CFP Lesson 1 Introduction To Risk Management Lesson

Insurance policies generally value and pay losses based on one of the three valuation methods:

- actual cash value - replacement cost - appraised or agreed upon value

Not all risks are created equal, and not all risks are insurable. A risk that is ideally situated to be an insured risk meets the following requirements:

1. It has a large number of homogeneous exposures. 2. The insured losses must be accidental. 3. The insured losses must be measurable and determinable. 4. The loss must not be financially catastrophic to the insurer. 5. The loss probability must be determinable. 6. The premium for risk coverage must be reasonable and affordable. Items 1 - 5 are required from the insurer's perspective for the insurer to be willing to provide insurance for a particular risk. Item 6 is a requirement of consumers and represents the likely willingness to purchase an insurance product to cover a pure risk.

With regards rate regulation what is "use and file law"?

A "use and file" state permits an insurer to increase rates, but they must file the rate increase within a specific time period, as determined by state law. Both the "file and use" and "use and file" laws avoid any delays associated with the rate increases being approved, as they allow the insurer to implement rate increases quickly.

What is a subrogation clause?

A subrogation clause in an insurance policy requires that the insured relinquish a claim against a negligent third party if the insurer has already indemnified the insured. A subrogation clause entitles the insurer to seek a claim against a negligent third party for any claims paid to the insured. The principle of indemnity and the subrogation clause are closely aligned to accomplish the goal of preventing an insured from profiting from insurance.

What is a waiver?

A waiver is relinquishing a known legal right. If an insurer waives a legal right, it may not deny paying a claim based on the insured violating or breaching that right.

What is a warranty?

A warranty is a promise made by the insured that is part of the insurance contract. The warranty can be a promise to perform or take a certain action. Alternatively, a warranty can be a promise by the insured to not do something. A breach in warranty may allow the insurer to void the insurance contract and not pay any claims.

What does express authority mean?

Express authority is given to an agent through a formal written document. In the case of an insurer and insurance agent, the express authority is an agency agreement. The agency agreement specifically outlines the duties, responsibilities, and scope of authority that the agent can act upon and thus bind the principal. The agency agreement stipulates the terms, conditions, and length of period the agent is allowed to sell insurance policies and bind the insurer to the insured.

What are hazards? Give 3 types of hazards:

Hazards are specific conditions that increases the likelihood of a loss occurring. A hazard does not cause the actual loss, but simply increases the probability of a loss. There are three types of hazards: • Moral • Morale • Physical The underwriter of the insurer must be aware of and be able to identify and manage these hazards.

What is a morale hazard?

Morale hazard is defined as indifference to risk due to the fact that the insured has insurance. Consider the person that drives to a convenience store to purchase a gallon of milk. They pull into the parking spot, leaving the car running and doors unlocked while they enter the convenience store. This person is not concerned about their car being stolen perhaps because they have auto insurance. Insurers want to incentivize an insured to prevent morale hazard. The way an insurer accomplishes this is through the use of deductibles.

What are policy provisions? What do they include?

Most insurance contracts are generally designed with similar provisions, including: • Definitions of terms used in the contract • Declarations • Description of what is insured • Perils covered • Exclusions • Conditions

With regards to insurance rate regulation what is open competition?

Open competition laws allow insurers to set their own rates, and the State presumes that supply and demand will determine the appropriate rates for various insurance products. The open competition approach assumes that fair competition among insurers will result in efficient premium prices.

What is a physical hazard?

Physical hazard is a physical condition that increases the likelihood of a loss occurring. Examples of physical hazards include wet floors, icy roads or roads with poor lighting.

What does it mean when it says premium must be reasonable?

Premiums must be reasonable and affordable for the insured. Before an individual transfers a risk to an insurer, the individual will conduct a cost benefit analysis of the premium relative to the risk and severity being covered.

With regards to insurance rate regulation what is file and use law?

States that allow a "file and use" law permit an insurance company to file the rate increase with the State Insurance Commissioner's office and immediately implement the rate increase. The state insurance commissioner may later deny the rate increase in which case the insurance company must rebate the premiums paid under the denied rate.

What is the primary observation when looking for an insurer?

The financial stability of an insurance company is a primary determinant for selecting an insurer. Rating agencies analyze and evaluate the financial health and ability of an insurer to pay claims.

What is the law of large numbers?

The law of large numbers is a principle that states that actual outcomes will approach the mean probability as the sample size increases. So, if a coin is flipped 10 times, we would expect five heads and five tails. However, with only ten flips, it is more likely that the actual results will be different than a 50/ 50 distribution between heads and tails. The law of large numbers is useful for insurance companies because the larger the insured pool, the more likely actual losses will approach the expected losses, thereby reducing forecasting error and objective risk. This results in insurance premiums that are more efficient and thus are less costly to the insured

Where are insurance rates regulated? What are some of the insurance rate regulation laws?

The rates that insurance companies use when determining premiums are regulated at the state level. The regulation varies by state and rate laws may also differ based upon the insurance product. Some of the insurance rate regulation laws include: • Prior Approval Law • File and Use Law • Use and File Law • Open Competition

Risks can be divided into four categories what are they?

