UNIVERSITY OF NAIROBI

COLLEGE OF AGRICULTURE AND VETERINARY SCIENCES

FACULTY OF AGRICULTURE

DEPARTMENT OF AGRICULTURAL ECONOMICS

COURSE CODE: AEB 405

COURSE TITLE: RISK MANAGEMENT AND INSURANCE

LECTURER
DR. J.R.BUSIENEI, PHD
 UNIVERSITY OF NAIROBI
COLLEGE OF AGRICULTURE AND VETRINARY SCIENCES
DEPARTMENT OF AGRICULTURAL ECONOMICS
BACHELOR OF SCIENCE AGRIBUSINESS MANAGEMENT
AEB 405: RISK MANAGEMENT AND INSURANCE
LECTURER: DR. J.R.BUSIENEI, PH.D
0721 497 580

[email protected]

PROPOSED COURSE OUTLINE, PROCEDURES AND REQUIREMENTS

Course Objective and Methodology

The general objective of this course is to develop an understanding of the importance of risk management. The course will
specifically aim at:

 Developing student’s understanding of concepts of risk, insurance and risk management;

 Create understanding of the role of risk management in the financial markets;
 Enabling students to actively use the principles and techniques of fiancé and risk management;
 Developing a problem driven approach for managing agribusiness risks;
 Developing and stimulating communication and interpersonal skills as well as group dynamics.

Course Content and Organization

1. The Nature of Risk

Introduction; the concept of risk and uncertainty and sources and types/classification of risks; the cost of risk; measurement
of risk; peril and hazard; types of pure risk; burden of risk on society and methods of handling risk. Introduction to risks-
definition of risk and risk management; objectives of risk management; The risk management statement and philosophy
(risk policy); the risk management department; risk management process; concept of moral hazard and adverse selection

2. Introduction to Risk Management

Definition; objectives of risk management, historical development of risk management, risk management policy; risk
identification; risk evaluation and analysis; risk retention; risk avoidance; risk transfer; risk management Vs insurance
management concept; risk management in the corporate structure; the functions of risk manager and the need for risk
management, loss control, statistical concepts for risk management, risk management department.

3. The Process of Risk Management

(i) Setting objectives of risk management; benefits of a precise/exact activity statement; pre-loss and post-loss objectives; risk
management philosophy statement; the risk management manual; (ii) Identifying the risks to which the firm is exposed to;
why do we need to identify risk; techniques of risk treatment, (iii) evaluating the risks facing the entity: critical risks; important
risks; unimportant risks; (iv) determining the risk statement (implementation): approaches to dealing with risks; reviewing and
upgrading; importance of review and upgrading. Risk identification- techniques of risk identification; physical inspection;
checklist method; flow charts and organizational chart; HAZOP; other methods; Risk management methods

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 4. Risk management through Insurance
(i) Introduction: definition; purpose; insurance mechanism; requisites of insurability; socio-economic role of insurance; historical
development in Kenya; Insurance Vs Gambling; insurance Vs speculation (ii) types/classes of insurance: life insurance
contract/product; life and health insurance; general insurance/non-life insurance; liability insurance; transport; motor insurance;
property and pecuniary insurance; marine and aviation insurance. (iii) basic principles of insurance: insurable interest; utmost
good faith; indemnity; subrogation; contribution; and proximate cause. Coinsurance: Definition; types of coinsurance companies;
merits and demerits of coinsurance companies. Reinsurance: Definition; types of reinsurance companies in Kenya; merits and
demerits of reinsurance companies. Self-Insurance: Definition; types of self-insurance companies; merits and demerits of self-
insurance companies. Captive Insurance: Definition; types of captive insurance companies; merits and demerits of insurance
companies. Risk management through Insurance- requisites for insurance; principles of insurance; practices of insurance

TEACHING METHODOLOGY
The course will be conducted by way of lectures, class discussions and case studies. Students are advised to read relevant text
materials for each topic before these are discussed in class to enhance their participation and understanding. Adequate
students’ practice on the application of the concepts to problem solving is very essential.

Course Assessment
CAT 1 10%
CAT 2 20%
Total Course Work 30%
Final Examination 70%
Grand Total 100%

Main References
1. George E.Rjda (). Priciples of Insurance, 3rd, Edition, Scott, Foresman and Co. New York, Latest Ed.
2. Julia H. and Weipers W. (). Insurance, 5th, Ed. IBT Global, London latest ed.
3. Emmer, V. and Theres V. Essentials of Insurance: A Risk Management Perspective, Johr. Wiley and Sons Inc. Latest
ed.
4. Crane, Frederick G. and Wiley, John & Sons (1980). Insurance: Principles and Practices; 2 nd Ed. Library of Congress
Cataloguing in Publication Data.
5. Williams, C. A. et al (2001) Risk Management and Insurance, Boston; McGraw Hill
6. George, E. R. (2005) Principles of Risk Management and Insurance, New Delhi; Pearson Educational Inc
7. Text Books for further Reading: Vaughan (2001) Essentials of Risk management and insurance, New York; John Wiley
and Sons Ltd
8. Other support materials: Various applicable manuals and journals; variety of electronic information resources as
prescribed by the lecturer

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 TABLE OF CONTENT
Course Content: ................................................................ Error! Bookmark not defined.
Recommended Text Books: .............................................. Error! Bookmark not defined.
Text Books for further Reading: ....................................... Error! Bookmark not defined.
TOPIC ONE: INTRODUCTION TO RISK MANAGEMENT .........................................1
Definition of Risk ...............................................................................................................1
Uncertainty versus Risks .....................................................................................................2
Basic Categories of Risk .....................................................................................................2
Risk and Insurance ..............................................................................................................6
Peril and Hazard ..................................................................................................................6
Moral Hazard and Adverse Selection .................................................................................6
Risk Management .............................................................................................................10
The Risk Management Department ..................................................................................12
Review Questions ............................................................. Error! Bookmark not defined.
Selected References .......................................................... Error! Bookmark not defined.
TOPIC TWO: RISK IDENTIFICATION .........................................................................17
Definition of Risk Identification .......................................................................................17
Techniques and Tools for Risk Identification ...................................................................18
Risk Description ................................................................................................................32
Outputs from Risk Identification ......................................................................................32
Review Questions .............................................................................................................33
Selected References .......................................................... Error! Bookmark not defined.
TOPIC 3. RISK ANALYSIS/EVALUATION .................................................................34
The Prouty Approach ........................................................................................................34
Risk Maps .........................................................................................................................35
Probability Theory ............................................................................................................36
Practical Application of Probability Theory .....................................................................45
Event Tree Analysis (ETA) ..............................................................................................46
Gain/Loss Curves ..............................................................................................................47
Tornado Charts ..................................................................................................................49
Risk Corrected / Adjusted Revenues ................................................................................50

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3. 8 Earnings at Risk .........................................................................................................51
Revision Questions ........................................................... Error! Bookmark not defined.
Selected References .......................................................... Error! Bookmark not defined.
TOPIC FOUR: RISK MANAGEMENT METHODS ......................................................52
Meaning of Risk Management .......................................................................................... 52
Methods of Handling Risks ..............................................................................................56
Risk Control and Risk Financing ......................................................................................57
Contingency or Catastrophe Planning ..............................................................................57
Information Management ..................................................................................................58
Role of Government in Risk Management .......................................................................59
Funding Arrangements ......................................................................................................59
Non insurance Transfers ...................................................................................................60
Agreements and Combination ...........................................................................................61
Factors Affecting Choice between Retention and Transfer ..............................................62
Commercial Insurance ......................................................................................................64
Review Questions ............................................................. Error! Bookmark not defined.
Selected References .......................................................... Error! Bookmark not defined.
TOPIC FIVE: RISK MANAGEMENT THROUGH INSURANCE ...............................65
Definition of insurance .....................................................................................................65
Elements of an insurance transaction ................................................................................65
Characteristics of Insurance ..............................................................................................65
Distinguishing Features of Insurance Contract .................................................................69
Principles of Insurance ......................................................................................................70
An Analysis of Insurance Contracts .................................................................................74
Endorsement and Riders ...................................................................................................76
Deductibles .......................................................................................................................77
Coinsurance .......................................................................................................................78
Other Insurance Provisions ...............................................................................................80
Benefits of Insurance ........................................................................................................81
Costs of Insurance .............................................................................................................82
Contemporary Issues in Risk Management ......................................................................82

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THE CONCEPT OF INSURANCE ..................................................................................83
Meaning of insurance ........................................................................................................83
SELF-INSURANCE .......................................................................................................102
Captive Management ....................................................................................................116
INTRODUCTION ..........................................................................................................118
1.0 What Businesses Do .................................................................................................118
CONCEPTS OF RISK ....................................................................................................120
2.0 INTRODUCTION ....................................................................................................120
2.1 OBJECTIVES ..........................................................................................................120
2.2 Relation of risk to insurance ..................................................................................... 120
2.3 Types of risk. ............................................................................................................120
2.3.1 Social Risks ............................................................................................................121
2.3.2 Physical Risks ........................................................................................................121
2.3.3 Economic Risks .....................................................................................................121
2.3.4 Financial risks ........................................................................................................122
2.3.5 Death and accident risks. .......................................................................................122
2.3.6 Personal and public risks. ......................................................................................122
2.3.7 Employee dishonesty risks .....................................................................................122
2.4. Terms Related to Risk ..............................................................................................123
2.4.1 Peril ........................................................................................................................123
2.4.2 Loss .......................................................................................................................123
2.4.3 Hazards ..................................................................................................................123
2.4.3.1 Physical Hazards .................................................................................................123
2.4.3.2 Moral Hazard ......................................................................................................124
2.4.3.3 Morale Hazard .....................................................................................................124
2.5 How Risk may affect Business ................................................................................125
2.5.1. There’s a Cost to Risk – Financial Distress ........................................................125
2.5.2. Impact on Stakeholders – Whether Contractual or Not ......................................125
2.5.3. Opportunity costs ................................................................................................126
2.6 SUMMARY ................................................................ Error! Bookmark not defined.
2.7 Activity/Exercise ......................................................... Error! Bookmark not defined.

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CLASSIFICATION OF RISKS ...................................................................................... 127
3.0 INTRODUCTION ...................................................................................................127
3.1 OBJECTIVES ..........................................................................................................127
3.2 CLASSIFICATION OF RISKS ................................................................................127
3.2.1 Objective and Subjective Risks ..............................................................................128
3.2.2. Financial and Non-financial Risks ........................................................................128
3.2.3. Static and Dynamic Risks .....................................................................................128
3.2.4 Fundamental and Particular Risks. .........................................................................129
3.2.5 Pure and Speculative Risks ....................................................................................129
3.2.6 Personal and Business Risks ..................................................................................130
BURDEN OF RISKS ......................................................................................................131
3.5.1 Introduction ............................................................................................................131
3.5.2 Objectives ...............................................................................................................131
3.5.3 Pervasiveness Of Risks In The Enterprise .............................................................132
3.5.4 Property ..................................................................................................................132
3.5.5 Personnel ................................................................................................................132
3.5.6 Marketing ...............................................................................................................133
3.5.7 Transportation ........................................................................................................133
3.5.8 Storage ...................................................................................................................134
3.5.9 Information .............................................................................................................134
3.5.10 Standardization .....................................................................................................134
3.5.11 Finance .................................................................................................................135
3.5.12 Production ............................................................................................................135
3.5.13 Environmental ......................................................................................................135
3.5.14 The Cost of Risks .................................................................................................136
3.5.14.1 Property Risks ...................................................................................................139
3.5.14.2 Direct Handling Costs and Loss Costs .............................................................139
3..5.14.3 Indirect Cost .....................................................................................................140
3.6 Personnel Risk Costs .................................................................................................140
3.6.1 Direct Handling and Loss Costs .............................................................................140
3.6.2 Indirect Costs .........................................................................................................141

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3.7 Marketing Risks Costs ..............................................................................................141
3.7.1 Direct Handling and Loss Costs .............................................................................141
3.8 Buying Risks .............................................................................................................142
3.8.1 Direct Handling and Loss Costs .............................................................................142
3.9 Finance ......................................................................................................................142
3.9.1 Direct Handling and Loss Costs .............................................................................143
3.10 Production Risks .....................................................................................................143
3.10.1 Handling and Loss Costs ......................................................................................144
3.11 Summary .................................................................................................................144
RISK MANAGEMENT: HISTORICAL DEVELOPMENT AND APPLICATION. ...146
4.0 Introduction ...............................................................................................................146
4.1 Objectives .................................................................................................................146
4.2 Definition of Risk Management ...............................................................................146
4.2.1 What is Risk management? ....................................................................................146
4.3 Historical Development of Risk Management ..........................................................147
4.4 The Nature of Risk Management ..............................................................................148
4.5 Risk Management in Practice. ..................................................................................150
RISK MANAGEMENT PROGRAMME .......................................................................152
(PROGRAMME OBJECTIVES) ...................................................................................152
5.0 INTRODUCTION ....................................................................................................152
5.1 OBJECTIVES ...........................................................................................................152
5.2 The Risk Management Programme ...........................................................................152
5.2.1 How is the risk management function articulated in the firm? ..............................153
5.2.2 Risk Management Programme Objective ..............................................................153
RISK MANAGEMENT PROGRAMME .......................................................................157
IDENTIFICATION AND MEASUREMENT OF RISK ...............................................157
6.0 INTRODUCTION ....................................................................................................157
6.1 OBJECTIVES ...........................................................................................................157
6.2 Risk Identification Process ......................................................................................157
6.2.1 How is risk identification systematic? ...................................................................157
6.3 Identification Tools ...................................................................................................157

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6.3.1 Key Risk Indicators (KRIs) ....................................................................................157
6.3.2 Checklists? .............................................................................................................159
6.3.3 Analysis Questionnaires .........................................................................................160
6.3.4 The Firm’s Financial Statements ...........................................................................160
6.3.5 Flow Charts ............................................................................................................161
6.3.5 Physical inspections. ..............................................................................................162
6.3.7 Information from Contracts ...................................................................................162
6.3.8 Use of Injury and Non-Injury Accidents ................................................................163
6.3.9 Organizational Charts ............................................................................................163
RISK HANDLING TECHNIQUES ...............................................................................164
IMPLEMENTATION AND REVIEW ...........................................................................164
7.0 Introduction: .............................................................................................................164
7.1 Objectives .................................................................................................................164
7.2 Risk Handling Techniques .......................................................................................164
7.2.1 What is Risk Control? ............................................................................................164
7.2.2 What is Risk Financing? ........................................................................................165
7.3 Risk Treatment Matrix ..............................................................................................167
7.4Implementation of a Risk Management Programme .................................................168
7.5Review and Evaluation of the Risk Management Programme ..................................169
DETERMINING RISKS USING PROBABILITIES .....................................................170
8.0Introduction ................................................................................................................170
8.1Objectives ..................................................................................................................170
8.2Probability Defined ....................................................................................................170
8.3Interpretation of Probabilities ....................................................................................170
8.4 The Law of Large Numbers and its Application: .....................................................172

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 TOPIC ONE
INTRODUCTION TO RISK MANAGEMENT

Learning Objectives
After studying this topic, you should be able to:
 Explain the meaning of risk
 Explain different types of risks
 Identify the major pure risks that are associated with financial insecurity
 Explain methods of handling risk
 Explain why risk management is important to an organization
 Describe an organization’s risk management philosophy and policy
Definition of 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.
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?

Uncertainty versus Risks

Uncertainty is the lack of complete knowledge about an event/ outcome. It implies there
exist more than one possibility and the "true" outcome/state/result/value is not known.
Uncertainty is measured by a set of probabilities assigned to a set of possibilities.
Example: "There is a 65% chance this market will double in five years"

Risk is a state of uncertainty where some of the possibilities involve a loss, catastrophe,
or other undesirable outcome. Risk is measured by a set of possibilities each with
quantified probabilities and quantified losses. Example: "There is a 30% chance the
proposed oil well will be dry with a loss of ksh.100 million in exploratory drilling costs".

These terms are used in such a way that one may have uncertainty without risk but not
risk without uncertainty. We can be uncertain about the winner of a contest, but unless
we have some personal stake in it, we have no risk. If we bet money on the outcome of
the contest, then we have a risk. In both cases there is more than one outcome. The
measure of uncertainty refers only to the probabilities assigned to outcomes, while the
measure of risk requires both probabilities for outcomes and losses quantified for
outcomes.
Basic Categories of Risk
The most important categories of risk are:
i. Pure and speculative risk
ii. Fundamental and particular risk
iii. Enterprise risk
iv. Pure and speculative risk
Pure risk is defined as a situation in which there are only the possibilities of loss or no
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loss. The only possible outcomes are adverse (loss) and neutral (no loss)
Types of pure risk
i) Personal risks: - risks that directly affect an individual. Examples include; risk of
premature death, risk of insufficient income during retirement, risk of poor
health/sickness, risk of unemployment etc.
ii) Property risks: - risk of property damage or lost due to various causes such fire,
theft etc. Direct losses can result from the physical damage, destruction or theft of
property. Indirect or consequential losses could also result from the occurrence of
a physical damage or theft such as loss of profits from a damaged factory.
iii) Liability risks: - under certain instances one may be held personally responsible if
they do something that result in bodily injury or property damage to someone
else. Examples include: negligent operation of vehicles, defective products,
professional misconduct etc
Speculative risk is a situation in which there is either profit or loss. For example an
investment in shares may either result in profits if the price of the share increases or in a
loss if the price falls. Other examples of speculative risks include gambling, oil
exploration, going into business for oneself etc

Fundamental and particular risk

A fundamental risk is a risk that affects the entire economy or large number of persons or
groups within the economy. Examples include rapid inflation, war, and natural disaster
such as floods, earthquakes, and more recently terrorist attacks.
A particular risk is a risk that affects only individuals and not the entire community
examples include car thefts, fires that destroy a business premise without significantly
affecting others etc

Enterprise risk Enterprise risk is a relatively new term that encompasses all major risks
faced by a business such risks include; speculative risk, pure risk, strategic risk,
operational risk and financial risk among other risks. Most risk in enterprise can be
grouped into three general categories ie financial risks, operational risks and strategic
risks. Enterprise risks may be broadly categorized into the following:

a) Financial Risks
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This risk concerns the continuous financial position of an enterprise. Any kind of
predisposition to activities that could result to possible loss of funds by the business is
a financial risk. Financial risks may include credit risks, liquidity risks, interest rate
risks, foreign exchange risks and investments portfolio risks. Financial risk results in
a business not meeting its financial obligations as and when they fall due for
payment.
b) Operational Risks
These risks concern the enterprises internal day-to day operations. An operational
risk is, therefore, a function of internal controls, information systems, employee
integrity and operating process. Examples of operational risks include:
i) Transaction risk
This is a risk that arises on a daily basis in the business as transactions are processed.
This risk is particularly high for enterprises that handle a high volume of small
transactions daily. Common operational risks in the management of an enterprise
include:
 Inconsistencies between the inventory management system data and the
accounting system data.
 Inconsistent implementation of programs and strategies in the
organization.
 Poor record keeping that results in loss of finances.

ii) Fraud Risk: Also referred to as integrity risk. Fraud risk is the risk of loss of
earnings or capital as a result of intentional deception by an employee or
client. The most common type of fraud in an enterprise is the direct theft of
Financial resources

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c) Strategic Risks
Strategic risk include internal risks like those from adverse business decisions or improper
implementation of those decisions, poor leadership, or ineffective governance and oversight, as
well as external risks, such as changes in the business or competitive environment. These
include:

i) Governance risk: One of the most understated and underestimated risks within any
organization are the risk associated with inadequate governance or a poor governance structure.
Direction and accountability come from the board of directors, who increasingly include
representatives of various stakeholders in the business (investors, customers, institutional
partners, etc). To protect against the risks associated with poor governance structure, businesses
should ensure that their boards comprise the right mix of individuals who collectively represent
the technical and personal skills and backgrounds needed by the institution.

ii) Reputation Risk: This refers to the risk to earnings or capital arising from negative public
opinion, which may affect an enterprise’s ability to sell products and services or its access to
capital or cash funds. Reputations are much easier to lose than to rebuild, and should be valued
as an intangible asset for any organization. Most successful enterprises cultivate their reputations
carefully with specific audiences, such as with customers (their market), their funders and
investors (sources of capital), and regulators or officials.

iii) External business environment risk: This refers to the inherent risks of the business’
activity and the external business environment. To minimize business risk, the enterprise must
react to changes in the external business environment to take advantage of opportunities, to
respond to competition,

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 iv) Regulatory and legal compliance risks: Compliance risk arises out of
violations of or non-conformance with laws, rules, and regulations, prescribed
practices, or ethical standards, which vary from country to country. The costs
of non-conformance to norms, rules, regulations or laws range from fines and
lawsuits to the voiding of contracts, loss of reputation or business
opportunities, or shut-down by the regulatory authorities.

Risk and Insurance

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.

Peril and Hazard

Peril is defined as a cause of loss. If a house burns in a fire the peril or cause of loss is
fire. Other common perils to property damage are fire, lightning, wind, theft, etc

A hazard is a condition that creates or increases the chance of loss examples include
physical (e.g. slippery road defective door lock) and legal hazard (e.g. adverse court
ruling, adverse regulatory action by state).

Moral Hazard and Adverse Selection

Moral hazard is the prospect that a party insulated from risk may behave differently from
the way it would behave if it were fully exposed to the risk. Moral hazard arises because
an individual or institution does not bear the full consequences of its actions, and
therefore has a tendency to act less carefully than it otherwise would, leaving another
party to bear some responsibility for the consequences of those actions. For example, an
individual with insurance against automobile theft may be less vigilant about locking his
car, because the negative consequences of automobile theft are (partially) borne by the
insurance company.
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Moral hazard is related to asymmetric information. Asymmetric information is a situation
in which one party in a transaction has more information than another. The party that is
insulated from risk generally has more information about its actions and intentions than
the party paying for the negative consequences of the risk. More broadly, moral hazard
occurs when the party with more information about its actions or intentions has a
tendency or incentive to behave inappropriately from the perspective of the party with
less information.

