal and that the relevant legal issues have been sorted out. Sufficient funds
must also be available before payment is made

g) Follow up on Subrogation and contribution cases.

The principles of subrogation should be called upon, especially in non-life
Insurance so that the cost of insurance is minimized.

3. Evaluation of performance in claims Settlements:

vi) Examining statistical indicators over a period of time.
vii) Examining arithmetic mean of amounts paid per claim
viii) Settlement time evaluation
ix) Examining loss verses Estimates and their relationship to actual payment made.
x) Look at the incidence of litigation.
xi) Carrying out claims audit.
 Compliance with procedures
 Adequacy of documentations
 Verification of claims.
 Appropriate ness of settlement amount.
 Recognition of salvage and subrogation possibilities.
 Promptness of recovery.
 Loss reporting times
 Adequacy of legal defense

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16.5 Computation of Premiums (Property Insurance)
Components of a premium
 Pure or Net Premium
The actual cost of coverage
Calculated by looking at the estimated future loss (claims) divided by the units
exposure.
Pure Premiums- = L
V
Where L L = Loss
V = Volume of units insured
 Gross Premium
The price changed for covering a particular risk.
Gross premium – Pure Premium + Expenses + Profit.

OR

Pure Premium
(1-Expenses Ratio)

Example:
Assume that you have 10,000 units of houses in Kayole Nairobi which you want to
insure. Your expectation of loss through fire during the year is Kshs. 75,000,000/-.
The industry expenses ratio experience is 30%. It is expected that a profit margin of
15% of net premium is to be realized.

Pure Premium = 75,000,000 = Kshs. 7,500/-

10,000

Gross Premium = 7,5000 + Profit = 10,714.30 + 1,607.15

1-0.3
= Kshs. 12,321.45

16.6 SUMMARY

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 In this lecture we have been able to see and understand
the process of underwriting. This is a process where we
select, classify and rate risks. It is so important that it
requires prudent judgment so that we do not experience
adverse selection.

The lecture also touched on the subject of claims administration. We saw that an
effective claims department can also act as a public relation tool for the company.
The manner in which it handles claims may lead to a repeat sell or loss of customers.
We also went through the process of preparing a claim. Certain collaborative
information is required before a claim is paid.

We were also able to learn the elementary process of premium determination. We

saw that a premium is the price charged for covering a specific risk. There are two
basic components of a premium viz. pure premium and gross premium. It is important
to understand what makes the gross premium.

16.7 Activity
1. Define underwriting
2. Briefly discuss various sources of information for the
underwriting process.
3. What do you understand by the following terms: Declaration,
Adverse Selection
4. Briefly explain the process of claims administration
5. What role do the following have in claims administration? The
police, doctors, assessors, lawyers
6. Discuss the components of a premium
References:
1. Vaughan, Emmett J, : Fundamentals of Risk and Insurance(Chapters
12-18)
2. Black, Kenneth Jr. and Harold D. Skipper Jr. : Life Insurance 12th Ed.

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 CHAPTER 17

REINSURANCE
17.0 INTRODUCTION
As we have seen from the concept of risk, insurance is the transfer of risk from the
insured to the insurer. It is also a form of pooling resources in order to deal with the
problem of individually facing an enormous loss. Insurers cannot be able to absorb
all the various risks they take on. If they were to do so then their business would be
wiped out on happening of even one event such as a derailment of a passenger train
leading to several deaths. There is therefore a need to transfer and share the risks
taken by the insurers even further.

17.1 Objectives
The objectives of this chapter are:
 To make the student understand the mechanism of
reinsurance
 Appreciation of some of the terminologies used in
Reinsurance
 To understand and appreciate the various types of
reinsurance
 To appreciate the role Kenya Reinsurance Corporation
and other play in the insurance industry in Kenya

17.2 Definitions of Terms

Reinsurance
We can define Reinsurance as the insurance of the insurer. In most cases, insurers
take on risks that they cannot handle and therefore they are forced to transfer a portion
of it to a reinsurer. The mechanism of transferring, sharing and pooling of risks also
apply in the reinsurance process.

Reinsurance is a contract by which an insurer processes a third party to insure him

against loss or liability by reason of an original insurance.
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 It is therefore a contract in which the original insurer transfers all or part of a risk he
has assumed to another insurer (Reinsurer) with the objective of reducing his own
commitment to an amount he can bear for his own account (net retention),
commensurate with his financial resources.

Can you remember the discussion on how to deal with risks?

Note:
(i) This is a distinct and separate contract from the original insurance and itself
takes the form of a contracting insurance.
(ii) Reinsurance need not cover the entire obligation under original insurance either
in terms of sums payable or perils covered. It cannot provide a wider cover than
originally insured.
(iii) Reinsurance must cover the same risk as originally insured.
(iv) The insurance and reinsurance contracts, generally speaking, must co-exist
concurrently with the insurance preceding the reinsurance contract.

17.3 Historical Background

The beginning of reinsurance is based on the practice of the early insurers. Whenever
an insurer accepted a risk that was large to handle alone, such insurer would shop
around for other insurers who would accept to take a portion of it. The terms of each
risk transferred were negotiated and the premiums shared on an agreed proportion.
Today this practice can still be found amongst certain insurers.

17.4 Terminologies used in Reinsurance

Let us look at some of the terminologies used in reinsurance.

17.4.1 Ceding Company

This is the direct writer of the risk, that is the insurer. When the insurer transfers
part of the risk to the reinsurer, this process is known as ceding.

Cede:
This is passing of business from insurer to a reinsurer
17.4.2 Cedant:
This is the original insurer who passes of part of his risk to a reinsurer.
17.4.3 Cession:
This is the actual amount of business passed by the insurer to the proportional
reinsurer.
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17.4.4 Retrocession
This is a mechanism whereby the reinsurer also reinsures further the risk to other
companies.

17.4.5 Retention
This is the risk that is retained and managed by the insurer. It is sometimes referred
to as “net line”.

17.4.6 Coinsurance
Coinsurance is used to mean more than on insurers sharing in the risk on some
agreed proportions.

17.4.7 Limit:
The maximum amount which an insurer is prepared to lose on a particular risk.
17.4.8 Reinsurer:
An organization which accepts part of the insurance risk underwritten by another
insurer.

