Principles of Risk Management and Insurance: Chapters 2, 5–8, and 9

Comprehensive review flashcards covering Chapter 2 (Concepts of Insurance, Pooling, Insurable Risk, Social and Economic Aspects), Chapters 5–8 (Insurer Operations, Distribution, Underwriting, Ratemaking, Performance Ratios, and Regulation), and Chapter 9 (Legal Principles of Insurance Contracts) for Exam 2.

How does the lecture define 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.

What are the four basic characteristics of insurance?

(1) Pooling of losses, (2) Payment of fortuitous losses, (3) Risk transfer, and (4) Indemnification.

What is the primary mechanism and purpose of the pooling of losses?

To spread losses incurred by a few over an entire group so that average loss replaces actual loss.

Under what condition is the Law of Large Numbers ideally applied in loss pooling?

When there is a large number of similar exposure units subject to the same perils.

In the auto loss sharing example ($150,000$ autos, $3\%$ chance of loss, typical loss of \\$20,000), how are total accidents, total losses, and the payment per auto calculated?

Total accidents = $3\% \times 150,000 = 4,500$; Total Loss Amounts = $\\$20,000 \times 4,500 = \\$90,000,000$; Payment per auto = \\$90,000,000 / 150,000 = \\$600.

Using the expected loss formula $E(X) = \sum [P \times X]$, what is the expected loss per auto in the auto loss sharing example?

E(X) = 3\% \times \\$20,000 = \\$600.

Based on the provided calculations for insuring a single building, what are the expected loss and standard deviation?

Expected loss is \\$5,000 ($0.90 \times \\$0 + 0.10 \times \\$50,000$), and standard deviation is \\$15,000 (\sqrt{0.90(\\$0 - \\$5,000)^2 + 0.10(\\$50,000 - \\$5,000)^2}).

Based on the two-building loss pooling matrices shown, what are the shared loss outcomes and their respective joint probabilities for owners A and B?

Shared losses are \\$0 ($81\%$ or $0.81$ probability), \\$25,000 ($18\%$ or $2 \times 0.09$ probability), and \\$50,000 ($1\%$ or $0.01$ probability).

What are the expected loss and standard deviation when two building owners pool their loss exposures equally?

Expected loss remains \\$5,000, while the standard deviation decreases from \\$15,000 to \\$10,607.

What is the bottom-line mathematical effect on standard deviation and expected loss as additional individuals are added to a pool?

The standard deviation continues to decline while the expected value of the loss remains unchanged.

What is the definition of a fortuitous loss?

An unforeseen and unexpected loss that occurs as a result of chance.

Why is moral hazard inconsistent with the requirement of fortuitous losses?

Fortuitous losses must occur purely by chance; moral hazard involves intentional, non-random acts by the insured to cause or inflate a loss.

How do homeowners and life insurance policies define an intentional loss exclusion?

Any loss arising out of any act an "insured" commits or conspires to commit with the intent to cause a loss.

What does risk transfer mean in the context of an insurance contract?

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

What is the meaning of indemnification in insurance?

The insured is restored to their approximate financial position before the occurrence of the loss.

What are the six characteristics of an ideally insurable risk?

(1) Large number of exposure units, (2) Accidental and unintentional loss, (3) Determinable and measurable loss, (4) Non-catastrophic loss, (5) Calculable chance of loss, and (6) Economically feasible premium.

Why must an insurable risk contain a large number of exposure units?

To enable the insurer to accurately predict average losses based on the Law of Large Numbers.

Why must an insurable loss be accidental and unintentional?

To prevent moral hazard, avoid increased premiums, and ensure the Law of Large Numbers operates on truly random occurrences.

Why must an insurable loss be determinable and measurable?

To allow the insurer to determine if the loss is covered under the policy and, if so, precisely how much money should be paid.

Why should an insurable loss not be catastrophic?

Because catastrophic losses affect many units simultaneously, causing the insurer to lose the pooling advantage.

What are three operational or financial solutions insurers use to manage catastrophic loss exposures?

(1) Dispersion of geographic coverage, (2) Reinsurance, and (3) Catastrophe bonds (CAT bonds).

In reinsurance, what is meant by the arrangement: "Primary Insurer = \\$20\text{ mil} in excess of \\$50\text{ mil}"?

When losses exceed \\$20\text{ mil}, the reinsurer will be responsible for the next \\$50\text{ mil} of losses.

Why must the chance of loss be calculable for a risk to be insurable?

To allow the insurer to calculate average frequency and average severity in order to set an appropriate premium.

What requirement must be met for an insurance premium to be economically feasible?

The premium must be substantially less than the face value of the policy, meaning the chance of loss must be low.

What are the program cap, federal trigger, insurer deductible, and co-shares established by the Terrorism Risk Insurance Act (TRIA) diagram?

