Class 4 Insurance and Risk Management

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Class 4Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2007

2
Law and the Insurance Agent

• An agent is someone who has the authority to act
  on behalf of a principal (the insurer)

3
Law and the Insurance Agent

• Several laws govern the actions of agents and
  their relationship to insureds
• There is no presumption of an agency relationship
• An agent must be authorized to represent the
  principal
• Authority is either express, implied, or apparent
• Knowledge of the agent is presumed to be
  knowledge of the principal with respect to
  matters within the scope of the agency
  relationship

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Law and the Insurance Agent

• Principal is
• Responsible for an agents torts, and
• Charged with agents knowledge of notice.

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Doctrines of Waiver and Estoppel

• Waivervoluntary relinquishment of a known legal
  right
• Estoppelrepresentation of fact made by one
  person to another person that is reasonably
  relied on by that person to such an extent that
  it would be inequitable to allow the first person
  to deny the truth of the representation

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Waiver Example

• Application received by insurer with missing
  information
• Insurer does not contact applicant for missing
  information
• Insurer cannot deny claim later on basis of
  incomplete application
• By issuing the contract, the insurer has waived
  its right to a complete application

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Estoppel Example

• Insureds auto premium is due.
• Calls asks agent for an extension of time
• Agent indicates there is a 10-day grace period
  for overdue premiums
• If insured has accident during so-called grace
  period, Insurer cannot deny claim
• Insurer is estopped or precluded from denying
  coverage due to non-payment, because the Insured
  relied on the agents statement

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Waiver and EstoppelSignificance

• Insurer legally may be required to pay a claim
  that it ordinarily would not have

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Basic Parts of an Insurance Contract

• Declarations
• Definitions
• Insuring agreement
• Exclusions
• Conditions
• Miscellaneous provisions

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Declarations

• Statements that provide information about the
  property or activity to be insured.
• Examples of items on declarations
• Name of Insurer
• Name of Insured
• Period of protection
• Amount of insurance
• Amount of premium
• Size of deductible

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Life Insurance No Declaration Page

• Instead, there is a first page containing
• Insureds name
• Age at issuance of policy
• Premium
• Issue Date
• Policy Number

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Definitions

• Purpose to define clearly the meaning of key
  words or phrases so that coverage can be
  determined more easily
• Key words have quotation marks or are in boldface
  type

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Insuring Agreement

• Summarizes the major promises of the insurer.
• For example, the insurer may agree to
• Pay losses from covered perils
• Provide certain services (loss prevention)
• Defend insured in a lawsuit

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Named Perils Coverage

• Only those perils specifically named in the
  policy are covered

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All-risks Coverage

• All losses are covered except those specifically
  excluded.
• All risk also known as
• open perils or,
• a special cause of loss coverage form

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Named Perils

• If the peril is not named, it is not covered
• Homeowners example
• Personal property is covered by fire, lightning,
  windstorm and 13 other named perils
• See pages 665 and 666, in Appendix A

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All Risks Example

• Personal Auto Policy, Coverage D, Damage to Your
  Auto
• See Appendix B, pages 664 - 666
• Also Note ACV under Limit of Liability, A.1 for
  Coverage D, p. 666

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Why is All-Risk Preferred to Named Peril?

• All Risk
• Broader coverage, fewer gaps
• Burden of proof on the insurer to show that the
  loss was excluded
• Named peril
• Burden of proof on the insured to show that loss
  was caused by a named peril

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New Terminology

• Insurance Services Office (ISO)
• Now uses risk of direct loss to property
  instead of the term all-risk
• Also special causes of loss form used in
  commercial property
• Purpose of deletion of all-risk terminology
• To avoid creating unreasonable expectations
  that all losses would be covered, even those
  specifically excluded

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Exclusions Three Types

• Excluded Perils
• Excluded Losses
• Excluded Property

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Reasons for Exclusions

• Perils not commercially insurable
• Extraordinary hazards involved
• Coverage provided by other contracts
• Moral hazard present
• Coverage not needed by typical insureds

