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RMIN 4000 Exam #2 Study Guide Chapter 2 Insurance involves not only risk transfer but also pooling

ing and risk reduction Pooling: the sharing of total losses among a group Risk reduction: a decrease in the total amount of uncertainty present in a particular situation Overall risk for the group is reduced, and losses that result are pooled. Usually through the payment of an insurance premium. Insurance: pooling of fortuitous losses by a transfer or risk to insurers who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurrence, or to render services connected with the risk Two main elements of insurance: o Financial Intermediation: pay a small premium in exchange for promise to pay for the costs of loss o Contractual Relationship: in the form of a policy Basic Characteristics of Insurance Definition o Pooling of Losses Pooling: the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss o Payment of Fortuitous Losses Fortuitous Loss: one that is unforeseen and unexpected by the insured and occurs as a result of chance o Risk Transfer: a pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position to pay the loss than the insured o Indemnification: the insured is restored to his or her approximate financial position prior to the occurrence of the loss Law of large numbers: the greater the number of exposures, the more closely will the actual results approach the probably results that are expected from an infinite number of exposures Requirements of an Insurable Risk o Large number of homogenous units o Fortuitous, accidental and unintentional losses o Determinable and measurable losses o Non-catastrophic losses o Calculable chance of loss o Economically feasible premium o Large loss principle o Probability of loss not too high Underwriting: the process of selecting and classifying applicants for insurance (note this is from the perspective of the insurer) Adverse selection: the tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates, which if not controlled by underwriting, results in higher-than-expected loss levels Insurance vs. Gambling

Gambling creates new, speculative risk. Insurance is a technique for managing a pure risk that is already present In gambling a winner comes at the expense of a loser. In insurance, both parties have an interest in protecting the exposure from loss. Insurance contracts seek to restore what the insured had lost. Insurance vs. Hedging Insurance must meet the characteristics of an insurable risk. Hedging doesnt meet these requirements and cover speculative risks. Insurance relies upon the law of large numbers, allowing insurers to better establish pricing and terms. Hedging involves only risk transfer for one contract at a time; does not reduce objective risk. Private Insurance Voluntary coverage o Life and health o Property: indemnifies property owners against the loss or damage of real or personal property caused by various perils o Liability: covers the insureds legal liability arising out of property damage or bodily injury to others; legal defense costs are also paid o Casualty insurance: broad field of insurance that covers whatever is not covered by fire, marine, and life insurance; casualty lines include auto, liability, burglary and theft, workers comp, and health o Liability / Casualty: if you may be responsible for someone elses property, life, or income Property and casualty coverages o Personal lines: coverages that insure the real estate and personal property or provide them with protection against legal liability Private passenger auto insurance: protects the insured against legal liability arising out of auto accidents Homeowners policy is a multiple-line policy, which refers to state legislation that allows insurers to write property and casualty lines in one policy Personal umbrella liability insurance: provides protection against a catastrophic lawsuit or judgement Boatowners o Commercial Lines Fire insurance Commercial multiple-peril insurance: can include property, general liability, business income, rents, and extra expenses General liability: for business firms or other organizations Workers comp Commercial auto Accident and health Inland marine: covers goods being shipped on land, imports and exports, domestic shipments, and instrumentalities of transportation, and personal property

Ocean marine: covers ocean-going vessels and their cargo from loss or damage because of perils of the sea Professional liability: physicians, surgeons, attorneys, accountants, etc Directors and officers: protects if they are sued for mismanagement of the companys affairs Equipment breakdown: covers losses due to accidental breakdown of covered equipment Fidelity bonds: cover loss caused by dishonest or fraudulent acts of employees Surety bonds: provide for monetary compensation in the case of failure by bonded persons to perform certain acts, such as failure of a contractor to construct a building on time Crime insurance Aircraft insurance Credit insurance Financial guaranty Public / Government Insurance Involuntary coverage; required by law Social Insurance o Social security o Medicare o Unemployment o Workers comp o Compulsory temporary disability o Railroad retirement act o Railroad unemployment act Legal types of insurers o Stock companies Management: incorp; stockholder owner; board of directors managers Assessment rule: never. Stockholders absorb losses Participating dividends: no. taxable stockholder dividends paid o Mutual companies o Lloyds of London