Program Cap: \\$100\text{ Billion}; Federal Participation Trigger: \\$200\text{m}; Insurer Deductible: $20\%$ prior year direct earned premium; Insurer's Share of Losses: $20\%$; Government's Share of Losses: $80\%$.

How does the catastrophe (CAT) bond transaction operate according to the provided flow chart?

The ceding insurer pays premiums to a special-purpose vehicle (SPV), which receives cash proceeds from investors and holds collateral in a U.S. Treasury money market fund (TMMF). If a covered catastrophe occurs, collateral is liquidated for loss payments; otherwise, principal and coupons are returned to investors.

What is adverse selection?

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

What is the primary difference between an insurance rate and an insurance premium?

A rate is the price per unit of insurance coverage, whereas the premium is the total amount paid by the insured.

If an insurer charges a rate of \\$6 per \\$1,000 in coverage for a property policy limit of \\$725,000, what is the premium?

Premium = $(\\$725,000 / 1,000) \times \\6 = 725 \times \\$6 = \\$4,350.

What is underwriting, and how does it prevent adverse selection?

Underwriting is the process of selecting and classifying applications for insurance so that high-risk applicants are either charged higher rates or rejected.

What are the two major divisions of private insurance?

(1) Life and health (L/H), and (2) Property and liability (P/L), also referred to as property and casualty (P/C).

What losses are covered by property insurance versus liability insurance?

Property insurance covers damage to real and personal property; liability insurance covers legal obligations arising from bodily injury, property damage, and legal defense costs.

Into what three primary categories does the provided table group insurance coverages?

Personal Lines, Commercial Lines, and Other Coverages.

What five coverages are classified under Personal Lines in the coverages table?

(1) Private passenger auto insurance, (2) Homeowners insurance, (3) Renters insurance, (4) Personal umbrella liability insurance, and (5) Boatowners insurance.

What are the commercial lines coverages listed in the coverages table?

Fire and allied lines, commercial multiple-peril, general liability, workers compensation, commercial auto, inland marine and ocean marine, professional liability, cyber, crime, and directors and officers (D&O) insurance.

What five coverages are listed under "Other Coverages" in the classification table?

(1) Identity theft insurance, (2) Pet insurance, (3) Title insurance, (4) Travel insurance, and (5) Event cancellation insurance.

How does the provided hierarchy categorize the major lines of Life/Health versus Property/Liability insurance?

Property/Liability is split into Personal Lines and Commercial Lines, while Life/Health encompasses Life, Health, Annuities, Disability, Long-Term Care, and Benefits.

What are the three primary social insurance programs in the United States?

(1) Social Security, (2) Medicare (for ages $65+$), and (3) Unemployment Insurance.

What are four examples of other government insurance programs at the federal and state levels?

(1) Federal Deposit Insurance Corporation (FDIC), (2) National Flood Insurance Program (NFIP), (3) Pension Benefit Guaranty Corp (PBGC), and (4) State workers' compensation state funds.

What are the primary characteristics of social insurance programs?

They are financed by mandatory contributions (employer and/or employee), are compulsory, link benefits to past contributions, weight benefits in favor of low-income individuals, and establish eligibility and benefit rights by statute.

What is the mandatory contribution rate for Social Security mentioned in the lecture notes?

$6.2\%$.

How does indemnification by insurance benefit society?

It maintains financial security and stability for individuals and businesses, decreasing demand for public assistance.

How does insurance benefit society through the reduction of worry and fear?

It eliminates uncertainty and anxiety about catastrophic financial losses both before and after an occurrence.

How does insurance promote loss prevention in society?

Insurers employ loss prevention personnel, conduct safety engineering, and promote fire and accident prevention to reduce loss frequency and severity.

How does insurance result in the enhancement of credit?

It guarantees the value of a borrower's collateral and gives lenders greater assurance that loans will be repaid, making the borrower a better credit risk.

What is expense loading?

The amount needed to pay expenses and earn a profit, including underwriting and loss adjustment expenses, commissions, state premium taxes, acquisition expenses, and an allowance for contingencies and profit.

What are two major costs of insurance to society beyond the operational expense loading?

Fraudulent claims and inflated claims.

What is an admitted insurer?

An insurer that is licensed to do business in the state and subject to state rate and form regulations.

What is a non-admitted insurer, and what regulatory status does it have?

An insurer not licensed in the state but authorized to write coverage; it is free of state rate and form regulation.

What common activities are performed by insurance companies?

Develop policies, price risk, underwrite risk, issue policies, sales, collect/invest premiums, handle/pay claims, and loss control.

Who owns a stock insurance company, and what is its primary operating objective?

It is owned by investors/shareholders, and its primary objective is to generate profit for its owners.

How are profits distributed or allocated in a stock insurance company?