In insurance markets, moral hazard occurs when the behavior of the insured party
changes in a way that raises costs for the insurer, since the insured party no longer bears
the full costs of that behavior.

There are two types of behavioral change. The first type is the risky behavior itself,
resulting in what is called ex ante moral hazard. In this case, insured parties behave in a
more risky manner, resulting in more negative consequences that the insurer must pay
for. For example, after purchasing automobile insurance, some may tend to be less
careful about locking the automobile or choose to drive at high speed, thereby increasing
the risk of theft or an accident for the insurer. After purchasing fire insurance, the insured
may tend to be less careful about preventing fires (say, by smoking in bed or neglecting
to replace the batteries in fire alarms).

A second type of behavior that may change is the reaction to the negative consequences
of risk, once they have occurred and once insurance is provided to cover their costs. This
may be called ex post moral hazard. In this case, insured parties do not behave in a more
risky manner that results in more negative consequences, but they do ask an insurer to
pay for more of the negative consequences from risk as insurance coverage increases. For
example, without medical insurance, some may forgo medical treatment due to its costs
and simply deal with substandard health. But after medical insurance becomes available,
some may ask an insurance provider to pay for the cost of medical treatment that would
not have occurred otherwise.

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Financial bail-outs of lending institutions by governments, central banks or other
institutions can encourage risky lending in the future, if those that take the risks come to
believe that they will not have to carry the full burden of losses. A moral hazard arises if
lending institutions believe that they can make risky loans that will pay handsomely if the
investment turns out well but they will not have to fully pay for losses if the investment
turns out badly. Taxpayers, depositors, and other creditors have often had to shoulder at
least part of the burden of risky financial decisions made by lending institutions.

Some believe that mortgage standards became lax because of a moral hazard-in which
each link in the mortgage chain collected profits while believing it was passing on risk-
and that this substantially contributed to the 2007-2008 subprime mortgage financial
crisis. Brokers, who were not lending their own money, pushed risk onto the lenders.
Lenders, who sold mortgages soon after underwriting them, pushed risk onto investors.
Investment banks bought mortgages and chopped up mortgage-backed securities into
slices, some riskier than others. Investors bought securities and hedged against the risk of
default and prepayment, pushing those risks further along. There are four different types
of hazards;

i) A physical hazard consists of physical properties that increase the chances of loss
from various perils such occupying a building under construction, smoking in a
petrol station etc.
ii) Moral hazard refers to increase in probability of loss those results from evil
tendency of insured persons. It’s the dishonesty tendency on part of the insured to
defraud the insurance company.
iii) Morale Hazard results from careless attitude on the part of the insured person
towards occurrence of a loss. The purchase of an insurance policy may create
morale because of the realization that the insurance company will bear the loss.
iv) Legal Hazard arises out of violations of or non-conformance with laws, rules, and
regulations, prescribed practices, or ethical standards, which vary from country to
country. The costs of non-conformance to norms, rules, regulations or laws range
from fines and lawsuits to the voiding of contracts, loss of reputation or business
opportunities, or shut-down by the regulatory authorities.

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Adverse selection, anti-selection, or negative selection is a term used in economics,
insurance, statistics, and risk management. It refers to a market process in which "bad"
results occur due to information asymmetries between buyers and sellers, where the "bad"
products or customers are more likely to be selected.

The term adverse selection was originally used in insurance. It describes a situation
where, as a result of private information, the insured are more likely to suffer a loss than
the uninsured. Insurance is not as profitable when buyers have better information about
their risk than sellers. Premiums set according to average risk will not be sufficient to
cover claims because buyers will be selected for higher risk (buyers carrying less risk are
less likely to purchase insurance).

In the usual case, a key condition for there to be adverse selection is an asymmetry of
information. People buying insurance know whether they have a given characteristic or
not, for instance if they are smokers or not, whereas the insurance company does not. If

the insurance company knew who smokes and who does not, it could set rates differently
for each group and there would be no adverse selection.

In the early days of life insurance, adverse selection forced many life insurance
companies out of business until the life insurance actuaries learned to compensate for
adverse selection and underwriting procedures were improved to minimize adverse
selection.

The risk of adverse selection generally arises when one does business with people of
whom he/she have no knowledge. Adverse selection is a problem is where asymmetric
information between the seller and the buyer; in particular, a trade will often produce an
asymmetric premium for buyer or seller, if one trader has better/more complete
information (e.g., about what other traders are doing, the complete trading book for a
stock, etc.) than the average. When a buyer has better information than does the seller (or
conversely), a trade may occur at a lower (higher) strike price than otherwise. Ideally,
trade prices should be set in an environment in which all the traders have complete
knowledge of ambient market conditions (or at least, equal knowledge thereof).

9
When there is adverse selection, people who know there is an above-average probability
of a certain favorable price move-more than the average investor of the group - will trade,
whereas those who know there is a below-average probability of a favorable price move
may decide it is too expensive to be worth trading, and hold off trading. In this way, the
'better informed' investors will obtain a trading advantage (i.e., a trading premium) over
the others.

One common source of adverse selection in the stock market is insider trading, in which
an insider (such as a corporation’s officers or directors) or a related party trades based on
material non-public information obtained during the performance of the insider's duties at
the corporation. Many jurisdictions attempt to address this problem by making the
practice illegal and imposing longer jail terms and heavy fines.

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.

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.

10
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.

Risk Management Philosophy

This is a broad and clear statement on where the company stands on risk management
issues. For instance “It is the philosophy of this company to take all reasonable steps in
the management of risk, to ensure that the company is not financially or operationally
disrupted”. The risk manager needs to ensure that the company is pro-active in the
management of risk. To meet this needs a risk management statement important in the
following ways:
a) Ensuring that the company is pro-active in its risk management functions and not
just managing crises if and when they arise.
b) Ensuring long term objectives are thought out.
c) This focuses attention on the work of the risk management department, and its
relationship to other sections.
d) Setting a benchmark for measuring the effectiveness of the risk manager and risk
management department.
e) Communicating clearly the philosophy of the company concerning risk
management.

11
 Risk Management Policy
Organizational policies are a set of rules that govern various day to day operations. Risk
management policy decomposes or breaks down the organization’s risk management
philosophy into clear and precise action plans/ rules that must be undertaken in order to
adequately tackle the various risks an organization is exposed to.
“In implementing this general philosophy, (as above) it is the policy of the company to”:
a) Identify those activities which have or may give rise to loss producing events.
b) Measure the impact of potential loss producing events on the company and its
subsidiaries.
c) Take reasonable physical or financial steps to avoid or reduce the impact of
potential losses.
d) Purchase insurance for those risks which cannot be avoided, always retaining risk
where this is economically attractive.
The policy also includes:

a) The lines of authority - who reports to whom. For example, it might say that all
new acquisitions of capital equipment are to be reported to the risk manager by
the divisional managers;
b) Areas of risk management which are outside the risk management department,
e.g. pure financial losses;
c) A statement emphasizing the approval and full support of the Board of Directors.
The directors have a duty toward the company and its shareholders to exercise skill and
care in managing and safeguarding its assets and operations. They are trustees of the
company’s assets. There is a growing awareness of these duties and responsibilities, and
the fact that they can be held accountable for a breach of these. In addition, there are
statutory requirements concerning occupational health and safety, involving the
possibility of criminal prosecution if the directors are negligent.

The Risk Management Department

Functions of the Risk Manager
a) To identify and quantify the organization’s exposures to accidental loss.
b) To adopt proper financial protection measures through risk transfer (to outside
parties), risk avoidance, and risk retention programs.
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 c) To develop and update a complete system for recording, monitoring, and
communicating the organization’s risk management program components and
costs.
d) To design master insurance programs and self-insurance programs including the
preparation of underwriting specifications.
e) Securing and maintaining adequate insurance coverage cost effectively.
f) To determine the most cost-effective way to construct, refurbish, or improve the
loss protection system of any facility.
g) To develop and implement loss prevention/loss retention programs.
h) To actively participate on all contract negotiations involving insurance,
indemnity, or other pure risks assumptions or provisions prior to execution of the
contracts.

i) To create and publish guidelines on the handling of all property and liability
claims involving the organization.
j) To comply with local insurance laws
k) To select and manage insurance brokerage representatives, insurance carriers and
other necessary risk management service providers.
l) To establish risk management policies and procedures.
The Risk Manager is more than just a: safety officer; or insurance buyer. However, the
risk manager cannot be solely/ individually responsible for managing the risks of the
business. In the more successful risk management programs, this is a collective
responsibility, with the Risk Manager;
a) Operating closely with other sectional heads;
b) Discussing problem areas; and
c) Improving safety measures.
The risk management department needs to be managed in the same way as any other.
There are questions of staffing, collecting and filing statistics and other information, and
budgeting for expenses. The functions of the risk management department are:
a) Identification
b) Analysis
c) Control; (terminate, treat, tolerate, transfer).
d) Record Keeping

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 e) Managing Insurance Portfolios
Identification
There are different methods and techniques can be employed in risk identification. These
methods and techniques will be discussed later in the course. The risk management
department is involved in working out combinations of these methods and techniques,
and inventing others suitable for use in their particular company environment and culture.
The risk manager needs to understand the firm and it does, and to consult with as many
stakeholders as possible who can provide insights on issues relating to risk. The manager
should clearly understand both the internal and external environment of the organization.
This includes managers involved in but not limited to:
a) Health and safety programs in the work place
b) Crisis management
c) Internal audits
d) Financial management
e) Corporate security and executive protection
f) Motor fleet maintenance
g) Product quality control
Analysis
Analysis involves the assessment of
a) The likelihood of a loss - the frequency with which it occurs;
b) The possible and probable consequences - the severity or magnitude of the loss.
Risk Control
The department has the responsibility of keeping up-to-date information on all the
operations within the company, and of ensuring that the risk control measures which have
been decided upon are implemented. There are two quite distinct tasks involved here.
a) Be aware, or make itself aware, of all the new developments in the company.
b) Implement risk control measurers which are most appropriate for the new
developments.
Linked to this is the continual need to keep abreast of new developments in the field of
risk control. This implies keeping up-to-date on safety technology and physical risk
control methods.
Record Keeping

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An important feature of any department’s work is keeping records. These records have to
be accurate and accessible, and they must be held in such a way that they can be updated
easily. The risk manager has different types of records and the computer is of great help
in storing and retrieving information. The kind of information a risk manager should have
on record includes:
a) Loss records; actual losses; near misses; costs of losses; reserves etc.
b) Details of insurance premiums;
c) Payroll figures;
d) Staff numbers;
e) Acquisitions and mergers;
f) All risk identification records;
g) Safety documents
Managing Insurance Portfolios
Insurance is still a major function in most risk management departments and while it is
only one aspect of risk control, it does occupy a great deal of the time of the risk
manager. Managing the insurance portfolio for a large corporation or company is almost
a job in its own right. It involves:
a) assessing the need for covers of different types;
b) selecting insurers and brokers;
c) evaluating premiums;
d) matching and dovetailing of covers;
e) negotiating on price;
f) drafting wordings;
g) dealing with claims;
h) keeping all insurance records

The primary objective of an organization-growth, determines its strategies for managing

various risks. Identification and measurement of risks are relatively straightforward
concepts. Volcano eruption may be identified as a potential exposure to loss, for example,
but if the exposed facility is in Nairobi the probability of volcano is rare and it will have a
low priority as a risk to be managed.

15
Businesses have several alternatives for the management of risk, including avoiding,
assuming, reducing, or transferring the risks. Avoiding risks, or loss prevention, involves
taking steps to prevent a loss from occurring, via such methods as employee safety
training. As another example, a pharmaceutical company may decide not to market a
drug because of the potential liability. Assuming risks simply means accepting the
possibility that a loss may occur and being prepared to pay the consequences. Reducing
risks, or loss reduction, involves taking steps to reduce the probability or the severity of a
loss, for example by installing fire sprinklers.

Transferring risk refers to the practice of placing responsibility for a loss on another party
via a contract. The most common example of risk transference is insurance, which allows
a company to pay a small monthly premium in exchange for protection against
automobile accidents, theft or destruction of property, employee disability, or a variety of
other risks. Because of its costs, the insurance option is usually chosen when the other
options for managing risk do not provide sufficient protection. Awareness of, and
familiarity with, various types of insurance policies is a necessary part of the risk
management process. A final risk management tool is self-retention of risks-sometimes
referred to as "self-insurance." Companies that choose this option set up a special account
or fund to be used in the event of a loss.

Any combination of these risk management tools may be applied in the fifth step of the
process, implementation. The final step, monitoring, involves a regular review of the
company's risk management tools to determine if they have obtained the desired result or
if they require modification. Some easy risk management tools for small businesses
include: maintain a high quality of work; train employees well and maintain equipment
properly; install strong locks, smoke detectors, and fire extinguishers; keep the office
clean and free of hazards; back up computer data often; and store records securely offsite.

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 TOPIC TWO: RISK IDENTIFICATION
Learning Objectives
After studying this topic you should be able to:
 Explain the meaning of Risk identification
 Describe the steps in risk in the risk management process
 Explain tools used in risk identification
 Describe the steps in conducting a HAZOP
 Explain a Risk Register

Definition of Risk Identification

Risk identification is a deliberate and systematic effort to understand and document all
the key risks facing the institution. Risk identification starts with understanding the
institutional objectives. Objectives spell out reasons for the organization existence.
Risks are those things/events/outcomes that will effect the institution form achieving
these objectives. The purpose of completing a risk identification exercise is to identify,
discuss and document the risks facing the institution. Risks are recorded is known as the
“risk register”. The risk register serves three main purposes.
a) It is a source of information to report the key risks throughout the institution, as
well as to key stakeholders.
b) Management uses the risk register to focus their priorities.
c) To help the auditors to focus their plans on the institution’s top risks.
There are many methods of risk identification. However, whatever the method, ensure
that it enables a comprehensive identification of risks, as unidentified risks cannot be
planned for and treated. When considering approaches to risk identification note the
following:
a) Personal experience or lessons from the past
b) Results of audits or physical inspections
c) Records of prior losses, (i.e. claims, financial or property losses, data/record loss,
lost time incidents/occupational health and safety reports)
d) Judgment- consensus, speculative/conjecture, intuition
e) Results of benchmarking for perceived performance deficiencies

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 f) Gap analysis- distinguishing between existing practice and business plan
objectives
It is critical in the identification of risk, that two key elements of actual or potential
exposure are identified, namely:
a) The cause of an exposure (i.e. failure of…, lack of..., loss of..., injury to. )
b) The effect of the exposure - the effects may include financial impact, impact on
staff, and other stakeholders, impact on reputation and probity, impact on
operational management and impact on the delivery of programs
Techniques and Tools for Risk Identification
1. Physical inspection
2. Checklists
3 Information-gathering techniques
a) Brainstorming
b) Delphi technique
c) Interviewing
d) Strengths, weaknesses, opportunities and threats (SWOT) analysis
4 Hazard and Operability Study
5 Diagramming techniques
a) System or process flow charts
b) Influence Diagrams
6 Documentation reviews
7 Combination Approach

Physical Inspection
This involves the physical examination (concerning things that can be experienced
through the five senses) to detect risks facing the organization
Forms of inspection
An inspection program should be flexible. There are no hard and fast rules about it. It
should be a combination of routine and non-routine inspection and includes:
a) routine inspection of all risks
b) routine inspection of a particular area of risk

18
 c) specific inspections resulting from recommendations, complaints, reports or
advice from staff, users, stakeholders and others -This includes investigations
and/or inspections recommended by the risk management or health and safety
committee inspections as a result of incidents or accidents
How often should inspections be undertaken?
Routine inspections should be carried out on a regular basis. The regularity depends on
the nature of the risks and the circumstances affecting it. It could be monthly or quarterly.
It should be more regular if circumstances warrant it. For example, if there is a high risk
of injury through slips and falls, it is necessary to carry out more regular and diligent
inspections to identify the causes of these slips and falls.
All risks should be reported even if you consider the source to be dubious. The risks
should be treated seriously and inspected. Only then can you be confident about
discounting them as possible risks.
What to inspect
Make a list of all possible areas of risk including physical and non physical risks. There
may be records of previous incidents and accidents logged in a database somewhere.
Injury and incident reports are also valuable sources of information.
The following example relates to the inspection of physical risks:
1. To identify physical risks, you should obtain plans of the premises
2. Keep the outdoor areas separate from the indoor
3. For a big facility, divide it into distinct and manageable portions
4. Prepare a standard checklist that can be used for the inspection. For example, it
cover any or all of the following:
Physical condition of facilities Lighting
Emergency management procedures Noise emission
Storage of goods especially dangerous chemicals Safety devices
Location and adequacy of first aid facilities Ventilation
Conformity with current standards Gas and electrical supply

19
Who should conduct the inspection?
 In large organizations either a risk management and/or health and safety
committee
 For small organizations it may be the carried by one person responsible for risk
management.
 The committee should coordinate the process
 Inspections should be carried out by those responsible for the management of the
different work areas from which the risk emanates.
 The committee is responsible for conducting regular audits to gauge the adequacy
of the inspection programs
 In the event of specialist or expert advice is required, the assistance of relevant
experts should be sought

How to conduct an inspection

 Procedures should be developed for all the different types of inspections
 These procedures should be made known to all relevant parties
 The inspection team should have properly clarified all procedures and developed
a checklist before any inspection begins
 Develop standard reporting documents that correspond with the checklist so that
the results of inspections and remedial actions (both immediate and future) to be
taken are properly documented
 Documentation is a key issue, as it would assist with any future audit or legal
process. The ability to provide documentary evidence is of paramount importance
when defending a claim of negligence
 Any dangerous risks should be treated immediately

Checklists
Organizations may develop checklists of risks based on information collected from past
activities. The checklist is a quick way to identify risks. A checklist should not be
considered as complete and the possibility of other risks should be addressed. Though
checklists are largely industry specific, a typical checklist is given below.

20
A typical risk Identification checklist
A. External risks
 Strategic- risks associated with threats to the organization’s purpose or
agenda. Public image- risks associated with negative perceptions of the
organization Stakeholder relationships- risks associated with working
relationships and trust.
 Media- risks associated with relationships with journalists/editors and/or with
unbalanced and negative reporting.
 Political- risks associated with losing control of a project or losing the confidence
of elected members/government.
 Commercial- risks associated with costs, competitive edge and sensitive
information release.
 Staff/employees- risks associated with availability of key staff and risks to staff
undertaking engagement.
 Technological- risks associated with loss of intellectual property, processes or
methods, obsolescence etc
 Business- risks associated with accomplishing core organizational objectives.
 Legal liability- risks associated with litigation, public liability and professional
negligence.
 Cultural/heritage- risks associated with loss of indigenous/non-indigenous
significant values or places.
 Opportunity cost- risks associated with not undertaking engagement.

B. Internal risks
Vision and business strategy- risk associated with organization vision and business
strategy not supporting societal focus.
Leadership- risks associated with:
 lack of support in decision-making
 leadership behaviors not reinforcing expectations
 societal concern with the different messages being presented
 poorly planned and executed activities
Organizational culture - risks associated with:
21
  poor communication across the organization
 resource allocation not supporting the activities
 lack of linkages between the engagement activities and the overall departmental
planning cycle
 lack of genuine commitment to the organization
Employee commitment and skills development strategies- risks associated with:
 staff lacking adequate skills to undertake tasks
 staff lacking adequate motivation to undertake tasks
 lack of resources to support and develop necessary skills
Internal communication and engagement strategies- risks associated with:
 incongruence (out of place) in internal communications and engagement
strategies, reflected in external approaches
 confusion of direction
 activities that are duplicated
 lack of support for outcomes
Decision-making and resourcing- risks associated with:
 reduced effectiveness
 inability to follow through on recommendations
Technological support- risks associated with:
 time and cost overruns
 technically flawed systems
 rate of obsolescence
Link to government policies and priorities- risks associated with:
 engagement activities not reflecting government policy and priorities
 organizations not meeting the expectations of society as reflected in government
policy and priorities
 the impact on the funding strategies of organizations
 the political impact of engagement not being considered
 stakeholder relationships being affected

22
Stakeholder relationships and cross-government partnerships- risks associated with:

 engagement initiatives developed at local level not being supported at head office
level
 engagement initiatives developed at head office level not being supported at local
level
 community groups trading-off one part of government against another

Information-Gathering Techniques
Several methods of information gathering can be used in risk identification. These may
include the list below.
a) Brainstorming
Probably the most frequently used risk identification technique. The goal is to compile
a comprehensive list of risks that can be addressed later in the risk analysis processes.
How Brainstorming Works?
A meeting is organized with a multidisciplinary set of experts. Under the leadership of
a facilitator, these people generate ideas about enterprise risks. The brainstorming
meeting proceeds without interruption, without expressing judgment or criticism of
others’ ideas and without regard to individuals’ status in the organization. Sources of
risk are identified in broad scope and posted for all to examine during the meeting.
Risks are then categorized by type of risk and their definitions are sharpened.
Brainstorming can be more effective if participants prepare in advance, the facilitator
develops some risks in advance, and the meeting is structured by business segment and
risk category.
b) The Delphi technique
The Delphi technique is a method by which a consensus of experts can be reached on a
subject such as project risk. Project risk experts are identified but participate
anonymously. The Delphi technique helps reduce bias and minimizes the influence of
any one person on the outcome.
How the Delphi Technique Works?
A facilitator uses a questionnaire to solicit ideas about the important project risks. The
responses are submitted and put into risk categories by the facilitator. These risks are then
circulated to the experts for further comment. Consensus on the main project risks may
23
be reached after a few rounds of this process.

c) Interviewing
Risks can be identified by interviews with experienced project managers or with experts
in the field. The appropriate individuals are selected and briefed on the project. The
interviewees identify risks on the project based on their experience, the project
information, and any other sources that they find useful.
d) Strengths, weaknesses, opportunities and threats (SWOT) analysis
Ensures examination of the organization from each of the SWOT perspectives to increase
the breadth of the risks considered

Hazard and Operability (HAZOP) Study

General Description
A HAZOP study identifies hazards and operability problems. The concept involves
investigating how the plan might deviate from the design intent. If, in the process of
identifying problems during a HAZOP study, a solution becomes apparent, it is recorded
as part of the HAZOP result; however, care must be taken to avoid trying to find
solutions which are not so apparent, because the prime objective for the HAZOP is
problem identification. HAZOP is based on the principle that several experts with
different backgrounds can interact and identify more problems when working together
than when working separately and combining their results.

