Chapter 1 - Exam FX

General Insurance (Key Terms)

Adverse selection

Insuring of risks that are more prone to losses than the average risk

Agent/Producer

A legal representative of an insurance company; the classification of producer usually includes agents and brokers; agents are the agents of the insurer

Applicant or proposed insured

A person applying for insurance

Beneficiary

A person who receives the benefits of an insurance policy

Broker

An insurance producer not appointed by an insurer and is deemed to represent the client

Indemnity

Main principle of insurance, meaning that the insured cannot recover more than their loss; the purpose of insurance is to restore the insured to the same position as before the loss

Insurance policy

A contract between a policyowner (and/or insured) and an insurance company which agrees to pay the insured or the beneficiary for loss caused by specific events

Insured

The person covered by the insurance policy. This person may or may not be the policyowner

Insurer (principal)

The company who issues an insurance policy

Law of large numbers

The larger the number of people with a similar exposure to loss, the more predictable actual losses will be

Policyowner

The person entitled to exercise the rights and privileges in the policy

Premium

The money paid to the insurance company for the insurance policy

Reciprocity/Reciprocal

A mutual interchange of rights and privileges

Insurance

• Insurance is a contract in which one party (the insurance company) agrees to indemnify (make whole) the insured party against loss, damage or liability arising from an unknown event.

• Insurance is the transfer of risk of loss. The cost of an insured's loss is transferred over to the insurer and spread among other insureds.

The following forms of protection are not considered insurance in this state:

• Private ambulance service contracts or private fire protection service contracts;

• Charitable gift annuities; or

• Collision damage waivers.

Risk

• Risk is the uncertainty or chance of a loss occurring. The two types of risks are pure and speculative, only one of which is insurable.

  • Pure risk refers to situations that can only result in a loss or no change. There is no opportunity for financial gain. Pure risk is the only type of risk that insurance companies are willing to accept.

  • Speculative risk involves the opportunity for either loss or gain. An example of speculative risk is gambling. These types of risks are not insurable.

Exposure

Exposure is a unit of measure used to determine rates charged for insurance coverage.

In life insurance, all of the following factors are considered in determining rates:

• The age of the insured;

• Medical history;

• Occupation; and

• Sex.

Homogeneous

A large number of units having the same or similar exposure to loss.

• The basis of insurance is sharing risk among the members of a large homogeneous group with similar exposure to loss.

Hazard

Conditions or situations that increase the probability of an insured loss occurring. Hazards are classified as physical hazards, moral hazards, or morale hazards. Conditions such as lifestyle and existing health, or activities such as scuba diving, are hazards and may increase the chance of a loss occurring.

Physical hazards

Individual characteristics that increase the chances of the cause of loss. Physical hazards exist because of a physical condition, past medical history, or a condition at birth, such as blindness.

Moral hazards

• Tendencies towards increased risk. Moral hazards involve evaluating the character and reputation of the proposed insured.

• Moral hazards refer to those applicants who may lie on an application for insurance, or in the past, have submitted fraudulent claims against an insurer.

Morale hazards

• Similar to moral hazards, except that they arise from a state of mind that causes indifference to loss, such as carelessness.

• Actions taken without a forethought may cause physical injuries.

Peril; examples of perils

Perils are the causes of loss insured against in an insurance policy.

• Life insurance insures against the financial loss caused by the premature death of the insured;

• Health insurance insures against the medical expenses and/or loss of income caused by the insured’s sickness or accidental injury;

• Property insurance insures against the loss of physical property or the loss of its income-producing abilities;

• Casualty insurance insures against the loss and/or damage of property and resulting liabilities.

Loss

Loss is defined as the reduction, decrease, or disappearance of value of the person or property insured in a policy, caused by a named peril. Insurance provides a means to transfer loss.

Methods of Handling Risk

• Avoidance

  • One of the methods of dealing with risk is avoidance, which means eliminating exposure to a loss.

  • For example, if a person wanted to avoid the risk of dying in an airplane crash, they might choose never to fly in an airplane.