• Pure and Speculative Risk • Subjective and Objective Risk • Fundamental and Particular Risk • Non-financial and Financial Risk

The following general guidelines may be recommended by advisors to clients for use in selecting insurance policies. Many of these guidelines will be expanded upon throughout the remaining chapters of this text.

• Recognize that cost is a constraint for most clients. The amount of money available in the budget to spend on insurance is finite; therefore, priorities must be established for which types of policies will be purchased and decisions must be made regarding what is considered a fair trade-off between adequate coverage and cost of premiums. • A client's subjective risk assessment (risk tolerance) will be a factor in determining which types of loss exposures he or she is willing to assume in their entirety or retain partially via deductibles and waiting periods. Determining which risks are essential to transfer to an insurance company will be largely based on frequency and severity; however, the client's psychological assessment of the risk will vary from person to person and situation to situation and will impact insurance decisions. For example, a client who has provided care for an aging parent may feel that long-term care insurance is essential because she does not want her children to endure the physical and emotional strain that she experienced caring for her own parent. A client who has not had such an experience may deem long-term care insurance an unnecessary expense. • Insure first and to high limits against risks that could be catastrophic to the client. Examples include loss of income to family due to death or disability of a "breadwinner;" loss of income or accumulated assets due to medical expenses associated with illness, accident, or long-term care; loss of accumulated assets and perhaps future income due to legal liability associated with ownership of land or premises, driving a car, boat or RV, and the carrying on of business or professional activities; and the possible serious reduction in standard of living due to outliving the assets accumulated to provide a retirement income. • Obtain an adequate amount of replacement cost property insurance on principal assets (e.g., the home, auto, or jewelry). • Use group coverages (such as those offered by an employer) and social insurance (such as Social Security) as a foundation and individual policies to fill in gaps in types and amounts of coverage. • Ensure that retained risks via deductibles, coinsurance, waiting periods, or the decision to self-insure align with assets (e.g., emergency funds) or disposable income available to cover the losses. • Avoid limited policies and highly restrictive policy provisions. • Shop for the best pricing among reputable and financially strong insurers. • Purchase home and auto insurance from the same insurer to receive discounts on premiums for both policies. • Insurance premiums can be reduced through actions such as installation of fire extinguishers and smoke and burglar alarms, maintenance of a good driving record, cessation of smoking, and increasing the insured's credit score.

What is the property and liability insurance?

An insurable interest for property and liability insurance must exist both at the inception of the policy and at the time of loss. If no insurable interest exists at the inception of the policy, then there is an incentive on the insured's behalf to damage the property. If there is no insurable interest at the time of loss, then the insured who received a monetary settlement would experience a profit from the insurance claim, which would violate the principle of indemnity.

What does it mean if there is a large number of homogenous exposure units?

An insurance company needs the pool of loss exposures to be homogeneous (alike). This allows the insurance company to more accurately predict the loss probability and charge an appropriate premium.

What is lawful purpose?

Another element of a valid contract is that the subject of the contract cannot be contrary to public policy or be in violation of any laws. If the subject matter of the contract is illegal, then the contract is not enforceable.

What is concealment?

Concealment occurs when the insured is intentionally silent regarding a material fact during the application process. The insurer has the right to void an insurance contract based on material concealments by the insured. In order for the insurer to void a contract or avoid paying a claim because of concealment, the insurer must prove that the insured knew the concealed fact was material.

What is unilateral?

Insurance contracts are unilateral in that there is only one promise made, and it is made by the insurer to pay the beneficiary in the event of a covered loss. The insured in not legally obligated to make premium payments. As long as the insured makes the required premium payments, the insurer is legally obligated to provide coverage under the terms of the policy.

What is mutual consent?

Mutual consent implies that both parties to the contract have a mutual understanding regarding the scope of the contract and they are in agreement as to the terms of the contract. Typically contracts may be terminated by mutual consent of both parties

What is the principle of indemnity?

The principle of indemnity asserts that an insurer will only compensate the insured to the extent the insured has suffered an actual financial loss. In other words, the insured cannot make a profit from insurance. However, the principle of indemnity does not assert that an insured will recoup 100 percent of any loss, as most policies have deductibles and limits on the amount of losses covered. An exception to the principle of indemnity applies for life insurance. Life insurance policies are "valued policies" in which the insurer agrees to pay the face amount of the policy, regardless of the value of the life insured.

What is underwriting?

Underwriting is the process of classifying applicants into risk pools, selecting insureds, and determining a premium. An underwriter is responsible for evaluating risks and determining whether the risk is insurable or non-insurable. The underwriter is also responsible for managing adverse selection.

What is representation?

A representation is a statement made by the applicant during the insurance application process. A representation can be an oral statement or information disclosed on an insurance application such as age, gender, occupation, marital status, and family medical history. A misrepresentation during the application process can lead to the insurer voiding the insurance contract. In order for the contract to be voidable, the misrepresentations must be material and the insurer must have relied on the misrepresentation to issue the policy. A misrepresentation is considered "material," if during the application process the insured knew the statement was false, and the insurer would not have issued the insurance contract but for the false misrepresentation. Misrepresentations about age and gender for a life insurance policy are not considered material. The insurance company will simply determine the benefit based upon the actual age or gender of the insured and the amount of premium actually paid.