The process is systematic and it is helpful to define the terms that are used:

a) Study Nodes - The locations or specific points (on piping and Instrumentation
drawings and procedures) at which the process parameters are investigated for
deviations.
b) Intention - The intention defines how the plant is expected to operate in the
absence of deviations at the study nodes. This can take a number of forms and can
either be descriptive or diagrammatic; e.g., flowsheets, line diagrams.
c) Deviations - These are departures from the intention which are discovered by
systematically applying the guide words (e.g., "more pressure").
d) Causes - These are the reasons why deviations might occur. Once a deviation has
been shown to have a credible cause, it can be treated as a meaningful deviation.
24
 e) Consequences - These are the results of the deviations (e.g., release of toxic
materials). Trivial consequences, relative to the study objective, are dropped.
f) Guide Words - These are simple words which are used to qualify or quantify the
intention in order to guide and stimulate the brainstorming process and so
discover deviations. Parameters include temperatures, reaction rates, composition,
or pressure etc

Examples of HAZOP Guide Words and Meanings

Guide Words Meaning

No Negation of the Design Intent
Less Quantitative Decrease
More Quantitative Increase
Reverse Logical Opposite of the Intent
Other Than Complete Substitution

The Concept
The HAZOP concept is to review the plant in a series of meetings, during which a
multidisciplinary team methodically ”brainstorms" the plant design, following the
structure provided by the guide words and the team leader's experience.

The team focuses on specific points of the design (called "study nodes"), one at a time. At
each of these study nodes, deviations in the process parameters are examined using the
guide words. The guide words are used to ensure that the design is explored in every
conceivable way. Thus the team must identify a fairly large number of deviations, each of
which must then be considered so that their potential causes and consequences can be
identified.

25
The best time to conduct a HAZOP is when the design is fairly firm. There is a natural
relationship between the HAZOP deviation approach and the usual control system design
philosophy of driving deviations to zero; thus it is very effective to examine a plant as
soon as the control system redesign is firm.

The success or failure of the HAZOP depends on several factors:

a) The completeness and accuracy of drawings and other data used as a basis for the
study
b) The technical skills and insights of the team
c) The ability of the team to use the approach as an aid to their imagination in
visualizing deviations, causes, and consequences
d) The ability of the team to concentrate on the more serious hazards which are
identified.

Steps in conducting a HAZOP

a) Define the purpose, objectives, and scope of the study
b) Select the team
c) Prepare for the study
d) Carry out the team review
e) Record the results.

It is important to recognize that some of these steps can take place at the same time. For
example, the team reviews the design, records the findings, and follows up on the
findings continuously. Each step is discussed below as a separate item.

Define the Purpose, Objectives, and Scope of the Study

The purpose, objectives, and scope of the study should be made as explicit as possible.
These objectives are normally set by the person responsible for the plant or project,
assisted by the HAZOP study leader (perhaps the plant or corporate safety officer). It is
important that this interaction take place to provide the proper authority to the study and
to ensure that the study is focused. Also, even though the general objective is to identify

26
hazards and operability problems, the team should focus on the underlying purpose or
reason for the study. Examples of reasons for a study might be to:
a) Check the safety of a design
b) Decide whether and where to build
c) Develop a list of questions to ask a supplier
d) Check operating/safety procedures
e) Improve the safety of an existing facility
f) Verify that safety instrumentation is reacting to best parameters.
It is also important to define what specific consequences are to be considered:
a) Employee safety (in plant or neighboring research center)
b) Loss of plant or equipment
c) Loss of production (lose competitive edge in market)
d) Liability
e) Insurability
f) Public safety
g) Environmental impacts.

Select the Team

Ideally, the team consists of five to seven members, although a smaller team could be
sufficient for a smaller plant. If the team is too large, the group approach fails. On the
other hand, if the group is too small, it may lack the breadth of knowledge needed to
assure completeness. The team leader should have experience in leading a HAZOP. The
rest of the team should be experts in areas relevant to the plant operation. For example, a
team might include:
a) Design engineer
b) Process engineer
c) Operations supervisor
d) Instrument design engineer
e) Chemist
f) Maintenance supervisor
g) Safety engineer (if not HAZOP leader).

27
The team leader’s most important job is to keep the team focused on the key task: to
identify problems, not necessarily to solve them.
In addition, the team leader must keep several factors in mind to assure successful
meetings:
a) Do not compete with the members;
b) Take care to listen to all of the members;
c) During meetings, do not permit anyone to be put on the defensive;
d) To keep the energy level high, take breaks as needed.

Prepare for the Study

The amount of preparation depends upon the size and complexity of the plant. The
preparative work consists of three stages: obtaining the necessary data; converting the
data to a suitable form and planning the study sequence; and arranging the meetings.

a) Obtain the necessary data.

Typically, the data consist of various drawings in the form of line diagrams, flowsheets,
plant layouts, isometrics, and fabrication drawings. Additionally, there can be operating
instructions, instrument sequence control charts, logic diagrams, and computer programs.
Occasionally, there are plant manuals and equipment manufacturers’ manuals.
b) Convert the data into a suitable form and plan the study sequence.
The amount of work required in this stage depends on the type of plant. With continuous
plants, the preparative work is minimal. The existing, up-to-date flowsheets or pipe and
instrument drawings usually contain enough information for the study, and the only
preparation necessary is to make sure that enough copies of each drawing are available.
Likewise, the sequence for the study is straightforward. The study team starts at the
beginning of the process and progressively works downstream, applying the guide words
at specific study nodes. These nodes are established by the team leader prior to any
meetings.
With batch plants, the preparative work is usually more extensive, primarily because of
the more extensive need for manual operations; thus, operation sequences are a larger

28
part of the HAZOP. This operations information can be obtained from operating
instructions, logic diagrams, or instrument sequence diagrams.

c) Arrange the necessary meetings.

Once the data have been assembled and the equipment representations made (if
necessary), the team leader is in a position to plan meetings. The first requirement is to
estimate the team-hours needed for the study. As a general rule, each individual part to be
studied, e.g., each main pipeline into a vessel, will take an average of fifteen minutes of
team time.
After estimating the team-hours required, the team leader can arrange meetings. Ideally,
each session should last no more than three hours (preferably in the morning). With large
projects, it has been found that often one team cannot carry out all the studies within the
allotted time. It may therefore be necessary to use several teams and team leaders. One of
the team leaders should act as a coordinator to allocate sections of the design to different
teams and to prepare time schedules for the study as a whole.

Carry out the Team Review

The HAZOP study requires that the plant schematic be divided into study nodes and that
the process at these points be addressed with the guide words. As shown in Figure below
the method applies all of the guide words in turn and either of two outcomes is recorded:
(1) More information is needed, or (2) the deviation with its causes and consequences. If
there are obvious remedies, these too are recorded.

29
HAZOP METHOD FLOW DIAGRAM

As hazards are detected, the team leader should make sure that everyone understands
them. As mentioned earlier, the degree of problem-solving during the examination
sessions can vary. There are two extreme positions:

a) A suggested action is found for each hazard as it is detected before looking for the
next hazard
b) No search for suggested actions is started until all hazards have been detected.

In practice, there is a compromise. It may not be appropriate or even possible for a team
to find a solution during a meeting. On the other hand, if the solution is straightforward, a
decision can be made and the design and operating instructions modified immediately. To
some extent, the ability to make immediate decisions depends upon the type of plant
being studied.

30
Record the Results
A HAZOP form should be filled out during the meeting. This form is best filled out by an
engineer who can be less senior than the team members. This recorder is not necessarily
part of the team but, as an engineer, can understand the discussions and record the
findings accurately. It has also been found useful to tape-record the sessions and have
them transcribed. This saves the only complete record of the discussions and the
reasoning behind the recorded findings, and it can be invaluable later in the plant life
when the plant is modified, or if an event occurs which is the result of a deviation. Other
means of recording can be developed as best suits the organization. Some have found that
when insufficient information is available to make a decision, cards are filled out so that
the responsible individual is reminded of the action item.

The recording process is an important part of the HAZOP. It is impossible to record

manually all that is said, yet it is very important that all ideas are kept. It is very useful to
have the team members review the final report and then come together for a report review
meeting. The process of reviewing key findings will often fine-tune these findings and
uncover others. The success of this process demands a good recording scheme.

Diagramming techniques
Cause-and-effect diagrams: - useful for identifying causes of risks
System or process flowcharts: - show how various elements of a system interrelate and
the mechanism of causation
Influence diagrams: - a graphical representation of a problem showing causal influences,
time ordering of events and other relationships among variables and outcomes

Documentation Reviews/Document Analysis

Document can aid in the process of risk identification. The assets listing on the balance
sheet may alert the risk manger of assets that might otherwise be overlooked. The income
/expenses classification in the income statement may likewise indicate areas of operation
of which risk manager was unaware.

31
 Combination Approach
This is a preferred approach to risk identification. This is where all the tools listed above
are used in risk identification. Each of these tools can provide a part of the puzzle and
together can be of considerable assistance to the risk manager.

No individual method or a combination of methods can replace the imagination and

diligence of a risk manager in discovering the risks that an organization is exposed. Since
many risks appear in many sources, risk managers need wide reaching information
systems designed to provide a continuous flow of information about changes in
operation, acquisition of new assets, new constructions and changing relationships in and
outside the organization.

Risk Description
Risk may be described in either or a combination of the following:
Labor and equipment productivity Permits and ordinances
Quality of work Change in government regulations
Labor, equipment, and material availability Delayed payment on contract
Safety Changes in work
Defective material Financial failure-any party
Contractor competence Change-order negotiations
Inflation Indemnification and hold harmless
Actual quantities of work Contract-delay resolution
Labor dispute Acts of God
Differing site condition Third-party delays
Defective design Defective engineering
Site access/right of way

Outputs from Risk Identification

Risk Register
Risk register is a record to document the results of the risk management processes. It
contains the following information:

32
a) List of identified risks with description
b) List of potential responses (added after responses are developed
c) Root causes of risk.
d) Updated risk categories. Process could lead to recognition of a new risk category.

Review Questions
1. Describe the steps in conducting a HAZOP
2. What is a risk register? Explain three main purposes served by a risk register
3. What factors are considered in selecting a method for risk identification?
4. Explain the following techniques for Risk Identification
o Physical inspection
o Checklists
o Hazard and Operability Study
o Diagramming techniques
o Documentation reviews
o Combination Approach
5. Explain how to conduct an inspection
6. Discuss the various Information-Gathering Techniques
7. Define the term risk identification

33
 TOPIC THREE. RISK ANALYSIS/EVALUATION
Learning Objectives
After studying this topic, you should be able to:
 Define risk evaluation/ analysis
 Describe risk maps and use
 Apply probability theory in risk management
 Explain how event tree analysis (ETA) is used in risk evaluation
Once risks have been identified, the risk manager must evaluate them. This involves
measuring potential losses and the probability that it is likely to occur. Risk analysis
involves the assessment of the likelihood (probability) and impact (severity).

Methods of measuring the likelihood and impact of risks ranging from qualitative to
quantitative methods.

1. The Prouty Approach

This straightforward non-mathematical approach identifies four broad categories of loss
likelihood
i) Almost nil - extremely unlikely
ii) Slight - has not happened, but could happen
iii) Moderate - happens once in a while
iv) Definite - happens regularly.

There are also three categories of loss impact:

i) Slight - the organization can readily retain each loss
ii) Significant - the organization cannot retain the whole of the loss, some part must
be transferred
iii) Severe - virtually all of the loss must be transferred or the survival of the
organization is endangered.
(i), (ii) and (iii) above vary with the size of the organization and its financial resources.

34
 Likelihood/Impact Slight Significant Severe
Almost Nil
Slight
Moderate
Definite

These broad categories can be readily understood, but the financial significance must be
inferred, thus there is need for some kind of mathematical basis.

2. Risk Maps
Companies not only generate risk maps to capture impact and likelihood but also to
demonstrate how risks look when put together in one place. The value of the map is that
it reflects the collective wisdom of the parties involved. Furthermore, risk maps capture
considerable risk information in one place that is easily reviewed. A basic risk map
captures both impact and likelihood.

High
High Impact High Impact
Low Likelihood High
Likelihood
Low Impact Low Impact
Impact

Low Likelihood High

Likelihood
Likelihood of Occurrence
Low High

When assessing likelihood or probability, the following scales can be used:

a) Low, medium, or high;
b) Improbable, possible, probably, or near certainty; and
c) Slight, not likely, likely, highly likely, expected.

35
The same is true for assessing impact:
a) Low, medium, or high impact;
b) Minor, moderate, critical, or survival; and
c) Money levels, such as Kshs. 1 million, Kshs. 5 million, etc.
When qualitatively assessing these risks, it is also possible to estimate ranges.

For example, a company might determine that there is a low probability of a customer-
related risk having an impact of Kshs.100 million, a moderate probability (or best guess)
of a Kshs.50 million impact, and a high probability of a Kshs. 10 million impact.

Risk maps can help an organization determine how to respond to a risk. One weakness in
risk maps (and in silo risk management) is that maps do not capture any risk correlations.
Ignoring risk correlations can lead to ineffective and inefficient risk management. Risk
correlations can be considered for financial risks or non-financial risks. For instance, how
some companies manage one foreign currency exposure should be considered with how
they manage another foreign currency exposure. Managing these in silos (without an
enterprise-wide approach) can be inefficient because dollar exposures to not only the yen
or euro ignore that the yen and euro are also correlated. Risk Silo is an informal (usually meant as
derogatory) characterization ascribed to organizational structures of Risk Management. It is meant to indicate that the
treatment of the range of various possible risks is done in isolation (autonomously) rather than in an integrated way.

Similarly, silo risk management would ignore the fact that the movement of interest rates
could influence an organization’s pension obligations and debt obligations differently.
Also how an organization manages commodity exposure today should be factored in with
how it plans to change its long-term strategy to manage that same exposure. As is
evident, correlations among risks and an enterprise-wide approach are critical.

3. Probability Theory
The probability of an event is measurement of the chance that the event will occur within
a given time period. Probability can be expressed as a number that varies between 0 and
1.
 0 = the event cannot occur

36
 1 = the event is certain to occur

37
Values in between can be expressed as fractions (1/2; 1/100) decimals, (0.5; 0.01) or
percentages (50%; 1%). The closer the probability to 1, (or 100%) the more likely the
event becomes. There are two possible approaches to determining probability:
 A Priori
 A Posteriori

A Priori
This is based on facts which are evident at the beginning. There are a known number of
outcomes. Each outcome has a probability which is known, or can precisely be
calculated.
Example 1
In the toss of a coin, the probability of this landing with the “head” up is ½ because:
There are two equally possible outcomes - a head or a tail; one of these two represents the
event being determined.
Example 2
In the same way, the probability of drawing an ace from a well-shuffled deck of cards is
1/13 because out of 52 cards there are four aces.

A Posteriori
Probabilities are based on past experience. (Posterior = back) This is sometimes known as
the statistical probability, because the true probability is estimated from the observed
number of exposures and previous occurrences.

Example 1
If a fast-food kiosk had 10,000 identical mandazi stalls throughout the country and 200
were damaged by fire in one year, they might assume that the probability of fire in one of
their stands was 200/10 000 or 1/50.
Example 2
In a fleet of 100 similar vehicles, 25 are damaged in accidents. The probability is 1/4.

The Multiplication Rule (First Law of Probability)

38
The first law of probability states:
a) The probability that two or more independent exposure units will suffer a loss is
equal to the product of the probabilities of loss for each of these units.
b) More simply, this is called the Multiplication Rule.

Suppose that four shipments are made to the same four customers, ABC and D, every
month. From past statistics, the spatial interpretation shows the probability of theft of any
one of the four shipments to be 1/4.
In our example, if the probability of each unit being involved is 1/4, then
Two units 1/4 x 1/4 = 1/16
Three units 1/4 x 1/4 x 1/4 = 1/64
Four units 1/4 x 1/4 x 1/4 x 1/4 = 1/256
On this basis, it may be possible to negotiate a reasonable rate of premium,
Formula
Shortening Probability to ‘P’ and calling the units A, B, C and D, this could be written as:
P (A and B) = P (A) x P (B)
P (A, B and C) = P (A) x P (B) x P(C), and so on.

Application
Now consider two buildings, A and B. A is a woodworking shop, with a probability of
fire of 0.05. B is a metal workshop, where the probability is 0.02. The buildings are so
close together that if one catches fire, there is an 85% chance (.85) that the other will
burn as well.
P (A) = 0.05
P (B) = 0.02
P (A/B) or (B/A) = 0.85
P (A and B) = P (A) × P (B/A)
= (0.05) (0.85)
= 0.0425 or about 1/24

39
Notice that this is the probability if building A starts the fire and spreads it to building B -
probability (A and B). There is a lesser probability that B is first to catch fire (B and A)
P (B and A) = P (B) × P (A/B)
= (0.02) (0.85)
= 0.017 or nearly 1/60.
Additions Rule
In the above examples, there are two probabilities - the event will, or will not occur.
Because the scenario represents certainty, the sum or total of all the alternatives must
equal one.
 If the probability of a car accident is 1/4, the probability of no accident is 3/4.
 If the probability of a building having a fire is 0.05, the probability of it not
having one is 0.95.

Probability Trees
We can use this fact in drawing up a probability tree, which is a useful way of illustrating
how events combine.
Example 1
At a particular site, the likelihood of a theft occurring is 0.2.

(0.2)
Theft

No theft
(0.8)

The respective probabilities are shown at the tips of the branches.

40
Example 2
Now we might think about the kind of theft. It might involve:
 Fixtures and fittings 0.3 probability
 Stock 0.5 probability
 Plant 0.2 probability
Notice again, that these add up to 1, being the total of all the probabilities.
Example 3
We said that the overall likelihood of a theft was 0.02; we can now split this figure as to
(0.2)(0.3) = 0.06
fixtures, stock or plant.
Fixtures (0.3)

Stock (0. 5)
Theft (0.2) (0.2)(0.5)
Theft (0.1)= 0.10

Plant (0.2)
No theft (0.8)

(0.2)(0.2) = 0.04

(0.8)

In each case - fixtures, stock, plant, the loss might be large, or small.

The Law of Large Numbers

The larger the number of similar exposure units, the more accurately you can predict the
probability that a particular unit will suffer loss. If the fast-food kiosk had only 100
stands instead of 10,000, and 2 sustained loss, the calculated probability would be the
same, 1/50. However, there would be less confidence in how close this would come to the
real probability of loss. The proportion of stalls that suffer loss could fluctuate widely
from year to year. Probability can be interpreted as the proportion of times a specified
event will almost certainly occur out of a large number of trials.

41
Probability Distributions
(a) The Binomial distribution
The binomial distribution describes the possible number of times that a particular event
will occur in a sequence of observations. The event is coded binary, it may or may not
occur. The binomial distribution is used when a researcher is interested in the occurrence
of an event, not in its magnitude (i.e. likelihood not impact) For instance, in a clinical
trial of a pharmaceutical drug, a patient may survive or die; in a production floor of a
manufacturing organization, an accident may or may not occur. Other situations in which
binomial distributions arise are quality control, insurance problems, medical research and
public opinion surveys.

The binomial distribution is specified by the number of observations, n, and the

probability of occurrence, which is denoted by p.
n!
P( x)  px (1  p)n  x
x!(n  x)!
The mean of a binomial distribution is given by np and the standard deviation is given by
np(1  p)

Example: Assume that goods of a certain firm faces the possibility loss of items through
theft while on transit, and the probability of loss of a single item is 0.4, when a group of
4 items are considered the possible number of losses are 0, 1, 2 , 3 or 4 and their
probabilities can calculated as;
4!
Probability of 0 losses = 0.40  0.640
0!(4  0)!
24
= 1 0.1296  0.1296
1 24

Probability of 3 losses = 4! 0.43  0.643

3!(4  3)!
24
=  0.064  0.6  0.1536
6 1
Note: that the probability of 0, 1, 2, 3 or 4 losses sum up to 1

42
 (b) The Poisson distribution
The Poisson distribution is an appropriate when the sample size is very large and the
probability of success is very small. Examples of such data are mortality of infants in a
city; the number of misprints in a book, the number of accidents in a production line etc
The Poisson distribution is a mathematical rule that assigns probabilities to the number
occurrences. The probability density function of a Poisson variable is given by:

x
P(x)  e  
x!
Where;  = mean given as np
e = the base of natural logarithms (approximately 2.718)

Application of Poisson distribution:

If out 100,000 items shipped by firm only 120 were damaged in transit. What is the
probability of having 0, 1, 2, 4 etc damaged items in a sample of 1000, items? Obviously
if the binomial distribution was used the calculations would be mind-boggling involving
the expression:
1000!
p( x)  0.00120  0.99881,000 x
x!(1000!x)!
However with Poisson distribution these probabilities can be easily calculated as follows:
 x
P(x)  e ,
x!
 =np
n=1000
p=120/100,000 = 0.0012
 =1000  0.0012 = 1.2
1.2 1.20
P(0)  2.718
0!
=0.3012 × 1 = 0.3012

43
 1.22
P(2)  0.3012  0.2169
2!
1.24
P(4)  0.3012  0.0260
4!
And so on.

