Ch 1 Introduction to Insurance

What is insurance

A person protects themselves against risk by purchasing an insurance policy. The insured (policyowner), pays a set amount of money (the premium) to the insurance company (the insurer). In return, the insurer agrees to pay the other party (the insured beneficiary) a set sum (the benefit) upon the occurrence of some event. For example, in life insurance, the benefit is paid when the insured dies.

Insurance gen

In the face of this uncertainty, insurance was developed as a means for spreading a financial loss among many persons so that the cost to any one person is relatively small.

exposure unit

is the item of property or the person insured.

The insured

policyowner

1. 6 Types of Insurance (cont.)

Accident and health or sickness insurance protects the insured against financial loss caused by sickness, bodily injury, or accidental death and may include benefits for disability income. It may reimburse the insured for actual medical expenses incurred as a result of an accident or illness (hospitalization insurance), or it may provide protection for loss of income experienced by the insured during periods of disability resulting from accident or sickness (i.e., disability income insurance). Health insurance can be written on either an individual or group basis and may include medical expense, hospital indemnity, major medical, hospital, surgical, disability, cancer, accident, dental expenses, eyeglasses, prescription medication, and other health-related expenses. Variable life and variable annuity products include insurance coverage provided under variable life insurance contracts and variable annuities. Variable products carry investment risk—that is, the insured may lose money because of a decrease in the price of the securities underlying the policy. For this reason, individuals selling such products are required to carry a securities license as well as an insurance license. Credit is a limited line of insurance protecting the insured, who is usually a creditor, against the financial consequences should a debtor be unable to pay debts as a result of illness or death. Other types of insurance, such as title insurance or crop insurance, may be authorized in individual states. These limited lines of insurance are more narrowly focused than the types of insurance listed above, generally falling within the broad scope of one of the types of insurance listed earlier in this section.

1. 5. 1. 1 Subrogation

Subrogation entitles one who has paid for another's loss to take over the other's right to recourse from the party responsible for the loss. A subrogation clause in an insurance policy gives the insurer the right to sue [only in health insurance cases.]

the premium

pays a set amount of money

Physical hazards

arise from material, structural, or operational features of a risk situation (slippery floors or unsanitary conditions would be physical hazards).

1. 5. 1 Indemnity

states that insurance should restore the insured, in whole or in part, to the condition the insured enjoyed before the loss. In life and health insurance, the concept of indemnity has a slightly different meaning in that a person's economic value or human life value is the individual's present and future earning power.

1. 5. 3 Deductibles

(the term has no application in life insurance)

1.10 Producers

1. 10. 1 Categories of Producers Producers may function as agents, representing the insurance company, or as brokers, representing the potential insured. Producers acting as agents are not only categorized by their function in the industry but also by the line of insurance they sell. 1. 10. 1. 1 Life and Health Agents Generally, life and health insurance agents represent the insurer to the buyer with respect to the sale of life and health insurance products. The agents are appointed by the insurer, and usually the agent's authority to represent the insurer is specified in the agency agreement between them, which is a working agreement between the agent and the insurer. Life and health insurance agents generally do not have the authority to issue or modify insurance contracts. Customarily, life and health insurance agents are authorized to solicit, receive, and forward applications for the contracts written by their companies. The agent may receive the first premium due with the application, but usually not subsequent premiums, except in industrial life insurance. The insurance company approves and issues the contract after receiving the application and premium from the applicant through the agent. The agent cannot bind coverage. This means that an agent cannot commit to providing insurance coverage on behalf of the insurance company.

1. 10 Producers (cont.)

1. 10. 1. 2 Property and Casualty Agents Agents appointed by property and liability insurance companies generally are granted more authority. These agents may bind or commit their companies by oral or written agreement. They sometimes inspect risks for the insurance company and collect premiums due. They may be authorized to issue many types of insurance contracts from their own offices. 1. 10. 1. 3 Brokers In contrast to the agent-client relationship in which the agent represents the insurer to the purchaser, a broker represents the buyer to the insurer. A broker may do business with several different insurers. Brokers are independent sales representatives who select insurance coverages from these various companies for their clients. Brokers must be licensed just like agents, and generally their routine activities and functions are similar to those of agents. Brokers solicit applications for insurance, may collect the initial premium, and deliver policies. Brokers do not have the authority to bind coverages. 1. 10. 1. 4 Solicitors A solicitor is a salesperson who works for an agent or a broker. This working relationship is most common in the property and casualty insurance field. 1. 10. 1. 5 Insurance Consultants A very small group of insurance professionals call themselves insurance consultants. Consultants are not paid by commission for the sales of insurance policies. Instead, they work strictly for the benefit of insureds and are paid a fee by the insureds they represent.