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Perils Not Commercially insurable

• Peril may depart substantially from the
  requirements of an insurable risk

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Perils Not Commercially InsurableExamples

• Property and liability contracts
• War
• Exposure to nuclear radiation
• Health insurance
• Losses within the direct control of the insured
  (e.g. intentional, self-inflicted injury
• Property insurance
• Wear and tear
• Inherent vice (damage without external force, e.
  g., fruit to rot, diamonds to crack)

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Extraordinary Hazards Involved

• Taxi Cab Example - Personal auto policy
• Personal Auto policy assumes vehicle used for
  personal or recreational purposes
• If car is used as a taxicab, the chance of an
  accident and resulting lawsuit is much higher
• Could result in inadequate premium, or
• Unfair rate discrimination against other insureds
  who are not using the policy as a taxicab

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Coverage Provided by Other Contracts

• Homeowners policy example
• Excludes coverage for autos because should be
  covered under PPA
• Commercial General Liability policy example
• Excludes claims covered under Workers
  Compensation policy

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Moral Hazard Present

• Homeowners example
• Coverage for money typically limited to 200
• If unlimited amounts were provided, fraudulent
  claims would increase.
• Also, there would be a problem determining the
  exact amount of loss.

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Coverage Not Needed by Typical Insureds

• Homeowners example
• Most Homeowners policies do not cover aircraft as
  personal property
• To cover aircraft would be unfair to most
  insureds, who do not own aircraft
• Because premiums would have to be substantially
  higher

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Conditions

• Provisions that qualify or place limitations on
  the insurers promise to perform
• Common provisions
• Notifying insurer of a loss
• Protecting property from further loss
• Preparing an inventory of damaged goods
• Cooperating with insurer in the event of a lawsuit

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Miscellaneous Provisions

• Property and Liability Policies
• Cancellation
• Subrogation
• Requirements if a loss occurs
• Assignment of the policy
• Other insurance provisions

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Miscellaneous Provisions

• Life and Health Policies
• Grace period
• Reinstatement of lapsed policy
• Misstatement of age
• Details of these provisions will be discussed
  later in the course
• When specific insurance contracts are analyzed

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Definition of Insured

• Contract must indicate the person or persons to
  whom protection is provided
• Several possibilities exist
• One person
• Definition of named insured
• Additional insureds

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Definition of Insured One person

• Most Life Insurance contracts
• Exception Second to die policies

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Definition of Named Insured

• Person or persons named in the declarations of
  the policy
• Homeowners example
• Named insured includes the person named in the
  declarations page and his or her spouse, if a
  resident of the same household
• See page 656 in Appendix A

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Other Insureds - Homeowners Example

• Resident relatives of the named insured or spouse
• Any person under the age of 21, who is in the
  care of the insured, such as a foreign exchange
  student
• Resident relatives under age 24 who are full-time
  students and away from home

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Definition of Insured - Personal Auto Example

• Named Insured and Spouse
• Resident relatives
• Any other person using the auto with permission
  of the named insured
• See Insight 6.2, p.112

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Endorsements and Riders

• Terms frequently used interchangeably.
• In P L, an endorsement is a written provision
  that
• Adds to, deletes from or modifies the provisions
  in the original contract
• In Life and Health, a rider is a provision
• that amends or changes the original policy

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Impact of /Restrictions on Endorsements

• Endorsement generally takes precedence over the
  conflicting terms of the contract
• However, if a law or regulation requires that a
  standard policy contain certain provisions
• An endorsement cannot be used to circumvent the
  purpose of legislation
• If an endorsement is contrary to a law or
  regulation, the policy is read as if the
  endorsement did not exist

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Deductibles

• Specified amount subtracted from total loss
  payment that would otherwise be payable
• Typically found in
• Property
• Health
• Auto
• Not Used in Life Insurance

