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INTRODUCTION TO INSURANCE AND RISK MANAGEMENT

Definition of fundamental terminologies

Insurance

There are no certainties or guarantees in life. There is no guarantee that the business will not
suffer an unexpected loss or damages. So while we cannot protect our interests against all risks,
we can opt for some insurance.

Insurance is defined as a contract, which is called a policy, in which an individual or organisation

receives financial protection and reimbursement of damages from the insurer or the insurance
company. At a very basic level, it is some form of protection from any possible financial losses.

The basic principle of insurance is that an entity will choose to spend small periodic amounts
of money against a possibility of a huge unexpected loss. Basically, all the policyholder pool
their risks together. Any loss that they suffer will be paid out of their premiums which they pay.

Insurance can be defined from the view point of several disciplines such as law, economics etc.
The Commission on Insurance Terminology of the American Risk and Insurance Association
defines insurance as the pooling of fortuitous losses by transfer of such risk to insurers, who
agree to indemnify insures for such losses to provide other preliminary benefits on their
occurrence, or to render services connected with risk.

Insurance is a risk-reducing investment in which the buyer pays a small fixed amount to be
protected from a potential large loss. On the other hand gambling is a risk-increasing investment,
wherein money on hand is risked for a possible large return, but with the possibility of losing it
all.

Purchasing a lottery ticket is a very risky investment with a high chance of no return and a small
chance of a very high return. In contrast, putting money in a bank at a defined rate of interest is a
risk-averse action that gives a guaranteed return of a small gain and precludes other investments
with possibly higher gain.

An insurance policy is a legally binding contract between an insurance company and the person
who buys the policy, commonly called the "insured" or the "policyholder."

In exchange for payment of a specified sum of money, called the "premium," the insurance
company agrees to pay the "beneficiary" (or for some benefits, the "owner") of the policy a fixed
or otherwise determinable amount of money, if circumstances that are set out in the policy,
occur.

Another way of looking at insurance is to consider that it is a group of people getting together
and paying on a regular basis into a 'pooled' account. If any of them need to claim off the

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insurance because of some personal calamity, the money is there to enable this to happen. In that
way, insurance serves as a risk transfer mechanism by which people or businesses can shift some
of their uncertainties or risks to the insurance companies.

The insurance companies charge a fee, known as a premium, for accepting these risks, and in
return, agree to pay for the financial losses that the policyholder may suffer.

Basic insurance definitions

1. Application – The first questionnaire an insurance applicant fills out when he applies for
insurance. This form will ask for information about the applicant and the subject to be
insured (i.e., the applicant’s car, houses, personal property, etc.).

2. Cancellation – The termination of insurance coverage during the policy period. This is
further divided into three types of cancellations:

i. Flat Cancellation – The cancellation of a policy as of its effective date, without any premium
charge.

ii. Pro-rata Cancellation – When the policy is terminated at midterm by the insurance company,
the earned premium is calculated only for the period for which the coverage was provided. For
example:

An annual policy with a premium of $1,000 is canceled after 40 days of coverage at the
company’s election. The earned premium would be calculated as follows:

Earned Premium = 40/365 days x $1,000

Earned Premium = .110 x $1,000

Earned Premium = $110

iii. Short-rate Cancellation – When the policy is terminated prior to the expiration date at the
policyholder’s request, then the earned premiums charged would be more than the pro-rata
earned premium.

Generally, the return premium would be approximately 90 percent of the pro-rata return
premium. However, the company may also establish its own short-rate schedule.

3. Decline – This refers to a situation when the company refuses to accept the request for
insurance coverage.

4. Effective Date – This is the date on which the insurance policy begins.

5. Expiration Date – This is the date on which the insurance policy ends.

6. Insurance Agent – A person authorized by, and acting on behalf of the insurer, to transact
all classes of insurance that the insurance company is licensed to sell.

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Other terms used in Insurance

Insured

The party or the individual who seeks protection against a specified task and entitled to receive
payment from the insurer in the event of happening of stated event is known as insured. An
insured is normally in insurance policy holder.

Insurer

The party who promises to pay indemnity the insured on the happening of contingency is known
as insurer. The insurer is an insurance company.

Beneficiaries

The person or the party to whom the policy proceeds will be paid in the event of the death or
happening of any contingency is called beneficiary.

Contract

An agreement binding at law between two or more parties is called contract.

Premium

The amount which is paid to the insurer by the insured in consideration to insurance contract is
known as premium. It may be paid on monthly, quarterly, half yearly, yearly or as agreed upon it
is the price for an insurance policy.

Policy

The insurance contract and all attached endorsements, including type of insurance coverage, the
limits paid for particular loss and the amount the insured paid in premium.

Insured sum

The sum for which the risk is insured is called the insured sum, or the policy money or the face
value of the policy. This is the maximum liability of the insurer towards the insured.

Peril

A peril is an event that causes a personal or property loss by fire, windstorm, explosion, collision
premature death, sickness, floods, dishonesty etc.

Hazard

Hazard is a condition that may create, increase or decrease the chances of loss from a given peril.