Note: that the probability of 0, 1, 2, 3 ……or 1000 damages sum up to 1 however as x

increases the probability diminishes drastically. For instance the cumulative probability
of up to 5 damages is 0.9984, thus the total probability of 6 damages to 1000 damages is
1- 0.9984 = 0.0016

(c) The Normal distribution

The normal distribution has two parameters, the mean mu () and the standard deviation
sigma (). Once the parameters are known, the distribution is completely specified. A
good guess or estimate for mu is the mean of the observed values. An estimate for sigma
is the standard deviation.

The normal curve can be fitted into a standard normal curve in which all the integration
for area under the curve has been done. This way the probabilities can be easily
computed. The standard normal variate Z is given by the expression:
x
Z( )

Example 1: In tossing a coin 1000 times, the mean np is 1000  0.5 = 500 heads and the
standard deviation np(1  p) is 1000  0.5  0.5  15.18

The probability of obtaining less than 470 heads is

x
Z( )

470  500
( )  1.9
15.18
P (X < 470) = P (Z < -1.9) = 0.0287

44
Example 1: The monthly demand for a product is approximately normally distributed
with a mean of 10,000 units and a standard deviation of 2000 units. What is the
probability of a monthly demand being less than 6000 units?
6,000  10,000
( )  2
2,000
= P (X < 6,000) = P (Z < -2) = 0.0228

This figure can be obtained from the normal distribution tables

Practical Application of Probability Theory

The distribution of fire damage to the warehouse belonging to X Company is shown
below
Amount in Ksh Probability
0 0.6
30,000 0.2
50,000 0.1
80,000 0.08
100,000 0.01
150,000 0.01

It is the policy of the company to insure fire risks if premiums charged do not exceed
10% of the expected loss, otherwise the risks are retained.
i) As the risk manger, advise the company on the course of action with regard to the
fire risk if cost for fire insurance is Ksh 5,000
ii) What is the probability of losses exceeding Ksh 80, 000?
Answer
i)
Amount in Ksh Probability(p) (p)(x)
(x)
0 0.6 0
30,000 0.2 6,000

45
 50,000 0.1 5,000
80,000 0.08 6,400
100,000 0.01 1,000
150,000 0.01 1,500
Expected loss 19,900
(p)(x)=

10% of 19,900 = 1,990

Since the cost of insurance premiums is Ksh 5, 000 it exceeds the expected loss
The firm would therefore be advised to retain the risks

ii) The probability of loss exceeding Ksh 80,000 is the probability of a Ksh 100,000
loss or the probability of Ksh 150,000 loss (( 0.01 + 0.01) = 0.02)

4. Event Tree Analysis (ETA)

ETA is based on a binary logic in which an event either has or has not happened or a
component has or has not failed. It is valuable in analyzing the consequences arising from
a failure or undesired event. An event tree begins with an initiating event such as a
component failure, increase in temperature/pressure or a release of a hazardous
substance. The consequences of the event are followed through a series of possible paths.
Each path is assigned a probability of occurrence and the probability of various outcomes
can be calculated.

Illustration: The likelihood and consequences of fire in a sprinkler installed plant may be
analyzed using ETA as follows

46
 Initiating Fire Sprinkler People Resultant Scenario
event spreads fails to work cannot event
quickly escape
P = 0.5 Multiple
Yes Fatalities 1
P = 0.3
Yes
P = 0.1 No Loss/ 2
Yes P = 0.5 Damage
Fire Starts No Fire 3
P = 0.7 Controlled
Frequency No Fire 4
= 1Year P = 0.9 Contained

ETA is a useful tool for major accident hazard assessment. In major accidents ETA is
used for the evaluation of possible consequences following a release of toxic/flammable
vapors cloud from a process and to analyze the impact on plant, personnel, general public
and the environment.

5. Gain/Loss Curves
Every item written into a firm’s profit and loss account and its balance sheet is a
stochastic variable with a probability distribution derived from probability distributions
for each factor of production. Using this approach we are able to derive a probability
distribution for any measure used in valuing companies and in evaluating strategic
investment decisions. Indeed, using this evaluation approach it is possible to calculate
expected gain, loss and their probability. In probability and statistics, stochastic variable is
described informally as a variable whose values depend on outcomes of a random phenomenon.
Random Phenomenon is a situation in which we know what outcomes can occur, but we do not know
which outcome will occur. We cannot predict each outcome, but there will be a regular distribution over
many repetitions. For a random phenomenon each attempt or trial generates an outcome.

47
Illustration: As a simple illustration assume that that the risk management department of
company X has generated the following probabilities for annual loss as a result of post
harvest deterioration risk.

Annual loss amount (in

Millions of Ksh) 0.3 0.48 0.68 1.13 1.15 1.50 1.98 2.73 4.28
Probability that loss will
not exceed amount 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1
shown
Plotting the above data produces the Gain/loss curve shown below

An Illustration of Gain/Loss Probability Curve for

Company X
1
0.9
Probability that loss will not exceed

0.8
0.7
amount shown

0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4 5
Annual loss amount (in Million Ksh)

Gain/loss curves are useful tools because they help an organization see how a risk can
influence its financial statements and result in a gain or a loss. They also reveal the
distribution of potential gains and losses. Gain/loss curves do not show correlations
between risks, however, and they do not show all the risks in one place. The curve shows
how much money the company loses or gains from post harvest deterioration risk. The
horizontal axis represents dollars, and the vertical axis represents probability. The curve
shows that the organization loses $1.15 million dollars on average

48
(at 50% probability in this illustration) as a result of this risk. Moving along the
probability scale shows that, 90% of the time, this organization loses $300,000 because of
this risk. The organization believes it loses $4.28 million about 10% of the time.

The shape of the probability curve provides concise information concerning risk. The
lower the risk the steeper the probability curve, whereas the flatter the curve the higher
the risk is evident. Knowing how big of an impact a risk causes over a distribution of
probabilities provides management with the information necessary to decide how much
money to spend managing the risk. Gain/loss curves can also reveal that some risks
occasionally generate gains instead of losses. Developing gain/loss curves require
substantial data collection, and a company has to balance the data collection efforts with
the benefits obtained.

6. Tornado Charts
Similar to gain/loss curves, tornado charts attempt to capture how much of an impact a
risk has on a particular parameter such as revenue, net income, or earnings per share.

Illustration: A firm is considering investing in a fish processing plant which costs Ksh
6,000,000 that is expected to generate constant net incremental cash flows of Ksh
3,000,000 for the next four years. If the cost of capital is 10% and 0.05% of the project
cost constitute capitalized transport cost for the project plant, construct a tornado chart
depicting the effect of (a) +/- 1% in interest rates (b) +/-10% in Plant cost and (c) +/-10%
in transport cost on the net present value (NPV).

Since the cash flow is constant it is an annuity thus the PV can be obtained using the
present value interest factor at annuity (PVIFA).

1 -- 1 
 n
PVIFA   (1  r) 
 r 

 

(a) @ 10% NPV= 3,000,000 × 3.169865446 – 6,000,000 = 3,509,596

@11 % NPV= 3,000,000 × 3.10244569 – 6,000,000 = 3,307,337

49
 @ 9% NPV= 3,000,000 × 3.239719877 – 6,000,000 = 3,719,160
(b) @-10% Plant cost = 3,000,000 × 3.169865446 – 5,403,000 = 4,106,596
@+10% Plant cost = 3,000,000 × 3.169865446 – 6,597,000 = 2,912,596
(c) @-10% Transport cost = 3,000,000 × 3.169865446 – 5,997,000= 3,512,596
@+10% Transport cost = 3,000,000 × 3.169865446 – 6,003,000 =3,506,596

With the ranges calculated, the tornado chart can be constructed around the projected
NPV as shown below

+/-10% Plant cost 2.912 - 4.106

3.307 – 3.719
+/-1% Interest rates

3.506 – 3.512
+/-10% Transport cost

1 2 3 4 5
NPV in Million Ksh

Tornado charts do not show correlations or distributions, but they are valuable because
executives can see, in one place, the biggest risks in terms of a single performance
parameter.
7. Risk Corrected / Adjusted Revenues
Risk-adjusted (or risk-corrected) revenues allow management to see how revenues could
look if risks were managed better. Risk-corrected revenues are smoother and more
controllable. Risk-corrected revenues also produce a tighter distribution of earnings. A
tighter distribution of earnings could potentially lead to improved performance of its
stock price. While stakeholders (e.g., investors) appreciate growth in earnings, they also

50
appreciate some level of stability and predictability and are often willing to pay a
premium for these attributes.

8. Earnings at Risk
Earnings at risk are determined by examining how earnings vary around expected
earnings. In this approach, variables are examined to see how they influence earnings,
such as determining the influence that a one-point movement in interest rates would have
on earnings. Similarly, expected or budgeted cash flows can be determined and then
tested for sensitivity to certain risks. Some companies trace the earnings-at risk to
individual risk sources. Knowing the actual root cause or source of the risk helps to
manage it more efficiently. Companies can also trace the earnings-at-risk to business
units to help gauge the hedge effectiveness of each business unit. Knowing which
business units have the greatest risk is valuable information. With this knowledge, a
company could compare a business unit’s earnings level to the earnings-at-risk. Those
units that generate low earnings and high levels of risk may not be desirable business
units. Having earnings-at-risk in the aggregate allows an organization to see which
months have the greatest risk. Also, distributions can be created that estimate the
probability of meeting earnings targets

51
 TOPIC FOUR: RISK MANAGEMENT METHODS
Learning Objectives
After studying this topic, you should be able to:
 Explain major methods of handling risks
 Explain the meaning of catastrophe planning
 Describe risk funding methods
 Explain non insurance transfers
Meaning of Risk Management
This is a process that identifies loss exposures faced by an organization and selects the
most appropriate techniques for treating such exposures. Because the term “risk” is
ambiguous and has different meanings, many risk managers use the term “loss exposure”
to identify potential losses. 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.
Objectives of Risk Management
These may be classified into two: pre loss and post loss objectives
Pre loss objectives are:
i) To prepare for potential losses in the most economical way:- This involves
analyzing the cost of safety programs , insurance premiums aid and the cost
associated with the different techniques for handling losses
ii) To reduce anxiety: - certain loss exposures can cause great worry and fear for the
risk manager and key executives for example the threat of a catastrophic law suit
from a defective product can cause greater anxiety than loss from a minor fire.
iii) To meet any legal obligations: - government regulations for instance may require
that the firm install safety devices to dispose hazardous waste materials properly
or label products appropriately. The risk manager must ensure that these legal
obligations are met

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Post loss objectives are:
i) To ensure survival of the firm: - after the loss occurs the firm should be able to
resume at least partial operations within some reasonable time frame.
ii) To continue operating:- for some firms ability to continue operating is of critical
importance public utilities such as water companies must continue to provide
service. Competitive firms such as banks must also continue operating otherwise
their businesses will be lost to competitors.
iii) To ensure stability of earnings: - earnings per share can be maintained if firms
continue to operate. The firm may however incur huge expenses to achieve this
goal and perfect stability may not be maintained if the firm is not cushioned from
the loss
iv) To ensure continued growth of the firm: - this may be achieved through new
products and markets development or by acquiring or by merging with other
companies. It is therefore imperative to consider the effect of a loss of the firm’s
ability to grow.
v) To minimize the effect the loss may have on other persons and on society: - a
severe loss can adversely affect employees, suppliers, creditors and the
community in general. A severe loss that shuts down a plant for an extended
period in a small town may cause considerable economic distress in the small
town
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
Each of these steps is discussed below
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:

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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)
- 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

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 - Theft of intellectual property
vi) Employee benefit loss exposures
- Failure to comply with government regulations
- Violation of fiduciary responsibilities
- Group life and health and retirement plan exposures
- Failure to pay promised benefits
vii) Foreign loss exposures
- Acts of terrorism
- Plants, business property, inventory
- Foreign currency risks
- Kidnapping of key personnel
- Political risks
viii) Reputation and public image of the company
A risk manager has several sources of information that he/she can use to identify the
precedent loss exposures. They include those methods discussed in topic two. Others
financial statements, risk analysis questionnaires and historical data.
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. Loss exposures analysis is carried out using risk analysis methods
discussed in topic three.
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.

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. Risk control refers to techniques

55
that reduce the frequency and severity of losses. Risk financing refers to techniques that
provide for the funding of losses. Many risk managers use a combination of techniques
for treating each loss.

Methods of Handling Risks

The existence of risk causes discontent to individuals and the uncertainty accompanying
it causes anxiety and worry. The following are the main five ways of handling risks.
i) Risk avoidance Risk is avoided when an individual refuses to accept the risk.
This is accomplished by merely not engaging in actions that would give rise to
risk. For instance if a firm wants to avoids risks associated with property
ownership, it will not purchase but lease it. The avoidance of risk is one way of
dealing with risk but it is a negative rather than a positive technique. Risk
avoidance if extensively utilized by both individuals and the society will lead to
lack of development.
ii) Risk Retention When an organization does not take the step of avoiding,
reducing or transferring the risk, then the possibility of risk involved will be
retained. The act of retention may be voluntary or involuntary. Voluntary risk
retention is characterized by the recognition that the risk exists and the
organization has decided to retain it. Involuntary retention occurs when and
individual exposed to risk does not recognize it existence until the risk occurs.
Risk retention is a legitimate way of dealing with risk and in most cases it’s the
best method of handling risk. Each organization must decide which risk it should
retain, avoid or transfer on the basis its ability to bear the loss. As a general rule
risks that should be retained are those that lead to relatively small certain loss.
iii) Risk Transfer Risks may be transferred from one firm to another that is more
willing and is capable of bearing the risk. Additionally risk may be transferred
through insurance contracts. Insurance is a mean of shifting or transferring risk,
in consideration of specific payments (premiums). The insurance company
undertakes to indemnify the party taking insurance up to a certain limit for a
specified loss that might occur.

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 iv) Risk Sharing The distribution of risk is accomplished in many ways in the
society. One way through which risk is shared is through co-operatives. These
organizations funds are pooled together each bearing only a portion of risk that
the enterprise will fail. Insurance is another device designed to deal with risk
through sharing.
v) Risk/Loss Reduction This is achieved through risk control (risk prevention) or
the law of large numbers. Risk control is achieved through safety and loss
prevention programs e.g. medical cover, fire sprinklers, guards, burglary alarms
are measures of dealing with risk by reducing its impact. Through the law of
large numbers of exposure units, a reasonable estimate of the cost of losses can
be made. On the basis of these estimates it is possible for an organization such as
an insurance company to assume responsibility of loss of each exposure unit.

Risk Control and Risk Financing

Risk control includes techniques, tools, strategies and processes that seek to avoid,
prevent, reduce or otherwise control the frequency and/ or magnitude of loss and other
undesirable effects of risks. Risk control also includes methods that seek to improve
understanding or awareness within an organization of activities affecting exposure to risk.

Risk control has a strong relationship to risk financing because the control of risks can
have a significant effect on the frequency and severity of losses that must be financed.
The positive effects of risk control on an organization’s risk financing usually occur
irrespective of the particular risk financing methods used: if losses do not occur, loss
financing is not needed. Therefore any efforts to control a risk will usually have a
positive effect on the cost of financing.

Contingency or Catastrophe Planning

This is an integrated approach to loss reduction. It is an organization wide effort to
identify possible crisis or catastrophes and develop plans for responding to such events.
Catastrophe planning usually involves a fairly lengthy process of research and evaluation
that ultimately yields a contingency plan for possible use in the event of catastrophe.

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A catastrophe plan involves the following activities:
 Backup, off-site storage computerized records.
 Updating fire suppressant system.
 Training employees on emergency safety procedures
 Disaster training/ planning with government agencies such as the fire department.
 Creation of an emergency response team or committee e.t.c.

Catastrophe plans are much less likely to succeed if imposed on an organization that has
no existing risk management culture in place at the time of a disaster. Duplication offers a
special case of loss reduction. Backing up of computers files and storing the files off-site
is a good example of duplication while storing of critical spare parts fall under the
concept of duplication too.
Separation is the other case of loss reduction. This technique isolates loss exposures
from each other instead of leaving them vulnerable to a single event e.g. a rule that
requires employees in a supermarket to move cash accumulations over stated amount
from cash registers to a secure location such as bank vault. The logic behind separation is
to reduce the likelihood that a single event could affect all organization’s exposure to loss
Separation does not necessarily reduce the chance of loss to a single exposure unit, but it
tends to reduce the chance of a catastrophic loss.

Information Management
To realize maximum benefits from a loss control program. The program objectives and
benefits should be communicated to stakeholders such as employees insurers, regulators
among others.
Lack of information can cause stakeholders to become uncertain about the nature of the
organizations actions with respect to matters affecting their interests. Communication
also increases awareness of the loss causing process, this allows better forecasts of the
consequences. One possibility for enhancing awareness is a reporting method and system
of rewards for employees who make suggestions leading to safer practices.

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 Role of Government in Risk Management
Governmental agencies are involved in loss control because;
(a) Public interest often demands loss control and quick response to emergencies.
(b) Governmental entities can provide certain services such as those of fire department
more efficiently and economically than can scattered firms.
(c) The government agencies exercise this responsibility through education,
statuses and codes regulating building construction, working conditions, safety
equipment and clothing, sewage disposal facilities and operation of motor vehicles
(d) The government ensures risk control through inspections designed to enforce
the status and codes, police fire departments, rehabilitation programs, assembly and
dissemination of data released to loss prevention etc.

Funding Arrangements
Funding arrangements for retention of risk range from not making any provisions out of
profits to sophisticated techniques such as captive insurance. These are discussed below
(i) No Advance Funding
Many decisions to retain property and liability losses do not involve any formal advance
funding. The organization simply bears the losses when they occur. However, if losses
fluctuate widely year to year the organization may experience distress when large losses
occur. Major losses are rarely financed through borrowing partly because creditors
consider retention of such losses to be financial mismanagement.
(ii) Earmarked liability Account
This account is created to absorb fluctuation in uncovered losses. Each year a provision
for loss is added to this account with profit or other financial gain being reduced by this
amount. When an uninsured loss occurs it is then deducted from this account rather than
from profits thereby smoothing the effects of uninsured loses.
(iii) Earmarked Asset Accounts
Organization may hold cash or investments which can be easily turned into cash for the
purpose of paying uninsured losses. This approach could be used when uninsured loss
could possibly exceed cash available for emergencies.

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iv) Captive Insurers
A captive insurer is an insurer that is owned by the insured. The parent organization
establishes a captive insurance subsidiary that writes insurance against the parents
insured risks. The captive insurers may write insurance for other parties not affiliated
with the parent. Since the captive insurers are part of the same organization with the
parent transfer of risk would not appear to be motive. The reasons for firms forming
captive are;
i) Lack of specialized firm which can offer the kind of insurance required.
ii) When there are no statistics about chance of loss so that accurate premiums can be
calculated.
iii) When the chance of loss is so rare that the parent company does not require re-
insurance.
Non insurance Transfers
Risk financing transfers in contrast to risk control transfers provide external funds that
will pay for the losses should an adversity strike. Non insurance transfers differ from
insurance in that the transferees are not legally insurers.
(i) Instruments of trade credit
Drafts: - are used in international trade. The seller draws up a draft and ships it to the
customer’s bank along with the shipping documents. The customer either pays or
acknowledges debt prior to being gives the shipping documents. The customer’s bank
then forwards the payment or the acknowledgement in the form of a trade acceptance.
Bank acceptance: - If there is uncertainty about a customers ability to pay the seller may
ask the customer’s bank for a guaranty of payment in the form of a bank acceptance.
Letter of Credit: - When an even stronger guaranty of payments is required the seller may
ask the customer to arrange a letter of credit with an established in a bank in the seller’s
country. The letter of credit signifies the customer credit worthiness and should the
customer default the bank will pay for the goods.
Stand by Letter of Credit: Serves the same purpose as letter of credit but in domestic
transactions and may apply to a category of transactions.
In theory, a letter of credit would satisfy financial security requirements for self
insurance. However the holder of a letter of credit faces default risk, hence the letter of

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credit should be confirmed by a bank in the letter of credit or a very reputable bank
outside the customer’s country.
(ii) Other Non-Insurance Transfers
Many of such transfers occur as a result of provisions in contracts dealing primarily with
other matters but in some cases the transfers occur through contracts specifically
designed to shift financial responsibility.
The transfers differ as to the extent of responsibility at one extreme the transferor shifts
only the financial responsibility for negligent act of the transferee (vicarious liability) and
at the other end is to be identified for losses covered under the contract no matter who
caused the loss e.g.
a) Lease contract where the landlord transfer responsibility for damage to the
rented property
b) A courier service contract obligating the bailee to pay for losses in excess of
its statutory or common law liability.
(iii) Hedging
A hedge is employed to offset a risk associated with holding an asset or arising from a
transaction hedging contracts such as options, forwards and futures, swaps have been
employed to offset such risks as price fluctuation of assets e.g. oil, currencies, interests
rates etc. A hedge could also employ assets whose rations are negatively correlated e.g. a
holder of stock in a corporation with oil reserves might hedge the stock to invest in an
electrical utility that uses oil to produce electricity efficient diversification.

Agreements and Combination

A pooling agreement may take the form of an agreement to store losses that occur among
pool participants e.g. municipalities may agree to share liability exposures arising from
fire protection activities through a pooling agreement. A pooling of risk exposures also is
called combination which refers to the combining or pooling of loses arising from a large
number of exposures. This results in the loss per unit becoming more predictable risk
control. The number of units in the pool serves as a proxy for the pools risk bearing
capacity which is in the form of financial resources.

