Historical Development


As early as 3000BC Chinese merchants utilized the techniques of sharing risks. About 500 years later, the famous Great Code of Hammurabi provided for the transfer of the risk of loss from merchants to moneylenders. Under the provisions of the code, a trader whose goods were lost to bandits was relieved off the debt to the moneylender who had loaned the money to buy the goods. Babylonian moneylenders loaded their interest charges to compensate for this transfer of risk. Loans were made to ship-owners and merchants engaged in trade, with the ship or cargo pledged as collateral. The borrower was offered an option, for somewhat higher interest charge, the lender agreed to cancel the loan if the ship or cargo was lost at sea. The additional interest on such loans was called a ‘premium’ and the term is still used even today. The contracts were referred to as ‘bottomry contracts’ in cases where the ship was pledged and ‘respondentia contracts’ when cargo was the security. Although these were insurance of sorts, the modern insurance business did not begin until the commercial revolution in Europe following the crusades.


Marine insurance the oldest of the modern branches of insurance was started in Italy during the 13th Century. This early marine insurance was issued by individuals rather than insurance companies. A ship-owner or merchant prepared a sheet with information describing the ship, its cargo, its destination among others. Those who agreed to accept a portion of the risk wrote their names under the description of the risk and the terms of the agreement. This practice of ‘writing under’ the agreement gave rise to the term ‘underwriter’.


Ship-owners seeking insurance found the coffeehouses of London convenient meeting places. One of the coffeehouses owned by Edward Lloyd, soon became the leading meeting place. Lloyds is known to have been in existence early in 1688.


Traditional African society

The concept of insurance is not new to Africa. The African communities have had traditional forms of managing risks facing them. It is still common for the old or sick to expect material support from members of their families or clan. The family was a strong compact unit and family meant more than just husband, wife and children. The cost (premium) was that any good fortune was shared by all. Relics of this practice exist even today and the famous ‘Harambee’ is a spin off these traditional insurance practices. These traditional forms of insurance are dying fast in most developing countries as a result of economic and social developments.


Modern Insurance in Kenya

Following the scramble for Africa towards the end of the 19th Century, various European powers established sovereignty on the African soil. This meant that trading operations needed certain services among them insurance. The insurance industry in Kenya owes its beginning to foreign nationals mainly of British and Asian origin. Although the exact date of birth of the insurance industry in East Africa is not known, there is evidence that the first marine agency was opened in the Island of Zanzibar in 1879. It took another twelve years before an insurance office was opened in Kenya. One British company was represented here in 1891. But the real birth of the industry was within the first two decades of the 20th Century. The foreign companies in Kenya operated through agents before establishing branches. Most of the agents were individuals or firms that transacted other businesses and not specialized in insurance. One of the early companies to open branches was Royal Exchange Assurance of London which opened a branch in Kenya in 1922. It was in 1930 that the first locally incorporated company was set up in the name of ‘Pioneer Assurance Society Limited’. The others that followed are Jubilee Insurance in 1937 and Pan Africa Insurance in 1946. The insurance industry has grown since then to the current position. There are about 200 registered insurance brokers, 193 loss assessors, 22 surveyors, 18 loss adjusters, 3 risk managers, about 3000 insurance agents, 43 insurance companies and 2 local reinsurance companies.


Insurance Mechanism

Individuals and companies (exposure units) reduce their risks by forming a pooling arrangement. Risk a verse individual and companies are persons who value lower risks and therefore they have the incentive to participate in the risk pooling arrangement, especially if such arrangements can be made at a lower cost.

It’s not costly to operate a pooling arrangement and indeed, the cost of organizing and operating this arrangement is the main reason for existence of insurance companies.


Meaning of insurance

From an individual’s perspective, insurance is an economic device whereby individual substitutes a small cost (insurance premium) for a large financial loss that is uncertain, that is, the contingency insured against would exist if it were not for insurance.


How the Insurance mechanism works

If there are 1000 vehicles in a given community, with a value of sh 1,000,000 each, the vehicle owners face the risk that they could be stolen or be involved in serious accidents, five etc.