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Indemnity

Compensation for actual loss suffered is call indemnity.

Exposure

An exposure is a measure of physical extent of the risk. An individual who owns a business
house may be subjected to economic loss and individual loss because of his business and
personal exposure.
Insurance companies in Kenya

 Jubillee

 ICEA/Lion Group

 APA

 AAR

 Britam

 CIC

Insurance Loss Exposures

What is meant by exposure in insurance?

This refers to the state of being subject to loss because of some hazard or contingency. Also used
as a measure of the rating units or the premium base of a risk.

A loss exposure is any situation or circumstance in which a loss is possible, regardless of

whether a loss occurs. Examples of loss exposure include manufacturing plants that may be
damaged in an earthquake or flood, defective products that may result in lawsuits against the
company, theft of company’s property because of inadequate security.

In the past, risk managers generally considered only pure loss exposure faced by the firm.
However, newer forms of risk management are emerging that consider both pure and speculative
loss exposures faced by the firm.

Risk, in insurance terms, is the possibility of a loss or other adverse event that has the potential to
interfere with an organization’s ability to fulfill its goals, and for which an insurance claim may
be submitted.

Risk management ensures that an organization identifies and understands the risks to which it is
exposed. Risk management also guarantees that the organization creates and implements an
effective plan to prevent losses or reduce the impact of losses.

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A risk management plan includes strategies and techniques for recognizing and confronting these
threats. Good risk management does not have to be expensive or time consuming; it may be as
uncomplicated as answering these three questions:

i) What can go wrong?

ii) What will we do, to prevent harm from occurring or our response to the harm or loss if it does
occur?
iii) If something happens, how will we pay for it?

Elements of an insurance transaction

Four elements are required for an insurance transaction

(i) A contractual agreement

(ii) A premium payment
(iii) A benefit payment occasioned by circumstances defined in the insurance contract
(iv) The presence of a pool of resources held by the insurer to reimburse claims

Characteristics of Insurance

i) Pooling of losses

Pooling is the spreading of losses incurred by the few over the entire group, so that in the process
average loss is substituted for actual loss.

Pooling or sharing of losses is the heart of insurance.

Pooling involves the grouping of a large number of exposure units so that there is:

a) The sharing of losses by the entire group

b) Prediction of future losses with accuracy based on the law of large numbers the law of large
numbers can operate to provide a substantially accurate prediction of future losses.

Pooling ensures that units/people/policy holder contribute a small amount as premium. In the
event of a loss to a unit/policyholder, the amount can be paid out of the pooled/contributed
resources.

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ii) Payment of fortuitous losses

A fortuitous loss is one that is unforeseen and unexpected and occurs as a result of chance. In
other words, the loss is accidental.

iii) Risks Transfer

Risk transfer means that a pure risk is transferred from the insured to the insurer, who typically is
in a stronger financial position to pay for losses than the insured.

From the view point of the individual pure risks that are typically transferred include the risk of
premature death, poor health, disability, destruction and theft of property and personal liability
law suits.

iv) Indemnification

Indemnification means that the insured is restored to his/her approximate financial position
before the occurrence of the loss.

Thus if one’s home burns in a fire, a home owner’s policy will restore him/her to his/her
previous position and not more.

v) Requirements of an Insurable Risk

Insurers normally insure only pure risks, but not all pure risks are insurable, certain requirements
must be fulfilled before a pure risk can be insured.

Risk

Risk is a concept that denotes a potential negative impact to some characteristic of value that
may arise from a future event, or we can say that "Risks are events or conditions that may occur,
and whose occurrence, if it does take place, has a harmful or negative effect".

In everyday usage, risk is often used synonymously with the probability of a known loss.

Risk is described both qualitatively and quantitatively. In some texts risk is described as a
situation which would lead to negative consequences.

Qualitatively, risk is proportional to both the expected losses which may be caused by an
event and to the probability of this event occurring.

Quantitatively, risk is often mapped to the probability of some event which is seen as
undesirable. Usually, the probability of that event and some assessment of its expected harm
must be combined into a believable scenario (an outcome), which combines the set of risk, regret
and reward probabilities into an expected value for that outcome.

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Risk Management

Risk management involves identifying, analyzing, and taking steps to reduce or eliminate the
exposures to loss faced by an organization or individual.

The practice of risk management utilizes many tools and techniques, including avoiding,
assuming, reducing, transferring or insurance, to manage a wide variety of risks.

Every business encounters risks, some of which are predictable and could be controlled by
management, and others which are unpredictable and uncontrollable.

Steps in the Risk Management Process

There are four steps in the risk management process:

a) Identify loss exposures

b) Analyze the loss exposures
c) Select appropriate techniques for treating the loss exposures
d) Implement and monitor the risk management program.

1. Identifying Loss Exposures

The first step in risk management process is to identify all major and minor loss exposures. This
step involves analysis of all potential losses.