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 Factors Affecting Choice between Retention and Transfer
a) Legal Economic and Public Policy Limitations
Significant limitations apply to transfer of risk especially non insurance transfers.
i) A contract may transfer only part of the risk that the organization though it had
shifted to someone else.
ii) The language is often so complicated that legal action may be required for the
meaning to become apparent.
iii) Courts interpret transfer provisions narrowly due to their being that broad shifts
of responsibilities are often declared invalid by being out of tune with public
policy or being grossly unfair to the transferee.
iv) Since contracts vary widely there are few precedents for courts to follow.
v) If the transferee is unable to pay the transferor must bear the loss.
vi) The transferee who has the major incentive for loss control may lack the
expertise or authority for effective control
b) Degree of control
When an organization has little or no control over the outcome, transfer becomes
attraction. The larger the degree of control the more attractive retention becomes over
transfer. Insurance weakens incentives to prevent or reduce loss because losses are
compensated moral hazard. As a consequence, the premium for insurance coverage is
higher than what it would be if some mechanisms for manifesting the loss prevention
incentives were present. The results are increase in the cost of insurance relative to
retaining the loss. Retention therefore increases the incentives of the organization to
establish the loss-prevention and loss mitigating activities. From a public policy
perspective, society benefits when the burden of loss falls on the party best equipped to
control the loss producing events.
c) Loading Commission, financial services fees and other transactions costs
Loading fees and transaction costs represent the amount by which the cost of transfer
exceeds the expected value of the benefit payments from the transferee. Holding other
factors constant higher loading fees increase the attractiveness of retention. Loading
commissions are fees charged for providing the insurance service. Fees charged by banks
other financial institutions for services such as providing letters of credit or other

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financial commitments are other examples. Securities transactions also entail transaction
costs, when options are used to hedge risk the transaction cost are incurred in buying and
selling securities to maintain the hedge.
d) Value of services provided by insurers and other financial institutions
Loading fees and transaction costs are not necessarily wasted money. In many cases
loading fees are compensation for providing services that the transferee would provide
itself in the absence of the transfer. A bank may provide valuable advice to a client in
arranging a letter of credit and the bank’s compensation may come from arranging the
required letter of credit. Insurers have the advantage that they can spread overhead costs
over many insureds’. They offset to some exert the services would have been provided by
the risk manager. These would otherwise spare the risk manager time in selecting the
insurer, negotiating terms of the insurance contract and the price to be charged and filling
a proof loss with the insurer incase of a loss.
e) Opportunity Costs
Evaluation of insuring a risk versus retention should consider the investment income that
should be earned during the time between payment of the insurance premium and the
ultimate payment of the claim. Investment income reduces the cost of a given claim.
This is often evaluated by comparing the present value of retention costs to the present
value of insuring the risk. In the absence of market restrictions or institutional constraints,
one would not expect the opportunity set of investments to differ between insurers and
organizations that retain risks. Similarly one would expect insurance premiums to reflect
anticipated investment income.
f) Tax Considerations
Generally insurance companies tend to receive favorable tax treatment relative to
consumers of insurance. Insurance companies are allowed to deduct from current taxable
income their provision for future claim payment. A firm paying claims using its own
funds in contrast cannot deduct payments from taxable income until economic
performance occurs (claim payments). Holding other factors constant the tax-induced
effects place insurers at the greatest advantage relative to heavily taxed organizations, but
this advantage declines with lowly taxed forms or non taxed firms. When tax related

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effects are believed to be important, experts in tax accounting and tax law may be
consulted to evaluate appropriate methods for risk financing.
g) Retention may be the only possible method
In some case, retention is the only possible, or at least the only feasible tool. The
organization cannot prevent the loss, avoidance is impossible or clearly undesirable, and
no transfer possibilities (including insurance) exist, consequently the organization has no
choice but to retain the risk. A firm with a plant in a river valley or an earthquake prove
area may find that no other method handling the flood) earthquake risk if feasible.
Abandonment and loss control would be to expensive and no insurance cover available
.In other passes, part but not all of the potential can be controlled or financed internally.
Sometimes insurance is not available unless the insured agrees to absorb the first part of
say Ksh. 5M of any loss. These uninsured losses cannot be completely controlled or
transferred elsewhere; the organization will be forced to retain them.

Commercial Insurance
Insurance is a risk financing transfer under which an insurer agrees to accept financial
burdens arising from loss. The insurer agrees as reimburse the insured the loss (as
defined, in the insurance contract) in return for premium payments. Insurance as a device
of handling risk is covered comprehensively in the next topic.

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 TOPIC FIVE: RISK MANAGEMENT THROUGH INSURANCE
After studying this topic you should be able to:
 Define the insurance
 Explain characteristics of insurance
 Differentiate between insurable and non-insurable risks
 Describe the distinguishing features of insurance contract

Definition of insurance
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.

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

The pool is able to provide a stronger guaranty as it becomes larger because of

pooling of resources. The low of large numbers allows the average loss per insured
unit to fall close to the true expected loss.

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

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the law of large numbers can operate to provide a substantially accurate predication of
future losses. Pooling ensures that units contribute a small amount as premium. Thus in
the event of a loss to unit it can be paid out of the pooled/contributed resources.
Therefore pooling implies
a) The sharing of losses by the entire group
b) Prediction of future losses with accuracy based on the law of large numbers
With regard to the first concept assume that there are 1000 residents in an estate in
Mombasa who agree to share the loss of fire to any of the resident’s house. Further
assume that each of the houses in the estate is valued of Ksh. 1M. With the pooling of
losses the expected loss (1,000,000/1000 = 1,000) is replaced with actual loss Ksh.
1,000,000

With respect to the second concept the law of large numbers states that the greater the
numbers of exposures the more closely will the actual results approach the probable
results that are expected from an infinite number of exposures. For example if you toss a
coin in the air, the apriori probability of getting a head is 0.5. If you flip the coin 20
times you may get a head 15 times. Although the observed probability is 0.75 the true
probability is still 0.5. If the coin is tossed a million times the actual number of heads
would be approximately 500,000. Thus as a number of random losses increases the
actual results approach the expected results.
For most insurance lines, the actuary seldom knows the true likelihood and impact. If
there are a large number of exposure units, the actual loss experience of the past may be a
good approximation of future losses.
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

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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 ones 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. From the insurers
perspective there are six requirements of an insurable risk
a) There must be a large number of exposure units
Ideally the large group of exposure units should be roughly similar but not necessarily
identified. The purpose of this requirement is to enable the insurer to predict loss based
on the law of large numbers.
b) The loss must be accidental and unintentional
The loss must be fortuitous and outside the insured’s control. The reason behind this
requirement is that if intentional losses were paid moral hazards would be substantially
increased and premiums would rise as a result. This would reduce the number of persons
buying insurance leaving an insufficient number of exposure units to predict future
losses. Second the loss must be accidental. Because the law of large numbers is based on
random occurrence of events, and prediction of future events may be inaccurate if a large
number of intentional or non-random events occur.
c) The loss must be determined and measurable
This means that the loss should be defined as to cause, time place and amount. Life
insurance in most cases meets this requirement cause and time of death and face amount
of policy. Some losses are however difficult to determine the cause and amount.
Sickness and disability are highly subjective and the same even can affect two persons
quite differently. The basic purpose of these requirements is to enable an insurer to
determine if the loss is covered under the policy and how much should be paid.
d) The Loss Should not be Catastrophic
This means that a large proportion of exposure units should not incur loss the same time.

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If all or most of the exposure units were to simultaneously suffer losses the pooling
techniques would breakdown and become unworkable. Premium must therefore be
increased to prohibitive levels and the insurance technique will no longer be a viable.
Ideally insures wish to avoid catastrophic losses in reality however this is impossible
since catastrophic loses periodically result from floods earth quakes etc. To meet the
problem of catastrophic loss the insurer:
i) May reinsurance where the insurer is indemnified for catastrophic loss.
ii) May avoid the concentration of risk by dispersing their coverage area over a
large geographic area.
iii) Use financial instrument as catastrophe bonds which are now available for
dealing with catastrophic losses.
e) The Chance of Loss Must be Calculable
The insurer must be able to calculate with the average frequency and average severity of
future losses with some accuracy. This requirement is necessary so that proper premiums
can be charged sufficient to pay all claims expenses and yield a profit to the insurance
company during the policy period. Not all loss can be easily calculated, certain losses are
difficult to insure because the chance of catastrophic loss is presence e.g. floods, wars etc.
f) The Premiums must be Economically Feasible
This means that the insurer must be able to pay the premium further for insurance to be
attractive the premiums paid must be substantially les than face value or amount of the
policy.
Practical Limits to the Requirement of an Insurable Risk
Few if any insurer risk meets all the requirements fully:
i) The condition requirement the loss to be accidental and preventable but cost
associated with monitoring the insured behavior limits the extent to which insurer
can require loss prevention
ii) Issue detaching related to behavior of insurer persons particularly if the insured
can conceal information related to the likelihood of his behavior.
iii) Another issue affecting the insurability of risk is the presence of substitutes for
coverage either through government programs

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 iv) Common law development through court interpretations of statutes and through
resolutions of civil disputes is factor determining whether a given risk is insurable
or not.
v) Most insurers hesitate to pioneer in not successfully tested by other insurers.
In conclusions note that a risk that is generally uninsurable today may be insurable at
some future date because of changes in the risk it self or because of improvement in the
technical knowledge or o ability of insurer or other more compelling reasons.

Distinguishing Features of Insurance Contract

The following are the normal requirements of a valid contract;
a) Offer and acceptance
b) Consideration
c) Legal capacity
d) Purpose not contrary to public interest
Apart from the above normal features of any general contract, the following
characteristics distinguish insurance contracts from other contracts.
i) Personal Contract
Insurance contract are personal contract .Though subject of a property contract .Through
subject of a property contract is an item of property the contract insurer the legal interest
of a person or an entity not property itself. If the owner of a property that is insured sells
it the new owner is not insured under the contract .This reduces the likelihood of moral
hazard that could arise if the identity of the insured were not known by the insurer.
ii) Unilateral Contract
This means that the court will enforce the contract in one direction only .i.e. against one
of the parties and in this case, the insurer. Soon after the insurer has received premiums
from insured, the insured has fulfilled his part of the agreement i.e. the contract is
executed with respect to the insured but still executory with respect to the insurer .
iii) Conditional Contract
The insurer can refuse to perform if the insured does not satisfy certain conditions
contained in the contract for example the insurer need the chance of loss pay the claim if

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the insured has increased the chance of loss in some manner prohibited under the contract
or has failed to submit proof of loss within a specified period.

iv) Aleatory Contract

Aleatory contract have a chance element and an uneven exchange. Under such contract
the performance of at least one of the parties depend on chance and the party promises to
do much more than the other party. The uneven exchange is not a few in the contract but
a fundamental feature of a contract that in both conditional and aleatory.
v) Contract of Adhesion
When legal despite arise over the meaning of contract language court usually follow the
principal of holding the writer responsibility for working a provision. Under contract of
insurance, ambiguous provision are interpreted in favors of insured. This principle is after
referred to as an ambiguity rule. If a provision is a standard insurance contract is
ambiguous court will interpret the provision in a manner favorable to the policyholder.
The principal is however unlikely to hold if the insured particularly in the drafting of the
contract wording the state or other legal authority dictates the working or where brokers
or other agencies negotiate on behalf of their customer over the contract wording. The
exclusions or qualifications must be conspicuous plain and clear. Other distinguishing
features of insurance contract are:
i) Contract of utmost good faith
ii) Valued and indemnity contracts
iii) Contracts employing subrogation
These three features will be discussed below under the principles of insurance

Principles of Insurance
i) Principle of Indemnity
This principle states that the insurer agrees to pay no more than the actual amount of loss
i.e. the insured should not profit from a loss. The principle does not imply that the loss
must be paid in full, because of deductibles or other contract provisions, the amount paid
could be less than the actual loss. This principle has two fundamental purposes. The first
is to prevent the insured from profiting from a loss and the other is to reduce moral

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hazard. Life insurance policies are not contracts of indemnity but valued contracts i.e.
contracts to pay the face amount upon death of the insured.
In property insurance, the basic method for indemnifying the insured is based on the
actual cash value of the damaged property at the time of loss. Courts have used three
major methods to determine the actual cash value.
a) Replacement cost less depreciation
This rule has traditionally been used to determine the cash value in property insurance. It
takes into consideration both inflation and depreciation of property values over time.
Depreciation is a deduction for physical wear and tea, r age and economic obsolescence.
Replacement cost is the current cost of restoring an item to its previous status and quality.
For example assume that a person has insured his car against an accident. A similar car
would cost Ksh 1M, but the car is 30% depreciated. The actual cash value under this
approach will be;
Replacement cost = 1,000,000
Deprecation = 300,000 (car is 30% depreciated)
Actual cash value = replacement cost - depreciation
= 1,000,000 – 300,000
= 700,000
b) Fair market value
This is the price a willing buyer would pay a willing seller in a free market. Some courts
have ruled that fair market value should be used to determine actual cash value of loss.
The fair market value may be below the actual cash value based on replacement cost less
depreciation due to poor location, deteriorating environment etc. If a loss occurs the fair
market value may reflect more accurately the value of loss. For instance if a building’s
value based on cost is Kshs 10m but the market value is Kshs 5m, the actual cash value
based on the fair market value is Kshs 5m and not Kshs10m.
c) Broad evidence rule
This means that the determination of the actual cash value should include all relevant
factors. The relevant factors include replacement cost less deprecation, fair market value,
expected present value of income from the property, opinions of appraisers and numerous
other factors.

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Exceptions to the Principle of Indemnity
There are several important exceptions to the principle of indemnity, these include:
a) Valued policy
A policy that pays the face amount of insurance if total loss occurs is referred to as a
valued policy such policies are typically used to insure antiques, rare paintings, family
heirlooms etc. Due to difficulty in determining the actual cash value of property at the
time of loss, the insurer and insured both agreed on the value of the property when the
policy is first issued. For example a painting worth Kshs.1m today may be insured for
this sum. When it is lost the face value of Kshs. 1m must be paid. As the amount paid
may exceed the actual cash value, the principle of indemnity is violated.
b) Valued policy laws
This are laws that exist in some countries that require the payment of the face amount to
the insured if a total loss the property occurs due a peril specified in the law. The
specified perils vary among the various countries and include fire; lightning etc. For
instance if a building is insured for Kshs. 2m it may have a cash value of Kshs. 1.75mbut
if a total loss occurs the face amount of Kshs. 2m must be paid.
The original purpose for valued policy laws was to protect the insured against allegations
that the property had been over issued by an agent order to receive higher commission.
After a total loss the insurer can not offer to pay less than the face amount for which
premiums had been paid on grounds that the property had been over insured.

c) Replacement cost insurance

Replacement cost insurance means that there is no deduction for depreciation in
determining the amount paid for loss. For example assume that the roof in your house is
7years old and has a useful life of 14years. The roof is damaged by wind storm and the
current replacement cost is Kshs. 500, 000. Under the actual cash rule you would receive
Kshs. 250, 000 (500,000 – 250,000) But under the replacement cost policy, you would
receive the full Ksh500, 000. Replacement cost insurance is based on the recognition that
actual cash value can still result in a substantial loss for the insured.

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 d) Life insurance
A life insurance is not a contract of indemnity but a valued policy that pays a stated sum
to the beneficiary upon insured’s death. For obvious reasons, the indemnity principle may
not apply to life insurance because human life can not be replaced. The need to provide a
specific amount of monthly income for the dependants of the insured, life insurance must
be purchased before death occurs.
ii) Principle of Utmost Good Faith
It states that a higher degree of honesty is imposed on both parties to an insurance
contract than is imposed on parties to other contracts. The principle has its roots in ocean
marine insurance where the insurer had to place great faith in the statement made by the
applicant for insurance concerning cargo to be shipped because the contract may be
formed in a location far from the cargo and ship making inspection difficult. The
principle of utmost good faith is supported by three important legal doctrines.
a) Representations
Representations are statements made by the applicant for insurance. Answers to questions
such as age, health status etc is called representations. A legal significance of
representations is that the insurance contract is voidable at the insurer’s option if the
representations are:
(i) Material
(ii) False and
(iii) Relied on by the insurer
Material means that if the insurer new the true facts the policy would not have been
issued or it would have been issued on different terms. False means that the statement is
not true or is misleading reliance means that the insurer relies on the misrepresentation in
issuing the policy at a specified premium. For example if a person applies for insurance
and states that he/she has not visited the doctor in the past 3 years but had heat surgery 9
months earlier. If the person later dies, the contract would be voidable at the option of the
insurer for making a false material statement that was relied upon by the insurer.
An innocent misrepresentation (unintentional) also makes the contract voidable. Further
the doctrine of material misrepresentation also applies after the loss has occurred. If the

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insured submits a fraudulent proof of loss or misrepresents the value of damaged items,
the insurer has the right to void the coverage.
ii) Concealment
It is intentional failure of the applicant for insurance to reveal a material fact to the
insurer. It is the same thing as non disclosure. The legal effect of a material concealment
is the same as misrepresentation – the contract is avoidable at the insurer’s option.
To deny a claim based on concealment, a non-marine insurer must prove two things:
a) The concealed fact was known by the insured to be material
b) The insured intended to defraud the insurer.
A marine insurer is not required to prove that the concealment is intentional. The
applicant’s lack of awareness of materiality of the fact is of no consequence. An applicant
should reveal all facts to the property. The insurer can successfully deny claim if they
prove that the concealed fact is material.
iii) Warranty
This condition that is affirmative before or on policy reception and promissory during the
period of the policy. A warranty is a statement that becomes part of the insurance contract
and is guaranteed by the maker to be true in all respect. E.g. a firm may warrant that an
automatic sprinkler system will be in working order throughout the term of the policy. A
clause describing the warranty becomes part of the contract. Based on the common law,
in its interest form, a warranty is a harsh legal doctrine that may affect many insured
parties. In cases where minor breaches of the warranty affects risk only temporary or
insignificantly, courts will interpret the breach liberally.

An Analysis of Insurance Contracts

Insurance contracts can be divided into the following parts:
c) Declarations
d) Definitions
e) Insuring agreement
f) Exclusions
g) Conditions
h) Miscellaneous provisions

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All insurance contracts do not necessarily contain all the six parts but the classifications
provide a convenient framework for insurance contracts analysis.
a) Declarations
These are statements that provide information about property or activity to be insured.
This section (declaration) is usually found on the first page contains information on the
identity of the insurer, name of insured, location of property, period of protection, amount
of insurance, amount of premium e.t.c. In life insurance declaration page though not often
the first page it contains the insured’s person name, age, premium amount, issue date and
policy number.
b) Definitions
Key words or phrases have quotation marks (“….”) or are bolded which are then defined.
The purpose of various definitions is to define clearly the meaning of key words or
phrases so that coverage under the policy can be determined more easily.
c) Insuring agreements
The insuring agreement summarizes the major promises of the insurer. There are two
basic forms of an insuring agreement in property liability insurance.
i) Named-perils policy
ii) All-risks coverage
Under a named-perils policy, only those perils specifically named in the policy are
covered. Under an all-risk policy, all perils are covered except those specifically
excluded. All-risk coverage is generally preferable to named-perils coverage, because the
protection is broader. If a loss is not excluded it is then covered. Further the burden of
proof is placed on the insurer to deny claim. To deny claim the insurer must proof that the
loss is excluded. In order to avoid unreasonable expectations the term all risks has been
replaced with risk of direct loss to property. However, this is interpreted to mean all
losses are covered except those excluded. Life insurance is an example of an all risk
policy with a major exclusions being suicide.

d) Exclusions
There are two major types of exclusions
i) Excluded losses
A contract may also exclude certain losses in property insurance for instance,
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 professional liability may be excluded
ii) Excluded property
A contract may exclude or place limitations on the coverage of certain property. In home
owners policy for instance, cars may be excluded.
Reasons for exclusions
i) Some perils are considered uninsurable – A given peril may substantially depart from
the requirements of an insurable risk discussed previously.
ii) Exclusions are also used because extraordinary hazards are present- a hazard is a
condition that increases the chance or severity of loss. As such personal car and a
passenger service vehicle (PSV) should not be charged similar premiums.
iii) Exclusions are also necessary because coverage can be better be provided by other
contracts. This avoids duplication of coverage and to limit coverage to policy best
designed to provide it e.g. a car is excluded from home owner’s policy.
iv) Certain property is excluded because of moral hazard or difficulty in determining or
measuring the amount of loss. A homeless policy may limit coverage of money to say
Ksh. 15,000/= to avoid unlimited coverage which would increase fraudulent claims.
v) Exclusions may also be used because coverage is not needed by the typical insured
party. - Most homeowners do not own planes. To cover planes as part of
homeowners’ policy would be grossly unfair to majority that does not own planes.

e) Conditions
These are provisions in the policy that qualify or place limitations on the insurer’s duty to
perform insurance contract terms. If these conditions are not met the insurer can refuse to
pay the claim. Common policy conditions include notifying the insurer when loss occurs,
protecting the property after loss, preparing an inventory of damaged items e.t.c.

f) Miscellaneous provisions
These include requirements if loss occurs, subrogation, cancellation e.t.c.

Endorsement and Riders

The two terms are often used interchangeably and means the same thing. In property and
Liability insurance, an endorsement is a written provision that adds to deletes from or
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modifies the provision in the original contract. In life and health insurance a rider is a
provision that amends or changes the original policy. For example a home owners policy
exclude coverage for earthquakes, however an earthquake endorsement can be added to
cover damage from earthquakes. Similarly a waiver of premium rider can be added to
life insurance policy if the insured becomes disabled. An endorsement takes procedure
over any conflicting terms of the contract unless it is contrary to the law or regulation.

Deductibles
A deductible is a provision by which a specified amount is subtracted from total loss
payment that otherwise would be payable. A deductible is not used in life insurance
because the insured death is always a total loss and a deductible would reduce the face
amount. Similarly due to the legal defense, personal liability insurance does not use
deductibles.
Purposes of deductible
i) It eliminates small claim that are expensive to handle and process e.g. an
insurer an incur Ksh 500,000 in processing a claim of Kshs. 10,000
ii) Deductible are used to reduce premiums by paid the insured-
Because deductible eliminate small claim, premiums can be substantially reduced. The
principles of insuring large losses instead of small losses are called the Large –loss
principle. Other factors being constant large deductibles are preferred to small ones.