17.5 Types and Methods of Reinsurance

(a) Proportional Reinsurance (Pro-rata or participating)
1. Facultative
2. Surplus
3. Quota Share

(b) Non-Proportional Reinsurance

1. Facultative Excess of loss
2. Risk Excess of Loss
3. Catastrophe excess of loss
4. Stop Loss Aggregate Excess of Loss.
The above categories are basically two forms of reinsurance.
(i) Facultative Reinsurance
(ii) Treaty Reinsurance.

17.5.1 Facultative Reinsurance.

Facultative means optional or the power to act according to free choice. Where an
insurer chooses to accept a risk greater than his gross retention, he has to offer the
excess amount to a fellow insurer, called co-insurance, or effect facultative

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 reinsurance. The reinsurer chooses how much to accept at what terms. He has a
right to full disclosure from the reinsured (cedant) in respect of all risk details like:
 Premium rate
 Cedants retention
 TSI/MPL
 Commission rates
 Location
 Claims record etc.
Advantage of Facultative Reinsurance.
The insured is able to:
1. Insure special risks outside the scope of treaties
2. Insure amounts in excess of treaty limits.
3. Restrict own and treaty reinsurers liability where physical hazard of the risk
is abnormally high.
4. Reduce exposures where due to accumulation the insurer is already heavily
committed.
5. Obtain expertise and experience of reinsurer.
6. obtain capacity when volume of business does not justify treaty arrangement
e.g. new lines of business.
7. Sharing of administrative costs with the reinsurer via commission.

Disadvantages:
The following disadvantages are common to Facultative Contracts:
1. High administrative cost and labour intensive as every risk has to be looked
at afresh. This makes it expensive.
2. Cumbersome because each risk is dealt with individually, probably with more
than one insurer.
3. Insurer cannot issue policies immediately because reinsurers have to confirm
first.
4. “Error factor” exists in hasty facultative placement of risks.

17.5.2 Treaty Reinsurance.

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 A treaty is an agreement between an insurer and reinsurer(s) in which the reinsurer
automatically accepts any cessions made by the reinsured so long as they are within
the terms of the agreement. The terms include:-
 Class of business
 Geographical limit
 Size of risk(limit)
 Brokerage Commission
 Taxes
 Period of insurance etc.
Treaties are blind facilities. The reinsured submits periodic summaries of premiums
and claims to the reinsurer. The reinsured is able to make immediate decisions to
accept the risk because automatically cover exists. There are three types treaty
reinsurance: Proportional, Quota and Facultative Treaties.

1) Proportional Treaties
The historical philosophy underlying all proportioned treaties is that if every risk ceded to
the treaty suffered a loss the reinsurer is obliged to pay all those losses.

(a) Surplus Treaties

This is an agreement where the reinsurer agrees to take a portion of each risk in
excess of the retention level of the insurer. This portion is measured by the number
of “lines” agreed upon. For example, if the retention level of the insurer is Kshs.
1,000,000 and the treaty states that the reinsurer (Kenya Re) will take only 5 lines
of the risk, then it can accept up to Kshs. 5,000,000 of the risk written by the direct
writer i.e. a multiple of the retention level. If the direct writer accepts a risk equal to
or less than Kshs. 1,000,000, then the reinsurer will not participate in any risk.

The treaties may be first surplus, second surplus, third surplus and so on. This
means that the insurer may have several agreements with various reinsurers. For
example in addition to Kenya Reinsurance, the insurer may have a second surplus
treaty with PTA Reinsurance Company of 4 lines. If there was a risk written worth
Kshs. 10,000,000, the sharing will therefore be as follows:
Original Underwriter: Kshs. 1,000,000/-
Kenya Re (5 lines) Kshs. 5,000,000/-
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 PTA Kshs. 4,000,000/-
Total Kshs. 10,000,000/-

It is the most common type of proportional treaty. Insurers are obliged to cede all
risks above their retention and the reinsurers are obliged to accept all such cessions.
Parties are “automatically bound in advance” hence a cession to the treaty is of
immediate effect.
Treaty capacity is usually a multiple of the insurers “line” or gross “retention”. A
second, third, fourth and so on treaties can be arranged over others in succession. A
risk must be ceded through each treaty in tern: capacity of first surplus treaty must be
utilized in priority to the second; that of second in priority to the third and so on.
Premium claims and commissions are in the proportion of the amount retained and
ceded.
Assume:
(i) Retention Kshs 10,000,000/ =
(ii) 4 line surplus treaty, Kshs 40,000,000/=
(iii) Therefore gross capacity is Kshs 50,000,000/=

The table bellow would be retained and ceded as hereunder:-

Risk Original sum insured Retention Treaty Ceded to surplus

1 10,000,000 10,000,000 (100%) Nil.
2 25,000,000 10,000,000 (40%) 15,000,000(68.75%)
3 32,000,000 10,000,000 (31.25%) 22,000,000 (58.75%)
4 40,000,000 10,000,000 ( 25%) 30,000,000 (75%)
5 50,000,000 10,000,000 (20%) 40,000,000 ( 80%)

A claim of Kshs. 5,000,000 would be shared as hereunder:-

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 Claim Original sum Company’s Cedes to Claim to
insured Retention (%) Surplus (%) Surplus
5,000,000 10,000,000 100 Nil Nil
5,000,000 25,000,000 40 60 3,000,000
5,000,000 32,000,000 31.25 68.75 3,437,500
5,000,000 40,000,000 25 75 3,750,000
5,000,000 50,000,000 20 80 4,000,000

Example 2:
Assume a 5-line second surplus treaty arranged over Example 1 (giving total capacity of
Kshs 100,000,000) The following risks would be apportioned as hereunder:-

Risk Original sum insured Retention Retains Cession to 1st Cession to 2nd
surplus Surplus
1 50,000,000 10,000,000 40,000,000 Nil
2 55,000,000 10,000,000 40,000,000 5,000,000
3 75,000,000 10,000,000 40,000,000 25,000,000
4 96,000,000 10,000,000 40,000,000 46,000,000
5 100,000,000 10,000,000 40,000,000 50,000,000

Advantages of Surplus
(i) A reinsurer can vary retention upon a particular risk
(ii) Automatic capacity is available
(iii) An insurer is allowed to retain a greater proportion of his income.

Disadvantages
(i) Insurer stands or falls by his chosen retention – keeps high proportion of both
good and bad businesses.
(ii) A surplus treaty is more complicated to administer than a quota share.

2) Quota Share Treaties.