What are stock insurers?

A stock insurer is an insurance company that issues stock, and is owned by shareholders with the intent of earning a profit. A stock insurer collects premiums, pays operating expenses, and may return dividends to shareholders based on the performance of the company. The Board of Directors for a stock insurer is responsible for making decisions to pay dividends to the shareholders. These dividends are taxable to the shareholders. Also, shareholders elect the Board of Directors.

Actual cash value is what?

Actual cash value represents the replacement cost less the depreciated value of the property. Actual cash value is used to value the amount of coverage for a personal auto or personal property in a homeowners policy or business property policy. For personal property in a homeowners policy actual cash value (ACV) means replacement cost less depreciation.

What is adverse selection?

Adverse selection is the tendency of those that most need insurance to seek it while those with the least perceived risk avoid paying the premiums by not buying insurance. In an ideal world the insurer would only insure those persons least likely to have a claim. However, that would not lead the insurer to profitability as those who are least likely to have a claim are also most likely to self insure. An underwriter wants to maintain an appropriate mix of those that need insurance and are likely to file a claim versus those that are unlikely to file a claim. The underwriter follows underwriting principles that are established by the company. These principles outline acceptable risks, borderline risks, and risks that are unacceptable

What are agents?

Agents are legal representatives of an insurer and act on behalf of an insurer. Agents are only permitted to sell the policies written by their company. Agents have the authority to bind the insurer to an individual. There is typically a difference between the authority an agent has when selling a property and casualty policy versus a life insurance policy. An agent may immediately issue a temporary binder on an auto policy over the telephone. A temporary binder is temporary insurance coverage until the insurance company issues the permanent policy. However, an insurance agent may not immediately bind an insurer when selling a life insurance policy. The insurer must approve the life insurance application before coverage is issued

What is apparent authority?

Apparent authority is when the third party believes implied or express authority exists, but no authority actually exists. If an insurance company and agent had an agency agreement which expired, it is the responsibility of the insurance company to lock the door to the office, take down any signs, and remove the business cards and company letterhead. The insurance company must take the necessary steps to remove any indications of implied authority. If a customer reasonably relies on apparent authority and is issued an insurance policy by an agent who no longer has either express or implied authority, the insurance company is bound by the policy

What is appraised or agreed upon value?

Appraised or agreed upon value is when items are hard to value or when the insured owns property that exceeds standard limits of a property insurance policy.

What are brokers?

Brokers are legal representatives of the insured and act in the best interest of the insured. A broker may sell insurance polices from any one of a number of different insurance companies. Since the broker does not represent the insurer, they may not bind an insurer. Insurance brokers typically help individuals obtain property and casualty, life, and health insurance. Some brokers assist in surplus lines market, which are markets where there is a need for a particular type of insurance but no insurance product exists in that state. A broker may use an insurer that is licensed in another state to provide the insurance product.

Coinsurance is also a term used in medical insurance indemnity policies. What does this mean? What is the out-of-pocket maximum definition?

Coinsurance is also a term used in medical insurance indemnity policies. In these policies, coinsurance refers to the percentages paid by the insurer and the insured for claims after a deductible has been met and before the out-of-pocket maximum (OPM) is reached. The out-of-pocket maximum represents the maximum dollar amount that the insured will pay under the policy in a given year and includes the deductible, the insured's portion of the coinsurance, and generally any copayments. For example, in a plan with an 80/20 coinsurance formula, a $1,000 deductible, and an out-of-pocket-maximum of $4,000, the insured will pay 100 percent of all covered costs until the $1,000 deductible is reached. After the first $1,000 in claims, the insured pays 20 percent of covered costs until the $4,000 OPM is reached. The insurance company is responsible for 80 percent of covered costs after the deductible is met and 100 percent of claims once the insured reaches the OPM.

What are conditions in an insurance policy?

Conditions are provisions in an insurance policy that require an insured to perform certain duties. If the policy conditions are violated, the insurer may refuse to pay the full amount of the claim. Examples of conditions include: • Notifying the insurer in the event of a loss • Filing of a police report in the event of a theft • Cooperating with the insurer after a loss • Taking appropriate steps to reduce further damage after a loss

What are copayments?

Copayments are paid in addition to deductibles or as a substitute for deductibles and are commonly used in health insurance policies. Copayments are loss-sharing arrangements whereby the insured pays a flat dollar amount or percentage of the loss in excess of the deductible. An example of a copayment is when a person is covered for health insurance by a HMO, PPO, or POS and pays $25 each time he or she goes to the doctor.

What are deductibles?

Deductibles are the first dollars in a loss, which the insured is responsible to pay. Deductibles may be a flat dollar amount such as $250, $500, or $1,000. A deductible may also be a percentage of the covered loss, which is typical for flood insurance or homeowners insurance in states like Florida. The purpose of such a deductible is to reduce the filing of small claims, reduce premiums, and eliminate moral and morale hazard. Without deductibles, the paperwork, time, and resources needed to process claims of $50 or $100 would make insurance premiums unaffordable

What is a financial risk?

Financial risk is a loss of financial value, such as the premature death of a family's primary wage earner. Life insurance can protect against this financial risk, help the family achieve financial goals and provide a lump-sum amount to pay expenses for the family during the grieving process

What is objective risk?