Deductible in property insurance

The following deductibles are commonly found in properly insurance
i) Straight deductible
With a straight deductible the insured must pay a certain number of shilling losses before
the insured is required to make a payment. If for example a car is involved in an accident
requiring Kshs. 100,000 and the policy has a Kshs. 10,000 deductible, the insured will
receive Kshs. 90,000 from the insurer and meets the rest.
ii) Aggregate deductible
An aggregate deductible means that all losses that occur during a specified time period
usually a policy year are accumulated to satisfied the deductible amount, once the
deductible is specified the insurer pays losses in excess of the deductible.
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For example if a policy has aggregate deductible of Ksh. 10,000 and a loss of Kshs. 5,000
occurs during the policy period, insurer pays nothing. If another loss occurs of Kshs
7,000, during the policy the period the insurer is required to pay Kshs. 2,000 i.e.
((5,000+7,000) - 10,000).
Deductible in health insurance
In health insurance a deductible can be stated in terms of money or time
i) Calendar year deductible
Usually found in basic medical expense and major insurance contracts. Eligible medical
expenses are accumulated during the calendar year and once they exceed the deductible
amount the insurer must pay the benefits promised under the contract.
ii) Corridor deductible
A corridor deductible is one that can be used to integrate a basic medical expense plain
with a supplement major medical expense plan. The corridor deductible applies only to
eligible medical expense that is not covered by the basic medical expense plain.
E.g. if a person has Kshs. 2m medical expense cover of which Kshs. 1.5m is paid by the
basic medical expense plan, and has a Kshs. 30,000 corridor deductible the person must
pay Kshs. 30,000 to receive the supplemental Kshs. 500,000 benefit subject to pay
limitations.

iii) Elimination (waiting) period

An elimination waiting period is a stated period of time at the beginning of a loss during
which no insurance benefits are paid. This are commonly used in disability –income
contracts that have elimination period of 30, 60 or 90 days or even longer.

Coinsurance
This requires the insured to insurer the property for a stated percentage of its insurable
value. If the coinsurance requirement is not met at the time of loss the insured must share
in the loss as a coinsurer. A coinsurance formula is used to determine the amount to the
paid
Amount of insurance earned
Amount of re cov ery   Loss
Amount of insurance required
For example if a commercial building has an actual cash value of Kshs. 50m and the
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owner has insured if for Kshs. 30m and an 80% coinsurance clause is present the required
amount of insurance is Kshs. 40m(80% of 50m)Thus if a loss of Kshs.1m occur only
Kshs. 0.75m will be paid i.e.
30M
Amount of re cov ery  1M  0.75M
40M

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The fundamental purpose of coinsurance is achieve equity in rating because most
property insurance losses are partial rather than total losses and if everyone insurers
partially the premiums will be higher. The term coinsurance in property insurance is not
an agreement to apportion loss between parties to contract but a contractual incentive to
carry an amount of coverage close to the value of the property being insured.

In contrast to property insurance a coinsurance clause in health insurance which is

technically called a percentage participation clause is an agreement to apportion loss.
E.g. if a person has a medical expense cover of Kshs 505,000 with a supplement medical
policy with a deductible of Kshs 5,000 and an 80-20 coinsurance clause. The insurer pays
80% of medical expense in excess of the deductible or Kshs 400,000 and the insured pays
20% of the bill plus the deductible or Kshs. 105,000.

Other Insurance Provisions

i) Pro rate Liabilities
If two or more policies insure the same type of insurable interest in the property, each
insurance shares the loss based on the proportion. Each insurance bears its proportion of
the total amount of insurance in the property.
E.g. if a given property is worth Kshs.100, 000 and is insured by insurer A B & C at
Kshs.20,000, Kshs.30,000 and Kshs. 50,000 respectively and a loss of Kshs.10,000
occurs,
20,000 30,000
A meets 10,000  2,000 , B meets 10,000  3,000 , and C meets
100,000 100,000
50,000
10,000  5,000
100,000
ii) Contribution by Equal Shares

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This is usually found in liability insurance and each insurer pays equal amounts until its
policy limits exhausted. In the above example each insurer will share a Kshs. 3333 loss.
(Ksh. 10,000 ÷ 3).

iii) Primary and Excess Insurance

The primary insurer pays first and the excess insurer pays only after the policy limits
under the primary policy are exhausted. e.g. if A owns a car and has a Kshs. 1m policy
for liability insurance and B a friend of A has a liability insurance of Kshs. 0.5 m. if B
drives A’s car and negligently injures C and the Court orders B to pay Kshs 0.75 M since
B is the Primary insurance, it pays the first Kshs. 0.5 m and the rest Kshs. 0.25 m is met
by A’s insurance policy.

Benefits of Insurance
i) Indemnification of the Insured Restoring individuals and families to their
financial position prior to loss allows them to maintain their financial
security, firms also remain in business, employees keep their jobs,
customers continue to receive goods and services, and suppliers still receive

ii) Reduction of uncertainty Worry and fear before and after loss is reduced.
iii) Source of investment funds Premiums paid to insurance firms are invested
in productive activities thus driving economic growth
iv) Interest in loss control The need for insurance gives insurance industry a
direct interest in loss control e.g. highway safety, fire prevention, prevention
of theft e.t.c. Society benefits when losses are reduced.
v) Enhancement of credit Insurance makes a borrower a better credit risk by
generating the borrower’s collateral. E.g. insurance of a house may be a
condition for issuance of a mortgage.

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 Costs of Insurance
i) Increases cost of doing business or operation expenses Administration
expenses, premium taxes, allowances for contingencies, profit e.t.c.
ii) Fraudulent claims/ moral hazard Faked accidents, phony burglaries e.t.c.
iii) Inflated claims Attorneys for plaintiff sue for high – liability judgments.
Insured inflate damages to property e.t.c.

Contemporary Issues in Risk Management

1. Piracy in the gulf of Aden
2. Continued difficulty in measuring the “actual value” added by risk management –
apart from reduced capital requirements.
3. Increased reliance on rating agencies to rate the quality of risk management efforts.
It’s not clear whether these rating agencies are equal to the task.
4. New emphasis on the development of “Generally accepted risk principles. Greater
closure of risk informal

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 THE CONCEPT OF INSURANCE
Meaning of insurance
From a functional point of view, insurance can be defined as a social device or mechanism to
spread losses caused by a particular risk over a large number of people who are exposed to it and
who agree to come together and contribute funds to cover themselves against the risk. Insurance
serves as a mechanism for transferring losses falling on an individual or his family to a large
number of persons each bearing a nominal expenditure and feeling secure against heavy loss. It
is the equitable transfer of the risk of a loss, from one entity to another, in exchange for a
consideration. In a contractual sense, insurance can also be defined as a contract in which a sum
of money known as a premium is paid in consideration of the insurer’s incurring the risk of
paying or large sum upon a given risk. Insurance is a contract in which one party (usually an
insurer) agrees to pay another party (usually the insured) or his beneficiary a certain sum upon
the occurrence of a given risk. The insurer is usually a company selling the insurance.

Insurance is a device that:

Spreads risk over a large number of persons who are exposed to it and are willing to cover
themselves against the risk.

Transfers each number’s individual risk to all the members of the group.

Enables each member’s individual loss to be borne by all the members of the group.

Allows for each member’s loss to be compensated for by the contributions of all the members.

Ensures that a certain sum called the premium is charged in consideration.

Guarantees that a large sum will be paid by the insurer who received the premium upon the
occurrence of the risk insured against.

Provides for the payment to depend upon the value of loss due to the particular insured risk
provided insurance is there up to that amount.

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 The main assumptions in insurance are:

 That a large number of units are exposed to the risk

 That it is possible to accurately predict the number of units that will suffer loss within a specified
period of time.

 That only a few of the units exposed to the risk will actually suffer loss within a specified period
of time.

 That the losses of the unfortunate few who suffer losses are compensated for by the contribution
of the fortunate many.

Conditions Necessary For Insurance:

A large number of homogeneous, similar and independent exposure units. The vast
majority of insurance policies are provided for individual members of very large classes. For
insurance to work, a large number of units must have been exposed to the risk in the past over a
period of time. Large numbers make it possible to examine and observe how the risk has caused
losses in the past which then make it possible to statistically estimate expected future losses
accurately.

The loss must be definite in time, place and value. The event that gives rise to the loss that is
subject to insurance should, at least in principle, take place at a known time, in a known place,
and from a know cause. It must also have a known value. Proof that a loss has occurred is only
possible if the place in which the loss occurred can be confirmed beyond any doubt without these
two, a loss could be an imaginary loss. Insurers only compensate for confirmed losses. Insurers
normally compensate for the value of the loss suffered.

The loss must be accidental. The event that causes the loss should be fortuitous, or at least
outside the control of the beneficiary of the insurance. The occurrence of the loss must be purely
a matter of chance and not the deliberate act of the insured. Insurance does not cover losses
intentionally caused in the hope of obtaining financial gain from the insurer. Events that contain
speculative elements, such as ordinary business risks, are generally not considered insurance.

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It must be economically feasible. It must make economic sense to insure.

There should be no catastrophically large losses or hazard. An insurance scheme cannot

work in a situation where most of the insured units suffer loss within a specified period of time.
If the same event can cause losses to numerous policy holders of the same insurer, the ability of
that insurer to compensate for all the losses will be limited.

There must be insurable interest. Insurable interest is essential for the validity of any contract
of insurance. Insurance contracts cannot be enforced in any court of law where insurable is
lacking. It is a necessary requirement for insurability.

Benefit of Insurance

1. Insurance eliminates uncertainty

Insurance provides certainty of payments at the uncertain of loss. The uncertainty of loss can be
reduced by better planning and administration. But the insurance relieves the person from such
difficult tasks. Moreover if the subject matters are not adequate, the self provision may prove
costlier.

2. Insurance provides protection

The main benefit of the insurance is to provide protection against the probable chances of loss.
The time and amount of loss are uncertain and at happening of the risk the person will suffer loss
in absence of insurance. The insurance provides safety and security against the loss on a
particular event. In case of life insurance payment is made when death occurs or when the term
of insurance expires.

3. Insurance affords peace of mind

The security wish is the motivating factor. This is the wish which tends to stimulate to more
work, if wish is unsatisfied it will create a tension which manifests itself to the individual in the
form of an unpleasant reaction causing reduction in work.

4. Risk sharing

The risk is uncertain and therefore the loss arising from the risk is also uncertain. When risk
takes place the loss is shared by all the persons who are exposed to the risk. The risk sharing in
ancient times was done only at time of date or death but today on the basis of probability of risk

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the share is obtained from each and every insured in the shape of premium without which
protection is not guaranteed by the insurer.

5. Prevention of loss

The insurance joins hands with those institution which are in preventing the loses of the society
because reduction in losses causes lesser payment to the assured and so more saving is possible
which will assist in reducing the premium.

6. It provides capital

The insurance provides capital to the society. The accumulated funds are invested in productive
channel. The death of capital of the society is minimized to a greater extent with the help of
investment of insurance.

7. It improves efficiency

The insurance eliminates worries and miseries of losses at death and destruction of property.
The carefree person can devote his body and soul together for better achievement. It improves
not only his efficiency but the efficiency of the masses are also advanced.

8. It helps economic progress

The insurance by protecting the society from huge losses of damage, destruction and death,
provides an initiative to work hard for the betterment of the masses. The next factor of economic
progress, the capital, is also immensely provided by the masses.

9. Insurance eliminates dependency

At death of the husband or father the destruction of family need no elaboration. Similarly at
destruction of property and goods the family would suffer a lot. The insurance is here to assist
them and provides adequate amount at the time of sufferings.

10. Life insurance encourages saving

The element of protection and investment are present only in case of life insurance. In property
insurance, only protection element exists. In most of the life policies elements of saving
predominates. These policies combine the programs of insurance and savings. The saving with
insurance has certain extra advantage.

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 Systematic saving is possible because regular premiums are required to be compulsory paid. The
saving with a bank is voluntary and one can easily omit a month or two and then abandon the
program entirely.

In insurance the deposited amount cannot be withdrawn easily before the expiry of the term of
the policy. As contrast to this the saving which can be withdrawn at any moment will finish with
no time.

The insurance will pay the policy money irrespective of the premium deposited while incase of
bank deposit only the deposited amount along with interest is paid. The insurance thus provide
the wished amount of insurance and the bank provides only deposited amount.

The compulsion or force to premium in insurance is so high that if the policy holder fails to pay
premiums within the days of grace he subjects his policy to lapse and may get back only a
nominal portion of the total premiums paid on the policy. For the preservation of the policy he
has to try his level best to pay the premium. After a certain period it would a part of necessary
expenditure of the insured. In absence of such forceful compulsions elsewhere life insurance is
the best media of saving.

11. Life insurance provides profitable investment

Individuals unwilling or unable to handle their own funds have been pleased to find an outlet for
their investment in life insurance policies. Endowment policies, multipurpose policies differed
annuities are certain better form of investment.

12. Life insurance fulfils the needs of a person

The needs of a person are divided into:

 Family needs

 Old age needs

 Readjustments needs

 Special needs

 The clean up needs

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 13. Family needs

Death is certain but the time is uncertain. So there is uncertainty of time when the sufferings and
financial stringencies may befall on the family. Moreover every person is responsible to provide
for the family. It would be a more pathetic sight in the world to see the wife and the children of
a man looking for someone more considerate and more benevolent than the husband and the
father who left them un-provided.

14. Old age needs

The provision of old age is required where the person is surviving more than his earning period.
The reduction of income in old age is serious to the person and his family. If no any other family
member starts earning they will be left with nothing and if there is no property it would be more
piteous state. The life insurance provides old age funds along with the protection of the family
by issuing various policies.

15. Readjustments needs

At the time of reduction in income whether by loss of employment, disability or death

adjustments in the standard of living is required. The family members will have to be satisfied
with the meager income and they have to settle lower incomes and social obligations.

16. Special needs

There are certain special requirements of the family which are fulfilled by earning member of the
family. If the member becomes disabled to earn due to old age or death those needs may remain
unfulfilled and the family will suffer:

17. Need for education

There are certain insurance policies and annuities which are useful for education of the children
irrespective of the death or survival of the father or guardian.

18. Marriage

The daughter may remain unmarried in case of father’s death or incase of inadequate provision
for meeting the expenses of marriage. The insurance can provide funds for the marriage if policy
is taken for the purpose.

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 19. Clean up funds

After death ritual ceremonies payment of wealth taxes and income taxes are certain requirements
which decrease the amount of funds of the family member. Insurance comes to help for meeting
those requirements. Multipurpose policy, education and marriage policies, capital redemption
policies are the better policies for the special needs.

Importance of Insurance to Businesses

1) Uncertainty of business losses is reduced

In world of business, commerce and industry a huge number of properties are employed. With a
slight slackness or negligence the property may be turned into ashes. The accident may be fatal
not only to the individual or property but the third party also. New construction and new
establishments are possible only with the help of insurance.

2) Business efficiency is increased with insurance

When the owner of a business is free from the botheration of losses he will certainty devote
much time to business. The carefree owner can work better for maximization of profit. The new
as well as the old businessmen are guaranteed payments of certain amount with insurance
policies at death of the person, at damage, at destruction or disappearance of the property or
goods.

3) Key man indemnification

Key man is that particular man whose capital, expertise, experience, energy, ability to control
goodwill and dutifulness makes him the most valuable asset in the business and whose absence
will reduce the income of the employer tremendously and up to that time when such employee is
not substituted.

4) Enhancement of credit

The business can obtain loan by pledging the policy as the collateral for the loan. The insured
persons are getting more loan due to certainty of payment at their deaths. The amount of loan
that can be obtained with such pledging of policy with interest thereon will not exceed the cash
value of the policy.

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5) Business continuation

In any business particularly partnership business may discontinue at death of any partner
although the surviving partners can restart the business, but in the cases the business and the
partners will suffer economically. The insurance policies provide adequate funds at the time of
death.

6) Welfare of employees

The welfare of the employees is the responsibility of the employer. The former are working for
the latter. Therefore the latter has to look after the welfare of the former which can be provisions
for early death, provisions for disability and provisions for old age.

Importance of Insurance to the Society

1) Wealth of the society is protected

The loss of a particular wealth is protected with insurance. Life insurance provides loss of
human wealth. The human material if it strong, educated and carefree will generate more
income.

2) Economic growth of the country

For the economic growth of the country insurance provides strong hand and mind, protection
against loss of property and adequate capital to produce more wealth. The agriculture will
experience protection against losses of cattle, machines, boilers and profit insurances provide
confidence to start and operate the industry.

3) Reduction in inflation

The insurance reduces the inflationary pressure in two ways: first, by extracting money in supply
to the amount of premium collected and secondly by providing sufficient funds for production
narrow down the inflammatory gap.

4) Insurance protects mortgaged property

At death of the owner of the mortgaged property the property is taken over by the lender of the
money and the family will be deprived of the uses of the property. On the other hand if the

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 mortgagee wishes to get the property insured because of the damage or destruction of the
property, he/she will lose his right to get the loan repaid. The insurance will provide adequate
amount to the dependants at the early death of the property owner to pay off the unpaid loans.
Similarly the mortgage gets adequate amount at the destruction of the property.

5) Principles of Insurance

The principles will act as a guideline both to person(s) who may want to persuade an insurance
company to bear on his or their own behalf the loss that may be incurred by a given risk and to
the insurance company that would as a result undertake the cover. The following is an outline of
these principles.

6) Insurable Interest

A contract of insurance affected without insurable interest is void. It means that the insured must
have an actual pecuniary interest and not a more anxiety or sentimental interest in the subject
matter of insurance. The insured must be so situated with regard to the thing insured that he
would have benefit by its existence and loss from its destruction.

Ways in Which Insurance Interest Can Arise

1) One’s own life

Life is the most valuable possession one could have. It’s priceless and therefore its value can’t
be quantified in monetary terms. There is therefore no financial limit to the insurable interest
that a person has in his life.

2) Husband-wife relationship

Spouses have insurable interest in each others life. This arises out of biblical and common law
concept that a man and his wife are one and the same person. Since their lives belong to each
other, this gives them insurable interest in each others life.

3) Creditor-debtor relationship

The creditor stands to suffer financial loss if the debtor dies before paying the debt. This gives
the creditor some insurable interest in the life of the debtor. The insurable interest is limited to
the total debt outstanding. The debtor on the other hand cannot suffer any financial loss if the
creditor dies. He therefore has no insurable interest in the life of the creditor.

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4) Partnership relationship

Business partners have insurable interest in each other’s life. This is because the business stands
to suffer financial loss if one partner(s) dies. This is as a result of withdrawal of capital from the
partnership to the dead partner’s estate. The surviving partners would therefore have financial
stress. This gives them insurable interest in each others’ life. The insurable interest is limited to
each partner’s financial involvement with the partnership.

5) Ownership

A person who is not the legal owner of a property stands to suffer financial if the property is lost
or damaged or incurs any liability. The extent of the loss would be limited to financially value of
the property itself or the resulting liability. This gives the property owner insurable interest in
the property owned. He can insure such property for any sum not exceeding its market or
financial value.

6) Joint ownership

A partner has insurable interest in any property jointly with another or others. The insurable
interest is limited to the full financial value of the property jointly owned at its full values, but he
will be insuring on his own behalf and on the behalf of other owner(s), it follows then that the
compensation will be made to all the owners if a loss occurs.

7) Bailee

A bailee is a person who is legally in possession of property or goods belonging to another

person. He is required by law to take care of the goods in his custody as if they were his own.
He can be held liable for any goods lost, damaged or which incurs liability while in his custody.
This gives him insurable interest in the goods in his custody. He can insure such goods for a sum
not exceeding their market value or financial liability that could arise.

8) Administrators, trustees and executors

These are people charged with the responsibility of taking care of the estates of others. They
have a legal duty to take care of the estates under their charge as if they were their own. This
gives them insurable interest in any property belonging to the estate. They can insure such
property at their full market or financial value, not on their own behalf but on the behalf of the

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 estate.

9) Potential liability

A person has insurable interest in any potential liability that could cause him or her financial
loss. He can insure for a sum that does not exceed the full financial extent of the potential
liability.

INDEMNITY

A contract of insurance where the insurable interest is limited and can be valued in financial
terms is a contract of indemnity. The object of every contract of insurance is to place the insured
in the same financial position as nearly as possible after the loss as if the loss had not taken place
at all. This means then that the insured in case of loss against which the policy has been insured
shall be paid the actual amount of loss he has suffered as a result of the operation of the insured
risk but not exceeding the amount of the sum insured in the policy. Indemnity therefore simply
means what the insured has actually lost is what he or she gets nothing more anything less. It is
exact financial compensation for a loss suffered through a particular risk.

Methods of Providing Indemnity

1. Cash payments

When the interest pays for the cash value of the item lost or the cash value of the assessed
reduction in the value of an item as a result of the occurrence of the insured peril. This is
the most common method of providing indemnity.

2. Replacement

In this case the insurer replaces the items lost by providing the insured with another item
of similar financial value. This method is mostly used where the items was still brand
new or doesn’t depreciate in value over a period of time. For example, jewellery like
gold ring, diamond etc.

3. Repairs

This method is mostly used in motor vehicle insurance where the insurer arranges for the

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 damaged vehicle to be repaired and pays for the cost of repairs with the garage
concerned. Adequate repairs constitute indemnity.

4. Re-instatement

This method is mostly used in fire insurance policies. The insurer rebuilds the premises
which have been damaged by fire. In ordinary circumstances the insurer prefers to pay
cash to the insured for the damaged premises so that the insured himself will undertake
the building. This is because the insurer would not like to be involved with the
disagreement which will arise between him and the insured when he undertakes to
rebuild himself.

5. Circumstances that Hinder Full Indemnity

In practice it is sometimes possible that a person who has suffered loss as a result of an
insured peril may not be taken to the name financial position he was in immediately
before the loss occurred. The following circumstances operate to prevent the insured
from obtaining full indemnity.

6. Sum received

The maximum liability of the insurer in a contract of insurance is the sum insured. There
is no obligation on the part of the insurer to pay for sum which exceeds the sum insured.
Therefore in a situation where the insured, insured his property for a sum which is less
than the market value or the financial value of the property insured he may not be fully
indemnified when a loss occurs as the insurer will only pay the sum insured which will be
less than the financial value of the loss.