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The ceding company agrees with the reinsurer to share all the risks written in a certain
proportion. For example Kenya Reinsurance Corporation may agree with Kenindia
Insurance Company Ltd to share on 40% to 60% ratio. This means that Kenya Reinsurance
Corporation will be responsible for 40% of all claims made under the treaty and it will take
40% of the premiums less any commissions paid to agents for placing the business plus any
reasonable expenses incurred by the direct writer.

 Kenindia Insurance Company Kshs. 1,000,000

 Kenya Reinsurance Corporation Kshs. 5,000,000
 PTA Reinsurance Company Kshs. 4,000,000

It’s the purest form of proportional reinsurance. Unlike facultative and surplus reinsurance,
quota share protects the cedant’s net retention.
A Quota share therefore reduces reinsured’s retention. Premiums, commissions and claims
are shared in the proportion of the Quota Share. Premiums and commissions levels have to
be carefully negotiated because they could hurt the reinsured’s financial position
irreparably.

Advantages of Quota Share.

(i) Administrative is easy because a fixed proportion is ceded.
(ii) To the reinsurer, there is no selection.
(iii) Flexibility exists to charge the quota share.
(iv) To reinsured unlimited cover against aggregation of loss of one event.
(v) To reserved, it is good for an experimental class of business.
Disadvantages of Quota Share.
(i) Large values of premiums are ceded away because a percentage of every
risk must be ceded.
(ii) It is inflexible because the reinsured can not exercise selection.

3. Facultative Obligation Treaty.

The insurer has option to cede risks to the treaty and the reinsurer has obligation to accept
the cessions. The treaty generates large capacity for small incomes but attracts superior
business because insured will commit themselves on large shares only on the loss of quality
business.
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The treaty offers flexibility to the reinsured and complements existing automatic treaties.
The reinsured has automatic capacity for target risks.

17.5.3. Open Covers

A reinsurer enters into an agreement with another party, usually a broker, to accept
cessions of a given class of business the broker wishes to place with him. This is an “open
cover”. The broker has binding automatically to bind the reinsurer. They can be surplus
quota share and usually cover contentious classes or types of business or under-rated or
non-standard risks.

17.5.4 Non- Proportional Reinsurance

1) Facultative Excess of Loss
A reinsured chooses a fixed monetary amount to retain on a particular risk and arranges
excess protection for any claim amounts in excess of that chosen limit. It’s common for
protection of a reinsured’s retention in estimated maximum loss (EML)
UNDERWIRTING. Some reinsurers prefer to write reinsurances on the business in excess
of the EML, big capacities are possible here. This form of reinsurance is common in the
protection of a captive exposure.

Advantages
(i) Risk is considered individually.
(ii) There is freedom of choice of any risk (reinsured) and accepting or
declining (reinsurer).
Disadvantages
(i) Administration is labour intensive and expensive.
(ii) Full risk details and loss information have to be disclosed.
(iii) Reinsured bears all losses within the retention
(iv) EML factor could be wrong.
2) Treaty Excess Loss.
Premiums would also be shared in the same proportion by all the parties.

This is based on the loss experience by the ceding company. Thus, if the ceding company
experiences a loss in excess of a certain limit, then the reinsurer comes in to pay the excess

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of the amount specified in the treaty. Usually there is a limit of participation by the
reinsurance placed in the agreement above which the reinsurer will not pay.
A reinsure chooses a fixed monetary amount to retain and arrange excess of loss protection
for excess amounts. The arrangements are usually in layers. All layers put together make a
programme.
Example:
Retention Kshs. 5,000,000
1st Layer Kshs. 5,000,000xs 5,000,000
2nd layer Kshs. 10,000,000 xs 10,000,000
3rd Layer Kshs. 30,000,000 xs 20,000,000
Total programme 45,000x5,000,000

Example of loss Recovery

Loss Loss Amount Xs Return 1st Layer XL Recovery 2nd XL Recovery
FGU Layer
1 4,400,000 5,000,000 Nil Nil
2 5,500,000 5,000,000 500,000 Nil
3 7,500,000 5,000,000 2,500,000 Nil
4 9,600,000 5,000,000 4,600,000 Nil
5 10,200,000 5,000,000 5,000,000 200,000

Any loss amounts beyond the programme limit revert to the ultimate net loss of the
reinsured:-
3) Catastrophe Excess of Loss.
Protects a reinsureds account against a loss series of losses arising from the same loss
event. Its usually arranged against disasters like earthquake, windstorm or floods.
There is usually a two risks warranty (loss event must be single) and event hours clause
(e.g. 72 or 168hrs). It’s a cover against aggregation of losses.

4) Working Excess of loss (per Risk x L or “Worker”)

Per risk covers protect individual risks on an excess of loss basis. The deductible is pitched
at such a low level that reinsurers are expected to participate in losses each year.
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5) Stop Loss or Excess of Loss Ratio
The other excess of loss reinsurance protect the reinsured against losses due to a single loss
event (per risk xl) or accumulation of losses from one event (cat.Xl)
Stop loss protects the reinsureds net absolute account against small losses that are relatively
small but have potentially substantial impact on overall loss ration. It prevents wide
financial year compared to another.
Limits are expressed as a percentage amount of the reinsured’s gross net retained premium
income.

6) Aggregates Excess of Loss

Work on the same principle as stop loss but expresses limits in monetary amount. Both
contain the reinsured’s total retained loss.

Example:
Kshs. 10,000,000 in the aggregates xs Kshs. 20,000,000.

17.6 Bases of Reinsurance Cover.

Problems would be caused if there were any gaps or overlaps in reinsurance protection. The
various bases of reinsurance covers are:-
(a) Risk Attaching
On this basis of cover, which is also called policies issued basis, excess of loss
reinsurers assume liability in respect of original policies issued or renewed during the
period of reinsurance (normally one year) provided the inception or renewal data of
an indulging policy falls within the reinsurance year then reinsurers liability attached
to all claims arising from those policies.

(b) Losses Occurring

Under this system of cover the reinsurer assumed liability for claims arising where
the date of loss falls within the reinsurance period. The great merit of this method of
excess coverage is its simplicity. The start and end of period for which reinsurers are
liable is clearly defined.
(c) Losses Discovered or claims made.

