INSURANCE AND RISK MANAGEMENT(TOPIC 3)

TOPIC 3: FUNDAMENTALS OF INSURANCE Definition of Insurance This is a form of risk management that involves equitable transfer of risk of a loss by the insured to another entity (insurer) in exchange for monetary payment known as premiums. It’s used to hedge against risk of a contingent or uncertain loss. Insurance in broad terms may be described as a method of sharing financial losses of few from a common fund of those who are equally exposed to the same loss. INSURANCE MECHANISM Insurance is a social device whereby a large group of individuals or companies through a system of equitable contribution may reduce or eliminate certain measurable risks of economic cost resulting from the accidental occurrence of disastrous events. Its effect is to spread the cost which otherwise would fall upon an individual in an equitable manner over the members of a large group exposed to the same hazard. The theory behind Insurance is that members of an insurance scheme contribute to a central fund from which payments are made in case one of their members suffers loss by the occurrence of the risk [event] insured against. The payment - individual contribution to the pool is the premium. Individuals who suffer financial loss are indemnified by those who do not hence escape meeting the total financial loss in the occurrence of the risk. The amount that each individual is required to pay will be calculated on the basis of past experience. In addition to the cost of loss there would be some administration cost and some mark up by insurance company to the entire cost of arrangement As can be observed from the above analysis, insurance is based on two basic laws: The law of large numbers Insurance derives its value from risk pooling based on the likelihood of an event taking place and makes predictions on the likelihood of such event happening on the assumption that the happening of the event can be predicted with certainty. It operates on the premise that the observed frequency of any event approaches the underlying probability as the number of trials approaches infinity. Hence the greater the number of exposure units [risks], the greater the certainty. Law of averages or the doctrine of probability This is where only a fraction of the insured persons end up encountering a loss. The probability of risk is determined with reference to the past and prevailing circumstances. ILLUSTRATION I 1000 Juja vehicle owners with cars worth Kshs. 1,000,000 each enter into an agreement to share the cost loss from accidents as they occur to the extent that no single vehicle owner will be forced to incur the entire financial loss. From the past experience only 3 out of the 1000 vehicles suffered loss. How much contribution should each of the vehicle owners make to ensure one is insured? Working; Kshs. 1,000,000 = 1,000 Each person will contribute sh. 1000 x 3 = Kshs. 3,000 1,000 ILLUSTRATION II 1,000 motor cars valued at an average of Sh. 500,000 are observed for five years. On an average 0.4% encounter total losses per year while a further 1% suffers major losses averaging half the values of the respective cars. 10% encounter minor losses averaging 10% of the car values. What is the minimum premium an insurance company should charge per car to cover over the risk of partial or total loss if administrative and other expenses amount to 1% of the car values and if the firm desires to earn a minimum profit of Sh. 2,500,000? Total loss cars value = 0.004*1000*500,000 2,000,000 Major loss car values = 0.01*1000*500,000*0.5 2,500,000 Minor losses =0.1*1,000*500,000*0.1 5,000,000 Total loss exposure 9,500,000 Operating and other expenses =1,000*500,000*0.01 5,000,000 Profit margin 2,500,000 Total amount to be covered 17,000,000 Number of insured /1,000 Charge per insured 17,000 Characteristics of Insurance Pooling of Risks and Losses ; This is a process of spreading of losses incurred by the few over the entire group so that in the process of average loss is substituted for actual losses Paying of fortuitous losses; These are the losses that are unforeseeable, unexpected which occur as a result of chance/accident. This law of large numbers is based on assumption that losses are accidental or occur randomly. Insurance policies do not cover intentional losses Risk Transfer; It means that part of the risk is transformed from insured to insurer who is typically in a stronger financial position to pay. Some of the insured’s pure risks that can be transferred to insurer include the risk of premature death, poor health, theft etc Indemnification; It implies that the insured is restored to his/her approximate financial position before loss occurred. It’s not possible to insure against all possibilities of loss e.g. house depreciation. Expectation Gap in Risk Pooling Arrangement There are two major expectation gaps; Some people believe that they have to some extent wasted money to purchasing insurance if a loss doesn’t occur. Other people believe that if they have not had a loss during a policy term they should be refunded their premium. Both points constitute essence of ignorance because insurance provides a variable feature which is freedom from uncertainty and therefore even if also doesn’t occur during the policy term the insured will have received the benefit for the premium paid which is the promise indemnification if a loss had occurred. The operation of the insurance principle is based on the contributors of many paying the loss of the unexpected few who have suffered loss therefore if premiums were to be returned to the many who didn’t suffer loss, there would be no funds to cater for the few who incurred loss. REQUIREMENTS OF INSURABLE RISKS/ PREREQUISITES OF INSURABILITY Although insurers only insure pure risks, not all risks are insurable. To be insured, a pure risk must fulfil the following conditions: Large number of exposure units For a risk to be insured