The financial loss that will therefore occur would be 1 billion. Some vehicles may actually incur loss, but the probability that all of them will actually suffer or incur loss is remote. If the vehicle owners enter into an agreement to share the cost of loss as they occur, to the extent that no single vehicle owner will be forced to incur the entire financial loss of sh 1M, it would mean that in case a vehicle incurs a loss, all the 1000 vehicle owners should contribute to that loss.


Under this arrangement, vehicle owners who suffer financial loss will be indemnified by those who do not suffer the accident hence owner who escape loss will be willing to pay those who suffer loss, because by doing so, they eliminate the possibility of themselves suffering the sh 1M loss.


The potential difficulty of this arrangement is that some group members may refuse to pay their assessment of sh 1M at the time of loss and this problem can only be solved by requiring advance payment of cash by each person contributing to the arrangement. The assessment that each individual is required to pay will be calculated on the basis of past exposure and experience.



If in the above only 3 out of 1000 vehicles suffer loss. Then each group member will be required to pay sh 3000.


In addition to the cost of the loss costs, there will be some administrative costs for the arrangement of risk sharing and cost to cater for the eventuality.


The insurance company administering the arrangement will also add up some mark up or profit to the entire cost the arrangement.


From above example;                          3000

Add admin costs                                  xxxx

Add imprecise prediction possibility   xxxx

Add profit mark-up                             xxxx

Cost of arrangement                            xxxx


Prediction of probable losses

In addition to eliminating losses, at the individual level, through risk transfer to a group, the insurance mechanism reduces risks for the society as a whole. The risk that insurance companies face is not merely a summation of the risk transfer from individuals to itself but insurance companies are able to do something that the group of individuals cannot, which to predict, in a more precise manner the amount of losses that are likely to occur.


If the insurer could predict future losses with absolute precision, then the insurer would face no possibility of loss because they would collect precisely each individual’s share of the expected losses in the group. But because the insurance predictions are not precise, the premiums that they may charge are likely to be inaccurate. The accuracy of the insurance prediction is based on the law of large numbers.


The law of Accuracy and large numbers in insurance

Accuracy of an insurance prediction is base on the law of large numbers. By combining a sufficiently large number of similar exposure units (insured persons), the insurer is able to make predictions for the group as a whole, and this is done through the theory of probability. The primary function of insurance is the creation of the counterpart of risk which is security.


Insurance does not decrease uncertainty of financial losses or alter the probability of occurrence, but reduces the probability of financial loss connected to the event.


Expectation gap in risk pooling arrangement

  • Some people believe that it’s a waste to purchase insurance especially if a loss does not occur and they are indemnified.
  • Other people believe that if they have not had a loss during the policy term, they should be refunded their premium.


Both points constitute ignorance because:

  1. Insurance provides a valuable feature which is freedom from uncertainty and even if a loss did not occur during the policy term the insured will have received the benefits for the premium paid, which is the promise of indemnification if a loss occurred.
  2. The operation of the insurance principle is based on the contribution of many paying for loses of the unfortunate few, who have suffered. Therefore, if premiums were to be returned to the many who did not suffer loss, there will be no funds to cater for the few who actually incurred losses.


 Requisites of Insurability

It is important to note that the world of businesses is not static and what may be uninsurable risk today could very well be insurable tomorrow. A good example is recent moves to ensure political risks through the African Trade Insurance Agency (ATIA).  However, the following would be the requisites for insurability:-


1)         Fortuitous – the happenings of the event must be entirely fortuitous to the insured.  This rules out inevitable events such as wear, tear and depreciation.  Any damage inflicted on purpose by the insured would be ruled out.  However, purposeful events by other persons would be covered provided they were fortuitous as far as the insured is concerned. In life assurance, although death is certain, the timing of death is what is fortuitous and that is the concern of life assurance.


2)         Financial Value – Insurance does not remove the risk but it endeavours to provide financial protection against the consequences. Therefore, the losses must be capable of financial measurement.  In some cases the court will decide the level of compensation due to an injured person while in property insurance it is possible to place a value on the loss or damage.  In life assurance, the level of financial compensation is agreed at the beginning of a contract.