1. 4. 6 Insurable Risks

1. 4. 6. 1 Large Numbers of Homogeneous Units A large number of similar exposure units is necessary in order for the pooling and sharing mechanisms of insurance to function. 1. 4. 6. 2 Loss Must Be Measurable The insurer must be able to place a specific monetary value on exposures and losses in order to be able to calculate rates and premiums and reach settlements. 1. 4. 6. 3 Loss Must Be Uncertain Insurance covers pure risks, which must involve an uncertainty of loss. If insurance policies covered certain losses (such as deliberate acts of destruction and inevitable loss events), insurance companies would lose money or coverage would be unaffordable. 1. 4. 6. 4 Economic Hardship There must be a significant potential for economic loss. You cannot insure a $2 pen against loss (because there is no threat of hardship and it would cost more than $2 to issue the policy). You cannot insure your neighbor's house against loss by fire (you do not have an insurable interest and would suffer no loss if the house burned). 1. 4. 6. 5 Exclusion of Catastrophic Perils The insurance system would collapse if it covered events that caused widespread losses to large numbers of insureds at the same time. There is no way to reasonably price catastrophic exposures. This is why many policies exclude losses resulting from war, nuclear hazards, flood, and earthquake. (Exclusion of catastrophic perils applies primarily to property and casualty insurance. Coverages for some of these exposures are available through government programs or specialty insurers.)

1. 7 Types of Insurers

1. 7. 4 Fraternal Insurers Fraternal benefit societies are primarily life insurance carriers that exist as social organizations and usually engage in charitable and benevolent activities. Fraternals are distinguished by the fact that their membership is usually drawn from those who are also members of a lodge or fraternal organization. They operate under a special section of the state insurance code and receive some income tax advantages. One distinctive characteristic of fraternal life insurance is the open contract, which allows fraternals to assess their certificateholders (charge additional, unscheduled premiums) in times of financial difficulty. 1. 7. 5 Lloyd's Lloyd's of London is not an insurance company, but it provides a meeting place and clerical services to its members who actually transact the business of insurance. Members are individually liable and responsible for the contracts of insurance into which they enter. 1. 7. 6 Reinsurers Reinsurers make up a specialized branch of the insurance industry that insures insurers. Reinsurance is an arrangement by which an insurance company transfers a portion of a risk it has assumed to another insurer. Usually, reinsurance takes place to limit the loss any one insurer would face should a very large claim become payable. The company transferring the risk is called the ceding company; the company assuming the risk is the reinsurer. Facultative reinsurance is negotiated on an individual risk basis. The reinsurer retains the right to accept or reject each risk, so there must be an offer and acceptance on each reinsurance contract. Treaty reinsurance involves an automatic sharing of risks by the ceding company.

1. 7 Types of Insurers (cont.)

1. 7. 7 Excess and Surplus Lines Occasionally, it may be difficult to place a risk in the normal marketplace. If the risk is very large or unusual in nature, typical carriers may be unwilling to assume it. For some special risks, the only market may be with specialty carriers. Excess and surplus lines is the name given to insurance for which there is no market through the original producer or that is not available through authorized carriers in the state where the risk arises or is located. Such business must be placed through a licensed excess or surplus lines broker, who will attempt to place it with an unauthorized carrier. 1. 7. 8 Risk Retention Groups Risk retention groups are composed of members who are engaged in similar businesses or activities. The group's primary activity consists of assuming and spreading all, or a portion, of the liability exposure of its members. These groups may only provide liability insurance, not workers' compensation or personal lines insurance. RRGs are regulated by the state where they are domiciled but can transact insurance in any other state without further regulation or the requirement to participate in the state guaranty fund. 1. 7. 9 Self-Insurers Self-insurance is a means of retaining risk. Some businesses intentionally self-insure all or a portion of specified risks. Frequently, self-insurers set aside reserve funds to cover losses and purchase excess insurance to cover large losses or aggregate losses above a given level. Individuals who neglect to purchase needed insurance coverage (such as health insurance or automobile insurance) are, in effect, self-insuring these exposures and risking their personal assets. 1. 7. 10 The United States Government as Insurer The federal government provides a wide variety of insurance benefits through various programs. These include Social Security benefits, military life insurance benefits, federal employee compensation benefits, and various retirement benefit programs. It also provides, supports, or subsidizes a number of insurance programs designed to cover catastrophic risks, including insurance for war risks, nuclear energy liability, flood, and crop losses. At the state level, governments are involved in providing unemployment insurance, workers' compensation insurance, disability insurance, and medical insurance for the needy. Local governments also participate in providing medical, disability, and retirement benefits.