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 The bases of cover works for its loss date or the claim is made by the insured. It has
arisen because of the problems of long-tail liability reinsurance a major problem
being the precise identification of when a claim occurred.
The problem for reinsurers providing coverage on this basis is that they can pick up
losses which occurred years before the coverage. The big advantage is that when they
get to the end of the reinsurance period they know that no further claims can be
notified to them in that year.

17.7 Reinsurance Markets

(a) Kenyan
The following companies are found in Kenya:
1. Kenya Reinsurance Corporation
2. African Reinsurance Corporation
3. PTA Re (Zep Re)
4. East Africa Reinsurance Company
5. Swiss Reinsurance
6. Various Insurance Companies which take business from other insurers.

(b) Worldwide
These are some of the common reinsurance markets worldwide:
1. London Reinsurance Market
(i) Lloyds
(ii) International Underwriting Association of London
2. Continental European Market
3. US Reinsurance Market
4. The Bermudan Market.
5. Far East Market (Japan, Australia, New Zealand, Hong Kong)

17.8 Premium Payments

Premium calculations differ for proportional and non-proportional covers. This is of
course due to the fact that in the former the reinsurer knows before hand what
proportion of each claim they will bear. In non-proportional forms this is only known
after the loss has occurred.

17.8.1 Proportional Premiums

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 The reinsurers will receive a premium based on the same proportions in which they
shared the risk, and will share claims, with the direct office. One problem arises,
however, due to the fact that the direct office incurs costs in processing the business
such as survey costs, advertising and administrative charges to meet. In addition in
very many cases it will not have received 100% of the premium as commission will
have been paid to a broker.

To take these factors into account the reinsurer pays commission to the direct office.
This commission will be in excess of the commission paid to the broker by the ceding
office and will be sufficient to cover the procurement costs incurred by the direct
company.

There can also be a profit commission where the reinsurance contract states that
additional commission will be paid to the direct office it the treaty is more profitable
than a specified amount.

17.8.2 Non-Proportional premiums

Premiums for excess of loss ration are a little more difficult to calculate. In non-
proportional covers the actual involvement of the reinsurers is only known after the
losses have occurred.
To overcome this problem a method of rating non-proportional covers known as
burning cost is now popular. Under this method the reinsurer looks over a number of
years and expenses the amount of any payment it would have made in each year as a
percentage of the direct office’s premiums income. The following is an example:-

(1) (2) (3) (4) (5)

Year Direct Office No. of Claims Net cost to Burning cost
Premiums Reinsurers %
1 3,000,000 3 23,550 0.785
2 3,400,000 2 42,500 1.250
3 4,000,000 4 56,000 1.400
4 4,7000,000 3 30,550 0.650

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 The reinsurer now knows that if it had charged these percentages of the direct office’s
premiums as the reinsurance premium then the amount collected each year would
have been “burned up” the claims it would have had too meet. The burning cost
percentage is calculated by expressing column (4) as a percentage of column (2).

The reinsurer will want a little more than the burning cost and will normally base the
percentage it will charge on these past figures and then multiply it by a standard
multiplier such as 100/70ths. This loading is intended to cope with worsening
experience, administration expenses and allow for the reinsurer’s profit.

No commission is usually paid on excess of loss treaties and as the burning costs can
only be calculated in arrears it is usual for the insurer to pay a deposit in advance.

17.9 Inflation
Inflation is a problem which affects all people taking out insurance protection. It is
essential for them to ensure that the level of their cover is adequate to cope with
changes inflation. How is the reinsurer affected by the changes in inflation.

In proportional forms of reinsurance there is little problem a the effect of inflation is

shared between the direct office and the reinsurer. If inflation puts up the cost of a
claim between inception and date of settlement then this extra cost will be distributed
in such a way that all parties will bear a proportion of the extra.

This follows from the fact that the direct office does not pay the percentage of each
risk they run and by calculating their percentage of the claims they automatically
include any amount due to inflation.

In non-proportional covers, however, the office does not pay a percentage of a claim
but has its liability restricted to an actual amount. Where the direct office’s retention
was ₤ 10, 000 and a claim valued at ₤ 7,000 arose soon after inception the full amount
would be met by the company. As inflation increases this same claim will increase in
value and as it does it will soon involve the reinsurer. Some time later, let us say the
claim is now valued ₤ 11,000 solely due to the effects of inflation, the reinsurers are
now involved to the extent of ₤ 1,000. Notice however that no matter how much this
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 claim is inflated the direct will not pay more than ₤ 10,000 in other words the full
effects of inflation is borne by the reinsurers.

This obviously not satisfactory and a clause known as the stability/ index clause is
normally inserted. The effect of this clause is to link the retention of the direct office
to an index which will reflect inflation. A common index for this purpose is the index
of commercial and industrial wages. An example will best illustrate the operation of
the clause.

Direct office retention: ₤ 10,000

Index at inception: 140
Claims settled at: ₤ 18,000
Index at date settlement: 154.

Direct office retention at

Date of claim settlement ₤ 10,000 x 154/140 = ₤ 11,000
Reinsurer(s) pay: ₤7,000
The index shows an inflation rate of 10% from inception to the settlement. The direct
office’s retention is increased by this 10% to ₤11,000.

17.10 Applications of Reinsurance.

Our knowledge and understanding of how reinsurance can be used to its best
advantage is always increasing and it is not possible to state with absolute certainty
what forms of reinsurance are best for particular classes of direct insurance business.

It is possible to give some guidance based upon the two divisions of reinsurance
already described, i.e. proportional and non-proportional. As we saw, proportional
reinsurances depended upon accepting a proportion of risk, paying claims in the same
proportion and charging a premium that was the same proportion of the direct
insurer’s premium. This is only possible where the extent of the risk is known before
beforehand, as in property insurances. In case of liability business, however, there is
no reasonably foreseeable limit to the amount which may have to be paid and for such
forms of direct insurance the non-proportional reinsurance are more appropriate.

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17.10.1 Property
Proportional forms of reinsurance are most common in the property field, as in most
cases there is a fixed sum insured upon which a proportion can be calculated. Surplus
and quota share treaties are used widely in the property market with facultative
catering for risks excepted by the reinsurers or for catastrophe cover. Excess of loss
reinsurance is now becoming more common in the property field as a result of the
American Influence on the British market.

17.10.2 Liability
Excess of loss reinsurance is used almost exclusively by liability insurer as it relies
on the values of claims as opposed to a proportion of the risk. In addition to straight
forward liability insurance, the excess of loss from of reinsurance can also be applied
to the liability sections of other policies, e.g. motor.