Chapter 9 Fundamental Legal Principles o Principle of Indemnity o Principle of Insurable Interest o Principle of Subrogation o Principle of Utmost Good Faith Principle of Indemnity Restoration of insureds prior to loss Insurer will pay no more than the actual amount Insured should not profit from a loss Reduce moral and morale hazards Actual Cash Value: replacement cost less depreciation

Fair Market Value: price a willing buyer would pay a willing seller in a free market Broad Evidence Rule: ACV should include all relevant factors that an expert would use to determine the value of property Valued Policy: insured and insurer agree on the value of the exposed item prior to a loss; a policy that pays the face amount of insurance if a total loss occurs o Ex. Life insurance is always a valued policy Valued Policy Laws: requires insurers to pay the face amount of the policy if a total loss to real property occurs from a peril specified in the law, regardless of ACV Replacement Cost Valuation: agreement between insured and insurer that damages/ replacement will be paid at market prices without deducting for depreciation Ex. Bought a dining room table for $10,000 in 2008. You have a fire that destroys the table in 2011. At the time of the fire, the table depreciated 50%. A new table will cost $14,000. How much will the insurance company pay? $7,000. If the table now cost $8,000, the company would pay you $4,000.

Principle of Insurable Interest The insured must be in a position to lose financially if a covered loss occurs Why is this principle necessary? o Prevents gambling o Reduces moral and morale hazard o Supports determinable and measurable loss Ex. I cant buy insurance on my neighbors car simply because I think theyre a bad driver, because I have no insurable interest. At the time of loss you have to have insurable interest Ex. If a house you are buying burns down on the day you are supposed to close, but you dont close that day then the insurance company will not pay you. Life insurance has to have insurable interest at the policy onset. Principle of Subrogation Substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third party for a loss covered by insurance. For covered insurance claims, the insured forfeits their right to collect from a negligent third party. That right now belongs to the insurer. Why is this principle necessary? o Reinforces the principle of indemnity can only collect once o Holds rates/ premiums below what they would otherwise be o Places burden of the loss on those responsible (negligence) You cannot collect claims twice from two different companies for the same damages. Ex. You get in a car wreck and both parties wind up in the hospital and neither of you know who is at fault. While in the hospital you file a claim from your own insurance. You later find out that the other party was at fault. You cant collect from their insurance, however your insurance company can go after the other persons insurance company for what they had to pay out. Aspects and Implications of Subrogation:

Subrogation does not exist where the principle of indemnity does not apply life insurance Subrogation is always waived for an insured. If an insured violates or destroys insurers subrogation rights, insured may forfeit collection rights under the contract The insurer is entitle to subrogation dollars only after insured has collected fully for the loss The insurer may waive its right to subrogate. To protect certain entities/ individuals from subrogation, the insured must obtain a waiver of subrogation from the insurer prior to the loss (usually as an endorsement to the policy).

Principle of Utmost Good Faith A higher degree of honest is imposed on both parties to an insurance contract than is imposed on parties to other contracts. Why is this necessary? o It is impractical for an Insurer to investigate all of the Insureds statements on an insurance application. Therefore, the Insured is relying upon the Insureds honesty. Likewise, the Insured depends upon the Insurers promise to pay in the event of a loss. Three legal doctrines support the Principle of Utmost Good Faith: representations, concealment, and warranty Representations o Statements made by the applicant for insurance before a contract starts to induce a party to enter the contract. o Oral or written statements. o Contract can be voided if the representation is false and material. Often times insurance companies will pay out if you lie, but you have to pay them the difference in premiums for what you lied about. Ex. If you receive a speeding ticket and the insurance company asks you about and you say no and then later you get in a car wreck because you were speeding then the contract is void. If the insurance company didnt ask you about it and you just didnt tell them then its concealment. If you didnt know about it then its not misrepresentation. Ex. If you were getting life insurance and they asked you if you have cancer. You said no because you didnt know you had cancer at the time. You later find out that you did have cancer. Not misrepresentation Material Misrepresentations o False: not true at the time of the statement o Material: would the insurer have declined the contract, changed the wording, or priced it differently if the truth were known o Statement of opinions are not sufficient to void the contract Concealment: intentional failure of the applicant for insurance to reveal a material fact to the insurer Silence when there is an obligation to speak Utmost good faith imposes duty to voluntarily divulge material information otherwise insurer can void contract