For an insurer, objective risk is the difference between the expected and actual losses. As the number of loss exposures (or the pool of insureds) increases, objective risk is reduced because the actual results are more likely to approximate expected claims. Objective risk varies indirectly with the number of loss exposures in an insured pool. The better an insurer is able to manage its objective risk, the more efficiently they can price premiums.

What is coinsurance?

For property insurance, coinsurance defines the percentage of financial responsibility the insured and the insurer must uphold in order to achieve equity in rating. Coinsurance in property insurance encourages insureds to cover their property to at least a stated percentage of the property's value, or else suffer a financial penalty. Because the vast majority of property losses are partial, without coinsurance clauses many insureds would attempt to save money on insurance by purchasing less insurance than the full value of their property. While underinsuring is not illegal, it presents a problem for the underwriter and actuary who base expected loss estimates, and thus premiums, on the full value of the properties in the insured pool. The amount paid for a property insurance claim with a policy with a coinsurance clause is determined by comparing several values. If the insured purchases coverage that meets or exceeds the coinsurance requirement (usually 80 percent of replacement value for homeowners insurance), then payment on a claim for a loss will be the lesser of the face value of the policy, replacement cost, or actual expenditures. However, if the insured purchases coverage that is less than the coinsurance requirement (say, 60 percent of the replacement value), then payment on a claim for such a loss will be the greater of the actual cash value (ACV) or the result of the following formula subject to the limit of the face value of the policy. The purpose of coinsurance in a property insurance policy is to encourage the insured to maintain a stated percentage of minimum coverage. Otherwise the insured will become a coinsurer and proportionately share in any loss. The maximum amount the insurer will pay is up to the covered loss or the face value of the policy or policy limits, less any deductible, even though the coinsurance formula may result in a percentage greater than 100 percent.

What is fundamental risk?

Fundamental risk is a risk that can impact a large number of individuals at one time, such as war or an earthquake. Fundamental risks are difficult for insurers to insure, because they can lead to severe financial consequences for the insurance company.

What is implied authority?

Implied authority is the authority an agent relies on to do their job when the expressed authority is insufficiently precise. It is also the authority that a third party relies upon when dealing with an agent, based upon the position held by the agent. When a customer walks into an insurance agent's office, the customer will see the company logo on the front door, signs on the wall of the agent's office with the company's logo, and business cards on the agent's desk. All of these signs would lead the customer to believe that the agent sitting behind the desk has the implied authority to bind the insurance company if the customer purchases an insurance policy

What is performance of delivery?

In order for a contract to be enforceable, the party to a contract must perform a duty under the contract. Using the previous example, if Joe is buying a car from Mike and gives Mike a check for $45,000, Joe has performed under the contract. He would expect Mike to hand him the keys and title to the car. If Joe asked Mike to deliver the car to his front door before Joe pays, then Mike cannot enforce payment from Joe until the car is delivered to Joe's front door

What is aleatory in insurance contracts?

Insurance contracts are aleatory in nature, which means the dollar amounts exchanged between the insured and the insurer are unequal. The insured may pay a lifetime of premiums for a disability insurance policy and never collect a benefit under the policy. Alternatively, an insured may pay a small premium for a life insurance policy, and his heirs may collect a large face value after only one premium payment if the insured dies while covered by the policy.

What does it mean when insurance contracts are conditional?

Insurance contracts are conditional in that the insured must abide by all the terms and conditions of the contract if the insured intends to collect under the policy. If the insured has violated any of the terms or conditions under the policy, the insurer may not pay a claim. One of the conditions of a policy is that the insured take steps to mitigate and reduce any additional damage to property after a covered loss. Another condition is that the insured timely pay the premiums.

What is adhesion?

Insurance contracts are contracts of adhesion, which is a "take it or leave it" contract. The insured has no opportunity to negotiate the terms of the contract. Before an insurance product can be sold in a state, the state insurance commissioner must approve the product. The product is then sold "as is" and the insured must accept the policy as written. . Since the insured has no ability to negotiate the terms of the insurance policy, the courts will rule in favor of the insured if there are ambiguities found in the contract. The insurer had the opportunity to draft the contract clearly and therefore will be charged for any ambiguities.

What are miscellaneous provisions? What are some examples?

Miscellaneous provisions in an insurance policy cover topics not addressed within other areas of the policy. Examples of miscellaneous provisions include: • Errors in Age or Sex: In the event of a misstatement of age or sex, the death benefit payable under a life insurance policy will be based upon the actual age or sex at death. • Suicide Exclusion: A typical exclusion under a life insurance policy is if the insured commits suicide within the first two years of the policy. Premiums will be returned in the event of the insured committing suicide. • Payment of Benefits: This section will outline where and how the death benefit will be payable to the beneficiary. • Grace Period: The grace period identifies the amount of time after the due date of the premium that the policy will stay in force. If the premium is not paid within the grace period, the policy will lapse. The typical grace period is 31-60 days.

What is non-financial risk?

Non-financial risk is a risk that would result in a loss, other than a monetary loss. An example of non-financial risk is the emotional distress a family experiences when a loved one dies.

