FI 435 Test 1

Ch 1, 2, 3, 5, and 8

Definition of Insurance

Insurance is the pooling of fortuitous losses by transfer of such risks 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

Four Basic Characteristics of Insurance

1. Pooling of losses

2. Payment of fortuitous losses

3. Risk transfer

4. Indemnification

Pooling of losses

• Spreading losses incurred by the few over the entire group

• Risk reduction based on the Law of Large Numbers

Payment of fortuitous losses

• Insurance pays for losses that are unforeseen, unexpected, and occur as a result of chance

Risk transfer

A pure risk is transferred from the insured to the insurer, who typically is in a stronger financial position

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 probable results that are expected from an infinite number of exposures

What is risk reduction based on ?

Law of Large Numbers

Six Requirements of an insurable risk

1. Large number of exposure units

2. Accidental and unintentional loss - Fortuitous

3. Determinable and measurable loss

4. No catastrophic loss

5. Calculable chance of loss

6. Economically feasible premium

(1) Large number of exposure units

To predict average loss

(2) Accidental and unintentional loss - Fortuitous

• to control moral hazard

• to assure randomness

(3) Determinable and measurable loss

• to facilitate loss adjustment

  • insurer must be able to determine if the loss is covered and if so, how much should be paid

(4) No catastrophic loss

• to allow the pooling technique to work

• exposures to catastrophic loss can be managed by:

  • dispersing coverage over a large geographic area

  • using reinsurance

  • catastrophe bonds

(5) Calculable chance of loss

• to establish an adequate premium

(6) Economically feasible premium

• so people can afford to buy

• Premium must be substantially less than the face value of the policy

Can personal, property, and liability risks be insured ?

Yes

Can Market risks, financial risks, production risks and political risks be insured ?

No

Adverse Selection

The tendency of persons with higher-than-average chance of loss to seek insurance at standard rates

What does adverse selection result in ?

Higher-than-expected loss levels

How can Adverse selection be controlled ?

• careful underwriting (selection and classification of applicants for insurance)

• policy provisions (e.g., suicide clause in life insurance)

Insurance vs. Gambling (Insurance)

• Handles an already existing pure risk

• Is always socially productive:

  • both parties have a common interest in the prevention of a loss

Insurance vs. Gambling (Gambling)

• Creates a new speculative risk

• Is not socially productive

  • the winner’s gain comes at the expense of the loser

Insurance vs. Hedging (Insurance)

• Risk is transferred by a contract

• Involves the transfer of pure (insurable) risks

• Moral hazard and adverse selection are more severe problems for insurers

Insurance vs. Hedging (Hedging)

• Risk is transferred by a contract

• Involves risks that are typically uninsurable

• Fewer problems of moral hazard and adverse selection for entities who buy or sell futures contracts

Types of Insurances

• Private Insurance

• Government Insurance

Private Insurance

Includes life and health insurance as well as property and liability insurance

Government insurance

Includes social insurance programs and other government insurance plans

Types of Private Insurance

• Life and Health

• Property and Liability

Life and Health (Types of Private Insurance)

• Life insurance pays death benefits to beneficiaries when the insured dies

• Health insurance covers medical expenses because of sickness or injury

Property and Liability (Types of Private Insurance)

• Property insurance indemnifies property owners against the loss or damage of real or personal property

• Liability insurance covers the insured’s legal liability arising out of property damage or bodily injury to others

• Casualty insurance refers to insurance that covers whatever is not covered by fire, marine, and life insurance

What are the two major categories that Private insurance can be grouped into ?