Profits are distributed as dividends to shareholders or retained on the balance sheet as surplus.

Who owns a mutual insurance company, and what is its primary operating objective?

It is owned by its policyholders, and its primary objective is to provide low-cost insurance.

How are profits distributed and capital raised in a mutual insurance company?

Profits are paid as dividends to policyholders or retained as surplus; capital comes from advance premiums, retained profits, or assessments (if allowed).

What is Lloyd's of London?

An insurance market that writes specialized lines of business, operating as a society of members who underwrite insurance in syndicates.

What are the seven core functions/operations of insurers?

(1) Production/marketing, (2) Contract development, (3) Underwriting, (4) Pricing/ratemaking, (5) Reinsurance, (6) Claims adjustment, and (7) Investments.

What are the definition and objectives of production/marketing in an insurance company?

The sale of products and services to buyers, with the objectives of informing buyers about products, rates, and services, and completing sales efficiently.

What is the key legal distinction between insurance agents and insurance brokers?

Agents represent insurers, whereas brokers represent insureds.

According to the Retail v. Wholesale diagram, what are the roles of retail brokers versus wholesale brokers/MGAs?

A retail agent/broker serves as an intermediary directly between the insurance buyer and admitted insurers; a wholesale broker/MGA acts as an intermediary between the retail agent and non-admitted insurers.

What are the three common property and casualty (P/C) distribution systems?

(1) Independent agency and brokerage system, (2) Exclusive (captive) agency system, and (3) Direct writer system.

What are the defining characteristics of an independent agency system regarding representation, legal status, and compensation?

The producer represents multiple insurers as an independent contractor, earning flat percent commissions, contingent commissions (based on volume/profit), and the same commission rate on new and renewal business.

What are the defining characteristics of an exclusive agency system regarding representation, legal status, and compensation?

The exclusive agent represents only one company as an independent contractor, receiving a salary during training and commissions with a lower percentage on renewal than new policies.

What are the defining characteristics of a direct writer system regarding representation, legal status, and compensation?

The direct writer represents only one company as an employee, compensated by salary, commission (flat and contingent), or a combination of both.

What is contract development in insurance, and who may draft these contracts?

The drafting of insurance contracts, which may be drafted by insurers, agents/brokers, policyholders, or advisory organizations.

What are the primary objectives of insurer contract development?

To facilitate the insurance transaction and reduce the chance of disputes.

How did the "WillProp" form define an "occurrence"?

All losses or damages attributable directly or indirectly to one cause or one series of similar causes; all such losses are added together and treated as one occurrence irrespective of the period of time or area.

What is the formal definition of underwriting?

The process of determining the risk to assume and avoid, the rates to be charged for risks assumed, and the policy terms and conditions under which risks are assumed.

What are the two primary objectives of underwriting?

(1) To develop a profitable "book of business", and (2) To avoid adverse selection.

What are the six steps in the underwriting process?

(1) Gather information and evaluate exposures, (2) Determine underwriting alternatives, (3) Select an alternative, (4) Determine appropriate premium, (5) Implement decision, and (6) Monitor exposures.

What are the three fundamental underwriting alternatives when reviewing an application?

(1) Accept it as is, (2) Accept subject to certain restrictions or modifications, or (3) Reject outright.

What modifications can an underwriter require when accepting a policy subject to restrictions?

Require loss control measures, change rates, deductibles, or policy limits, amend terms and conditions, or obtain reinsurance.

What is pricing/ratemaking, and why is it uniquely challenging in insurance?

The determination of appropriate rates and premiums; it is unique because production costs are unknown at the time the product is sold, requiring prediction of future losses and expenses.

What are the three statutory regulatory ratemaking objectives?

Rates should be: (1) Adequate, (2) Not excessive, and (3) Not unfairly discriminatory.

What is an exposure unit in insurance ratemaking?

The unit of measurement used in insurance pricing (e.g., per \\$1,000 in sales, per \\$100 in coverage, car-year).

What is the formula connecting exposure unit, gross rate, and premium?

$\text{Premium} = \text{Exposure Unit} \times \text{Gross Rate}$.

What is the difference between pure premium and loading?

Pure premium (PP) is the portion of the rate needed to pay losses and loss-adjustment expenses, while loading is the amount added for other operating expenses, profit, and contingencies.

What are the three ratemaking methods used in property and casualty insurance?

(1) Judgment rating, (2) Class/manual rating (charging identical rates to exposures with similar characteristics), and (3) Merit rating (adjusting class rates based on individual loss experience).

What is reinsurance?

An arrangement by which the primary insurer that initially writes the insurance transfers to another insurer part or all of the potential losses associated with such insurance.

What are the meanings of primary insurer, retention limit, cession, and retrocession in reinsurance?