What is offer and acceptance?

Offer and acceptance consists of one party making an offer to purchase a good or service and the acceptance is when consideration is received. Consideration can be in the form of a cash payment or providing a service. With insurance there is also a temporary binder or a "conditional acceptance." For property insurance, the agent can issue a binder providing immediate temporary coverage until a permanent policy is issued by the insurance company and premium paid by the insured. Alternatively, the insurance company may determine that their underwriting standards have not been met and they will not issue a permanent policy.

When Evaluating the Identified risks for the probability and the severity of the loss what does this mean? Step 3

Once the potential risks are identified, the planner must analyze each of the risks based on expected loss frequency and loss severity. When evaluating risks based on their expected loss frequency, the objective is to determine how often the event is likely to occur. Loss severity measures the dollar magnitude or the absolute dollar amount of the expected financial loss were it to occur. Based on the relationship between expected loss frequency and loss severity, an appropriate risk management response to the risk can be identified and implemented. Only those risks that have severe financial consequences but occur infrequently are appropriate to transfer or insure. Examples include the inability to work because of sickness or accident, premature death, an auto accident, or a house fire.

What are perils?

Perils are the immediate cause and reason for a loss occurring. Perils can be the result of an accident or sickness. Common perils include: • Accidental death • Disability caused by sickness or accident • Property losses caused by fire, windstorm, tornado, earthquake, burglary, and, collision of an automobile Perils can be specifically insured (named) in an insurance policy on a "named peril" basis where only the specific perils listed in the policy are covered. Alternatively, a policy can cover perils on an "open perils" basis, which covers all perils unless specifically identified and excluded.

When discussing insurance what does personal mean?

Property insurance polices are personal contracts between the insurer and the insured. Therefore, the policy cannot be assigned to a third party without the consent of the insurer. When applying for property insurance, the insurer evaluates the riskiness of the applicant based on their credit score, work history, and other personal factors. When the property is sold, the new buyer needs to apply for their own property insurance to give the insurance company an opportunity to evaluate the riskiness of the new owner. Life insurance contracts, unlike property insurance contracts, can be assigned without the consent of the insurer because the contract continues to cover the insured regardless of who owns the policy. Assigning ownership rights to someone else even one who has no insurable interest under the life insurance contract does not change the underlying insurer's risk associated with the insurance contract.

What is Pure Risk?

Pure risk is the chance of a loss or no loss occurring. With pure risks, there is no chance of experiencing a gain. An example of a pure risk is, either your car is in an accident and damaged or it is not. Pure risks are insurable, since an insurance company is only going to pay when the insured actually suffers a financial loss.

What is reinsurance?

Reinsurance is a means by which an insurance company transfers some or all of its risks to another insurance company. The company that transfers the risk is the ceding company, while the company accepting the risk transfer is the reinsurer. The primary reason an insurance company may want to transfer risk is to reduce the exposure in their portfolio of insured risks. A company may decide to transfer some of their risks to create additional portfolio capacity so as to underwrite new policies.

What is replacement cost?

Replacement cost represents the amount to repair or replace property, without any deduction for depreciation. Replacement cost is the method used to value damage to a personal residence (dwelling) under a property insurance policy.

What is risk avoidance?

Risk avoidance is a risk management technique used for any risks that are high in frequency and high in severity. Activities that will very frequently result in severe financial consequences should be avoided. Avoidance can be applied to many pure risks, such as: • The risk of being injured on a construction site - avoid the construction site. • The risk of dying in a private plane crash - avoid flying in private planes. • The risk of getting a DUI - avoid drunk driving. • The risk of getting into an accident while talking or texting on a cell phone - avoid cell phone use while driving.

What is risk?

Risk is defined as the chance of loss, uncertainty associated with loss, or the possibility of a loss.

When determining the objectives of the risk management program what does this mean? Step 1

Risk management objectives are typically to protect assets, earning capacity, human life value, and health. Objectives may also include less tangible aspirations such as providing peace of mind or protecting family relationships. The objective for each area of risk can range from obtaining only the amount of protection required by law (e.g., auto insurance) to obtaining the most cost-effective protection against risk to providing the most comprehensive protection with little regard to cost.

Risk reduction is referring to what?

Risk reduction is the process of reducing the likelihood of a pure risk that is high in frequency and low in severity. Examples of risks that are high in frequency and low in severity are: car door dings, the common cold, and damage to inexpensive personal property. Risks that are high in frequency and low in severity are risks that should be reduced by taking steps to reduce the likelihood of a loss occurring.

What is risk retention or accepting the risk?

Risk retention is accepting some or all of the potential loss exposure for risks that are low in frequency and low in severity. Examples of risks that are low in frequency and severity include minor property damage to a personal residence or personal auto. Deductibles and copayments are forms of risk retention where the insured is sharing in the first dollar of a financial loss.

When determining and selecting the best risk management alternative what does this include? Step 4

Selecting the appropriate risk management technique is the most critical component of the risk management process. A risk that is not properly managed may have severe financial consequences for the client. Determining the appropriate response to a pure risk requires an understanding of the techniques for risk management, which include: • Risk Reduction • Risk Transfer • Risk Avoidance • Risk Retention Risk reduction and avoidance are primarily used to control or reduce the frequency or severity losses, while risk retention and transfer are used to finance losses that actually occur.