17.10.3 Marine and aviation.

Marine and aviation risks are really a combination of property and liability insurance
and, for this reason, direct insurers must arrange insurances to suit such perils.
Facultative reinsurance is still common in the marine market with quota share and
excess loss also being employed. The catastrophe element attached to marine and
aviation risks must also be catered for and the pooling method of reinsurance, referred
to above can be used.

17.10.4 Life and personal accident.

As might be expected, the reinsurance arrangements for life and personal accident
contracts are slightly different from those is the non-life field.

It is common to refer to “reinsurance” for these long term contracts in line with the
use of the term life “insurance”.
For ordinary life assurance risks, reassurance may be arranged on a facultative or
treaty basis, the difference between reassurance and reinsurance lies in the basis upon
which reassurance is provided. Two options are available. Original terms and risk
premium basis. In the furrier, the reassure(s) divided the total premium and sum
assured in a given proportion, with the reassurers following all the terms and

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 conditions of the direct office’s policy, as the chance of the assumed dying is very
low, and receives more of the premium as the years pass.

Particular reassurance pools are in existence for substandard lives such as those
assureds with a history of diabetes, high blood pressure or coronary heart disease

17.11 The Functions of Reinsurance

Reinsurance plays a very important role in the insurance industry and in the
economy as a whole. Let us look at a few of these functions:

17.11.1 Spreading of risks

It would have been catastrophic if insurers undertook to manage all the risks that
they write. Through the reinsurance and retrocession processes, the risks are shared
amongst many companies, and therefore the impact may not be as severe if a
catastrophe occurred.

Geographical Spread of Risk.

The basic principle of insurance and reinsurance is to make the law of large
numbers operate as far as possible by achieving a “spread” of risk.
The reinsured retains what he can be able to pay and pass over the balance to the
reinsurance all over the world, a company’s reinsurance acceptance could be so
controlled as to attract business from oversees. This can be done by reciprocal
exchange of business. Thus by spread of risk through reinsurance an insurance
company will be able to diversify the balance its portfolio.

It should be noted by the student that a locally placed risk may be found spread all
over the world. Insurers and the insured are able to have a peace of mind knowing
that the risks that face them are well taken care of.

17.11.2 Improvement on Reserves

This is not a very obvious function. Financially and legally, an insurer and even the
reinsurer, is expected to maintain a certain level of reserves to hedge against the
unearned premiums.
Unearned premiums means that premiums cannot be regarded as income as
long as the period of coverage has not lapsed.
As premiums grow, so do the required reserves. Without reinsurance, insurance
companies may be required to keep very high reserves.

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17.11.3 Affords Insurers to take on Large Risks
Reinsurance makes it possible for the insurers to take larger risks more than they
would have if there was no reinsurance. In this respect, the insuring community is
able to seek protection for the risks that they are exposed to. In Kenya especially,
reinsurance made it possible for small and upcoming insurance companies to
venture into the insurance business. At the same time, it provided confidence in the
public regarding insurance.

17.11.4 Promotes Good Underwriting Practices

Although insurers have the sole responsibility of selecting the risks that will
eventually end up with a reisurer or retrocession, the insurer cannot afford to take
all poor risks knowing very well that some of it will go further scrutiny by the
reinsurer, especially in the facultative contracts. This is because if the insurers
written business were to be rejected by the reinsurer, then all the burden will be
upon such insurer, and a loss occurs it would wipe out the insurer.

17.11.5 A Source of Income for Investment

The premiums generated through reinsurance is available for investment and
therefore in economic development of the nation. Before local reinsurance came
onto the scene, all reinsurance business was done abroad, meaning that premium
income was used elsewhere.

17.11.6. Source of Employment

Reinsurance companies provide employment opportunities to the citizen. From the
employment, many economic benefits accrue. For example, families and
individuals earn an income for personal welfare and participation in economic
activities of their own choice. Many are able to meet their basic needs and this
enable the country to have healthy, educated and active people.
1.
17.11.7 Providing Capacity.
A company grows only when it has sufficient capacity to accept risks with larger
sums involved. Growth means a process of going beyond capacity steady growth
and stability can be achieved only with creation of capacity for the reinsured as a
result of insurance facility. If he/she was no insurance the insurer will be able to
accept only small sums insured.

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The following diagram explains the transaction:

Risk past to
Proposed Insurer Reinsurer
Original
Insurer

Risk Retains 10,000,000 Reinsurer

Ksh 50,000,000 Cedes 40,000,00 Accepts
40,000,000

17.11.8 Financial Advantage

Reinsurance boosts capacity and allows underwriting to write a larger line on business than
they would with just a net balance acceptance.

(i) An underwriting who is offering a small line to the market, receives

much less income than organization offering larger capacities.
(ii) Administration costs of management expenses are very similar for a
small or lager acceptance. Writing a large line boosted by insurance
promotes efficiency in administrative costs.

(iii) A third financial advantage is through reinsurance commission where

the cedant gets a contribution from reinsurance towards the costs of
acquiring of business and management expenses.
1711.9 For conservation of Foreign Exchange
in developing countries professional reinsurance companies are formed to prevent
foreign exchange drain when Insurance in foreign markets. As reinsurance is an
international trade. It can conserve, preserve and earn foreign exchange for the
country.

17.11.10 Catastrophes
The direct insurer is insurer is directly exposed from the possibility of complete
catastrophe through which it may even go out of business. By purchasing
reinsurance it thus transfer the risk to the insurer. Catastrophe may occur due to:

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 (i) Accumulation of risk i.e. Commercial Premises adjacent to each other and
the risk of fire spread.
(ii) Exposure to catastrophe perils e.g. earthquake.

17.11.11 Professional Expertise and Co-operation.

Professional insurer also play a very important role in giving technical advise. They
also organize technical training courses and international seminars.

17.12 Coinsurance
Coinsurance means sharing of the risk on some equitable or agreed manner, thus the
writing company requests another company to jointly take the risk and share the
premiums and any loss that may occur. This is very common in life insurance.
The student should also note here that reinsurance is not necessarily between an
insurer and a reinsurer. It may be between an insurer and an insurer. We have some
insurance companies that are financially stable and can be able to reinsure risks ceded
to it by another insurer. There are even larger insurance companies around the world
that can also take business from reinsurance companies in retrocession. This is a
common practice.