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Liability Insurance and Deductibles

• Generally not found in liability insurance
  because
• The insurer must provide a legal defense even for
  a small loss
• Insurers usually want all liability losses to be
  reported to control the loss

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Purposes of Deductibles

• To eliminate small claims
• To reduce premiums
• To reduce moral and morale hazard

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Deductible Eliminate small claims

• Insurer can easily incur expenses of 500 or more
  in processing a 100 claim
• Because deductibles eliminate small claims, loss
  adjustment expenses are reduced

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Deductible Reduce Premiums

• Because deductibles eliminate small claims,
  premiums can be reduced
• Gross premium Pure Premium Expense Ratio

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Deductibles and Claim Processing Costs

• Deductibles reduce cost of processing small
  claims
• Example
• Fixed claim processing cost of 200
• 2000 with probability 0.01
• Loss 100 with probability 0.10
• 0 with probability 0.89
• Expected claim cost claim processing cost
  without a deductible 30 22 52
• Expected claim cost claim processing cost with
  a 100 deductible 20 2 22
• Marginal cost of insuring the 100 loss equals
  30

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Deductibles and Large loss principle

• Insurance should be used to cover large
  catastrophic events, rather than small losses
• Objective is to prevent financial ruin

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Deductible Reduce Moral and Morale Hazard

• Moral Hazard Tendency of some dishonest people
  to cause a loss deliberately to profit from
  insurance
• Deductibles reduce moral hazard because the
  Insured may not profit from the loss

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Deductible Reduce Moral and Morale Hazard

• Morale Hazard Carelessness or indifference to
  loss because of insurance
• Deductibles reduce morale hazard because the
  Insured will suffer a loss too, if there is a
  loss
• Thus deductibles encourage Insureds to be more
  careful in protecting against incurring a loss

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Deductibles in Property Insurance

• Straight deductible
• Insured must pay a certain number of dollars of
  loss before the Insurer is required to make a
  payment
• Aggregate deductible
• Usually found in commercial insurance
• All losses occurring during a given time, usually
  a policy year, are accumulated before the insurer
  pays losses in excess of the deductible

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Straight Deductible

• Insured must pay a certain number of dollars of
  loss before the Insurer is required to make a
  payment
• Personal auto example
• 500 collision deductible
• 7,000 collision loss
• Insured receives 6,500 payment
• Insured pays remaining 500 amount

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Aggregate Deductible

• Usually found in commercial insurance
• All losses occurring during a given time, usually
  a policy year, are accumulated
• Before the insurer pays losses in excess of the
  deductible

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Aggregate Deductible Example

• Aggregate deductible of 10,000
• Losses of 1,000 and 2,000 occur
• Insurer pays nothing
• Third loss of 8,000 occurs
• Insurer pays 1,000
• Insurer would pay any other losses occurring in
  policy year in full

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Health Insurance Deductibles

• Calendar-year deductible
• Corridor deductible
• Elimination (waiting) deductible

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Calendar-year Deductible

• Type of aggregate deductible, found in
• Basic medical expense contracts
• Major medical policies
• Eligible medical expenses are accumulated during
  calendar year
• Once they are exceeded, the insurer must pay the
  benefits promised under the contract
• Once deductible is satisfied, no additional
  deductibles are imposed on insured

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Corridor Deductible

• Used to integrate a basic medical expense plan
  and a supplement major medical expense plan
• The corridor deductible must be satisfied before
  the major medical expense plan pays
• Corridor deductible applies only to eligible
  medical expenses not covered by the basic medical
  expense plan

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Corridor Deductible Example

• Assume
• 20,000 of covered medical expenses, and
• Basic medical expense plan pays 16,000
• Supplemental major medical plan has a 300
  corridor deductible
• Then
• Supplemental plan pays 3,700
• Insured pays 300

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Elimination (Waiting) Deductible

• Stated period of time from the beginning of a
  loss during which no insurance benefits are paid
• Used in disability income policies, which replace
  part of a disabled persons income