• Personal lines: coverages that insure the real estate and personal property of individuals and families or provide protection against legal liability

• Commercial lines: coverages for business firms, nonprofit organizations, and government agencies

Types of Government Insurance

• Social insurance programs

• Other Government Insurance programs

Social Insurance Programs (Types of Government Insurance)

• Financed entirely or in large part by contributions from employers and/or employees

• Benefits are heavily weighted in favor of low-income groups

• Eligibility and benefits are prescribed by statue

• Examples: Social Security, Unemployment, Workers Comp

Other Government Insurance Programs (Types of Government Insurance)

• Found at both the federal and state level

• Examples: Federal flood insurance, state health insurance pools

Social Benefits of Insurance

• Indemnification or Loss

  • Contributes to family and business stability

• Reduction of Worry and Fear

  • Insureds are less worried about losses

• Source of Investment Funds

  • Premiums may be invested, promoting economic growth

• Loss Prevention

  • Insurers support loss-prevention activities that reduce direct and indirect losses

• Enhancement of Credit

  • Insured individuals are better credit risks than individuals without insurance

Social Costs of Insurance

1. Cost of Doing Business

2. Cost of Fraudulent and Inflated Claims

3. Higher premiums

Cost of Doing Business (Social Costs of Insurance)

• Insurers consume resources in providing insurance to society

• An expense loading is the amount needed to pay all expenses, including commissions, general administrative expenses, state premium taxes, acquisition expenses, and an allowance for contingencies and profit

Cost of Fraudulent and Inflated Claims (Social Costs of Insurance)

• Payment of fraudulent claims results in higher premiums to all insureds, thus reducing disposable income and consumption of other goods and services

Higher Premiums (Social Costs of Insurance)

• Costs to cover additional losses are absorbed by consumers and thus it reduces disposable income and consumption of other goods/services

Meaning of Risk Management

Risk Management is a process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures

What is loss exposure ?

A loss exposure is any situation or circumstance in which a loss is possible, regardless of whether a loss occurs

What do new forms of risk management consider ?

They consider both pure and speculative loss exposures

• Traditional RM = pure risks

• Enterprise RM = all risks

  • pure

  • speculative

Pre-loss Risk management Objectives

• prepare for potential losses in the most economical way

• reduce anxiety

• meet any legal obligations

Post-loss risk management objectives

• Survival of the firm

• continue operating

• stability of earnings

• continued growth of the firm

• Minimize the effects that a loss will have on other persons and on society

Important loss exposures

• Property loss exposures

• Liability loss exposures

• Business income loss exposures

• Human resources loss exposures

• Crime loss exposures

• Employee benefit loss exposures

• Foreign loss exposures

• Intangible exposures (Market reputation and public image of company)

• Failure to comply with government regulations

Steps of loss exposures

1. Identifying loss exposures (Most important)

2. Measure and analyze loss exposures

3. Select the appropriate combination of techniques for treating the loss exposures

4. Implement and monitor the risk management program

5. Implement and monitor the risk management program

Step 1: Identifying Loss Exposures

• Property

  • building/structures

  • furniture/equipment

  • Inventory

  • Accts. Receivable

• Liability

  • Defective products

  • Sexual harassment

  • Premises Liability

• Human resources

  • Death of EE

  • Retirement/Unemployment

  • Job related injury

• Crime

  • Burglary/Robbery

  • EE theft/dishonesty

  • Fraud/embezzlement

• EE Benefits

  • Failure to follow laws

  • Group life/retirement plans

  • Failure to pay benefits

• Foreign

  • Kidnap/Ransom

  • Political risks

  • Foreign Currency Valuation

What can industry trends and market changes do to loss exposures ?

They can create new loss exposures

Step 2: Measure and Analyze Loss Exposures

• Estimate for each type of loss exposure:

• Rank exposure by importance

• Loss severity is more important than loss frequency:

Loss frequency

Refers to the probable number of losses that may occur during some time period

Loss severity

Refers to the probable size of the losses that may occur

What is the maximum possible loss?

The worst loss that could happen to the firm during its lifetime

What is the probable maximum loss ?

The worst loss that is the likely to happen

What is Risk Control ?

Refers to the techniques that reduce the frequency and severity of losses W

What are the methods of risk control?

• Avoidance

• Loss prevention

• Loss reduction

• Duplication

• Separation

• Diversification

What does Avoidance mean ?