17.13 Commissions
In most of the cases, the insurer acts as an agent in the reinsurance business.
Therefore a commission is usually paid to the insurer for placing business with the
reinsurer.
17.14 Record-Keeping and Payment of a Claim
When a claim occurs, the insured does not have to deal with the reinsurer. He
makes his claim directly to the insurer. Depending on the nature of the claim, it is
upon the insurer to process the claim and pay the insured and in turn claim from the
reinsurer. Both the insurer and the reinsure must maintain proper records of claims
lodged and claims paid. They must also keep proper records of earned and unearned
premiums.

17.15 Reinsurance Companies in Kenya

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 The reinsurance business in Kenya is fairly recent. The first local reinsurance
company in Kenya was the Kenya Reinsurance Corporation, which was created under
an act of parliament in 1978. The purpose of the Kenya Re as popularly known, was
to create an avenue to provide capacity for the companies that were newly formed in
Kenya. A majority of reinsurance business at this time was placed abroad.

To-date (2007), we have three other reinsurance companies operating business in

Kenya. These are: PTA Reinsurance, Africa Reinsurance Company and the East
Africa Reinsurance Company. The market share of these four reinsurance companies
is very minimal. Only 10% of business is reinsured locally while the rest is insured
abroad.

17.16 SUMMARY
From the foregoing, we can now appreciate what we referred
to in the earlier chapters regarding risk management. We have
seen that the insurance mechanism is one way of managing
risks.
Reinsurance even improves the process of risk management because through it risks
are diversified and shared by many. In this case no single insurer may suffer a loss
alone. Also, the insureds can rest assured that when a loss occurs, many people will
participate in compensating him.
The various treaties discussed above, are a means of ensuring that many options are
available in the management of risks. These arrangements also ensure that no one
reinsurance company is forced to deal in only one form of contract. As we have seen,
reinsurance is a very recent phenomenon in Kenya (1978). However, this is not to
mean that risks from Kenya were never reinsured. During the pre-independence
period, most insurance business were transacted outside Kenya and therefore all
reinsurance business was also transacted outside Kenya.

We have seen some of the economic and social benefits of reinsurance. The student
should recognize these benefits. Reinsurance is a business and therefore it must
accrue benefits to the owners, the insuring community and society as a whole.

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 ACTIVITY

1. Define the following as used in reinsurance business: net

line, ceding, retrocession.
2. Explain how the following methods of reinsurance work:
Facultative Agreements, Excess of Loss Treaty, Quota
Share Treaty.
3. What are the functions of reinsurance in general and how
has the reinsurance business impacted on Kenya?

References

1. Vaughan, Emmet J: Fundamentals of Risk and Insurance, 5th

Ed. John Wiley & Sons NY 1989.
2. Modern Concepts of Insurance; Mishra M.N., S. Chand &
Company Ltd. ,Ram
Nagar, New Delhi, 2004
3. Insurance, 4th Ed. Holyoake Julia and William Weipers.
Institute of Financial
4. Services U.K, A.I.T.B.S. Publishers & Distributors (Regd)
Delhi-51 (2005)
5. Success in Insurance. Diacon S.R and R.L. Carter. John
Murray (Publishers) Ltd (1998)
6. Risk Management: Carter R.L , C.I.I Tuition Service Study
Course 313, London

LECTURE 18

MARKETING OF INSURANCE

18.0 INTRODUCTION
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 Marketing is one of the most important functions of any organization. It is from this
function that any business is able to make an income. The insurance market is
therefore a mechanism where sellers and buyers of risk coverage meet. Like any
other market, the insurance market consists of sellers, intermediaries and other
specialized service providers. The uniqueness of the insurance market is in its
dealing with uncertainties.

18.1 OBJECTIVES
 Describe marketing environment
 Identify functions of marketing insurance and techniques
used
 Apply the knowledge to insurance
 Understand broking and its role in insurance marketing.
 Understand an urgent and his role.
 An appreciation of cooperative bodies in the insurance
industry

18.2 Dynamism of marketing.

Virtually all of the products and services we buy or use are the result of some
elements of marketing activity. Consciously and unconsciously we are bombarded
with consumer information that at times we don’t need to be coerced to buying a
product or a service such as insurance by a salesman. This has been achieved
through:-
- Access to consumer information
- Improved communication (Electronic and print media)
- Elaborate displays of products and services.
- State of the art technology
- Improved technologies of advertising especially affecting the mind.
- Quick respond to consumer needs.
- Improve pricing.
- Availability of alternative products and services through competition.

18.3 What Is Marketing

Some Definitions:
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 1) Marketing is a social process by which individuals and groups obtain what they
need and want through creating and exchanging (and services) and value with
others.
2) The Marketing concept is a philosophy, not a system of marketing or an
organizational structure. It is founded on the belief that profitable sales and
satisfactory returns on investment can only be achieved by identifying and
satisfying customer needs and desires.
3) Marketing is the primary function which organizes and directs the aggregate of
business activities involved in converting purchasing power into effective
demand for a specific product or service and in moving the products or services
to the final consumer or user so as to achieve company set profit and other
objectives.
4) Marketing is the management process which identifies anticipates and supplies
consumer requirements efficiently and profitably.

18.4 Principles Comprising Marketing Of Insurance

 Marketing focuses attention towards the needs and wants of the market place.
 Marketing is concerned with satisfying those needs and wants.
 Marketing involves analysis planning and control.
 Marketing should tell us that business decisions must be made with a careful
and systematic consideration of all the customer.
 Marketing led business are concerned with meeting customer needs and wants
and obtaining satisfaction Not selling to them.
 Marketing is dynamic, that is it must respond and react to changing trends and
cannot therefore be static. It therefore requires action and review as well as
planning.
 Marketing led organizations require specific systems of management.
 Marketing cannot just be specific function within a business, it must be the
basis of understanding philosophy of the business. i.e. identity of the business.

Note: Marketing is both a functional area of management and a business

philosophy.

18.5 What Does Marketing Do?

Identifies and measures:-
Needs – Basic requirements
Wants – Changed or refined needs conditioned by experience
Drives – Desires.
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18.6 Approaches To Marketing Business
18.6.1 Product-Led
This type of firm/business tend to look inwards and is concerned with:-
 Producing existing products efficiently.
 Developing products which meet its requirements and constraints.
 Selling the products it has made to whoever it can find to buy them.
Note:
Business that put emphasis on product have little emphasis on sales and the
consumer. Emphasis is on effective production.