there should be a large group of roughly similar but not necessarily identical exposure units that are subject to the same risk. This will help/ enable the insurer to predict loss based on the law of large number of exposure units where the loss caused can be then spread aver all the insured. Accidental and Unintentional For a loss to be insured, it must be fortuitous i.e. beyond the insured’s control. Intentional losses are not insured because of the following reasons; Moral hazards (This refers to the increase in probability of loss that result from dishonesty tendencies in the character of insured persons) will increase leading to high premium which will result to just a few persons purchasing insurance The insurer may not get adequate number of exposure and cannot be able to predict future losses Determinable and Measurable Loss This means that the loss must be definite in terms of cause, place of occurrence, and amount of loss. However some losses may be difficult to determine or to measure e.g. disability income. This requirement helps insurers to determine if the loss is covered under the policy and if covered how much should be paid. Non- Catastrophic Loss This means that large proportion of exposure units should not have losses at the same time. If all risk exposures in a given class simultaneously incur a loss then the essence of the pooling technique will break down and become unworkable. Catastrophic losses will lead to increased premiums and the aspect of pooling will no longer be viable. In spite of this condition, insurance may still have to deal with catastrophic losses. Approaches that can be used to deal with catastrophic losses include; Reinsurance Calculable chance of Loss For a risk to be insurable the insurer must be able to determine between the average frequency and average severity of future losses with some accuracy. This condition helps insurance company to determine proper premium adequate to pay all claims, expenses as well as some profits Some losses may be hard to insure since the chance of such losses may not be accurately estimated at the same time the potential for catastrophic loss may be present e.g. floods, wars occur on an irregular basis hence the average severity and frequency of such losses is difficult to predict. Valuable Interest Individuals or persons transferring a risk through an insurance cover must have with an interest in something which can be valued (valuable), monetary or otherwise. The thing in which one has interest should be subject to loss by a peril. Economically Feasible Premiums The cost of insurance must be economically feasible (managerial premiums). The insured must be able to pay the premium charged thus the premium must be substantially less than the face value or amount of policy. If potential loss isn’t significant no one would be interested to transfer risk to the insurer. Loss must be large compared to size of premium FACTORS THAT LIMIT INSURABILITY OF RISK Premium Loading These are the extra costs that add on top of premium for instance administration and capital cost. Risk averse people desire insurance covers but the extent to which they purchase insurance will depend upon the insurance policy premium loading. Moral Hazards This refers to the increase in probability of loss that result from dishonesty tendencies in the character of insured persons. It’s a situation where the insured takes undue risks AFTER getting an insurance cover owing to the fact that the cost of the risk will be borne by the insurer. Examples of Moral Hazards; Driving at a very high speed since a vehicle is insured (expected claim cost for vehicle insurance will depend on the speed at which the car is being driven out); Being less cautious in locking a car that is insured; A person with a life cover who now starts smoking. How to reduce Moral Hazards Monitoring the insured Feedback and reputation systems (Positive, negative, or neutral rating, along with a short comment by customers where now buyers and sellers build reputations that are based on that.) Share part of risk with insured. Deductibles (fixed amount of money before deriving compensation from the insurance) Adverse Selection It arises when it is too costly for insurance to classify perfectly who to be insured, how much to be charged for the insurance purchased. It’s a situation that occurs BEFORE getting an insurance cover as a result of those in highly risky situations or jobs now taking a cover. Different covers are charged different premiums due to the lack of information by insurance companies. Example of Adverse Selection; A smoker is more likely to go for insurance than a non-smoker. How to reduce Moral Hazards Third party verification Screening Self selection Certification/ Signaling Deductibles A common way of limiting the amount of coverage is through deductibles which usually eliminate the small claim losses. The mechanism of deductibles is said that for every accident that occurs the insured will be required to pay some fixed amount of money before deriving compensation from the insurance. Therefore any losses, accidents less than the amount of the deductible will not be compensated. Co- insurance This is a provision of an insurance policy that provides that the insurer and insured will apportion between them any loss covered by the policy according to a fixed percentage of the value for which the property or person is insured. It is a co-sharing agreement between the insured and insurer. Policy Limit Insurance policies often limit the amount of coverage by placing an upper limit on the amount of compensation to be made on property insurance. Policy limit ensure that the insured will not take covers in excess of what the coverage will sustain Exclusions This excludes the coverage for specific types of losses which the insurance company does not desire to cover. Such losses could be the high impact and high likelihood type PAGE \* MERGEFORMAT 2