It means a certain loss exposure is never acquired or undertaken, or an existing loss exposure is abandoned

• the chance of loss is reduced to zero

• It is not always possible, or practical, to avoid all losses

Loss Prevention

Refers to measures that reduce the frequency of particular loss

Loss reduction

Refers to measures that reduce the severity of a loss after it occurs

Duplication

Refers to having back-ups or copies of important documents or property available in case a loss occurs

Separation

Means dividing the assets exposed to loss to minimize the harm from a single event D

Diversification

Means spreading the loss exposure across different parties, securities, or transactions, to reduce the chance of loss

Risk Financing

Refers to techniques that provide for the payment of losses after they occur

Methods of risk financing include:

• Retention

• Non-insurance Transfers

• Commercial Insurance

What does Retention mean ?

Means that the firm retains part or all of the losses that can result from a given loss W

When is Retention effectively used?

• No other method of treatment is available

• The worst possible loss is not serious

• Losses are highly predictable

What is retention level ?

It is the dollar amount of losses that the firm will retain

What are the methods a risk manager has for paying retained losses?

• Current net income: losses are treated as current expenses

• Unfunded reserve: losses are deducted from a book-keeping account

• Funded reserve: losses are deducted from a liquid fund

• Credit line: funds are borrowed to pay losses as they occur

Advantages/Disadvantages of Retention

Advantages:

• Save on loss costs

• Save on expenses

• Encourage loss prevention

• Increase cash flow

Disadvantages:

• Possible higher losses

• Possible higher expenses

• Possible higher taxes

What is a non-insurance transfer ?

It is a method other than insurance by which a pure risk and its potential financial consequences are transferred to another party

• Examples: contracts, leases, hold-harmless agreements

Advantages/Disadvantages of Non-insurance transfers ?

Advantages:

• Can transfer some losses that are not insurable

• Less expensive

• Can transfer loss to someone who is in a better position to control losses

Disadvantages

• Contract language may be ambiguous, so transfer may fail

• If the other party fails to pay, firm is still responsible for the loss

• Insurers may not give credit for transfers

Risk Transfer via Insurance

Insurance is appropriate for low-probability, high-severity loss exposures

• Risk manager selects the coverages needed, policy provisions and the insurer

• A deductible is a specified amount subtracted from the loss payment otherwise payable to the insured

• In an excess insurance policy, the insurer pays only if the actual loss exceeds the amount a firm has decided to retain

Advantages/Disadvantages of Insurance (Risk Financing)

Advantages:

• Firm is indemnified for losses; can continue to operate

• Uncertainty is reduced

• Firm may receive valuable risk management services

• Premiums are income tax deductible

Disadvantages:

• Premiums may be costly

• Negotiation of contracts takes time and effort

• The risk manager may become lax in exercising loss control

Underwriting cycle

• In a “hard” market, profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

• In a “soft” market, profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

Hard market impact on underwriting

• In a “hard” market, profitability is declining, underwriting standards are tightened, premiums increase, and insurance is hard to obtain

Soft market impact on underwriting

• In a “soft” market, profitability is improving, standards are loosened, premiums decline, and insurance become easier to obtain

Implement and Monitor Risk Management Program

• Implementation of a risk management program begins with a risk management policy statement that:

  • outlines the firm’s objectives and policies

  • Educates top-level executives

  • Gives the risk manager greater authority

  • Provides standards for judging the risk manager’s performance

Benefits of Risk Management

• Enables a firm to attain its pre-loss and post-loss objectives more easily

• A risk management program can reduce a firm’s cost of risk

• Reduction in pure loss exposures allows a firm to enact a enterprise risk management program to treat both pure and speculative loss exposures

• Society benefits because both direct and indirect losses are reduced

Stock Insurer

Is a corporation owned by stockholders

• earn profit for stockholders by increasing value of stock and paying dividends

• Stockholders elect board of directors

• Stockholders bear all losses

• Insurer cannot issue an assessable policy

Mutual insurer

Is a corporation owned by the policy owners

• policy owners elect board of directors, who have effective management

• policy holders may receive dividends or rate reductions

Three main type of Mutual insurers

1. Advance premium mutual

2. Assessment mutual

3. Fraternal insurer

Advance premium mutual insurer

Is owned by the policy owners; there are no stockholders, and the insurer does not issue assessable policies

Assessment mutual insurer

Has the right to assess policy owners an additional amount if the insurer’s financial operations are unfavorable

Fraternal insurer

Is a mutual insurer that provides life and health insurance to members of a social or religious organization

Why is the corporate structure of mutual insurers changing ?