3)         Insurable Interest – Refer to principles of insurance to be discussed later


4)         Homogenous Exposure – The law of large numbers entails that given a sufficient number of exposure to similar risks, the insurance company can forecast the expected extent of their loss and therefore move towards accuracy in setting premium levels. There might be a few cases where heterogeneous exposures are insurable but on the whole insurers prefer homogenous exposures in order to benefit from the law of large numbers.


5)         Pure Risks – Insurance is primarily concerned with pure risks. Speculative risks are generally not covered because it may act as a disincentive to effort e.g. insuring profit would mean no effort to achieve desired results. But the pure risks consequences of speculative risks are insurable e.g. risks of a new line of business selling or not – though in itself a speculative, the risk of the factory being damaged by fire is pure and therefore insurable.


6)         Particular risks – Fundamental risks are generally not insurable e.g. war, inflation etc. However fundamental risks arising out of physical cause e.g. earthquakes may be insurable.


7)         Public Policy – Contracts must no be contrary to what society would consider right and moral e.g. contracts to kill a person, no insurance for criminal venture.


Factors Limiting Insurability of Risks

i) Premium Loading

Risk averse people desire insurance cover but the extent to which they purchase the insurance depends on the insurance premium loading. The premium and insurance is equal to the total claim cost and a loading for administration and capital costs.

If the loading is 0, the premium will be equal to the expected payments from the insurer and therefore the risk averse will purchase full insurance cover

Unfortunately the premium loading is rarely zero because the insurer must be compensated for their costs.


ii) Moral Hazard

It refers to increased probability of loss that result from existence of insurance fraud. This may result from reduced incentive of the policy holders to prevent losses or engage in activities that cause loss for personal gain.


iii)        Adverse Selection

Arises when it is too costly for the insured to classify perfectly the insured on how much they should be charged for the insurance purchased.

Different covers are charged different premiums yet due to the information given to the insurance companies concerning the high and low risks, insurance purchased may be charged for similar risks. Ideally, high-risk persons should be charged a higher rate in order to generate funds compensating such persons. However, since classification is costly, insurance companies will only classify if it is cost effective.


iv) Subsidization- Occurs as a result of the insurer’s inability to classify perfectly the insured, some insured’s are wrongly classified and are made to pay more than their fair share of the risk they face. For example classifying 20 year olds in the same class with 60 year olds. The 20 yr olds will subsidize for the 60 yr olds.


The guiding principles in establishing risk classes


Separation and class homogeneity

If the insurer constructed its risk classes carefully, each class will have a significantly different expected loss (separation). Moreover, each member of a given class will have approximately the same chance of loss (class homogeneity). This rule prevents combining males ages 20 and 40 in the same life insurance pool and causes a mathematically fair insurance exchange.



If insurers decide to use a particular factor for classifying insured’s, information about the factor should be easily obtained and not subject to manipulation by the insured. The variables of age and sex would meet this standard, but asking an applicant kilometers are driven each year or whether drugs or alcohol are used would not do as well because insured’s can provide false information.


Incentive value 

If risk classes are crafted in a way designed to promote using society’s resources carefully, insured’s should be rewarded for maintaining clean driving records or for applying loss prevention measures. Thus, factors used for risk classification should reward good insured’s (those with below-average loss potential) with better insurance rates.


Social acceptability

This is the underwriting criterion that is the most difficult to handle. Who is to define social acceptability? Moreover, this measure has the possibility of being at odds with the preceding risk classification criteria. How are such conflicting outcomes to be resolved? What do we do when the desirability of a mathematically fair insurance exchange conflict with a socially desired outcome?


 Functions of Insurance

  1. Risk Transfer – The primary function of insurance is that it is a risk transfer mechanism which exchanges uncertainty for certainty. It exchanges the uncertain loss for a certain premium.
  2. Creation of Common Pool – This enables the losses of a few to be met by the contributions of many. An insurance company operates such a pool.  It takes contributions in form of premium and is able to pay the losses to a few.  The insurer benefits from the law of large number i.e. the actual number of events occurring will tend towards the expected where there are large similar situations.
  3. Equitable Premiums – An insurance company maintains several pools for each risk. This enables the insurer to tell the profitable from the unprofitable ones.  However, similar types of risks could be brought into a common pool although they will represent different degrees of risk to the pool.  This should be reflected in the contributions to the pool. It wouldn’t be equitable for private car owners to subsidize commercial vehicle owners.  The insurer has to ensure that a fair premium is charged, which reflects the hazard and value of risk brought to the pool. The completive forces must also be taken into consideration in premium rating.