What does it mean when it says the loss must be measurable and determinable?

Since most losses covered by an insurance contract result in a financial payment to the insured, the actual timing of the loss and amount of the loss must be known. A typical insurance contract is going to offer the promise to pay in the event of a loss, but that promise to pay is only good for a period of time. Losses must also be measurable in terms of the amount of loss. If the probability of a loss is too uncertain, the risk will be considered uninsurable. If an insured owns items that exceed these limits, it will be necessary to provide the insurance company with documentation regarding the value and then increase the underlying limits of the policy. Riders and endorsements enable an insured to increase these underlying limits for an increased premium and are discussed later in this text.

What does it mean when it says a loss must not be financially catastrophic to the insurer?

Some loss exposures are so financially devastating because the loss would impact too big an area or segment of the population, that an insurance company cannot afford to pay all the claims if the event occurs. The amount that an insurance company receives for any loss is relatively small in comparison to the total possible. A loss exposure that would be financially catastrophic to the insurer is an uninsurable risk, which is why an insurer excludes perils such as flood, earthquake, nuclear hazard and acts of war. The objective for each area of risk can range from obtaining only the amount of protection required by law (e.g., auto insurance) to obtaining the most cost-effective protection against risk to providing the most comprehensive protection with little regard to cost.

What is speculative risk? Is insurance available for speculative risks?

Speculative risk is the chance of loss, no loss, or a profit. Speculative risk is the risk that an investor takes when buying a stock or an entrepreneur takes when starting a business. Insurance is not available for speculative risks because most speculative risks are willingly entered into for the purpose of making a profit.

What is subjective risk?

Subjective risk is the risk that an individual perceives based on their prior experiences and the severity of those experiences. Individuals perceive risks differently and their behavior in addressing those risks depends upon that perception. If an individual perceives the subjective risk to be high, then the individual will take appropriate steps to reduce the subjective risk.

What is the National Association of Insurance Commissioners do? What is it's goals? Does it have regulatory power?

The National Association of Insurance Commissioners (NAIC) is a voluntary organization of insurance regulators from the 50 states, the District of Columbia and the five U.S. territories (Guam, Puerto Rico, Virgin Islands, American Samoa, and Commonwealth of the Northern Mariana Islands).4 The mission of the NAIC is to "assist state insurance regulators" in serving the public. The goals of the NAIC are to: • Protect the public • Promote competition • Promote fair treatment of insurance consumers • Promote the solvency of insurance companies • Support and improve state regulation of insurance The NAIC does not have regulatory power, but it does issue model legislation to address problems within the insurance industry. The NAIC also provides a watch list of insurance companies based upon financial ratio analysis. The ratio analysis measures the financial health of an insurance company. To promote solvency and avoid insurers from being unable to pay claims, life and health insurance companies are subject to a Risk-Based Capital test (RBC) that was developed by the NAIC. Risk-based capital measures how much capital is invested and the riskiness of the investments

What is the declarations section?

The declarations section describes exactly which property or person is being covered. For property insurance, the declarations page will describe the property, address, owner of the property, name of the insured, amount of coverage, deductible, and premium. For life insurance, the declarations page will contain the insured's name, face value of the policy, term or length of the policy, and the issue date. • End of Initial Term Period: This identifies the last date the policy is effective. • Amount of Insurance: This is the amount of the death benefit or policy limit that is payable to the beneficiary of the policy. • Premiums: Depending on the type of the policy, this section may identify the amount of the current premium and perhaps any renewable premium.

What is the definition section?

The definition section of an insurance policy defines key words or phrases used throughout the insurance contract. The purpose of these definitions is to define the meaning of the words, phrases, or terms as used in the contract. A policy may include the following definitions, among others: • Insured: Upon the insured's death a death benefit is payable to the beneficiary. • You, Your: Refers to the owner of the policy. • We, Us, Our: Refers to the insurance company (insurer).

What is the description of what is being insured?

The description section describes exactly what is being insured. For a life or health insurance policy, the name of the insured is included in this section. For a property and casualty policy, the address of the property is in the description. • Insured: Name of the insured • Effective Date: The start date of when the policy is effective • Age and Sex of the Insured: Used to determine the insured class and premium due for life, health, and disability policies

What is the exclusions section?

The exclusions section of an insurance policy will exclude certain perils, losses, and property. Perils are excluded because they may be uninsurable, there is a moral hazard, or the coverage is potentially financially catastrophic to the insurer. Examples of excluded perils for a property insurance policy include: • War or nuclear hazard • Flood • Power failure • Intentional acts • Neglect • Movement of ground Losses excluded from a policy may be due to the insured not taking steps to mitigate after a covered loss has occurred. Also, some property is not covered such as damaged or stolen business property in the home.

The insurance industry is highly regulated by three levels of state government which are:

The insurance industry is highly regulated by three levels of state government, which are: • legislative • judicial • executive or State Insurance Commissioners

How is the insurance industry regulated?

The insurance industry is regulated primarily at the state level, but federal law also overlaps state insurance regulation.

In insurance regulation what does the judicial branch do?