1. 9 Types of Distribution Systems

1. 9. 1 Agency System Insurance is made available to the public through a number of distribution systems, including the following. Independent insurance agents sell the insurance products of several companies and work for themselves or other agents. The independent agent owns the expirations of the policies he sells, meaning the individual may place that business with another insurer upon renewal if in the best interest of the client. Exclusive or captive agents represent only one company. These agents are sometimes referred to as career agents working from career agencies. Most often, these captive or career agents are compensated by commissions. General agents or managing general agents (MGAs) hire, train, and supervise other career agents within a specific geographical area. The MGA is compensated by commissions earned on business sold by herself as well as an overriding commission (overrides) on the business produced by the other agents managed by the general agent. An MGA has field underwriting and binding authority only in property and casualty insurance. Direct-writing companies usually pay salaries to employees whose job function is to sell the company's insurance products. Technically, these salaried employees do not function as agents. Commissions are usually not paid and the insurer owns all of the business produced. 1. 9. 2 Mass Marketing Mass marketing has grown in general use over the past several years. The most common types of mass marketing systems are direct response, franchise, noninsurance sponsors, and vending machine sales. 1. 9. 2. 1 Direct Response Direct-response marketing is conducted through the mail, by advertisements in newspapers and magazines, and on television and radio. Policies sold using this method have limited benefits and low premiums, such as disability only. 1. 9. 2. 2 Franchise Marketing The franchise marketing system provides coverage to employees of small firms or to members of associations. Unlike group policies where benefits are standard for classes of individuals, persons insured under the franchise method receive individual policies that vary according to the individuals' needs. Franchise plans are attractive to employers who do not, according to the laws of their state, meet the qualifications for a true group. These plans allow the employers to offer individual insurance to their employees at a lower premium than for insurance purchased on an individual basis. Premiums may be deducted from the individual's paycheck.

1. 4. 5 Insurable Interest

A basic rule governing insurance states that before an individual can benefit from insurance, that individual must have a legitimate interest in the preservation of the life or property insured. For life insurance, insurable interest must exist at the time of the application for insurance, but it need not exist at the time of the insured's death. This prevents the insurer from needing to obtain proof of such emotional issues as existing love and affection in the emotional time following a death. In contrast, property and casualty insurance generally does require an insurable interest to exist at the time of loss. Loss of property is not generally as emotional as the loss of a life, and the existence of an insurable interest in property is more easily determined.For life insurance, insurable interest must exist at the time of the application for insurance, but it need not exist at the time of the insured's death. This prevents the insurer from needing to obtain proof of such emotional issues as existing love and affection in the emotional time following a death. In contrast, property and casualty insurance generally does require an insurable interest to exist at the time of loss. Loss of property is not generally as emotional as the loss of a life, and the existence of an insurable interest in property is more easily determined. Insurable interest affects who may purchase a policy but not who may benefit from a policy. For example, an individual could purchase life insurance on her own life and name a charitable organization as the beneficiary.

1. 8. 1 Insurer's Domicile (Domestic, Foreign, and Alien Insurers)

Domestic insurers A company is a domestic insurer in the state in which it is incorporated. Foreign insurers A foreign insurer is licensed to conduct business in states (the District of Columbia or other US territories) other than the one in which it is incorporated. Alien insurers Alien insurers are companies incorporated in a country other than the United States, the District of Columbia, or any US territorial possession.