Primary insurer (ceding company): the initial writer; Retention limit: the amount of risk retained by the primary insurer; Cession: the risk transferred to the reinsurer; Retrocession: the process where a reinsurer reinsures part of its risk with another reinsurer.

What are three primary reasons an insurer utilizes reinsurance?

(1) Increase underwriting capacity, (2) Stabilize profits, and (3) Protect against catastrophic losses.

What is claims adjustment, and what is its primary objective?

The process of determining if a loss occurred, whether it is covered by the policy, and how much should be paid; its objective is the prompt, fair payment of legitimate claims.

What are the five steps in the claims settlement process?

(1) Validate (validity of proof/occurrence of loss), (2) Investigate (the scene of loss), (3) Estimate (amount of loss), (4) Interpret (policy language), and (5) Respond (approve or deny claim).

What are the two primary objectives of insurer investments?

(1) To reduce the cost of risk transfer (subsidization), and (2) To make risks acceptable that would be unacceptable based on premiums alone.

From what two different sources do insurers generate income?

Underwriting operations and investment activities.

Based on the provided slide, what is the formula for the Combined Ratio, and how are its component ratios calculated?

Combined Ratio = Loss Ratio + Expense Ratio; where $\text{Loss Ratio} = \frac{\text{Incurred Losses} + \text{Loss Adjustment Expenses}}{\text{Premiums}}$ and $\text{Expense Ratio} = \frac{\text{Underwriting Expenses}}{\text{Premiums}}$.

How is the Combined Ratio interpreted regarding insurer underwriting performance?

If the Combined Ratio is $<100\%$, the insurer achieved an underwriting profit; if it is $>100\%$, the insurer experienced an underwriting loss.

What is the formula for the Operating Profit/Loss Ratio shown on the slide, and how is the Investment Income Ratio calculated?

Operating Profit/Loss Ratio = Combined Ratio - Investment Income Ratio; where $\text{Investment Income Ratio} = \frac{\text{Net Investment Income}}{\text{Premiums}}$.

At what level of government is insurance primarily regulated in the United States, and what are the four reasons for this regulation?

At the state level; reasons: (1) Maintain insurer solvency, (2) Ensure reasonable rates, (3) Protect and educate consumers, and (4) Make insurance available.

What capital requirements and early warning systems are utilized in solvency regulation?

Risk-Based Capital (RBC) requirements, and early warning systems such as the Insurance Regulatory Information System (IRIS) and Financial Analysis of Solvency Tools (FAST).

What is the prohibited sales practice known as "twisting"?

Inducing a policyowner to drop an existing policy and replace it with a new one through misrepresentation or incomplete comparison.

What does the Principle of Indemnity state, and what are its two main purposes?

The insurer agrees to pay no more than the actual amount of the loss; its purposes are to prevent the insured from making a profit and to reduce moral hazard.

How is Actual Cash Value (ACV) calculated, and how is replacement cost defined?

$\text{ACV} = \text{Replacement Cost} - \text{Depreciation}$; Replacement cost is the current cost of restoring the damaged property with new material of like kind and quality.

What are three major exceptions to the Principle of Indemnity?

(1) Valued policies (pays face amount upon total loss), (2) Replacement cost insurance (no deduction for depreciation), and (3) Life insurance (valued policy paying stated death benefit).

What are the three parties to a life insurance contract and their roles?

Insured: person whose death triggers the policy obligation; Policyowner: owner holding the policy rights; Beneficiary: party entitled to receive the death benefit.

What does the Principle of Insurable Interest state, and what are its two purposes?

The insured must be in a position to lose financially if a covered loss occurs; its purposes are to prevent gambling and reduce moral hazard.

How does insurable interest differ between Property/Liability insurance and Life insurance?

Property/liability insurable interest arises from property ownership, potential legal liability, or secured credit (collateral); life insurance requires close family ties/marriage, pecuniary interest (e.g., key person insurance), or self-insurance (beneficiaries do not need an insurable interest).

When must an insurable interest exist for property insurance versus life insurance?

For property insurance: at the time of the loss; for life insurance: at the inception of the policy.

What is the Principle of Subrogation, and what are its three purposes?

The insurer is entitled to recover from a negligent third party loss payments made to the insured; its purposes are: (1) Prevent the insured from collecting twice, (2) Hold the negligent person responsible, and (3) Help hold down insurance rates.

What are three general rules governing the Principle of Subrogation?

(1) The insurer is entitled only to the amount paid under the policy, (2) Subrogation does not apply to life insurance, and (3) The insurer cannot subrogate against its own insureds.

What is the Principle of Utmost Good Faith, and what three conditions make a contract voidable under the doctrine of material misrepresentation?

A higher degree of honesty is imposed on both parties to an insurance contract; a contract is voidable at the insurer's option if a representation is (1) material, (2) false, and (3) relied on by the insurer.