Benefits of Insurance

  1. Peace of Mind – The knowledge that insurance exists to indemnify provides peace of mind for individuals, industry and commerce. Insurance encourages entrepreneurship by way of transfer of risk.  It also stimulates the business in existence by releasing funds for investment. The recent spate of robberies to banks in Kenya could have easily sent some closing, but because of insurance these risks are catered for. The need of peace of mind has led the government to make some forms of insurance compulsory e.g. third party liability cover, workmen’s compensation and employer’s liability.
  2. Loss Control – Insurers play a great role in reduction of the frequency and severity of losses. The surveyor plays the role of risk control specialist. Advise could be given on  pre-loss control (e.g. wearing safety  belts) and post –loss control (e.g. having fire extinguishers).  
  1. Social Benefits – The fact that insurance provides indemnity after loss means jobs may not be lost and goods and services can still be sold. 
  1. Investment of Funds – Because of the time lapse between receipt of premium and payment of claims, insurers are major investors of funds. By having a spread of investments, insurance helps government in borrowing, offers loans through mortgages, buying of shares on the stock exchange etc. They form a part of institutional investors including banks, building societies and pension funds. They also invest in property e.g. ICEA Building, Jubilee Insurance House, etc. Most life funds are invested in longer term ventures as apposed to general insurance. Insurance therefore assists in mobilizing savings.
  2. Invisible Earnings – Insurance is one of the invisible earning forums including such areas as tourism, banking etc. Risks outside the country can be insured in Kenya and money earned on these transactions represents a substantial volume of earnings. It contributes to a favourable balance of trade i.e. exports exceed imports.


Insurance Contracts

Insurance law is mainly derived from the general law of contract. Therefore the insurance contract will have certain elements that are legally binding. These include:

  1. Legal form
  2. Offer and acceptance
  3. Consideration
  4. Legal objects
  5. Competent parties


Legal Form: – There is no requirement that insurance contracts be in writing but in many instances, the form and content is carefully governed by law. To be a legal form, the insurance contract must have same standard wording as the legal standard wording as the legal standard policy and must be properly filed by with the government.


Offer and Acceptance:– To have a legally enforceable contract, there must be a definite and qualified offer made by one party to be accepted in the exact terms by the other party. In the case of insurance, the offer is made by the prospect when applying for insurance; acceptance occurs when an agent of the insurance company binds the coverage or when the policy is issued by the insurer.


Consideration: – The binding cost to any contract is the consideration, i.e an item of value that each party gives to the other. For insurance contracts consideration will be in the form of promise by the insurer to compensation the insured in the event that a loss occurs.


Legal Object: – A contract must be legal in its purpose or objectives. For example a contract to commit murder by one party for a specific amount of money will not be enforceable in a count of law. The same concept applies for insurance, and such contracts whose objectives are not legal will not be honored.


Competent Parties: – The parties to the agreement must be capable of entering a contract as per the law. Minors, mentally incompetent persons, or bankrupt persons are not permitted by law to enter into an insurance contract because they are regarded as incapable of understanding the contractual terms.


Insurance as a contract of adhesion

A contract of adhesion is one prepared by one party, the insurer to be accepted or rejected by another party. If the insured does not like the contract terms, he may choose not to purchase the insurance. Therefore, if he purchases the insurance, he must accept the policy the way it is. Under this doctrine, the counts of law have ruled that a person is bound by the terms of a written contract that he signs or accepts whether or not the person reads the contractual terms


Insurance as a leatory contract

A leatory means that the outcome is affected by chance and the money given by the contractual parties will be unequal. That is the insured pays the required premiums and if no loss is suffered, the insurer pays nothing. However, if a loss occurs, the compensation made to the insured will outweigh the insured’s premium.


Insurances as a contract of good faith (fiduciary contract)

Applicants for insurance must make full disclosures and fear disclosure for the risk to the insurance agent or company. The risk that the insurer assumes must be equal to the risk that is being transferred to them by the insured.