  • Risk avoidance is effective, but seldom practical

• Retention

  • Risk retention is the planned assumption of risk by an insured through the use of deductibles, co-payments, or self-insurance.

  • It is also known as self-insurance when the insured accepts the responsibility for the loss before the insurance company pays.

  • The purpose of retention is

    • To reduce expenses and improve cash flow;

    • To increase control of claim reserving and claims settlements; and

    • To have funds for losses that cannot be insured.

• Sharing

  • Sharing is a method of dealing with risk for a group of individual persons or businesses with the same or similar exposure to loss to share the losses that occur within that group.

  • A reciprocal insurance exchange is a formal risk-sharing arrangement.

• Reduction

  • Since we usually cannot avoid risk entirely, we often attempt to lessen the possibility or severity of a loss.

  • Reduction would include actions such as installing smoke detectors in our homes, having an annual physical to detect health problems early, or perhaps making a change in our lifestyles.

• Transfer

  • The most effective way to handle risk is to transfer it so that the loss is borne by another party.

  • Insurance is the most common method of transferring risk from an individual or group to an insurance company.

  • Though the purchasing of insurance will not eliminate the risk of death or illness, it relieves the insured of the financial losses these risks bring.

  • There are several ways to transfer risk, such as hold harmless agreements and other contractual agreements, but the safest and most common method is to purchase insurance coverage.

Elements of Insurable Risks

• Due to chance — A loss that is outside the insured’s control.

• Definite and measurable — A loss that is specific as to the cause, time, place and amount. An insurer must be able to determine how much the benefit will be and when it becomes payable.

• Statistically predictable — Insurers must be able to estimate the average frequency and severity of future losses and set appropriate premium rates. (In life and health insurance, the use of mortality tables and morbidity tables allows the insurer to project losses based on statistics.)

• Not catastrophic — Insurers need to be reasonably certain their losses will not exceed specific limits. That is why insurance policies usually exclude coverage for loss caused by war or nuclear events: There is no statistical data that allows for the development of rates that would be necessary to cover losses from events of this nature.

• Randomly selected and large loss exposure — There must be a sufficiently large pool of the insured that represents a random selection of risks in terms of age, gender, occupation, health and economic status, and geographic location.

Adverse Selection

• Insurance companies strive to protect themselves from adverse selection, the insuring of risks that are more prone to losses than the average risk.

  • Poorer risks tend to seek insurance or file claims to a greater extent than better risks.

• To protect themselves from adverse selection, insurance companies have an option to refuse or restrict coverage for bad risks, or charge them a higher rate for insurance coverage.

Law of Large Numbers

• The basis of insurance is sharing risk among a large pool of people with a similar exposure to loss (a homogeneous group).

• The law of large numbers states that the larger the number of people with a similar exposure to loss, the more predictable actual losses will be.

• This law forms the basis for statistical prediction of loss upon which insurance rates are calculated.

• As the number of people in a risk pool increases, future losses become more predictable.

Insurers

Insurance is available from both private companies and the government.

The major difference between government and private insurance is that the government programs are funded with taxes and serve national and state social purposes, while private policies are funded by premiums.

Private insurance companies can be classified in a variety of ways:

• Ownership — stock or mutual;

• Authority to transact business — authorized or unauthorized;

• Location (domicile) — domestic, foreign, and alien;

• Marketing and distribution systems; or

• Rating (financial strength).

Stock Insurers

• Stock companies are owned by the stockholders who provide the capital necessary to establish and operate the insurance company and who share in any profits or losses.

• Officers are elected by the stockholders and manage stock insurance companies.

• Traditionally, stock companies issue nonparticipating policies, in which policyowners do not share in profits or losses.

• A nonparticipating (stock) policy does not pay dividends to policyowners; however, taxable dividends are paid to stockholders.

• The dividends are not guaranteed as they are based on company profit.

Mutual Insurers

• Mutual companies are owned by the policyowners and issue participating policies.

• With participating policies, policyowners are entitled to dividends, which, in the case of mutual companies, are a return of excess premiums and are, therefore, nontaxable.