Important loss exposures relate to the following:

i) Property loss exposures

- Building, plants , other structures
- Furniture, equipment, supplies
- Computers, computer software, and data
- Inventory
- Accounts receivable, valuable papers and records
- Company planes, boats mobile equipment

ii) Liability loss exposures

- Defective products
- Environmental pollution (land, water, air, noise)

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- Sexual harassment of employees, discrimination against employees, wrongful termination
- Premises and general liability loss exposures
- Liability arising from company vehicles
- Misuse of the internet and e-mail transmission, transmission of pornographic material
- Directors’ and officers’ liability losses

iii) Business income loss exposures

- Loss of income from a covered loss
- Continuing expenses after a loss
- Extra expenses
- Contingent business income loss

iv) Human resources loss exposures

- Death or disability of key employees
- Retirement or unemployment
- Job-related injuries or disease experienced by workers

v) Crime loss exposures

- Holdups, robbers, burglaries
- Employee theft and dishonesty
- Fraud and embezzlement
- Internet and computer crime exposures

2. Analyze the Loss Exposures

The second step in risk management process is to analyze loss exposures. This step involves
measuring the frequency and severity of a loss.

Frequency refers to probable number that may occur during a given time.

Severity refers to the probable size of the loss which may occur. Once the risk manager estimates
the frequency and severity of loss for each type of loss exposure, the various loss exposures can
be ranked according to their relative importance.

For example a loss exposure with the potential of bankruptcy of a firm is much more important
than an exposure with a smaller potential.

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3. Select the appropriate Techniques for Treating the Loss Exposures
The third step in the risk management process is to select the most appropriate, or a combination
of techniques, for treating the loss exposures.

These techniques can be classified broadly as either risk control or risk financing.

4. Implement and monitor the risk management program

Essentials of risk management

The term risk management is a relatively recent (within the last 20 years) evolution of the term
"insurance management."

The concept of risk management encompasses a much broader scope of activities and
responsibilities than does insurance management.

Risk management is now a widely accepted description of a discipline within most large
organizations.

Basic risks such as fire, floods, employee injuries, and automobile accidents, as well as more
sophisticated exposures such as product liability, environmental impairment/degradation, and
employment practices, are in the province of the risk management department in a typical
corporation.

Although risk management has usually pertained to property and casualty exposures to loss, it
has recently been expanded to include financial risk management, such as interest rates, foreign
exchange rates, and derivatives, as well as the unique threats to businesses engaged in e-
commerce.

With the increasing role of risk management, some large companies have begun implementing
large-scale, organization-wide programs known as enterprise risk management.

In enterprise risk management, a risk is defined as a possible event or circumstance that can have
negative influences on the organization.

Its impact can be on its very existence, the resources (human and capital), the products and
services, or the customers of the enterprise, as well as external impacts on society, markets, or
the environment.

In a financial institution, enterprise risk management is normally thought of as the combination

of credit risk, interest rate risk or asset liability management, market risk, and operational risk.

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Risk Management Approaches
After the company's specific risks are identified and the risk management process has been
implemented, there are several different strategies companies can take in regard to different types
of risk:

1. Risk avoidance 

While the complete elimination of all risk is rarely possible, a risk avoidance strategy is designed
to deflect as many threats as possible in order to avoid the costly and disruptive consequences of
a damaging event.

Risk avoidance-This strategy is used where a certain plan of action is

developed since elimination of all risk is seldom possible. Business can
assimilate this policy incase complete elimination of the risk is impossible, a
the company can set up a risk avoidance strategy which would shield it from
incurring any unnecessary expenses.

Risk reduction-This strategy occurs if the company can reduce the amount of
damage certain risks can have on the companies processes. If this policy is
assimilated a company has the ability to reduce and limit the effects of certain
risks which can affect the normal running of the business.

Risk retaining-This strategy is put into action in a case where a company

decides to continue with a certain risk that is profitable to the business and
deal with the eventual result. If a business qualifies a certain risk to be
beneficial in the long turn processes of the company, the management may
decide to retain its risk.

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2. Risk reduction

Companies are sometimes able to reduce the amount of damage certain risks can have on
company processes.

This is achieved by adjusting certain aspects of an overall project plan or company process, or by
reducing its scope.

3. Risk sharing

Sometimes, the consequences of a risk are shared, or distributed among several of the project's
participants or business departments.

The risk could also be shared with a third party, such as a vendor or business partner.

4. Risk retaining

Sometimes, companies decide a risk is worth it from a business standpoint, and decide to keep
the risk and deal with any potential fallout.

Companies will often retain a certain level of risk if a project's anticipated profit is greater than
the costs of its potential risk.

Importance of Risk Management

1. Risks management is an important process because it empowers a business with the

necessary tools so that it can adequately identify and deal with potential risks. Once a risk’s
been identified, it is then easy to mitigate it.

2. Risk management provides a business with a basis upon which it can undertake sound
decision-making.

3. For a business, assessment and management of risks is the best way to prepare for
eventualities that may come in the way of progress and growth. When a business evaluates
its plan for handling potential threats and then develops structures to address them, it
improves its odds of becoming a successful entity.

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4. Progressive risk management ensures risks of a high priority are dealt with as aggressively as
possible. Moreover, the management will have the necessary information that they can use to
make informed decisions and ensure that the business remains profitable.

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