Parts of Insurance policy contract

Even though insurance contracts may be different, they may have similar characteristics. They are composed of four basic parts:


  • Declarations – statements made by insured considered 2B legal representation
  • Exclusions – what insurer will not cover
  • Insuring agreement – insurer promises 2 pay insured should a loss occur
  • Conditions – rights and duties both parties


a) Declarations – This section will contain statements made by the insured that are considered to be legal representations. Also to be the insured this section is the policyholder’s name, property insured, its value and other factors relating to.


b) Exclusions – In this section, the insurance company state what it will do. The number of exclusions has a direct relationship with the broadness or narrowness of the insurance company. If the policy is written on a name variable basis for example five, theft etc, the exclusions will be few but if the policy is an open peril e.g general accident policy, it will have more exclusions to eliminate coverage of risks that are not insurable.


Reasons for exclusions in insurance contracts

i) Eliminate losses arising from catastrophic events.

Insurance companies do not provide for losses arising from catastrophic events such as tsunami. This is because they do not occur regularly thus can not attract an insurance pool to cater for claims when losses occur

ii) To eliminate losses as a result of moral or morale hazard

E.g. car insurance policy denies liability to pay a claim if the insured was driving drunk

iii) To eliminate coverage not needed by the typical insured.

This is because incase an insured wants a special coverage (i.e. coverage different from the standard policy) that covers for more losses, then the insurance company charges extra premium to remove the exclusion.

iv) To eliminate coverage where another policy is designed to cover for the loss. E.g. the home ownership policy excludes cover for automobiles.

v) To exclude non insured parties from benefiting from coverage.

This is where a party other than the owner has custody of the property and insures on behalf of the owner e.g. bailer (party with custody of property which does not belong to him) will not be allowed to claim in the presence of bailer incase a loss occurs.

vi) To control costs and keep premiums affordable

This is because like any other business, insurance businesses have competitors. To attract customers, insurance companies charge relatively low premium compared to they competitors, thus the more losses covered in a policy the higher the premium.


c) Insuring agreement – Here, the insurer promises to pay for the loss should the loss occur due to the peril covered.


d) Conditions – This section spreads out in details the rights and duties of both parties to the insurance agreement. For example, the duty of the insured in the event of a loss such as to report immediately to the insurer in cases of loss.


Insurance and Bonding

A bond is a legal instrument whereby one party (the surety) agrees to be held responsible to a second party to the (obliged) for the obligation of a third party (the principal).  Thus if a contractor furnishes a bond to the owner of a building the surety will reimburse the owner if the contractor fails to perform his duty as agreed and thereby cause loss to the owner.  The surety lends his name and credit to guarantee the obligation of the principal.


Difference between a bond and a contract of insurance


Bond   Contract of Insurance
1. This is a third party contract i.e. surety, principal and oblige. 1. This is a two party contract i.e. insurer and insured.
2. If the principal defaults, and the surety makes good to the oblige, the surety has legal right to recover losses from the principal. 2. Insurer has no right to recover losses from the insured.
3. Nature of risk is different i.e. bond guarantees honesty, capacity and ability of an individual to perform. 3. Insurance covers losses, outside the control of the individual.
4. Surety is liable to beneficiary regardless of breach of warranty or fraud on the part of principal. 4. Contract is cancelable by either party, non-payment of premiums or breach of warranty by insured.


Examples of bonds

  1. Performance bond – Used when a contractor fails to complete contractual work.
  2. Bid/tender bond – Used when the cost of new tending has to be incurred should the highest bidder fail to take up an offer.
  3. Immigration/Security bond – These are issued to non-Kenyans who conduct the insurer guarantee, but if one fails to be of good conduct, the insurer undertakes to pay the cost of deportation or the consequences of his bad conduct.
  4. Court bonds – Used when a court has the responsibility of administering the affairs of persons unable to do so for themselves for some reasons. The court appoints a receiver who gives it a bond that will take care of any mal-administration that might take place.
  5. Customs or import bonds – These ensure, that dutiable goods on which duty has not been paid, do not find their way into the local market. If it so happens the insurer mix the duty payable by the insured.
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