• An increase in company mergers

• Demutualization, whereby a mutual company is converted into a stock insurer

• The creation of mutual holding companies

  • A holding company is a company that directly or indirectly controls an authorized insurer

Lloyd’s

is not an insurer, but is the world’s leading insurance market that provides services and physical facilities for its members to write specialized lines of insurance

• members join together to form underwriting syndicates

• New members have limited legal liability

• Corporations with limited legal liability and limited liability partnerships can also join Lloyd’s of London

• Members must meet stringent financial requirements

• Lloyd’s is licensed only in the small number of jurisdictions in the U.S

Blue Cross and Blue Shield Plans

Are generally organized as nonprofit, community oriented plans

• Blue Cross were initially organized to cover hospital services

• Most plans have merged into one entity

• Some plans have converted to a for-profit status to raise capital and become more competitive

Captive Insurer

Is an insurer owned by a parent firm for the purposes of insuring the parent firm’s loss exposures

• A single parent, or pure, captive is an insurer owned by one parent

• An association captive is owned by several parents

Agent

An agent is someone who legally represents the principal and has the authority to act on the principal’s behalf

• Authority may be:

  • expressed

  • Implied

  • Apparent

• The principal is legally responsible for all acts of an agent when the agent is acting within the scope of authority

A binder

provides temporary insurance until the policy is actually written

• a property and casualty agent has the power to bind the insurer

• a life insurance agent does not have the authority to bind the insurer

What is a broker

Is someone who legally represents the insured, and:

• solicits applications and attempts to place coverage with an appropriate insurer

• is paid a commission from the insurers where the business is placed

• does not have the authority to bind the insurer

A surplus lines broker

Is licensed to place business with a non admitted insurer

• surplus lines refer to any type of insurance for which there is no available market within the state, and coverage must be placed with a non admitted insurer

Selected Types of Marketing Systems

• Independent agents

• Brokers

• A direct response system

• A direct writer

• A direct response

• A mass merchandizing plan

Independent agents

Are independent contractors who represent several insurers and sell primarily property and casual insurance

Brokers

Are independent agents who do not have an exclusive contract with any single insurer

A direct response system

Is a marketing system by which insurance products are sold directly to consumers without a face-to-face meeting with an agent

• complex products are difficult to sell this way

A direct writer

is an insurer in which the salesperson is an employee of the insurer, not an independent contractor

• employees are usually compensated on a “salary plus” arrangement

A direct response insurer

Sells directly to the consumer by television or some other media

Mass merchandizing plans

Some property insurers employ mass merchandizing plans

Other insurers today may use commercial banks and other financial institutions as a distribution system

More details on independent agency

Is a major distribution form for property and casualty insurance

• The agency is a business firm that usually represents several unrelated insurers

• Agents are paid a commission based on the amount of business produced, which vary by the line of insurance

• The agency owns the expirations of renewal rights to the business; it may bill the policyholders and collect premiums, but most insurers use direct billing

More details on exclusive agency

the agent represents only one insurer or group of insurers under common ownership

• agents do not usually own the expirations or renewal rights to the policies

• Agents are generally paid on a lower commission rate on renewal business than on new business

• Exclusive agency insurers provide strong support services to new agents

Paul v. Virginia (1868)

Affirmed the right of the states to regulate insurance.

• The Supreme Court ruled that insurance was not interstate commerce, and that the states rather than the federal government had the right to regulate the insurance industry