• Dividends are generated when the premiums and the earnings combined exceed the actual costs of providing coverage, creating a surplus.

• Dividends are not guaranteed.

Fraternal Benefit Societies

• A fraternal benefit society is an organization formed to provide insurance benefits for members of an affiliated lodge, religious organization, or fraternal organization with a representative form of government.

• Fraternals sell only to their members and are considered charitable institutions, and not insurers.

• They are not subject to all of the regulations that apply to the insurers that offer coverage to the public at large.

• In most states, fraternal benefit societies are permitted to issue life insurance (including endowments), health insurance (including medical and disability), and annuities.

• They do not issue property or liability policies.

Lloyd's Associations

• Lloyd's is not an insurance company.

• Lloyd's provides support facilities for underwriters or groups of individuals that accept insurance risk.

• Lloyd's associations are a group of individuals who operate an insurance mechanism using the same principles of individual liability of insurers that Lloyd's of London uses, in that each individual underwriter assumes a part of each risk.

• Each individual promises to pay a specified amount in the event that the contingency insured against occurs.

• Members are liable only for their portion of the risk and are not bound to assume any portion of a defaulting member.

• While Lloyd's formed in this country operate in essentially the same manner as Lloyd's of London, they are not subject to the strict regulation which Lloyd's of London imposes upon its members.

• Most states have laws which prohibit the organization or licensing of American Lloyd's.

• Those Lloyd's which do exist operate almost exclusively in the property insurance field.

Reciprocals

• A reciprocal exchange is insurance resulting from an interchange of reciprocal agreements of indemnity among persons known as subscribers.

• A reciprocal exchange is an unincorporated insurance company managed by an attorney-in-fact common to all subscribers, that operates like a mutual company.

• Subscribers agree to become liable for their share of losses and expenses incurred among all subscribers, and they authorize the attorney-in-fact to manage and operate the exchange.

Risk Retention Groups

• A risk retention group (RRG) is a liability insurance company owned by its members.

• The members are exposed to similar liability risks by virtue of being in the same business or industry.

• The purpose of a risk retention group is to assume and spread all or part of the liability of its group members.

• A risk retention group may reinsure another risk retention group's liability as long as the members of the second group are engaged in the same or similar business or industry.

Certificate of Authority

• Before an insurer may transact business in a specific state, they must apply for a license or Certificate of Authority from the state Department of Insurance and meet any financial (capital and surplus) requirements set down by the state.

• A Certificate of Authority is issued by the state Department of Insurance and shows that the insurer has power to write insurance contracts in that state.

Domestic, Foreign and Alien Insurers

Insurance companies are classified according to the location of incorporation (domicile).

Regardless of where an insurance company is incorporated, it must obtain a Certificate of Authority before transacting insurance within the state.

• A domestic insurer is an insurance company that is incorporated in this state. In most cases, the company's home office is in the state in which it was formed — the company's domicile. For instance, a company chartered in Pennsylvania would be considered a Pennsylvania domestic company.

• A foreign insurer is an insurance company that is incorporated in another state, the District of Columbia, or a territorial possession. Currently, the United States has 5 major U.S. territories: American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin Islands.

• An alien insurer is an insurance company that is incorporated outside the United States.

TYPE OF MARKETING ARRANGEMENTS: Independent Agency System / American Agency System

• One independent agent represents several companies

• Nonexclusive

• Commissions on personal sales

• Business renewal with any company

TYPE OF MARKETING ARRANGEMENTS: Exclusive Agency System / Captive Agents

• One agent represents one company

• Exclusive

• Commissions on personal sales

• Renewals can only be placed with the appointing

  insurer

TYPE OF MARKETING ARRANGEMENTS: General Agency System

• General agent-entrepreneur represents one company

• Exclusive

• Compensation and commissions

• Appoints subagents

TYPE OF MARKETING ARRANGEMENTS: Managerial System

• Branch manager (supervises agents)

• Salaried

• Agents can be insurer’s employees or independent contractors

TYPE OF MARKETING ARRANGEMENTS: Direct Response Marketing System

• No agents

• Company advertises directly to consumers (through mail, Internet, television, other mass marketing)

• Consumers apply directly to the company

Private vs. Government Insurers

• Federal and state governments provide insurance in the areas where private insurance is not available, called social insurance programs.

