Business Studies Form 2 Notes : INSURANCE

Insurance

Insurance is a contract between an individual or business and an insurance company against the occurrence of risks—events that are unforeseen but cause financial losses or suffering to the affected parties.

Risks, also called contingencies, hazards, or perils, include:

• Fire outbreak
• Accidents
• Thefts
• Deaths
• Disabilities

Risks are real and unforeseen. Attempts to eliminate such risks have achieved little, necessitating the need for insurance.

Importance of Insurance

1. Continuity of business
   Every business faces various risks, such as fire or theft. Insurance provides protection by compensating losses from insured risks, enabling business operations to continue.
2. Investment projects
   Insurance enables investors to engage in profitable but risky projects. Not all premiums are used for compensation; some are invested to earn profits.
3. Creation of employment
   Insurance provides job opportunities to the public.
4. Government policy
   Insurance companies generate revenue for the government through taxes on their profits.
5. Credit facilities
   The insurance industry offers credit or loans for investment projects and personal needs.
6. Development of infrastructures
   Insurance firms contribute to urban development by constructing residential and office buildings and other infrastructural facilities.
7. Life policies can be used as security for loans from insurance companies or financial institutions.
8. Life and general insurance encourage planning for dependants, reducing future needy students.
9. Loss prevention
   Insurance companies encourage insured parties to avoid accidents, channeling unclaimed resources into the economy.

The Theory of Insurance

Insurance relies on the law of large numbers, which requires a large group facing similar risks spread over a geographical area.

Each person contributes small amounts called premiums into a common pool managed by the insurance company.

1. Geographical spread prevents concentration of risks in one area.
2. The law allows accurate estimation of probable losses and the number of applicants to determine appropriate premiums.

Pooling of Risks

Insurance operates on the principle that only a few people in a group suffer losses. The losses are spread over all contributors, each bearing a small portion, so the burden is shared.

Benefits of Pooling of Risks to Insurance Companies

1. Creates a common fund from premiums.
2. Enables compensation for losses.
3. Spreads risks over many insured people.
4. Allows investment of surplus funds.
5. Meets operating costs from the pool.
6. Calculates premiums for clients.
7. Enables re-insurance with other companies.

Terms Used in Insurance

Insurance

A written contract transferring financial responsibility for losses from the insured to the insurer.

Premium

The amount paid regularly by the insured to the insurer for coverage.

Risk

Events or perils against which insurance is taken, causing potential losses.

Note: Premiums depend on the type and probability of risk; higher risk means higher premiums.

Pure Risk

A risk that results only in loss or no change, e.g., a car accident causes loss; no accident causes no gain or loss.

Speculative Risk

A risk that may result in loss or profit, e.g., buying shares that may increase or decrease in value.

Insured

The individual or business taking the insurance cover and paying premiums.

Insurer

The company providing insurance cover and compensation for losses.

Actuaries

Professionals who calculate expected losses and premiums.

Claim

A demand by the insured for payment due to loss from an insured risk.

Policy

The document detailing terms and conditions of the insurance contract, issued after the first premium payment.

Information Contained in a Policy Includes:

• Name, address, and occupation
• Policy number
• Details of insured risks
• Value of insured property
• Premiums payable
• Special conditions, e.g., nominees

Actual Value

The true value of the insured property.

Sum Insured

The value stated by the insured for which the property is insured.

Surrender Value

The amount refunded to the insured if premiums stop before contract maturity, usually less than total premiums paid.

Grace Period

The allowed time between contract signing and first premium payment, usually up to 30 days, during which the contract remains valid.

Proposer

A person wishing to take out insurance (prospective insured).

Cover Note (Binder)

A temporary document given upon first premium payment as proof of coverage while the policy is processed.

Annuity

A fixed annual payment by the insurer to the insured until death, in exchange for a lump sum saved with the insurer.

Consequential Loss

Loss incurred due to business disruption following an insured risk.

Assignment

Transfer of an insurance policy to another person, who then receives any claims.

Beneficiaries

People named in a life assurance policy to receive payment upon the insured’s death.

Nomination

Designation of beneficiaries (nominees) in case of the insured’s death.

Average Clause

A clause discouraging under-insurance by allowing compensation proportional to the insured sum relative to property value.

The formula for compensation is:

Compensation = (Value of the policy × Loss) / Value of property

Example:

If a house worth Kshs. 800,000 is insured for Kshs. 600,000 and suffers a loss of Kshs. 400,000, compensation is:

Compensation = (600,000 × 400,000) / 800,000

Double Insurance

Taking insurance policies with more than one company for the same risk and subject matter. If one insurer is insolvent, claims can be made against the solvent insurer; if both are solvent, compensation is shared.

(Insolvency means inability to pay liabilities from assets.)

Co-insurance

Multiple insurance companies share coverage of the same risk, each covering a proportion of the total value. The insurer with the largest share acts as the leader, handling premiums and claims.

Note: Co-insurance involves insurers sharing risk; double insurance involves the insured taking multiple policies.

Re-insurance

When an insurance company insures itself with a larger insurer (re-insurer) to share risks and reduce loss burden.