The judicial branch of state government rules on the constitutionality of laws passed by the legislative branch. The judicial branch also rules on decisions and actions taken by the executive branch. The judicial branch provides oversight of the legislative and executive branch, along with the insurance industry.

What does law of agency mean?

The law of agency describes the relationship and authority an agent possesses when acting on behalf of a principal. A principal, such as an insurance company, hires an agent (insurance agent) to act on the principal's behalf and enter into agreements on behalf of the principal. The authority that an agent possesses is the result of express, implied, and/or apparent authority. In the case of an insurance agent, the statements or actions of the agent that are in the course and scope of the agency agreement will bind the insurance company to the insured.

What does the law of large numbers tell us?

The law of large numbers tells us that the more similar the events or exposures, the more likely the actual losses will equal the expected losses. This is important for an insurance company so that the actual claims they pay are very close to the probability of total losses.

What does the legislative branch do?

The legislative branch of state government passes laws and regulations that regulate how insurance companies conduct business in their state. The legislature defines how insurance products are sold, controls how insurance agents are licensed, and protects consumer rights by passing consumer protection laws.

What does it mean when it says identifying the risks to which the individual is exposed?

The next step is to identify all possible pure risk exposures of the client. Identifying the potential risk is primarily a function of the client's lifecycle position. The risk exposures for an individual may be subdivided into the following categories. 1. Personal risks that may cause the loss of income (untimely death, disability, health issues), or cause an increase in the cost of living (disability, health issues). 2. Property risks that may cause the loss of property (automobile, home, or other asset). 3. Liability risks that may cause financial loss (injury to another or to property for which the client is determined to be financially responsible). Identification of loss exposures for individuals and families can also be approached through the use of checklists, survey forms, questionnaires, or financial statement analysis. These types of systematic approaches help to ensure that the advisor and client avoid overlooking potential risk exposures.

When identifying the risks to which the individual is exposed what does this mean? Step 2

The next step is to identify all possible pure risk exposures of the client. Identifying the potential risk is primarily a function of the client's lifecycle position. The risk exposures for an individual may be subdivided into the following categories. 1. Personal risks that may cause the loss of income (untimely death, disability, health issues), or cause an increase in the cost of living (disability, health issues). 2. Property risks that may cause the loss of property (automobile, home, or other asset). 3. Liability risks that may cause financial loss (injury to another or to property for which the client is determined to be financially responsible). The client's lifecycle position will help to determine if the client needs to protect against premature death, disability, and long-term care.

What is the perils covered section?

The perils covered section may cover perils on a named peril basis where specific perils are listed as covered in the policy. Alternatively, the policy may cover perils on an open peril basis, which covers all risks of loss that are not specifically identified and excluded in the exclusions section of the policy. For term life insurance, the peril covered is death of the insured within the term period.

What does it mean to implement the risk management plan selected? Step 5

The planner should work closely with the client to insure implementation of appropriate risk management techniques. Implementation may require collaboration with other professionals such as insurance agents, brokers, or specialists.

What is the principle of insurable interest?

The principle of insurable interest asserts that an insured must suffer a financial loss if a covered peril occurs, otherwise no insurance can be offered. The principle of insurable interest is closely aligned with the principle of indemnity, which both limit the insured from experiencing a gain using insurance

Periodically evaluating and reviewing the risk management program does what for the client? Step 6

The purpose for periodic evaluation and review is twofold. First, the risk management process does not take place independently from external influences. Circumstances change over time, and risk exposures can change as well. The risk management response that was suitable last year may not be the most appropriate this year, and adjustments may need to be made. Second, errors in judgment regarding the selected alternatives may occur, and periodic reviews allow the planner and client to discover such errors and revise the risk management plan as appropriate.

What are the two important requirements for a risk to be insurable?

There are two important requirements for a risk to be insurable. The first requirement is that there are a large number of exposures. The second requirement is that the large number of exposures is homogeneous.

What is an estoppel?

Through the legal doctrine of "estoppel," the principal will not be able to deny the insured an insurance contract. Estoppel is where a person is denied a right he might otherwise be entitled to under the law. Estoppel applies when one party relies on information from another party and that information causes harm to the party who relied on the information. The party who made the statements can be estopped from denying the statements.

With regards to insurance rate regulation what is "prior approval law"

Under prior approval law, an insurance company must file the rate increase request with the State's Insurance Commissioner's office. The rate increase will either be approved, disapproved, or modified. During 2009 and 2010, many states denied health insurance rate increases due to the increasing unemployment rate and potential political fallout arising from 10 to 20 percent health insurance rate increases.

What is legal competence of all parties when entering into a contract?

When entering into a contract, both parties must be legally competent. Otherwise, the contract is unenforceable. Legal competence includes the following situations: •Minors - In most states, a minor is under the age of 18. If a minor enters into a contract, the minor can void the contract at any time. If one party can void a contract at any time, there really is not an enforceable contract. •Lacking Sound Mind - A person lacking a sound mind does not have the capacity to understand the purpose and terms of the contract. Therefore, the contract lacks a meeting of the minds or mutual consent. Examples of persons lacking sound mind include a person who is drunk, mentally handicapped, or under the influence of drugs. Other important considerations of a contract include the parol evidence rule, which provides that "what is written prevails." Any oral agreements prior to writing the contract have been incorporated into the written contract. Oral agreements that are not reflected in the written contract are not valid.