• Government insurance programs include Social Security, Medicare, Medicaid, Federal Crop insurance and National Flood insurance.

• The major difference between government programs and private insurance programs is that the government programs are funded with taxes and serve national and state social purposes, while private policies are funded by premiums.

Reinsurance: Insurance for Insurers

• Reinsurance is a contract under which one insurance company (the reinsurer) indemnifies another insurance company for part or all of its liabilities.

• The purpose of reinsurance is to protect insurers against catastrophic losses.

• The originating company that procures insurance on itself from another insurer is called the ceding insurer (because it cedes, or gives, the risk to the reinsurer).

• The other insurer is called the assuming insurer, or reinsurer.

• There are two types of reinsurance agreements: facultative and automatic.

• When reinsurers use facultative reinsurance, they underwrite each application separately (on a case-by-case basis).

• Automatic reinsurance (also known as treaty reinsurance) is a predetermined, blanket arrangement.

Producer and General Rules of Agency

• A producer is an individual licensed to sell, solicit, or negotiate insurance contracts on behalf of the principal (insurer).

• The producer is considered an agent of the insurer.

• The law of agency defines the relationship between the principal and the producer: the acts of the agent within the scope of authority are deemed to be the acts of the insurer.

In the producer/agency relationship, it is a given that

• An agent represents the insurer, not the insured;

• Any knowledge of the agent is presumed to be knowledge of the insurer;

• If the agent is working within the conditions of the agent's contract, the insurer is fully responsible; and

• When the insured submits payment to the agent, it is the same as submitting a payment to the insurer.

• The agent is responsible for accurately completing applications for insurance, submitting the application to the insurer for underwriting, and delivering the policy to the policyowner.

• Insurance agents represent the insurer (principal). "Who is your pal? The principal!”

Authority and Powers of Producers

• The agency contract details the authority an agent has within the company.

• Contractually, only those actions that the agent is authorized to perform can bind the principal (insurer) — In reality, an agent's authority is much broader.

• There are 3 types of agent authority:

  • Express

    • Express authority is the authority a principal intends to grant to an agent by means of the agent’s contract.

    • It is the authority that is written in the contract.

  • Implied

    • Implied authority is authority that is not expressed or written into the contract, but which the agent is assumed to have in order to transact the business of insurance for the principal.

    • Implied authority is incidental to and derives from express authority since not every single detail of an agent’s authority can be spelled out in the written contract.

  • Apparent

    • Apparent authority (also known as perceived authority) is the appearance, or the assumption of authority based on the actions, words, or deeds of the principal or because of circumstances the principal created.

    • For example, if an agent uses insurer's stationery when soliciting coverage, an applicant may believe that the agent is authorized to transact insurance on behalf of the insurer.

Responsibilities to the Applicant and Insured

• Although the agents act for the insurer, they are legally obligated to treat applicants and insureds in an ethical manner.

• Because an agent handles the funds of the insured and the insurer, the agent has a fiduciary responsibility.

• A fiduciary is someone in a position of trust.

  • More specifically, it is illegal for insurance producers to commingle premiums collected from the applicants with their own personal funds.

Contracts

A contract is an agreement between two or more parties enforceable by law. Because of unique aspects of insurance transactions, the general law of contracts had to be modified to fit the needs of insurance.

In order for insurance contracts to be legally binding, they must have 4 essential elements:

• Agreement — offer and acceptance;

  • There must be a definite offer by one party, and the other party must accept this offer in its exact terms.

  • In insurance, the applicant usually makes the offer when submitting the application.

  • Acceptance takes place when an insurer’s underwriter approves the application and issues a policy.

• Consideration;

  • The binding force in any contract is the consideration.

  • Consideration is something of value that each party gives to the other.

  • The consideration on the part of the insured is the payment of premium and the representations made in the application.