Note: Re-insurance protects insurance companies, while insurance protects individuals and businesses.

Factors Necessitating Re-insurance

1. Value of property: High-value items like ships require re-insurance.
2. High risk of loss: High-risk exposures necessitate re-insurance.
3. Number of risks covered: Many insured risks increase compensation costs, requiring re-insurance.
4. Need to spread risk: Sharing liability in major losses.
5. Government policy: Legal requirements may mandate re-insurance.

Under-insurance

When the sum insured is less than the actual property value, e.g., insuring a Kshs. 500,000 property for Kshs. 400,000.

Over-insurance

When the sum insured exceeds the property’s value, e.g., insuring a Kshs. 300,000 property for Kshs. 600,000. Compensation is limited to actual loss.

Agents

Individuals who sell insurance policies on behalf of companies, earning commission based on sales.

Insurance Brokers

Professional intermediaries connecting clients with insurers, advising on policies, and handling correspondence. They earn brokerage commission.

Principles of Insurance

These principles guide insurance contracts and ensure fair operations:

1. Determine validity of contracts at claim time.
2. Provide checks for successful insurance operations.

Prospective insured persons should understand these principles.

1. Insurable Interest

An insurance claim is valid only if the insured suffers a direct financial loss. One cannot insure others’ property without financial interest.

For example, Mr. X has no insurable interest in neighbors’ property and cannot claim if it is damaged.

In life insurance, one has unlimited interest in their own life and insurable interest in spouse and children.

1. Indemnity

The insurer pays only the replacement value of the loss, restoring the insured to the financial position before the loss.

Gaining from misfortune by receiving more than the loss is not allowed.

This principle does not apply to life assurance, where the policy states a fixed claim amount.

1. Utmost Good Faith (Uberrima Fides)

The insured must honestly disclose all relevant facts about the property or life insured. Failure may void the contract.

Examples:

• Disclosing terminal illness to the insurer.
• Not under-insuring or over-insuring property.

1. Subrogation

This complements indemnity by transferring ownership of any remaining insured property to the insurer after compensation.

Example: If Daisy’s car is fully compensated after an accident, the insurer owns the scrap metal.

Note: Not applicable to life assurance.

1. Proximate Cause

Compensation is paid only if the loss is directly caused by the insured risk.

Example:

1. If fire causes property damage but looters steal items afterward, theft is not covered.

If sparks from a fireplace cause fire damage, compensation applies as fire is the proximate cause.

Classes of Insurance

Insurance is mainly classified into:

1. Property (non-life) general insurance
2. Life assurance

1. Life Assurance

Life assurance covers life contracts, which are not contracts of indemnity since life cannot be valued in money.

Premiums depend on:

1. Age: Older age means higher premiums due to increased death risk.
2. Health condition: Poor health leads to higher premiums.
3. Exposure to health risks: Occupation-related risks affect premiums.

Types of Policies

1. Whole Life Assurance
   Regular premiums are paid until death; sum assured is paid to beneficiaries. Covers disabilities due to illness or accidents.
2. Endowment Policy/Insurance
   Regular premiums over a specified period; sum assured paid at maturity or death, whichever comes first.
   Note: Anticipated Endowment Policy pays a percentage of the sum assured at intervals before maturity.

Advantages of Endowment Policies

1. Serve as savings for future investments.
2. Premiums payable over a chosen period.
3. Sum assured paid if policy matures.
4. Can be used as loan security.

Differences Between Whole Life and Endowment Policies

3. Term Insurance
   Coverage for a specified period; compensation paid if death occurs within period; no compensation otherwise. Renewal possible.
4. Education Plan/Policies
   Policies taken by parents for children’s future education, detailing payment schedules.
5. Statutory Schemes
   Government schemes providing welfare like medical services and retirement benefits, funded by member and employer contributions.

Examples

1. N.S.S.F
2. N.H.I.F
3. Widows and Children Pension Scheme (W.C.P.S)

Characteristics of Life Assurance

• Coverage for life or specified period.
• May serve as a savings plan.
• Long-term contract without annual renewal.
• Has surrender value.
• Maturity date with payment of sum assured, bonuses, and interest.
• Assignable to beneficiaries.
• Policy amount depends on ability to pay premiums.
• Can be used as loan security.

2. General Insurance (Property Insurance)

Covers property against loss or damage risks. Insurable interest is required.

General Insurance Divisions

1. Fire insurance
2. Accident insurance
3. Marine insurance

Accident Insurance

Covers risks from accidents, including:

1. Motor Policies

– Compensation for partial or total vehicle loss from accidents.

– Policies can be third party or comprehensive.

– Third party covers damages to others, including pedestrians and property.

Motor-vehicle owners in Kenya must have third party insurance by law. Optional policies include third party, fire, and theft.

– Comprehensive covers third party, fire, theft, malicious damage, and vehicle owner injuries.

2. Personal Accident Policy

– Protects against injury, disability, or death from accidents.

• Injury
• Partial or total disability
• Loss of income due to death

– Death benefits paid to beneficiaries; disability compensation may be periodic or lump sum; hospital expenses covered.