18.6.2 Sales-Led
This philosophy is based on the precept that demand could be created by sales
techniques and that the selling organization is the key to future prosperity.
Sales led philosophy has led to development of techniques such as:-

 Branding
 Product differentiation
 Advertising
 Sales promotion’s
 Free gifts etc
Selling theory is based on three precepts:-
 Customers can be persuaded to buy more through sales techniques.
 Customers have a resistance to purchasing and the sales persons
should overcome this.
 The key task of the business is to organize an effective sales efforts.

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18.6.2 High Pressure selling
We have all experienced High pressure selling, especially in certain types of
insurance such as life- insurance. That is why sometimes we refer to life insurance
being “sold” rather than “bought”

High pressure selling, though it sometimes meets consumers needs it can be

destructive and may ruin the prospects of repeat selling.

18.6.3 Marketing-Led
A marketing led company places the customer at the heart of the business and the
function of identifying and fulfilling that customer’s needs becomes central to the
organization. The Marketing Department of such an organization is placed at the top
of the organizational structure.

Managing Director

Production Marketing Finance

Advertisement Sales Marketing Research

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18.6.4 Difference between Marked led and Sales led Business

MARKET LED SALES LED

Focuses on needs of buyer Focuses on the needs of seller
Focuses on satisfying needs of the Preoccupies with sellers needs to
customer by means of the product and convert production into cash.
the whole cluster of things associated
with creating, delivering and finally
consuming it

18.7 Development of Insurance Market.

18.7.1 Early Development
- The oldest form of Insurance was the Marine Insurance having been crafted
by the Lombards in the 13th centaury. The form of coverage that existed were
almost like a merger between the financier and the owner of a ship. Through
experience and interaction of the law the more refined contracts were
developed with the operation of the principle of Insurable Interest coming into
play.
- Progressively though Tudor times (1485-1603) there was tremendous growth
in overseas trade, which brought with it increasing demand for marine
insurance.
- Initially there was direct contract between the insurer and the insured
especially if the business was simple.
- When the business was complicated, the insured would seek the advice of
intermediaries who were familiar with international trade and the types risks
and coverage required.
- Policies were not really standard and at each time a policy would be drafted
to suit the business at hand. These were drafted by people referred to as
“Notaries”.
- These notaries and other groups in essence hawked around for people who
would be willing to have a stake in any maritime trade by taking
(understanding) or proportion of it. This was the beginning of brokerage
business.
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 - It is through this type of business that the famous Llyod’s London was
established and is still the most re-known brokerage firm to this day.

18.8 Types of Insurance Companies

The insurance industry comprises of various types of companies that sell insurance
products. Let us look at some of these companies:
18.8.1 Proprietary Companies:
These are companies owned by shareholders who appoint directors and managers to
run them on their behalf. They must be registered under the Insurance Act 1984
(Laws of Kenya)

18.8.2 Specialist Companies

The specialist companies specializes in one particular line of insurance business, or
a limited number of insurance business. For example the Old Mutual Life Assurance
Co. Ltd specializes in life business. Other companies may specialize in non-life
business of a particular type or all of them.

18.8.3 Composite Companies

They underwrite several classes of business, life and non-life. They may also provide
management of pension schemes and annuities.

18.8.4 Captive Companies

Captive insurance means internal self-insurance. A particular organization, not
necessarily an insurance company, may decide to provide coverage of risks facing its
organization including its subsidiaries or units. Such an organization need not turn to
a formal insurance company for coverage. It is captive in the sense that it does not
provide coverage to other organizations or the public. For example, the National
Christian Council of Kenya (NCCK) may decide to ask its member churches to come
together and contribute resources for coverage of their various risks. In this way they
achieve reductions in premiums they would have paid to a commercial insurer.
18.8.5 State Owned Companies
These are companies that are created by an Act of Parliament to serve a particular
purpose. Insurance parastatals were fairly common at independence and their
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 functions were discussed earlier. Kenya National Assurance Company was such a
company though it went under due to mismanagement. Kenya Reinsurance Company
is another example. Today there is a move towards privatizing these companies
because the Government’s function is not to engage in business.

18.8.6 Mutual Companies

These are companies owned by certain members, usually by policyholders. Unlike
the shareholding companies where the shareholders may not necessarily be
policyholders, the policyholders or a specific group of individuals with a common
goal or purpose owns the Mutuals.

18.8.7 Reinsurance Company

Remember the topic on reinsurance? This is a company that insures the insurer. hus
it provides a market for the risk undertaken by the insurer.

18.9 Intermediaries
18.9.1 Brokers
Definition of Brokers.
Persons who, acting with complete freedom as to their choice of understanding bring
together with a view to the insurance or reinsurance of risks, persons seeking
insurance or reinsurance undertakings, carry out work preparatory to the conclusion
of contracts of insurance or reinsurance and where appropriate, assist in the
administration and performance of such contracts, in particular in the event of a
claim.

Brokers are expected to be experts in all insurance matters. In essence they act on
behalf of the customer- the insured. The broker deals with many insurers

Expertise: The broker will understand the market and is expected to match the
customer needs to what is available.
Convenience: It is simpler and efficient for the broker to canvas a wide
range of markets than the insured.

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 Cost: The broker can achieve the lowest cost commensurate with quality of service
and security.
Service: Brokers will offer services such as claim processing.
Fees/ commission
In early times, brokers charged a fee to their customers until the advent of the Lloyds
Today, it is the insurer who pays a commission to the broker.

Business Engaged in
Traditionally and the very nature of insurance business, most brokers engage
themselves in non-life business. this is so because non-life business area straight
forward and short-term.
Experience in Kenya
Brokerage Business in Kenya is as old as the insurance business. In Kenya today, we
have both small and large brokerage firms doing mostly non-life business. They may
also be engaged in certain life business such as group life insurance.

Requirements
The Insurance Act requires that to start a brokerage business, you must not only have
a business license, but must be professionally qualified. This therefore brings into the
business professionalism and quality.