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Typical Elimination Periods

• 30 days
• 60 days
• 90 days
• Longer periods (e. g., 180 days)

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Property Coinsurance Clause

• Requires Insured to insure property for a stated
  percentage of its insurable value
• If coinsurance percentage is not met, the Insured
  must share in the loss as a coinsurer
• Insurable value may be stated as
• ACV
• Replacement Cost
• Some other value

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Coinsurance Formula

• Amount of insurance carried X Loss
• Amount of insurance required
• Amount of Recovery

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Property Coinsurance Example

• Commercial Building
• ACV 500,000
• 80 coinsurance clause
• Insurance amount 300,000
• Loss 10,000
• 300,000 X 10,000
• 400,000
• 7,500 Amount of Recovery

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Purpose of Coinsurance

• To achieve equity in rating
• Most property losses are partial rather than
  total losses

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Practical Coinsurance problems

• Inflation can result in a serious coinsurance
  penalty, if the amount of insurance is not
  periodically updated
• Values could fluctuate widely as in inventory of
  goods
• Solutions
• Agreed value endorsement
• Reporting form with audit premium
• Financial hardship to take inventory of damaged
  and undamaged goods
• Solution Waiver of inventory clause, if the loss
  is less than 2 of the amount of insurance

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Coinsurance in Health Insurance

• Technically called a percentage participation
  clause
• Twofold Purpose
• To Reduce Premiums
• To Prevent Over-utilization of policy benefits.

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Coinsurance in Health Insurance (cont.)

• Specifically, Major Medical policies typically
  require the Insured to pay a percentage of
  covered expenses in excess of the deductible
• Typical percentage 20-25 in excess of deductible

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Major Medical Coinsurance Example

• Covered expenses 50,500
• 500 Deductible
• 80-20 coinsurance clause.
• 50,500 500 50,000
• 50,000 x .80 40,000
• How much does Insured pay?
• 10,000 coinsurance 500 deductible 10,500

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Other Insurance Provisions

• Typically present in P L and Health Insurance
  policies
• Apply when more than one contract covers the same
  loss.
• Purpose To prevent profiting from insurance and
  violation of the principle indemnity

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Types of Other Insurance Provisions

• Pro Rata Liability
• Contribution by Equal Shares
• Primary and Excess Insurance

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Pro Rata Liability

• Applies when two or more policies of the same
  type cover the same insurable risk in property.
• Each insurers share of the loss is based on the
  proportion that its insurance amount bears to the
  total amount of insurance

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Contribution by Equal Shares

• Frequently found in Liability Insurance Contracts
• Each Insurer shares equally in the loss until the
  lowest limit of liability is paid.
• The remaining Insurers continue to share equally
  in the remaining amount of the loss until
• Each insurer had paid its policy limit in full,
  or
• The full amount of the loss is paid.

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Primary and Excess Insurance

• Primary Insurer pays first
• Excess Insurer pays only after the policy limits
  under the primary policy are exhausted
• Examples
• Personal Auto Policy
• Coordination of benefits in Group Health Insurance

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Primary and Excess Insurance Personal Auto Example

• Bob borrows Jills car
• Limits of liability
• Bob 100,000 per person for BI
• Jill 50,000 per person for BI
• Normal rule Liability insurance on borrowed
  vehicle is primary any other insurance is
  considered excess
• Court judgment of 75,000
• Jills policy is primary pays 50,000
• Bobs policy is excess pays 25,000

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Primary and Excess Insurance Group Health

• Applies if a person is insured under more than
  one group health plan
• Purpose To prevent over-insurance and
  duplication of benefits
• Coverage as an employee is primary to coverage as
  a dependent.

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EXHIBIT 6.3 Pro Rata Liability Example
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EXHIBIT 6.4 Contribution by Equal Shares
(Example 1)
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EXHIBIT 6.5 Contribution by Equal Shares
(Example 2)