Insurance - Principles of Insurance

Elements of a Legal Contract

COALL: Competent parties Offer and Acceptance Legal consideration and Lawful Purpose

Principle of Indemnity

An insured is only entitled to compensation to the the extent of the insured's financial loss An insured cannot make a profit from an insurance company

Characteristics of Insurance Contracts

Adhesion • An insurance policy is basically "take it or leave it." There are no negotiations over terms and conditions. • As a result, any ambiguities in an insurance contract are found in favor of the insured. Aleatory • The money exchanged may be unequal. In other words, there's a small premium, but the insured may receive a large benefit. Unilateral • Only one promise is made by the insurer which is to pay in the event of a loss. • The insured is not obligated to pay the premiums. If the premiums are not paid, then there's no promise by the insurer. Conditional • The insured must abide by the terms and conditions of the insurance contract. If the terms and conditions are not followed, the insurer may not pay a claim

What type of hazard results from the indifference a person has to the potential loss because of the existence of insurance? a) Peril. b) Physical Hazard. c) Moral Hazard. d) Morale Hazard.

Answer: D Moral hazard is a character flaw or dishonesty, e.g., burning your own house down. Morale hazard is the indifference a person has towards loss because of insurance (e.g., leaving the keys in your car and the car running).

Raj owns a house with a replacement value of$300,000 . He purchased $200,000 of homeowners insurance with a coinsurance requirement of 80% and a $500 deductible. Raj experiences a $40,000 loss. What will the insurance company pay?

Coinsurance Formula: [$200,000 / (0.80 x $300,000)] x $40,000 200,000 / 240,000 x 40,000 - 500 = $32,833 If coverage is less than the coinsurance requirement, then the insurer pays the greater of actual cash value or the following formula: (Face Value /Coinsurance) x Loss - Deductible

Estoppel

Estoppel - Takes place when a party is denied assertion of a right to which they are otherwise entitled. Consider an insured who causes a car accident. The insured's insurance agent says, "Your auto insurance premiums won't increase because of one accident." The insurer could be "estopped" from raising premiums at the next opportunity because of the informal agreement between the insured and insurance agent.

NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)

Provides a watch list of insurance companies based upon financial ratio analysis. Be sure to know that the NAIC has no regulatory power over the insurance industry. Regulation occurs at the state level.

SIX STEPS OF RISK MANAGEMENT

1. Determine the objectives of the risk management program. 2. Identify the risks to which the client is exposed. 3. Evaluate the identified risks as to the probability of occurrence and potential loss. 4. Determine alternatives for managing risks, and select the most appropriate alternative for each. 5. Implement the program. 6. Evaluate, monitor, and review (control). D-I-E-D-I-E: Don't Insure Everything (Squared)

Which of the following is an insurable risk? a) Objective Risk. b) Pure Risk. c) Subjective Risk. d) Speculative Risk.

Answer: B Pure risk involves the risk of loss or no loss and is the only insurable risk.

When the insured is silent to a fact that is material to the risk being insured, what has occurred? a) Breach of Warranty. b) Misrepresentation. c) Concealment. d) Breach of Indemnity.

Answer: C Breach of Warranty - you don't do something you agree to do (e.g., install a home alarm security system). Misrepresentation - you say you don't smoke when you do. Breach of Indemnity - you can't make a profit.

Jennifer is applying for life insurance, with her two children as beneficiaries. Jennifer has always been told she looks young for her age and although she is 58, she stated that she is 28 on her life insurance application. What would the insurer be most likely to do if Jennifer's beneficiaries attempt to collect on the life insurance policy? a) Void the policy. b) Require payment on premiums for a 58-year-old insured. c) Recalculate the face value of the policy based on actual premiums paid. d) Bring a lawsuit against the estate.

Answer: C The insurance company will simply calculate how much coverage she could have bought based upon her real age and actual premiums paid.

Which of the following statements regarding the characteristics of an insurance contract is false? a) They are a contract of adhesion, which means the insured must take it or leave it. b) They are aleatory contracts, which means amounts exchanged may be unequal. c) They are unilateral, meaning there is only one promise, which is a promise by the insured to pay the premium. d) The contracts are conditional, which means the terms are under the condition that premiums are paid.

Answer: C The promise is by the insurer to pay if a loss occurs.

Which of the following is not a requisite for an insurable risk? a) A large number of homogeneous exposure units must exist. b) Insured losses must be accidental from the insured's standpoint. c) Insured losses must be measurable and determinable. d) Loss must not pose a catastrophic risk for the insured.

Answer: D Loss must not pose a catastrophic risk for the insurer. All others are a requisite for an insurable risk.

The tendency for individuals of higher-than-average risk to seek out or purchase insurance policies is? a) Peril. b) Hazard. c) Law of Large Numbers. d) Adverse Selection.

Answer: D The underwriter attempts to manage adverse selection and weed out or manage those that need insurance.

Insurable Risks are CHAD

not Catastrophic, Homogeneous exposure units, Accidental, and measurable and Determinable.

Hazard

• A hazard is a condition that increases the likelihood of a loss occurring. • There are three types of hazards: Moral, Morale, and Physical Hazard.

Physical Hazard

• A physical hazard is a tangible condition that increases the probability of a peril occurring. • For example: Icy or wet roads, poor lighting, or defective equipment.