Generally involves en element of deception Test for Concealment o Did the insured know of a certain fact? o Was the fact material? o Was the insurer ignorant of the fact? Warranty: a statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all respects A warranty creates a condition in a contract. Any breach of warranty, even if not material, will allow the insurer to void the contract (strict interpretation) Types of Warranties: o Express: written o Implied: not written o Promissory: condition to continue throughout contract period (this will be true throughout the time of the policy) o Affirmative: exists at contracts inception; promises nothing about the future (true as of the day you tell them) o Ex. If you said you had an alarm system at the time of the contract, and then later your alarm decides to stop working. Under affirmative, they cannot change your policy. Under promissory, they can. Breach of Utmost Good Faith o Commonly referred to as a bad faith claim o Used when the insured feel the insurer is not acting in good faith o Used to force insurance companies to perform according to the contract

A contract is an agreement embodying a set of promises that are legally enforceable. Requirements of a Valid Contract Legality o Needs to be for a legal purpose o Must not encourage or protect illegal activities Capacity: the legal ability to enter into a contract o Capacity is assumed by all individuals except: Minors Insane Intoxicated Corporation acting outside the scope of its charter Offer and Acceptance o A meeting of the minds between the parties of the contract o Applicant always makes the offer o Property Insurance: Agent solicits offer, applicant offers, agent accepts (binds) If the company doesnt want the contract, it may cancel the contract according to the contracts cancellation clause o Life Insurance: Agent solicits offer

Applicant offers Insurance company accepts, rejects, or counter offers Counter offer may be accepted or rejected by applicant Consideration o Property: monetary payment and an agreement to abide by conditions and stipulations in the contract o Life: monetary payment and making truthful statements in the application Checks must be honored by bank before they are consideration Insurance Contracts Aleatory: dollar outcome is unequal; one party usually pays out more Unilateral: only one party has to perform, the insurer Conditional: insurer only has to perform if the insured adheres to the conditions of the contract Personal: requires privity of contract o Ex. If you have a car and you sell it to your friend, you cant sell him your insurance on it as well. Its based upon you and your personal interest in the property and your ability to protect it. Contract of Adhesion: ambiguities are construed against the contracts writer o If there is something that is unclear in the contract then the court is going to rule in favor of the insurance buyer Agents and Brokers Agent: person authorized to act on behalf of another person (principal) o Duties of Agent o Duties of Principal Insurance Agent: represents the insurance company (insurer) Insurance Broker: represents the buyer (insured) Agents are independent of the insurance company Exclusive Agent: only works on behalf of one insurance company; they still arent employed by the insurance company; slightly higher pay contracts Independent Agent: functions more like a broker; they can represent many different insurance companies Social Benefits of Insurance o Reduced reserve requirements o Lower cost of capital o Reduced credit risk o Business and social stability o Facilitates offering of new products and services o Loss control activites Social Costs of Insurance o Expense loading etc. to insured (paying > actuarially fair premium); Cost of doing business Expense loading: amount needed to pay all expenses o Fraudulent claims o Inflating claims Chapter 10

Major Parts of a Policy o Declaration o Insuring Agreement o Exclusions o Conditions o Definitions o Basis of Recovery o Clauses limiting the amount of recovery Declaration Usually on the first page and provides: o Policy number o Address of the insured or insured property o Insureds name o Agents name o Premium amount o May contain some underwriting info o If policy contains options they will be listed Insuring Agreement Normally states what the insurer agrees to do and major conditions under which it so agrees Statement of what the insurer promises is the most crucial part of the agreement May also find a list of the perils insured against and the definition of the insured Named Perils: lists the perils that are covered Open Perils: states that it is the insurers intention to cover risk of accidental loss to the described property (except those perils specifically excluded) Named insured: person or organization that is to receive the benefit of the coverage provided o In life insurance that person may also be called the policyholder Additional insureds: normally receive coverage somewhat less complete than that of the named insured Exclusions Used to help define and limit the coverage provided by an insurer Policies often have very broad insuring agreements, with the coverage narrowed by the use of exclusions Typically exclusions are used to restrict coverage of given perils, losses, property, and locations Excluded Perils: normally a separate section of the contract; lists and describes all excluded perils o Practically all insurance policies exclude from coverage certain perils o Policies may define and limit the peril such that it is partially covered Perils that are basically uninsurable o Losses cannot be predicted with any degree of reliability and are often catastrophic o Ex. Wear and tear, gradual deterioration, and damage by moth and vermin are excluded in most property policies. Loses from these sources are not accidental.