7. Where the insurance policy is subject to average

Where the property is insured on the understanding that the sum insured is the financial
value or the property insured, the policy will become subject to average if it turns out that
the property was actually more than the sum insured.

8. Excess

This is a statement or a clause in motor vehicle insurance policy which states that; if a
loss occurs and the insured want to make a claim for competition he will pay a specified

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 sum of money to the insurer before his claim can be processed and paid. This clause
serves to prevent the insured from launching what is called petty or trivial claims. It
results in less than the indemnity being paid.

9. Franchise

A franchise policy is similar to the policy excess in that they serve the same purpose of
eliminating trivial or petty claims. The difference is only that in a franchise there is a
clause stating that the insurer will only compensate for a loss of total value exceeds a
specified sum of money. Compensation can only be paid where the value of the loss is
greater than the franchise amount.

UTMOST GOOD FAITH

Since insurance shifts risk from one party to another, it is essential that there must be utmost
good faith and mutual confidence between the insured and the insurer. In a contract of insurance
the insured knows more about the subject matter of the contract than the insurer. Consequently
he is duty bound to disclose accurately all materials facts and nothing should be withheld or
concealed. Any fact is material which goes to the root of the contract of insurance and has a
bearing on the risk involved. It is only when the insurer knows the whole truth that he is in a
position to judge if he should accept the risk and what premium he should charge. If that were so
the insured might be tempted to bring about the event insured against in order to get the money.

PROXIMATE CAUSE

The rule of proximate cause means that the cause of the loss must be proximate or immediate
and not remote. If the proximate cause of the loss is a peril insured against, the insured can
recover. When a loss has been brought about by two or more causes, the question arises as to
which is the proximate cause, although the result could not have happened without the remote
cause.

But if the loss is brought about by any cause attributed to the misconduct of the insured, the
insurer is not liable.

1. Remote causes

These are when an original event has occurred and started the motion towards loss, when

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 another new and independent cause occurs and the loss happens. Usually a period of time
lapses between the original cause of the remote cause.

2. Perils relevant to proximate cause

There are three types of relevant perils, which are as follows:

3. Insured perils

Those which are stated in the policy as insured, such as fire and lighting.

4. Exempted or excluded perils

Those stated in the policy as excluded either as causes of insured perils, such as riot or
earthquake or as a result of insured perils.

5. Uninsured or other perils

Those not mentioned in the policy at all. Storm, smoke and water are-not excluded nor
mentioned as insured in a fire policy. It is possible for water damage claim to be covered
under fire policy, if for example a fire occurs and the fire brigade extinguishes it with water.

6. Indirect causes

Some policies sometimes exclude a peril if it caused directly or indirectly by another one.

7. Concurrent causes

These are losses whereby it is clear that more than one event has occurred at the same time,
contributing to the loss. If there is no expected peril involved and the causes cannot be
identified or the parts of the loss separated, then all the damage will be insured. If the losses
can be filtered, then the appropriate settlements will be made, if insured. If an expected peril
is involved in loss involving concurrent causes and the damage cannot be separated then
none of the loss is insured. If it can then only the insured part of the damaged is insured.

SUBROGATION

In insurance subrogation is the right of an insurer to stand in the place of the insured and to avail
to himself all the rights and remedies available to the insured, whether such rights have been
exercised or not. It is a corollary to the principle of indemnity and applies only to contracts of
indemnity. It operates to prevent the insured from making a profit out of a contract of insurance

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by claiming twice. Where the insured property is lost or damaged through the negligence of say
a third party, the insured can make a profit by claiming in full from both his insurer and the third
party. This would be contrary to the requirements of the principles of indemnity which prohibits
parties from making profits out of contracts of insurance. Subrogation only applies to contracts
of indemnity where the insurable interest is limited and can be valued financially. It does not
apply to those life assurance contracts and personal accident insurances where the insurable
interest is unlimited and cannot be valued in monetary terms. Subrogation requires that when an
insured has received full indemnity in respect of his loss, all rights and remedies which he has
against any third person will pass on to the insurer and will be exercised for his benefit until the
(insurer) recoups the amount he has paid for the loss for which he is liable under the policy and
this right extend only to the rights and remedies available to the insured in respect of the thing to
which the contract of the insurance relates.

CONTRIBUTION

Contribution is the right of an insurer to call upon other insurers who have insured the same risk
to share in the cost of an indemnity payment. Where there are two or more insurers on one risk,
the principle of contribution comes into play. The aim of contribution is to prevent the insured
from making a profit by claiming in full from all insurers against the loss. It achieves this by
distributing the actual amount of loss among the different insurers who are liable for the same
risk under different policies in respect of the same subject matter. Any one insurer may pay to
the insured the full amount of the loss covered by the policy and then become entitled to
contribution from his co-insurers in proportion to the amount which each has undertaken to pay
in case of the same subject matter.

The following conditions are necessary for contribution to apply:

(i) There must be at least two or more policies of indemnity existing.

(ii) The two or more policies of indemnity must cover the same perii or risk.

(iii) The two or more polices of indemnity must cover the same subject matter of insurance.

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 (iv) They must cover the same interest of the same insured.

(v) They must be in force at the time of loss.

Methods of Calculating Contributions

There are two methods that can be used in calculating contribution. These include

1. Sum limited method;

This method is used where the total of all the sums insured is either equal to or greater than the
financial value of the insured property. It applies where the whole-risk is transferred to the
insurers and they therefore share in contributing for the whole loss. The formula for calculating
the contribution is

2. Independent liability method;

This method is normally used when a policy is subject to average. This means that the whole risk
was not transferred to the insurer. The insured retained part of the risk. It is therefore applied
where the total of all sums insured by the different insurers is less than the market value of the
subject matter insured. The formula used is;

In conclusion the principle of the contribution only applies to contracts of indemnity where the
nimble interest can be valued in monetary terms.

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 TYPES OF INSURANCE POLICIES

Introduction

Insurance is a concept, a technique, and an economic institution. It is a major tool of' risk
management, and plays an important role in the economic, social, and political life of all
countries.

1. LIFE INSURANCE

There are two basic types of life insurance:

Term Life Insurance covers an individual for a period of time or term that one chooses.

Permanent Life Insurance offers a few more variations, and provides a lifetime of coverage. Each
has benefits that may be important to yon depending on the needs in your life

(i) Permanent life insurance

Permanent insurance, including Whole Life Insurance, Universal Life Insurance and Variable
Universal Life Insurance, can provide protection for your entire lifetime, or in certain instances
up to a specific age at which point the insurer pays the policy owner the cash value. Permanent
life insurance policies can build cash value money that you can borrow against and in some
instances, withdraw to help meet future goals, such as paying for a child's college education.

(ii) Term Life Insurance

Term insurance is generally the least expensive and least complicated type of life insurance. It
provides insurance protection for a specified period of time, such as 1, 10, 20 or 30 years. If you
die within the term period and the policy is in force, a death benefit is paid to your beneficiary. If
you are still living at the end of the term, protection ceases unless the policy is renewed. There is
no “accumulation” element, or cash value with term insurance.

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 2. HEALTH INSURANCE

Health insurance is a type of insurance whereby the insurer pays the medical costs of the insured
if the insured becomes sick due to covered causes, or due to accidents. The insurer may be a
private organization or a government agency. A Health insurance policy is an annually
renewable contract between an insurance company and an individual. With health insurance
claims, the individual policy-holder pays a deductible plus co-payment (for instance, a hospital
stay might require the first Ksh 5000 of fees to be paid by the policyholder plus 500 per night
stayed in hospital). Usually there is a maximum out-of- pocket payment for any single year, and
there can be a lifetime maximum. Prescription drug plans are a form of insurance offered
through many employer benefit plans in Kenya where the patient pays a co-payment and the
prescription drug insurance pays the rest. Some health care providers will agree to bill the
insurance company if patients are willing to sign an agreement that they will be responsible for
the amount that the insurance company doesn’t pay, as the insurance company pays according to
“reasonable” or “customary” charges, which may be less than the provider's usual fee. The
“reasonable” and “customary” charges can vary. Health insurance companies also often have a
network of providers who agree to accept the reasonable and customary fee and waive the
remainder. It will generally cost the patient less lo use an in-network provider. An example of an
insurance company which offers this type of insurance is Madison Insurance Company

UNDERWRITING

This selection and rating of risks, which are offered to an insurer, hi essence, the task of the
underwriter is to manage the pool (created through insurance) as effectively and profitably as he
can. Thus roles of an underwriter may be said to be:

 To assess the risk which people bring to the pool.

 Decline whether to accept or not to accept the risk, or how much of the risk, to accept.

 Determine the terms, conditions and scope of cover to be offered.

 Calculate a suitable premium base.

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 Equally, an underwriter has the task of assessing the hazards associated with the various perils-
brought to the common pool. The concern here is to look out for those hazards that may or might
alter the frequency or severity of the peril. There are two aspects of the hazard, physical and
moral which the underwriter is concerned with.

CLAIMS

Handling claims is the most important aspect of the insurer's advertising. A claim form is the
means by which claims are intimated. The insured may submit his claims personally or through a
duly authorised agent acting on his behalf such as solicitor or an insurance broker. Similarly
different persons may act on behalf of the insurer namely:-

 Insurers' employees - claims department.

 Loss adjusters - professional claim investigators/quantifiers.

 Other agents - solicitors, brokers to agree settlement on their behalf.

Claims Procedure

Claims procedure involves three stages as listed and discussed here after:

 Claims notification

 Claims processing

 Claims settlement

 Claims notification

Insurers needs be notified of a claim as soon as possible usually within, a period of 48hours. This
helps to investigate the claim while evidence is still fresh in the minds of persons involved and
witnesses can be found without difficulties. All events, which may give rise to a claim in due
course, must be communicated to the insurer. This is necessary since investigations may have to
be made to verify the loss, which may be prejudiced by delay, and chances of recovery from the
negligent party are also reduced if inquiries are not made within a reasonable dispatch. Nearly
every insurance policy will require the policyholder or his legal personal representative to notify
the insurer of a possible claim within the stipulated period. The Limitations Act broadly allows

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three years for submitting a claim involving death or injury and six years for other claims. It is
important to note that the above procedure relates to general insurances. In life assurance, the
procedure involves the use of courts because the rife assured may be dead and thus the cause of
the claim. It is essential to have the system in force for the insurer to receive proper proof of
death, proper legal identification of the recipient of any proceeds incorporating any wills and
assignments that may have been made.

SELF-INSURANCE
Self-insurance describes a situation in which a person does not take out any third party
insurance. The essence of the concept is that a business that is liable for some risk, such as health
costs, chooses to "carry the risk" itself and not take out insurance through an insurance company.
In the United States the concept applies especially to health insurance and may involve, for
example, an employer providing certain benefits – generally health benefits or disability benefits
– to employees and funding claims from a specified pool of assets rather than through an
insurance company, as the term is traditionally used. In self-funded health care, the employer
ultimately retains the full risk of paying claims, in contrast to traditional insurance, where all risk
is transferred to the insurer.

Health plans
In the United States, a self-funded health plan is generally established by an employer as its own
legal entity, similar to a trust. The health plan has its own assets, which, under the Employee
Retirement Income Security Act of 1974 (“ERISA”), must be segregated from the employer’s
general assets. The health plan’s assets are derived from pre-tax (in most cases) contributions
made by employees, and sometimes additional contributions made by the employer.

The contributions to the health plan’s assets are required to be immediately segregated from the
employer’s general assets. Any claims incurred by plan members in excess of the amount
contained within the health plan’s pool of assets are the sole responsibility of the employer. The
employer, in that case, must deposit its own funds into the health plan’s trust account sufficiently
to fund any outstanding claims liabilities.

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Health plans that cover dependents as well as employees collect contributions for dependents
from the employee’s payroll deductions. Similar to in traditional insurance, the plan sponsor
determines the cost of health coverage and generally requires different payroll deductions
depending on whether an employee elects self-only coverage, self plus spouse, self plus spouse
plus child(ren), or certain other permutations as determined by the plan sponsor. Self-funded
health care allows some flexibility in structuring a benefit plan; some plans allow fewer options,
for example only a choice between self-only coverage and full family coverage, with two
contribution tiers.

Affordable Care Act

The Affordable Care Act has had huge ramifications on self-funded health plans; market reforms
have invalidated many plan designs that were previously used, and now that employees are
required to have health insurance and many employers are required to offer health benefits as
well,[1] the self-funded industry has enlarged.

ERISA
ERISA is a federal law that sets minimum standards for employee benefit plans, including
pension plans and health benefit plans, in private industry within the United States. ERISA
neither requires an employer to establish a pension plan, with few exceptions,[2] nor dictates what
benefits must be offered; instead, it requires that employers who establish plans meet certain
minimum standards. The law is designed for the protection of plan participants, and to ensure a
uniform statutory body of law regulating applicable benefit plans, throughout every jurisdiction
in the country.

Plan sponsor and plan administrator

There are two primary entities involved in the formation and administration of a health plan – the
plan sponsor and the plan administrator. These terms are defined separately and the difference is
important.

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Plan sponsor
The plan sponsor (also known as the “employer” or “group”) is the entity that sponsors, crafts,
offers, maintains, and funds the plan. While the duties of a plan administrator may be delegated
to an entity other than the employer, the law invariably requires that the employer be considered
the plan sponsor.

Plan administrator
The plan administrator is the entity charged with general plan administration duties, similar to a
trustee in the case of a trust. The plan administrator is always a plan fiduciary; the plan
administrator can share the fiduciary duty with other entities, but the plan administrator is
required to assume some fiduciary duty and cannot disclaim that duty. In general, the plan
administrator is the employer – but new trends in the industry are seeing more and more groups
outsourcing plan administrator duties to TPAs or other entities for a fee.
Employers that sponsor self-funded insurance plans often contract with a third-party
administrator (TPA), which is an entity that provides ministerial services on behalf of the health
plan and the plan sponsor. Traditionally, TPAs do not make discretionary claims determinations;
if a determination requires interpretation of the governing plan document, most TPAs do not
make it but instead require the plan administrator to provide its own determination. This is
because a fiduciary duty is incurred by any entity that exercises discretion over plan assets or in
connection with making a binding determination under a health plan. According to ERISA, no
matter which entity is identified as a fiduciary within the health plan, any entity will be
considered a fiduciary if that entity acts as a fiduciary in a given case. Plan sponsors contract
with their chosen TPA by means of an agreement known as an Administrative Services
Agreement, which outlines the TPA’s duties, generally including administering payment for
claims, issuing benefit determinations, and distributing documentation. This agreement generally
contains provisions that provide for the TPA’s access to the employer’s claims funding bank
account, and TPAs generally charge on a per-employee-per-month fee.

Contrast to traditional insurance

Traditional insurance is, in general, a way for individuals to manage the risk of their health care

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expenses. Individuals pay a set premium to an insurer, and in turn the insurer agrees to pay that
person’s eligible healthcare claims. All risk transfers to the insurer; no matter how much is
racked up in eligible claims, the insurer bears the risk of paying those claims and the insured can
rest easy knowing that he or she will not be responsible. In self-funded health care, plan
sponsors have broad discretion to determine what terms will be used in the plan, as well as to
decide which entities will have the authority to make benefits determinations, factual
determinations, appeals determinations, and language interpretations. In traditional insurance,
those responsibilities (and risks) are all borne by the insurer. Part of every insurance premium is
allocated to the payment of health claims, and part is allocated to profit for the insurance
company. Profit generated by a traditional insurer comes directly from the policyholders, while a
self-funded health plan is, or is funded by, a trust.

Funding
Self-funding involves a transfer of risk from the employee and his/her dependents to the
employer directly. Self-funded health plans pay health claims out of plan assets; there is no
element of traditional insurance on these programs, and the employer assumes all additional
liability for claims that have not been paid by plan (trust) assets. Some health plans have no plan
assets; known as an unfunded plan, a plan with no assets is funded solely from the general
corporate assets of the plan sponsor.

Plan assets can never inure to the benefit of the plan sponsor. Once funds become plan assets –
whether through payroll deductions from employees or employer contributions to the plan –
those assets invariably belong to the plan.

Stop-loss insurance
Stop-loss insurance is a form of reinsurance that insures self-funded plans and their assets. Due
to the limited assets at the disposal of an average employer as compared to an insurance
company, an employer could easily bankrupt itself if its employees incur a large number of high-
dollar claims and the employer is unable to fund them all. This risk is where the concept of stop-
loss insurance comes into play, as it provides the employer with an additional source for funding
to pay for catastrophic losses. Smaller managed care organizations also may purchase stop-loss

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insurance to protect themselves from the risk of catastrophic claims loss, but larger insurance
companies, such as those that more commonly provide fully insured policies to employers,
typically have a large enough pool of assets to be able to assume all of the risk of paying claims.
Most employers, however, have a tangibly limited pool of assets.
As employers turn to ERISA pre-emption as a way to bypass variable state regulations and state
regulations unfriendly to self-funded health plans, it has become apparent that for many, the only
way to achieve this is through the health plan’s purchase of stop-loss insurance; however, many
states have passed laws that attempt to regulate or limit the issuance of stop-loss insurance to
certain groups, either by prohibiting the sale of stop-loss insurance to “small groups” or by
setting a statutory minimum attachment point. A 2013 Kaiser Family Foundation study[5]
revealed that 59% of self-insured groups’ employees are members of plans that have purchased
stop-loss insurance. That number may be a significant underestimate, however, due to groups'
being hesitant to admit that they have stop-loss coverage.

In a traditional fully insured health plan, the employer regularly pays a premium, which is a fixed
rate for a given time period, and the covered employees pay a monthly contribution to the
employer designed to partially offset the employer’s premium. In general, the premium does not
change except in certain specific instances, such as, most commonly, a change in the number of
covered employees. The insurer collects the premiums and pays the health care claims based on
the benefits in the health insurance policy that was underwritten and purchased. The employees
are responsible to pay any deductibles or co-payments required under the policy.

A self-funded plan has fixed components similar to an insurance premium; but to contrast, the
self-funded plan pays the claims incurred by the plan participants, and the employer’s risk is not
capped. Even with stop-loss insurance, the employer still retains one hundred percent of the risk
of claims payments, in a purely self-funded scenario. Stop-loss insurance reimbursements are
made if the claims costs exceed the catastrophic claims levels in the policy, but if a stop-loss
carrier became defunct or simply breached the contract, there would be nothing alleviating the
self-funded plan from responsibility for the full amount of claims.
State regulation
While ERISA preempts some state laws that relate to self-funded employee benefit plans, ERISA

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does not regulate stop-loss insurance, since stop-loss insurance does not protect employees but
instead protects a health plan itself or the employer.

Benefits and risks

One of the main benefits of self-funding is that the group is able to customize the benefits it
offers and tailor the plan to its employee base. With this in mind, the sponsor can craft plan
provisions to cover certain benefits and exclude others as it sees fit. Less is sometimes more, a
Plan which covers the services its employees will likely need and excludes the others will have
much lower cost. As described above, employers that choose to sponsor a self-funded health
benefits plan truly do so at their own risk. To be self-funded, the employer necessarily retains
one hundred percent of the risk of the payment of the health benefits claims of plan participants.
The practical effect of that is that many small groups simply cannot afford to self-fund; a
common theory is that groups with too few employees are unable to collect a contribution
sufficient to allow the employer to pay health benefits claims without bankrupting itself. While
the practical solution to this is simply to charge a higher and higher contribution as necessary,
both the Affordable Care Act and the general business considerations prevent raising the
employee’s required contribution amount above a certain level.
Another major risk of self-funding is that the obligation to make claims determinations falls upon
the Plan Administrator, which is most commonly the employer. While the employer’s chosen
TPA pays or denies claims when the SPD is clear on how a given claim should be treated,
dubious claims are referred to the Plan Administrator for final decision, because most ASAs
specify that the TPA is not permitted to make claims determinations (which protects the TPA
and Plan Administrator alike). Sponsoring a self-funded plan has its risks, but it also has its
rewards. While the group may incur unexpectedly catastrophic claims amounts, stop-loss is
designed to mitigate those claims.

Size of self-funded market

A recent study has reported that as of 2014, about 81% of workers covered by healthcare through
an employer were in a partially or completely self-funded plan,[7] which is up 21% since 1999.
According to the Department of Health and Human Services,[8] over 82% of employers with over
500 employees offer a self-funded health plan, and over 25% of firms with between 100 and 499

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employees, and over 13% of employers with fewer than 100 employees also offer a self-funded
health plan.

As is demonstrated by these statistics, self-funded health plans are rooted in the same underlying
mathematical principal as insurance in general: Spread of risk. Larger employers have more
plan participants over which to spread the risk (loss), and are therefore able to more accurately
predict and budget for the cost of the plan. In contrast, an employer with only 50 employees has
a small number of participants over which to spread the risk, and therefore may experience wide
fluctuations in plan costs as the result of covered losses from only a small number of
participants.

Non-traditional plan models

MEWAs
A Multiple Employer Welfare Arrangement, or MEWA, is a vehicle through which more than
one employer can come together and offer a self-funded plan to employees – a type of co-op.
MEWAs are useful for small groups that on their own would not be able to self-fund; for
instance, a number of local small businesses, each with a dozen employees, can pool their assets,
form a MEWA, and offer a self-funded plan as successfully as one company with the same
number of total employees.
ERISA defines a MEWA as:
The term “multiple employer welfare arrangement” means an employee welfare benefit plan, or
any other arrangement (other than an employee welfare benefit plan), which is established or
maintained for the purpose of offering or providing any [welfare benefit] to the employees of
two or more employers (including one or more self-employed individuals), or to their
beneficiaries…

The definition goes on to except rural telephone and electric cooperatives, and any plan
established or maintained pursuant to a collective bargaining agreement. The benefits included
as welfare plan benefits are broadly described and wide-ranging. Virtually any type of health,
medical, sickness, or disability benefits will fall into this category, regardless of whether the
benefits are offered pursuant to a written instrument or informally, funded or unfunded, offered

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on a routine or ad hoc basis, or limited to a single employee-participant.
If it is determined that qualifying benefit is being provided, a determination then must be made
as to whether the benefit is being provided by a plan “established or maintained by an employer
or by an employee organization, or by both.” For example, MEWAs provide medical and
hospital benefits, but MEWAs generally are not established or maintained by either an employer
or employee organization, and, for that reason, do not constitute ERISA-covered plans.