18.9.2 Agents
An agent is an employee of the Insurer i.e. he acts on behalf of the insurer.

Type of Business.
An agent deals in most cases in Life and pensions business. Life business needs a lot
of pushing before a sale is realized.
Types of Agent
- Insurers will appoint agents according to their needs and objective to be
achieve.
- Sales-led techniques seems to be practiced by many insurers

Captive Agent

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 This is the agent who acts only for a specified insurer. He is not allowed to do
business for another insurer. However, in Kenya today, the law allows an agent to do
business for a maximum of three principals. There is a move to increase this number,
but time will tell. Can you perhaps imagine reasons why it would be prudent to have
an agent only dealing with one principal?

Independent Agent
Operates independently, but given specific responsibility e.g. in charged of a
particular region. He operates on a commission.

18.9.3 Direct Marketing

Insurance business can also be marketed directly without going through the
intermediaries. That is direct placement of business through the insurance company
by the insured.
The advantages of using direct placing are that:
 There is savings for the insurer in terms of commissions which would have
been paid to the agent or broker.
 The insurer can have a first hand assessment of the risk as he deals with
insured directly.
 The insured on the other hand can be able to receive first hand information
about the coverage and benefits under the policy.
 There is no delay in preparing the policy as premiums are paid directly to the
insurer.
The disadvantages include:
 The insurer is forced to incur costs of hiring staff to deal with insureds.
 The insurer may not have an access to information that would help him assess
the risk appropriately.
 The insured does not have the benefit of the experiences the broker or agent
has in the market.
 Competitive premiums may not be available to the insured if he only goes to
one insurer.

18.9.3.1Company Branch Office

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 A branch office may be in charge of a particular region. It receives applications and
premiums for coverage, processes them and delivers them to the head office for
further processing and issuance of the policy document. Payments of future premiums
may also be done at the branch office for policyholders in that region.

18.10 Premium Payments

On filling the proposal form, the first premium must be accompanied with the form.
As soon as the receipt is issued for the first premium, the contract of insurance is
concluded. The policy can then be processed and delivered to the insured. Depending
on the contractual agreement and as stated in the proposal form, premiums must be
paid on the dates stated. Non-payment may lead to the lapsing of the insurance
contract.

18.11 Cooperation in the Insurance Industry

The industry generates a lot of competition. In Kenya for example, we have well over
40 insurers. This is a very large number of players. As a result, there must be some
order in the manner in which these companies operate. Some of the key players in
bringing order in the industry are as follows:

a) Commissioner of Insurance (IRA):

Remember we discussed this earlier, but for purposes of a reminder, the
Commissioner’s responsibility is to register and licence the insurer. He also insures
that the insured is treated fairly by the insurer by for example not overcharging in
terms of premiums and that claims are paid when they are due among others.

b) The Association of Kenya Insurers (AKI)

 This is a voluntary, independent and non-profit making body which is consultative
and advisory in nature. It comprises insurance companies transacting business in
Kenya. The objectives of AKI are as follows:
 Bringing together insurers transacting insurance business in Kenya
 Promoting the advancement of, and put on a sound basis, the insurance business in
Kenya.
 Deal with general matters that affect the insurance industry.
 Create a better understanding of insurance among all sections of the community.
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 Avail opportunities for consultation and cooperation on any matter affecting the
common interests of its members.
 Provide technical services through its technical committees.
 Act as a medium of consultation and communication with the government, or any
party, on matters affecting the insurance industry.
 Gather and collate market-wide statistics from its members; and
 Administer the provision of motor insurance certificates

c) The Association of Insurance Brokers of Kenya (AIBK)

Like AKI, the AIBK is a lobby group of insurance brokers who have met the legal
requirements of carrying out insurance brokerage business. There are about 200
registered brokers in Kenya today (2006) and slightly over 50% are members. The main
objectives of the association are:
 To ensure that its members adopt sound insurance practices.
 To take action whenever interests of its members are threatened by way of legislation.
 Arbitrates or settles disputes between its members and insurers or third parties.
 To support it’s members on legal issues.
 To contribute to social worthy causes
 Cooperate with other bodies having similar objectives.

d) The Kenya Insurance Agents Association

Like the brokers, the Kenya Insurance Agents Association is a voluntary association of
agents transacting insurance business in Kenya. Its main objective is to promote the
agents professional welfare by representing the interests of its members and to negotiate
with the government and the Association of Kenya Insurers (AKI) on policies relating to
and legislation affecting insurance agents.

e) Other Co-operative Bodies

Other co-operative bodies of mutual interests include: Livestock Insurance Group, The
Aviation Underwriters of Kenya, Kenya Engineering Insurance Group. These groups as
their names suggest, deal with issues unique to their class of insurance. They for example
arrange for common pools that solicit for reinsurance.

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 All these bodies contribute tremendously to the marketing of the insurance products and
ensure that professionalism is practiced in the industry. They are also expected to act as
self regulating bodies in all aspects of insurance.

18.12 SUMMARY
This chapter has looked at various aspects of selecting the risk and
rating it (underwriting), marketing it and dealing of claims. These are
important functions of any insurance company. Underwriting is so
important that if the company is careless in the selection, classifying
and rating of the risk (premium computation) properly it may find that
it is unable to meet its obligations (claims and owners needs).

Marketing on the other hand ensures that the insurance products meet the needs of
consumer (insured). The various channels discussed above should be able to make this
possible. As we have seen marketing is not just a selling concept, but through it the
philosophy of the company is also sold.

Claims administration is also important. Just as much as marketing sells the company so
does a good claims administration approach. Before a claim is made appropriate
investigations should be made to ensure that policy conditions and terms have been
adhered to by the insured, while at the same time timely payment of claims is encouraged.

ACTIVITY:
1 State the reasons why we say that marketing is dynamic
2. Give one definition of marketing
3. Explain and relate the principles of marketing to the
insurance market in Kenya
4. Differentiate between the three marketing approaches
discussed in this chapter
5. What do you understand by the term “High Pressure
Selling”?
6. Discuss the various intermediaries used in the marketing of
insurance stating their respective advantages and
disadvantages

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 7. Discuss some of the supporting institutions in the insurance
industry.

References
1. Vaughan, Emmet J: Fundamentals of Risk and Insurance, 5th Ed.,
John Wiley & Sons, NY 1989
2. Easton C and J. Fyfe: Personal Insurance, Claims, Marketing and
Management. The Chartered Insurance Institute Study Course
605, Mackays of Catham,Kent 1991
3. Green, Mark R and Oscar N. Serbein: Risk Management: Text
and Cases, Boston Publishing Company, Reston Virginia 1983

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