Perils to be covered elsewhere o Some perils can be more easily covered in contracts specifically designed for them Perils covered under endorsement at extra premium Excluded Losses: many insurance contracts contain provisions excluding certain types of losses Even though the policy may cover the peril that causes these losses Ex. If a health insurance policy is designed to cover medical expenses due to accident or illness (direct loss). It will not cover lost wages (indirect loss). The indirect loss must be covered under a separate contract, disability insurance. Excluded Property Ex. A common exclusion is loss to money, deeds, bills, bullion, and manuscripts. Excluded Locations: coverage applies only while the insured property is at a location specified in the declarations Relatively few property insurance contracts give complete worldwide protection Rationale for limitation o Property risks vary greatly depending on the location of the property o Insurers wish to restrict their coverage to area that they have had an opportunity to inspect and approve Exception in property policies o If a loss threatens and the property is moved to a safe place for the sake of preserving it from destruction o Permission is granted to move the good for a limited time All insurance contracts are written subject to certain conditions. Breach of them is usually grounds for refusal to pay in the event of a loss Most conditions have to do with o Loss settlements o Actions required at the time of loss o Valuation of property o Cancellation of coverage o Suits against the insurer Fraud: many contracts state that misrepresentation of a material fact, concealment, or fraud will void the contract Notice of loss: most contracts require the insured to give an immediate written notice of any loss, if practical. If not practical, the loss must be reported within a reasonable length of time. o Purpose of Provision: to give the insurer a reasonable opportunity to inspect the loss before important evidence is dissipated Proof of Loss: the insured has a period, usually 60-90 days, to give the insurer formal proof of the loss and its amount o Once the proof-of-loss is agreed upon by all parties, payment is due within 60 days o Any legal suit must be commenced within twelve months of the loss Appraisal: if two parties cannot agree on a loss settlement, each may select an appraiser to determine the loss

o During the settlement process, the insurer reserves the right to: Take over the damaged property and to pay the insured its sound value Repair or rebuild it Make a cash settlement for the amount of the loss (normally used method) Preservation of the Property: requires the insured to do everything possible to minimize losses to insured property from the insured peril Cancellation: all contracts specify the terms under which the policy may or may not be cancelled o Life and some health insurance may usually be cancelled by the insured but not by the insurer o Property and liability may usually be cancelled by either party Assignment: the transfer of the rights of one party to another, usually by means of a written document Its common to allow the insured to assign personal rights under the contract to another person, such commission must be specifically granted o Assignor: the party granting the right o Assignee: the party to whom the right is granted In life insurance, the policy provides that if you give another person rights than the insurance company must be notified When property is sold the existing insurance policy may be transferred to the new owner. Need written consent of the issuer. Many property policies state that only ACV of the property at the time of loss will be reimbursed o Not to exceed the amount that it would cost to repair or replace the property with like material o The insurers sets the ACV as the max reimbursement o ACV= replacement cost depreciation (actual economic dep) Replacement Cost: allows for recovery with no deductions or depreciation Total reimbursement figure is limited to cost of repairing, replacing, or rebuilding To collect on replacement cost basis the property must actually be replaced Provisions such as deductibles, coinsurance, time limitation, and apportionment clauses may limit the amount of recovery payable. Specific Dollar Limits: restrict payments to a max amount on any one type of loss o May be a specific type of property or one resulting from a specific peril Aggregate dollar limits: restrict payments on any one group of property items or group of losses from the same peril to some overall max Ex. Car wreck. Specific limit of liability for damage to any one person. Aggregate limit of liability for loss in any one accident Deductible: specific dollar amount that will be borne by the insured before the insurer becomes liable for payment Reasons for deductibles o To eliminate small claims o Small losses are expensive to pay, sometimes causing more administrative expense

o To reduce the moral and morale hazards that might otherwise be present Straight Deductible (each and every): applies to each loss and is subtracted before any loss payment is made; one the simplest and most effective deductibles o Every single time you have a loss you have to pay the deductible Aggregate Deductible: applies for an entire year; the insured absorbs all losses until the deductible level is reached, at that point the insurer pays for all losses over the specified amount Calendar-year Deductible: aggregate deductibles in the health expense industry Never take a deductible higher than you can pay Disappearing Deductible: the size of the deductible decreases as the size of the loss increases. At a given level of loss, the deductible completely disappears. Franchise Deductible: expressed either as a percentage of value or as a dollar amount. o They set a dollar amount or percentage and if the loss is less than that amount then the insured pays for all of it. Health Coinsurance: functions like a straight deductible, expressed as a percentage. Often referred to as the copayment Property Coinsurance: device used to make the insured bear a portion of every loss when underinsured Underinsurance is undesirable. Need to protect the whole value of the property. It costs relatively more to insure the businesses of those who are underinsured than those who purchase appropriate insurance. Coinsurance typically pro-rates partial losses between the insurer and the insured Usually 80 or 90% of the value of the property is the amount required Places the burden on the insured to keep proper amount of insurance Slide 28 ppt