3. Cash and/or Goods in Transit Policies

Covers loss of cash and goods during transit between locations, e.g., from business to market.

d) Burglary and Theft Policies

Covers losses from robbery and theft, enforceable only if safety measures are met.

Examples of safety measures:

• Money limits in safety boxes
• Proper positioning of cash boxes

Note: Measures reduce loss extent and probability.

e) Fidelity Guarantee Policies

Covers employers against losses caused by employees through embezzlement, fraud, or errors.

Coverage may be for specific or all employees.

7) Workmen’s Compensation (Employer’s Accident Liability)

Compensates employees injured during work. Employers insure against industrial injuries.

f) Public Liability

Covers injury, damage, or loss caused by business or employees to the public. Insurer pays claims up to an agreed limit.

g) Bad Debts

Covers firms against losses from debtors failing to pay debts.

iii) Marine Insurance

Covers ships and cargo against sea risks like fire, theft, collision, storms, and sinking.

Types of Marine Insurance Policies

Classified as Hull, Cargo, Freight, and Ship Owners’ Liability.

1. Marine Hull

Covers the ship’s body and equipment against sea perils. Includes part policies for specific periods during loading or service.

2. Marine Cargo

Covers goods carried by ship. Subdivisions include:

1. Voyage Policy: Covers specific voyages; ends on arrival.
2. Time Policy: Covers losses during a specified time regardless of voyage.
3. Fleet Policy: Covers multiple ships under one owner.
4. Floating Policy: Covers losses on a route for all insured ships during a period.
5. Mixed Policy: Covers ship and cargo on specified voyages and times; no compensation if voyage differs.
6. Composite Policy: Multiple insurers cover a large sum insured for one ship.
7. Construction/Builders Policy: Covers risks during ship construction, testing, or delivery.
8. Freight Policy: Covers ship owner against failure to pay hiring charges.
9. Third Parties Liability: Covers claims from damage to others’ property.

Description of Marine Losses

Common marine losses include:

1. Total Loss

Complete loss or damage to ship and cargo, either actual or constructive.

Actual Total Loss occurs when ship/cargo is destroyed or missing for a long time.

• Salvaged items have no market value.
• Ship missing long enough to assume sinking.

Constructive Total Loss occurs when ship/cargo is damaged but retrieved, and abandonment is decided due to imminent total loss or high prevention costs.

• Ship/cargo damaged but still has market value.
• Cost of preventing loss exceeds value or risks lives.

2. General Average

Loss from deliberately throwing cargo into the sea to save ship and remaining cargo. Losses shared proportionally by ship and cargo owners.

3. Particular Average

Partial accidental loss to ship or cargo. Affected parties bear their own losses unless loss exceeds 3% of insured value, then claimable.

Fire Insurance

Covers property damage or loss from accidental fire, including domestic, commercial, and industrial premises and contents.

Conditions for claiming compensation:

• Fire must be accidental.
• Fire must be the immediate cause of loss.
• Actual fire must occur.

Types of fire insurance policies include:

1. Consequential Loss Policy (Profit Interruption Policy)

Compensates loss of profit due to business interruption from fire damage.

2. Sprinkler Leakage Policy

Covers loss or damage from accidental leakage of fire-fighting sprinklers.

3. Fire and Related Perils Policy

Covers buildings and contents but excludes loss of profit.

Characteristics of General Insurance

• Contract of indemnity.
• Cannot be assigned, even to relatives.
• Insurable interest required.
• Premiums depend on risk degree.
• Compensation limited to insured value or sum insured.
• No surrender value.
• Short-term contract, renewable annually.

Factors Affecting Premiums

• Health of the insured
• Frequency of previous losses
• Extent of previous losses
• Value of insured property
• Occupation
• Age of person or property
• Location
• Policy period
• Residence

Procedure for Taking a Policy

1. Fill proposal form
2. Calculate premium
3. Issue cover note (Binder)
4. Issue policy

Procedure for Claiming Compensation

1. Notify insurer immediately after incident.
2. Fill claim form detailing the risk.
3. Investigation by insurer to assess loss and validity.
4. Payment of compensation upon agreement.

Insurance and Gambling

Though both involve contributions to a common fund benefiting few, insurance and gambling differ:

Past KCSE Questions

1. 1995: Describe the procedures for taking an insurance policy. (10 marks)
2. 1996: Explain four ways the insurance industry promotes business growth. (5 marks)
3. 1997: Explain four ways the insurance industry contributes to Kenya’s economy. (10 marks)
4. 1998: Discuss insurance policies under which compensation is not paid. (10 marks)
5. 1999: Discuss insurance policies useful for a supermarket owner. (12 marks)
6. 2000: Explain four benefits of pooling risks to an insurance company. (8 marks)
7. 2001: Explain factors making re-insurance necessary.
8. 2002: Define the following insurance terms: (10 marks)
   i) Uberrimae fidei
   ii) Indemnity
   iii) Third party motor vehicle insurance
   iv) Contribution
   v) Subrogation
9. 2003: Discuss four circumstances terminating an insurance contract. (8 marks)
10. 2004: Explain five benefits of taking an endowment policy. (10 marks)