There are certain requirements of a MEWA, and many benefits; MEWAs are governed by state
insurance law, rather than ERISA, regardless of whether the MEWA’s constituent groups would
separately be governed by ERISA if they were to sponsor separate plans.
Section 514(b)(6)(A)(ii)[10] of ERISA provides that in the case of an employee welfare benefit
plan which is a MEWA, any law of any state which regulates insurance may apply to the extent
not inconsistent with Title I of ERISA. Accordingly, if a MEWA is self-funded rather than fully
insured, the only limitation on the applicability of state insurance laws to the MEWA is that the
law not be inconsistent with Title I of ERISA. In general, a state law would be inconsistent with
the provisions of Title I to the extent that compliance with such law would abridge an affirmative
protection otherwise available to plan participants under Title I or would conflict with any
provision of Title I, making compliance with ERISA impossible. For example, any state
insurance law which would adversely affect a participant’s or beneficiary’s right to request or
receive documents described in Title I of ERISA, or to pursue claims procedures established in
accordance with Section 503 of ERISA, or to obtain and maintain continuation health coverage
in accordance with Part 6 of ERISA would be viewed as inconsistent with the provisions of Title
I. Similarly, a state insurance law that would require an ERISA-covered plan to make imprudent
investments would be inconsistent with the provisions of Title I.

Conversely, a state insurance law generally will not be considered inconsistent with the
provisions of Title I if it requires ERISA-covered plans constituting MEWAs to meet more
stringent standards of conduct, or to provide more or greater protection to plan participants and
beneficiaries than required by ERISA. The Department of Labor has expressed the view that any
state insurance law which sets standards requiring the maintenance of specified levels of reserves
and specified levels of contributions in order for a MEWA to be considered, under such law, able

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to pay benefits will generally not be considered inconsistent with the provisions of Title I. The
Department of Labor also has expressed the view that a state law regulating insurance which
requires a license or certificate of authority as a condition precedent or otherwise to transacting
insurance business or which subjects persons who fail to comply with such requirements to
taxation, fines and other civil penalties, would not in and of itself be considered inconsistent with
the provisions of title I.

School trusts
School trusts are MEWAs, but some states impose slightly different requirements upon MEWAs
established solely by a group of public schools. It is unclear whether some states treat these
particular MEWAs differently due to the government funding of the schools or the public interest
served, but some states have lowered the enforcement or standards or other requirements for
these MEWAs.

Captives
Rather than a co-op, as each of the previous sections has described, a captive is a subsidiary
created to provide benefits to its parent company or companies – although when a captive is
offered by more than one employer, the captive is a form of co-op. Captives present risk-
management resources for employers who provide self-funded health plans to their respective
employees. As is the case with all self-funding arrangements, when a self-funded health plan is
offered by a captive, the captive, as opposed to any one particular employer, bears the risk.
In October 2006, the International Association of Insurance Supervisors published an “Issues
Paper on the Regulation and Supervision of Captive Insurance Companies.” The Issues Paper
defines a captive as:
an insurance or reinsurance entity created and owned, directly or indirectly, by one or more
industrial, commercial or financial entities, the purpose of which is to provide insurance or
reinsurance cover for risks of the entity or entities to which it belongs, or for entities connected
to those entities and only a small part if any of its risk exposure is related to providing insurance
or reinsurance to other parties.

Shock loss is the direct loss that is borne by a self-funding entity; if a self-funding entity has

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purchased stop-loss, amounts of shock loss that rise above an amount known as the specific
deductible are covered by the applicable stop-loss policy. Under the captive model, the parent
companies do not themselves offer health plans. Instead, the captive is the only entity offering,
sponsoring, and maintaining the self-funded health plan. Accordingly, the captive bears the risk
of shock-loss.

A captive increases the ability of a group to properly manage risk. Self-funding is simply not an
option to some employers; in order to be able to efficiently fund shock losses from the general
assets of the Plan Sponsor, members of a group must contribute enough to the Sponsor’s general
assets, in the aggregate, that the Plan Sponsor is able to pay claims incurred by participants of the
plan.

Advantages and Disadvantages of Self-Funded Insurance Plans

Some businesses provide health or disability benefits to their employees through a self-funded
plan, also referred to as Administrative Services Only (ASO). In this type of plan, instead of
paying fixed monthly premiums for insurance coverage to an insurance company, the employer
uses company funds to pay each claim as it is incurred. In essence, the employer stands in the
shoes of the insurer. This type of arrangement is not for every business, and works best for those
that have more than 50 employees but more prevalent with groups over 100. Companies with
fewer employees may decide it could work for them, but they must have sufficient cash flow to
make a self-funded plan viable. In order to assist employers to decide whether or not it would be
in their interest to have a self-funded plan, they need to evaluate their existing plan and review
past claims experience if available, specifically large claimant information. They also need to
weigh the advantages and disadvantages to such a plan before making the final decision to
transition from a fully insured plan to a self-funded one.

Advantages To Employers

 Improvement of cash flow: Self-funded plans only pay submitted claims and can reserve
the funds that normally would have been used to pay for a fully insured plan to
accumulate interest and increase cash flow.

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 Ability to avoid state mandates: Self-funded plans are regulated by ERISA, which is
federal law, and not controlled by the individual state’s insurance laws.
 Flexibility in benefit design: Employers can choose what benefits to provide as opposed
to insurance companies which must provide coverage consistent with the plan provisions
they have filed with the state.
 Flexibility with plan components: Employers can select vendors, such as plan
administrators, health care providers and others with whom to contract to best serve the
specific needs of their employees.
 State tax savings: Self-funded plans save about two to three percent on every dollar since
they only pay taxes on the Stop-Loss coverage they purchase, not on the total cost of a
fully funded plan.
 Savings on insurance carrier risk charges: Claims processing by employers is less
expensive than the cost of fully insured plans.
 Rebates for prescription drugs: The plan may be able to receive a portion of
pharmaceutical rebates
 Claims data access: Employers of self-funded plans have access to claims data they do
not have access to under fully-insured plans due to HIPAA privacy requirements. This
helps them analyze and predict future plan costs.
 Cost of plan administration: This may be slightly less expensive than a fully-funded plan.
 Disadvantages To Employers

 Potential for higher costs: There is always the chance that the actual costs will be greater
than the prediction and that could mean the self-funded plan was actually more expensive
than a fully-funded one.
 Need to purchase stop-loss insurance: In order to limit employer liability for catastrophic
events, employers purchase stop-loss insurance.
 Budgeting problems: The amount needed to pay claims varies from week to week,
making it difficult to budget.
 Employer becomes a fiduciary as plan administrator.
 Privacy requirements of HIPAA: Employers must develop procedures for protecting the
privacy of the health records of their employees.

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  Cost of drafting plan documents: Employers are responsible for all plan documents
including a plan summary and description.
 Requirement to have an appeals process: This must be in place so employees have
recourse if their claims are denied.
 Must meet IRS non-discrimination requirements: If these requirements are not met, there
may be a substantial penalty imposed.

The major issue employers who are considering self-funded programs must consider is that in the
self-funded plan, the employer is the one at risk for paying the claims. For companies with fewer
than 50 employees, self-funded plans may not be the best option, although it is possible to reduce
the risk somewhat by purchasing excess-risk coverage. For small business employers, it is
recommended they make this decision after consulting with SIG and providing the company with
as much information as possible concerning the type of work force and past claims. This will
make it easier for SIG to help the business owner assess whether or not to choose a fully insured
or self-funded benefit plan. Employers are continuously searching for ways to reduce employee-
benefit costs while still providing competitive plans. One option employers should consider is
self-insurance. Traditionally, self-insurance has been utilized by large employers with at least
1,000 employees. However, medium-sized employers with as few as 200 to 250 employees
should also consider this funding alternative.

Self-insuring a medical plan differs from the traditional insured plans in a few key ways. In a
self-insured plan, the employer pays an administration fee (usually a fixed fee per employee) to a
third-party administrator to adjudicate and pay claims to providers. The employer also pays the
amount of the actual claims processed up to their reinsurance amount(s) as well as any
reinsurance premiums. The employer is "the Plan," and the administrative and reporting
requirements of the plan are the responsibility of the employer, unless contracted to a third party.
In a fully insured plan, an employer's liability is limited to the premium rates multiplied by the
enrollment and prior to the Patient Protection and Affordable Care Act, the reporting and other
administrative requirements were limited.

There are two types of reinsurance an employer can purchase to protect from catastrophic claims.

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Specific reinsurance offers per-member protection. A specific reinsurance limit of $50,000
provides reimbursement or advancement for all covered claims paid over $50,000 per member in
the policy/contract period. Aggregate reinsurance offers overall protection. An aggregate
reinsurance limit of 125 percent provides reimbursement of all covered claims paid (after
subtracting any specific claims reimbursements) over 125 percent of the total expected claims for
the policy/contract period.

Some advantages and disadvantages of self-insurance are:

Advantages
* Plan-design flexibility and customization.
* Availability of detailed claim data.
* Lower administration fees.
* Expanded claim-appeals policies and procedures.

The decision to self-insure is one that an employer should make carefully and thoughtfully.
Professional advice from a broker or consultant should be utilized in order to ensure that the
proposals from TPAs and reinsurers are evaluated properly and compared on the same basis.
There are many different terms and policy provisions in self-insurance. An understanding of
contract terms like "15/12," "paid and incurred," "aggregating specific" and "terminal liability"
are all critical to the evaluation of the alternative-funding arrangements. Additionally, provider-
discount analyses need to be performed on the different provider networks that are proposed to
ensure adequate stop-loss coverage is purchased. Similarly, the prescription-drug list needs to be
reviewed to ensure specialty drugs are covered either by the medical carrier or separate
pharmacy benefit manager, and which drugs are not covered or require pre-authorization or step
therapies. In the right circumstances, self-insurance can cut the cost of medical plans, benefitting
the employers and employees, but a careful evaluation must occur before a wise decision can be
made.
In order to seek knowledge of advantage and disadvantage of self insured business, support
employers to make a decision whether or not it would be in their concern to have a self insured
business, they need to weigh up their existing plan and evaluate past claims occurrence if

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available, specifically large applicant information. They also need to evaluate the advantages and
disadvantages of self insured business before making the final decision to move self insured
business. Business owners may also become more reluctant to taking risks and become
provisional in their decision-making. This could restrain the growth potential of the business.
Additionally, self insured business may restrain business activities. This is because many
financial service providers, particularly banks, want to see evidence of risk administration efforts
and may require certain types of insurance before they provide business finance. Suppliers may
also be deterred from dealing with a business that is not insured. Some business owners provide
health or disability benefits to their employees through paying fixed monthly premiums for
insurance coverage to an insured business, the employer uses company resources to pay each
claim as it is incurred. Following few lines will help you to decide whether or not a business
should be self insured:-

Manageable Investment and Reserves

When you self insured, you choose the hoard you want to invest in, within reason. When a
business uses self insurance plan for health insurance, the investments do have to follow some
guidelines, though the guidelines vary by state. The procedure of self insuring means you may
take additional risks in your investments that an insurance corporation wouldn't or couldn't take.
You may end up with enough cash reserves at a lower effective premium cost than if you had
used an insurance corporation to move the risk away from you.

Manage benefit expenditure

With self insurance, you can manage when claims are paid. With an insurance corporation, there
may be claim forms to fill out and you may have to have your claim approved by an adjuster.
When you self-insure, you won't have any of that to worry about. You simply withdraw the
funds as desired. When you withdraw the funds from your bank account, or whatever investment
account you're using for your cash assets, you may spend the money any way you wish. With an
insurer, the insurance corporation may otherwise specify how those funds are to be used and may
require proof that the funds were used a positive way.

Improved Regulation

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When a business tries to self-insure, it may be subject to strict systematic regulations. This is
especially true in the case of health insurance. A corporation wishing to self-insure for medical
operating expenses often needs to establish significant cash reserves, which may hinder the
company's ability to spend money on business growth. The regulations may also specify that
only part of the liability may be self-insured while the company may be required to purchase
catastrophic coverage in the event the company's reserves fall below a certain threshold.

Increased accountability
Regardless of whether you're a business or individual, you're retaining all of the speculation risk
yourself. This could be considerable. If you have to use your cash reserves to fund an otherwise
insurable event, then you may be left with low or no cash reserves to fund future insurable events
as they occur. A series of unfortunate insurable events may completely drain your cash reserve
account, causing you to incur damages that you have no way to pay for. In some instances, like
self insured business for health insurance, you may be sued by creditors or employees to provide
promised benefits. You may be fined by the state, in a business perspective, if you're unable to
provide the promised advantage costs. One of the Advantages of self insured business is
economic sense when the premiums you would pay far compensate the risks you are covering
the yearly damages costs less than the premiums. And disadvantages of self insured business is
You can't predict the future, the once in two hundred year event can happen any year, so you
could end up with a huge loss.

Captive Management

A captive is an insurance company created and wholly owned by one or more non-insurance
companies to insure the risks of its owner (or owners). Captives are essentially a form of self-
insurance whereby the insurer is owned wholly by the insured. They are typically established to
meet the risk management needs of the owners or members. Captives are formed to cover a wide
range of risks; practically every risk underwritten by a commercial insurer can be provided by a
captive.

Captives can be established to provide coverage where insurance was unavailable or

unreasonably priced. The benefits of a Captive include:

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  Asset protection from the claims of business and personal creditors;
 Reduction in the amount of insurance premiums presently paid by the operating
company;
 Access to the lower cost reinsurance market;
 Insuring risks that would otherwise be uninsurable and the
 Opportunity to accumulate wealth in a tax favoured vehicle.

This alternative form of risk management is becoming a more practical and popular means
through which companies can protect themselves financially while having more control over
how they are insured.

There are various types of captive structures. The vast majority of captives insure only the risk of
its parent (‘pure’ captive).

Captives operate on two main bases;

Reinsurance captives

This is the most prevalent form of captive in Europe. This type of captive underwrite risks
through a local insurer, termed a fronting insurer, which is generally a conventional external
insurer.

The parent and/or its subsidiaries pay premiums to the fronting company in exchange for cover
which is provided on the understanding that a large proportion of the total risk is reinsured to the
captive.

One of the primary reasons for operating a reinsurance captive, rather than a direct writing
captive, is that in some territories the law requires that certain types of coverage can only be
purchased from insurers licensed within that territory

Direct-writing captives

These are captive insurers which underwrite the risks of the parent company, without the use of a
fronting insurance company.

The fundamental advantage of this form of captive lies in the fact that the entire underwriting
process takes place in house, thus eliminating the expenses of the fronting company.

In addition, the use of a direct writing captive structure facilitates access to the wholesale
reinsurance market and thus provides a highly cost effective risk transfer solution to corporate

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 INTRODUCTION

1.0 What Businesses Do

The Value Chain

It’s a perspective which sees as a chain of activities that transforms inputs into outputs that
consumer’s value. In the insurance markets it’s an audit of internal strengths which gives an
insurer its competitive strength and weaknesses which that may put it at risk. It examines how a
business creates customer value by examining the contribution of separate activities and business
process that are performed to design, produce, market, deliver and support a product/ service and
how well they create customer value.

It consists of two types of activities:-

Primary activities which create customer value which include
 Inbound logistics – costs of obtaining RM, parts and components, merchandise from
suppliers, receiving, storing inspection and inventory management.
 Operations – converting inputs to outputs i.e. Production assembly, packaging,
equipment maintenance, facilities, quality assurance and environmental protection.
 Outbound logistics – activities in distributing the product to buyers i.e. warehousing,
order processing, packing shipping and delivery.
 Sales and Marketing – activities, costs and assets related to the sales force i.e. advertising,
promotion, market research, planning and distributor support. For insurance companies

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 Sales and Marketing involves direct and intermediary sales, websites advertising and
public relations
 Service – activities that are involved in providing buyer assistance e.g. installation, spare
part delivery, maintenance and repair, technical assistance, buyer inquiries and
complaints.

Support activities which include

 Procurement – purchasing RM, supplies, services, outsourcing necessary to support the
firm in its activities
 Research, Technological and systems development – product and process R& D,
process design improvement, equipment design, computer software, telecommunications
and so on.
 Human resource management – activities, costs and assets related with recruitment,
hiring, training, development and compensation of all types of personnel, labor relations
and development based skills.
 General Administration – activities and costs associated with general management
accounting and finance, legal and regulation, safety and security, MIS and overheads.

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 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

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
v. Social risks

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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.

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.

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.

Economic risks are those risks that a business or an individual faces because of this changes in
economic conditions. Such changes may be caused by droughts, floods, wars, overpopulation,

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coup de tat, 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.

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.

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2.4. Terms Related to Risk
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.

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

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

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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

When we talk of moral hazard we mean behavioral 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

Hazards may or may not cause loss per se, but may increase the probability of a loss occurring
i.e. increasing the risk.

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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

2.5.1. There’s a Cost to Risk – Financial Distress
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 cost of pure risk includes the 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.

2.5.2. Impact on Stakeholders – Whether Contractual or Not

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

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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.

2.5.3. Opportunity costs

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.

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.

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 CLASSIFICATION OF RISKS
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.

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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 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 werechanges 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

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regularity. Dynamic risk occur without any 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.

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

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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.
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!

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 BURDEN OF RISKS
Outline of the lecture
 Introduction
 Objectives
 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

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 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 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

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 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

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 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
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.

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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
 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.

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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

Loss prevention involves incurring costs to prevent any losses from occurring. Most of the risks

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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

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 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:
Expected value may be calculated as follows:

EV = Sum (pjxj)

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

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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
 Cost of hiring a property manager
 Cost of maintenance
Premiums paid to insurers to cover any possible damage to the property
Loss Costs

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 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

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
1. Cost incurred in treating an injured staff

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2. Liability cost for negligence of staff
3. Cost of replacing, repairing damaged property by staff

3.6.2 Indirect Costs

1. Cost of damaged image as a result of the actions of staff
2. Cost of demoralized staff in meeting their targets
3. 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.
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

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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
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.

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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

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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
 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,

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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.

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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?
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”.
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

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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”.
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.

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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 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

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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.
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

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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 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.

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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.
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.

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 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:
 Identify the level of management that is charged with the risk management task;
 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.
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

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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.
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
program 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

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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 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

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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.
(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.
(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.
(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.

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(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.
(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.
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.
The more ambitious the economy objective, the bigger this conflict will be. Tradeoffs 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.

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 RISK MANAGEMENT PROGRAMME
IDENTIFICATION AND MEASUREMENT OF RISK

6.0 INTRODUCTION
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:-
 Logically explain the importance of the identification and measurement steps in the risk
management process.
 Discuss the usage, merits and demerits of the various identification tools.
 Discuss the measurement and basis for ranking risks that have been identified.

6.2 Risk Identification Process

It is important to note that a 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.

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.

6.3 Identification Tools

6.3.1 Key Risk Indicators (KRIs)

Key risk indicators provide information on the risk of potential future losses. They should make
it possible to identify areas with elevated risks early on and to take appropriate measures.
Thresholds (“triggers”) may be defined for KRIs. They permit statements to be made on trends
and can serve as indicators in an early-warning systems, e.g. in combination with a traffic-light

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 system (red, yellow, green).
Examples of KRIs are:
i. staff fluctuation rate,
ii. days of sickness leave,
iii. hours of overtime,
iv. number and duration of system failures,
v. internal audit findings,
vi. frequency of complaints,
vii. Wrong account entries.
In addition to risk indicators, the following related indicators are sometimes mentioned:
i. key control indicators (KCIs),
ii. key performance indicators (KPIs),
iii. key management indicators (KMIs).
The application of KRIs, however, involves several problems. For example, difficulties with
regard to classification and, hence, comparability already.
Common KRI’s in Insurance according to Mark Verheyen are:
 Production
o hit ratios,
o retention ratios,
o item count,
o pricing levels (renewal business and new business),
o rate per unit of exposure;
 Internal controls
o audit results,
o audit frequency;
 Staffing
o employee turnover,
o training budget,
o premium per employee,
o policies per employee;
 Claims

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o frequency,
o severity,
o new classes of loss

6.3.2 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.
Here also, the risk manager only needs to scrutinize such a catalogue, picking out the positions

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 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.
6.3.3 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”
6.3.4 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.
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

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ii. Sales and Production Budgets
iii. Cash Budgets
(c) Cash-flow Budgets
i. Cash movements
(d) Income Statement
ii. Revenues
iii. Expenditures

6.3.5 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.
(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

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 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.
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.
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:
1. Premises
2. Processes in the organization
3. Goods/Services produced
4. Operations outside the premises
5. Key Employees
6. Transport
7. Security Arrangements
8. Research and Development Activities
9. Loss Prevention Arrangements
6.3.7 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.

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6.3.8 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.
6.3.9 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

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 RISK HANDLING TECHNIQUES
IMPLEMENTATION AND REVIEW
7.0 Introduction:
In this lecture, we 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 program.
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.
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.

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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?

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

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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.
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

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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.
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.

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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.
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.

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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 firefighting 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

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 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.

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 DETERMINING RISKS USING PROBABILITIES
8.0 Introduction
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
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

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 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
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

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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:
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.

Measurement of Risks Using Probabilities:

Assume population of 1,000 houses for consideration:
Dispersion and Probability considering two scenarios:

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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:

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 Year Average Actual Loss Difference Diff. Sq
Loss
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

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

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standard deviation the less risky it is. The insurers take into consideration these dispersions in
categorizing or determining the rates for various risks.

END

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