Chapter 5 Legal Types of Insurers Stock insurer: corporation owned by stockholders o Objective: earn profits for stockholders Mutual Insurers: corporation owned by the policyholders o Advanced premium mutual: owned by the policy owners; there are no stockholders, and the insurer doesnt issue assessable policies (most common) o Assessment mutual: has the right to assess policy owners an additional amount if the insurers financial operations are unfavorable o Fraternal insurer: provides life and health insurance to members of a social or religious organization Changing corporate structure of mutual insurers o Increase in company mergers o Demutualization: a mutual insurer is converted into a stock insurer More flexible capital structure Mergers and acquisitions possibilities Tax advantages Stock options for employees 3 ways to convert

Pure conversion: amend articles of incorporation and is reorganized as stock insurer Merger: mutual and stock join and the stock in the surviving company Bulk reinsurance: mutual cedes all assets and liabilities to stock and the mutual is dissolved o Mutual holding company: company that directly or indirectly controls an authorized insurer Lloyds of London: not an insurer, but the worlds leading insurance market that provides services and physical facilities for its member to write specialized lines of insurance o Society of members (corporations and individuals) who underwrite insurance in syndicates o The insurance is written by the various syndicates that belong to Lloyds o New individual members or Names who belong to the various syndicates now have limited legal liability o Each member assumes risks personally and does not bind the organization for these obligations o Each investor is individually liable for losses on the risks assumed to the fullest extent of personal assets Insolvency risk: risk of bankruptcy o Increase of capital reduces insolvency risk o Other ways to reduce: diversification and reinsurance Agent o Express authority: specific powers that the agent receives from the insurer o Implied authority: agent has the authority to perform all incidental acts necessary to exercise the powers that are expressly given o Apparent: authority the public reasonably believes the agent possesses based upon the actions of the principal o May bind coverage immediately Broker o Nonadmitted insurer: not licensed to do business in the state o Surplus lines broker: licensed to place business with a nonadmitted insurer o Typically paid via commission from insurer and fees from insured o They do own renewal rights o Cannot bind the insurer to a deal or make statements on behalf on the insurer o Must contact with insurer before coverage is binding o Many hold agency contracts Independent agengy o Business firm that usually represents several unrelated insurers o The agency owns the expirations or renewal rights to the business o The independent agent is compensated by commissions that vary by line of insurance o Most insurers use direct billing, by which the policyowner is billed directly by the insurer

Exclusive agency: the agent represents only one insurer or group of insurers under common ownership o Do NOT own renewal rights expirations to policies o Typically paid by commission. Highest in first year and lower in subsequent years. o Insurers usually provide a large amount of support to exclusive agencies. Direct Writer: an insurer in which the salesperson is an employee of the insurer, not an independent contractor Direct Response: insurance sold directly to the public through advertising on tv, radio, newspapers, magazines, direct mail, and internet o No sales agents are employed o Fairly standardized, more specialized, less costly Multiple distribution systems: Insurance marketing method that refers to the use of several distribution systems by an insurer; for example, a property and liability insurer may use the independent agency method and direct response system to sell insurance.

Chapter 6 Ratemaking: refers to the pricing of insurance and the calculation of insurance premiums Actuary: person who determines rates and premiums o Reviews past and projected future results o Regulatory compliance issues o Calculation of participating dividends Underwriting: refers to the process of selecting, classifying, and pricing applicants for insurance o Must be a skillful judge of people o Goal is to produce a group of insureds whose actual experience will approach expected Line underwriter: make daily decisions concerning the acceptance or rejection of business; expected to follow company policy Basic underwriting principles o Attain an underwriting profit o Select prospective insureds according to the companys underwriting standards o Provide equity among the policyowners In property/ liability insurance agents can make binding decisions in the field