Moral Hazard

• Amoral hazard is a character flaw. • A character flaw would lead to a filing a false claim. • For example: A famous running back for Ohio State claimed his car was broken into and $10,000 worth of CDs were stolen. There certainly wasn't $10,000 worth of CDs in his car and thus is an example of a moral hazard.

Perils

• Perils are the actual cause of a loss. • For example: Fire, wind, tornado, earthquake, burglary, and collision.

The subrogation clause is: a) A person is entitled to compensation only to the extent that financial loss has been suffered. b) Insured cannot indemnify himself from both the insurance company and a negligent third party for the same claim. c) The insured must be subject to emotional or financial hardship resulting from the loss. d) The insured and insurer must both be forthcoming with all relevant facts about the insured risk and coverage provided for that risk.

Answer: A B describes subrogation. C describes an insurable interest. D describes concealment.

Which of the following methods of dealing with risk does not match its action? a) Risk Avoidance: Wearing a hard hat on a construction site. b) Risk Reduction: Installing a sprinkler system in a building. c) Risk Transfer: Carrying automobile insurance. d) Risk Retention: Health insurance policy deductibles.

Answer: A Avoidance would mean not going anywhere near a construction site.

Donna owns a house with a fair market value of$500,000 . She purchases $300,000 of insurance with a coinsurance requirement of 80%. If Donna's house is hit by a tornado and suffers a $150,000 loss, what will the insurer pay? a) $75,000. b) $112,500. c) $150,000. d) $250,000.

Answer: B ($300,000 /($500,000 x 0.80)) x $150,000 = $112,500

Chris walks into his insurance agent's office and notices his agent's name on a business card and the insurer's name on letterhead. If the agent has a valid agency agreement, what type of authority does Chris believe his agent has to enter into an insurance contract? a) Express Authority. b) Implied Authority. c) Apparent Authority. d) None of the Above.

Answer: B Implied authority is based upon the agents business card, letterhead, and insurance company sign on the door. Express authority is the agency agreement between the insurance agent and insurance company. Apparent Authority is when no authority actually exists

Morale Hazard

• Morale hazard is the indifference created because a person is insured. For example: Beth goes to the convenience store to get milk for her baby. Beth leaves the keys in her car and the car running while she goes into the store, not concerned that her car may get stolen because she has car insurance.

The principle of indemnity is: a) A person is entitled to compensation only to the extent that financial loss has been suffered. b) Insured cannot indemnify himself from both the insurance company and a negligent third party for the same claim. c) The insured must be subject to emotional or financial hardship resulting from the loss. d) The insured and insurer must both be forthcoming with all relevant facts about the insured risk and coverage provided for that risk.

Answer: A B describes subrogation. C describes an insurable interest. D describes concealment.

Which of the following statements regarding loss frequency is true? a) Loss frequency is the expected number of losses that will occur within a given period. b) Loss frequency is the potential size or amount of a loss. c) Loss frequency is a measure of the total amount of losses incurred by an insurer. d) Loss frequency is a measure of variability between actual and expected losses

Answer: A Frequency measures the number of losses expected to occur. Severity measures the potential size in dollars.

Which of the following statements regarding loss severity is true? a) Loss severity is the expected number of losses that will occur within a given period. b) Loss severity is the potential size or amount of a loss. c) Both A and B. d) Neither A nor B.

Answer: B Frequency measures the number of losses expected to occur. Severity measures the potential size in dollars.

Dispute Remedy

Parol Evidence Rule - Once the contract is placed in written form all previous and prior understandings may not contradict the written contract. Essentially the parol evidence rule stipulates that the contract reflects the complete understanding of both parties. • Reformation - Contractual remedy in which the contract is revised to express the original intent of all parties. • Rescission - Deems a contract void from inception.

When must an insurable interest exist for a life insurance claim? a) At the policy inception and time of loss. b) At the policy inception only. c) At the time of the loss. d) Either at the policy inception or at the time of the loss.

Answer: B Insurance company can collect against a negligent third party.

When must an insurable interest exist for a property insurance claim? a) At the policy inception and time of loss. b) At the policy inception only. c) At the time of the loss. d) Either at the policy inception or at the time of the loss.

Answer: B Insurance company can collect against a negligent third party.

Insurance regulation is primarily conducted at what level? a) Securities and Exchange Commission. b) State Insurance Commissioner. c) Federal Insurance Commission. d) NAIC

Answer: B NAIC - The National Association of Insurance Commissioners tries to have similar laws across states, but the end result is that each State Insurance Commissioner regulates insurance products and companies.

Which of the following is correct regarding a peril and hazard? a) A hazard is the proximate or actual cause of a loss. b) A peril is the proximate or actual cause of a loss. c) A peril is the condition that creates or increases the likelihood of a loss occurring. d) None of the above.

Answer: B Peril is proximate cause of a loss. Hazard is a condition that creates or increases the likelihood of a loss occurring.

Types of Authority

Express Implied Apparent - Apparent authority is when the insured believes that agent has authority to act on behalf of the insurer when in fact, no authority actually exists. - Apparent authority could be inferred based on business cards or a sign on the wall, but the agency agreement actually expired. - If an agent represents that insured can pay premium late, but is wrong, then the insurer is still responsible