What information is used in the underwriting process and where is it obtained?

nformation used in the underwriting process is typically obtained from the following sources: • the application and any pertinent appended documents, • affidavits submitted by the agent or broker, • routine and detailed investigations when warranted, • insurance bureaus and associations (for example, life insurance companies have access to the Medical Information Bureau (MIB), an association of approximately 430 insurance companies that accumulates and provides medical information relative to life insurance applicants), • actual medical examinations for life insurance applicants and on-premises inspections for property insurance applicants, and • outside agency reports such as driving records from the DMV or the insured's credit score. An underwriter groups risks into similar classes and assigns a premium or class rate to all members of the class, such that the premium is expected to cover all claims, operating expenses, and produce a profit. The underwriter attempts to manage adverse selections with the use of deductibles, copayments, and coinsurance.

What does the risk management process include?

• Determining the objectives of the risk management program • Identifying the risks to which the individual is exposed • Evaluating the identified risks for the probability and severity of the loss • Determining the alternatives for managing the risks • Selecting the most appropriate alternative for each risk • Implementing the risk management plan selected • Periodically evaluating and reviewing the risk management program

Most Individuals require some or all of the following:

• Life insurance to protect against financial losses due to premature death • Health insurance to protect against the financial impact of injury or sickness for all family members • Disability insurance to protect against the loss of income from the inability to work due to sickness or accident • Property insurance to protect a home, personal property, the personal auto, or other assets • Long-term care insurance to provide benefits for custodial care and/or skilled nursing care • Personal liability insurance to protect personal assets and future earnings from potential liability judgments

What are examples of pure risks?

• Premature death of a primary wage earner • A prolonged illness or injury of a client or family member • The inability of the client to work because of sickness or accident • Wind damage to the personal residence • The inability of the client to take care of himself in old age • A legal judgment against the client

In insurance regulation what does the executive or state insurance commissioner do?

All states have a state insurance commissioner, which is an elected or appointed position. The state insurance commissioner is responsible for enforcing the legislature's laws and regulations, licensing of insurance agents, reviewing rate increases, and auditing insurance companies.

What is an endorsement? What is a rider?

An endorsement is a modification or change to the existing property insurance policy. A rider is a modification or change to a life or health insurance policy. Riders and endorsements are a way for an insured to customize a policy, since insurance policies are contracts of adhesion and the insured has no opportunity to negotiate the terms of the contract. If there are conflicting terms between the policy and a rider or endorsement, then the rider or endorsement language prevails.

What is life insurance?

An insurable interest for life insurance need only exist at the inception of the policy. A life insurance policy is not an indemnity policy. It instead pays the face value of the policy based on the "value" of the amount of insurance purchased. Some people refer to this as a "modified" indemnity policy or an "agreed to value" policy. To purchase life insurance, the owner of the policy must have an insurable interest in that person's life. An insurable interest exists for a person to purchase life insurance on their own life and name either themselves or someone else as the beneficiary. An insurable interest also typically exists for close family relationships and may also exist for business relationships.

What is insurance?

Insurance is simply a legal contract between the insured and the insurance company (insurer), by which the insured transfers risks to the insurer and the insured pays a premium to the insurer.

What is Risk Transfer?

Risk transfer involves transferring a low frequency and high severity risk to a third party, such as an insurance company. Examples of risks that are low in frequency but high in severity include disability (or the inability to work), premature death, or damage to a personal residence.

What is the principle of utmost good faith? What are the 3 doctrines:

The principle of utmost good faith requires that the insurer and insured act in a manner that is forthcoming with all information about the risks being considered during the underwriting process. The insured and the insurer follow three legal doctrines during the application and throughout the life of the policy: • Representation • Warranty • Concealment

What is the probability of a loss?

The probability of loss is the chance that a loss will occur

What is the law of insurance contracts? What are the following elements that must be present for a contract to be valid:

A contract is a legal agreement that binds two parties to each other to perform certain obligations. The following elements must be present for a contract to be valid: • Mutual Consent • Offer and Acceptance • Performance or Delivery • Lawful Purpose • Legal Competency of all Parties

What are mutual company insurers?

A mutual company is an insurance company that is owned by the policyholders, not shareholders. The policyholders elect the Board of Directors for a mutual company. Profits earned by a mutual company are returned to policyholders in the form of a dividend. The dividend is not treated as taxable income but it is a return of premiums paid

What is particular risk?

A particular risk is a risk that can impact a particular individual, such as death or the inability to work because of a sickness or accident. An important difference between fundamental risk and particular risk is that fundamental risk will impact a large group of individuals simultaneously, whereas a particular risk only impacts one individual.

What does it mean when insured losses must be accidental?

Actual losses must be accidental because premiums are based on the probability of a loss occurring based on historical information and claims. intentionally burning down a house that you own and insure to collect the insurance proceeds is an intentional act and is not a covered loss.

What is a moral hazard

Moral hazard is the potential for loss caused by the moral character of the insured such as the filing of a false claim with the insurance company