1. 6 Types of Insurance

Insurers market a variety of insurance products. The most common products offered are property, casualty, life, and health insurance and annuities. Property insurance protects the insured against the financial consequences of the direct or consequential loss or damage to property of every kind. Property insurance policies cover the risk of damage or loss to property, which is defined as building, equipment, stock, or contents. Casualty insurance protects the insured against the financial consequences of legal liability, including that for death, injury, disability, or damage to real or personal property. Casualty insurance contracts include automobile policies, general liability policies, workers' compensation coverage, crime insurance, surety (bonding), boiler and machinery coverages, and many others. Life insurance is insurance coverage on human lives, including endowments and annuities, and may include benefits in the event of accidental death or dismemberment and benefits for disability. It is designed to protect against the risk of premature death, which exposes a family or a business to certain financial risks, such as burial expenses, paying debts, loss of family income, and business profits. An annuity provides guaranteed income for the life of an annuitant. Annuities are designed to protect against the risk of living too long—that is, outliving one's financial resources during retirement.

1. 5. 4 Coinsurance

It means that within a specified coverage range, the insured and insurer will share the allowable expenses. It is usually expressed in percentages (e.g., 20-80%).

1. 5. 2 Limit of Liability

Life insurance policies usually use the term face amount to refer to the maximum liability of the insurer for a death claim.

STARR

Sharing—Sometimes, when a risk cannot be avoided and retention would involve too much exposure to loss, we may choose risk sharing as a means of handling the risk. By sharing risk with someone else, an individual also shares potential losses. That is, the individual's own loss may not be as great if it occurs, but the individual may have to pay a portion of the losses experienced by others. Transfer—Risk transfer means transferring the risk of loss to another party, usually an insurance company, that is more willing or able to bear the risk. Some non-insurance transfers of risk occur, such as when one agrees to assume the risk of another under the terms of a written contract. Avoidance—As the name implies, this technique deals with risk by avoiding the risk in the first place. This usually means not undertaking an activity that could involve the chance of loss. For example, by never flying, one could eliminate the risk of being in an airplane crash. Reduction—Sometimes, when risks cannot be avoided, they can be reduced. Risk reduction can work in one of two ways: it can reduce the chance that a particular loss will occur, or it can reduce the amount of a potential loss if it occurs. For example, installing a smoke alarm in a home would not lesson the possibility of fire, but it would reduce the risk of the loss from the fire. Retention—Retention simply means doing nothing about the risk. In other words, people assume or retain the risk and, in effect, become self-insurers. For example, the insured would pay a smaller portion of the loss than the insurer, such as paying a deductible.

1.3

The agreement between the insurer and the insured, the person who is covered by the insurance, is established in a legal document referred to as a contract of insurance or a policy. The insurer promises to pay the insured according to the terms of the policy if a loss occurs. Loss is defined as reduction in the value of an asset. To be paid for a loss, the insured must notify the insurer by making a claim. The claim is a demand for payment of the insurance benefit to the person named in the policy. Insurance plays an important role in society. As a result of the sharing, or pooling, of a large number of similar risks, insurance coverage is available to most individuals for a reasonably affordable premium.

Moral hazards

arise from people's habits and values (filing a false claim is an example of moral hazard)

Morale hazards

arise out of human carelessness or irresponsibility (failing to take safety precautions is an example of morale hazard).

Speculative risk

involves both an uncertainty of loss and of gain. Insurance does not protect individuals against losses arising out of speculative risk because these risks are undertaken voluntarily. For example, betting at the race track and investing in the stock market are examples of uninsurable risk.

Insurance

is a contract that indemnifies another against loss, damage, or liability arising from an unknown event

hazard

is any factor that gives rise to a peril. For purposes of life insurance, there are three basic types of hazards: physical, moral, and morale.

Peril

is the immediate specific event causing loss and giving rise to risk. It is the cause of a risk. For example, when a building burns, fire is the peril. When a person dies, death is the peril.

Pure risk

means that there is only a chance of loss—the loss may or may not happen—and there is no possibility for gain. The risk associated with the chance of an accident is an example of pure risk. Only pure risk is insurable.

Indemnify

means to make a person whole by restoring that person to the same financial position that existed before the loss.

1.4 risk

simply means uncertainty of financial loss, or the chance of loss, when more than one outcome is possible.

the insurer

the insurance company

1. 4. 4 Law of Large Numbers

the larger the group the more predictable the outcome of loss is. Example Consider two groups of 40-year-old males. The first group has 10,000 males, and the second group has 50,000 males. A more accurate prediction can be made of how many of those individuals will die in a year in the group of 50,000 than in the group of 10,000.