  • The consideration on the part of the insurer is the promise to pay in the event of loss.

• Competent parties; and

  • The parties to a contract must be capable of entering into a contract in the eyes of the law.

  • Generally, this requires that both parties be of legal age, mentally competent to understand the contract, and not under the influence of drugs or alcohol.

• Legal purpose.

  • The purpose of the contract must be legal and not against public policy.

  • To ensure legal purpose of a Life Insurance policy, for example, it must have both: insurable interest and consent.

  • A contract without a legal purpose is considered void, and cannot be enforced by any party.

Distinct Characteristics of an Insurance Contract

In addition to required elements, insurance contracts have unique characteristics that distinguish them from other types of legal contracts. It is important to understand these features and how they affect parties to an insurance contract.

• Contract of Adhesion

  • A contract of adhesion is prepared by one of the parties (insurer) and accepted or rejected by the other party (insured).

  • Insurance policies are not drawn up through negotiations, and an insured has little to say about its provisions.

  • In other words, insurance contracts are offered on a take-it-or-leave-it basis by an insurer.

    • Any ambiguities in the contract will be settled in favor of the insured.

• Personal Contract

  • In general, an insurance contract is a personal contract because it is between the insurance company and an individual.

  • Because the company has a right to decide with whom it will and will not do business, the insured cannot be changed to someone else without the written consent of the insurer, nor can the owner transfer the contract to another person without the insurer's approval.

  • Life insurance is an exception to this rule:

    • A policyowner can transfer (or assign) ownership to another person. However, the insurer must still be notified in writing.

• Aleatory Contract

  • Insurance contracts are aleatory, which means there is an exchange of unequal amounts or values.

  • The premium paid by the insured is small in relation to the amount that will be paid by the insurer in the event of loss.

• Unilateral Contract

  • In a unilateral contract, only one of the parties to the contract is legally bound to do anything.

  • The insured makes no legally binding promises.

  • However, an insurer is legally bound to pay losses covered by a policy in force.

• Conditional Contract

  • As the name implies, a conditional contract requires that certain conditions must be met by the policyowner and the company in order for the contract to be executed, and before each party fulfills its obligations.

  • For example, the insured must pay the premium and provide proof of loss in order for the insurer to cover a claim.

Legal Interpretations Affecting Contracts

Ambiguities in a Contract of Adhesion

• Because only the insurance company has the right to draw up a contract, and the insured has to adhere to the contract as issued, the courts have held that any ambiguity in the contract should be interpreted in favor of the insured.

• Reasonable Expectations

  • It is not always practical or necessary to state every direct and indirect provision or coverage offered by an insurance policy.

  • If an agent implies through advertising, sales literature or statements that these provisions exist, an insured could reasonably expect coverage.

• Indemnity

  • Indemnity (sometimes referred to as reimbursement) is a provision in an insurance policy that states that in the event of loss, an insured or a beneficiary is permitted to collect only to the extent of the financial loss, and is not allowed to gain financially because of the existence of an insurance contract.

  • The purpose of insurance is to restore, but not let an insured or a beneficiary profit from the loss.

• Utmost Good Faith

  • The principle of utmost good faith implies that there will be no fraud, misrepresentation or concealment between the parties.

  • As it pertains to insurance policies, both the insurer and insured must be able to rely on the other for relevant information.

  • The insured is expected to provide accurate information on the application for insurance, and the insurer must clearly and truthfully describe policy features and benefits, and must not conceal or mislead the insured.

• Representations and Misrepresentations

  • Representations are statements believed to be true to the best of one's knowledge, but they are not guaranteed to be true.

  • For insurance purposes, representations are the answers the insured gives to the questions on the insurance application.

  • Untrue statements on the application are considered misrepresentations and could void the contract.

  • A material misrepresentation is a statement that, if discovered, would alter the underwriting decision of the insurance company.

  • Furthermore, if material misrepresentations are intentional, they are considered fraud.

• Warranties

  • A warranty is an absolutely true statement upon which the validity of the insurance policy depends.

  • Breach of warranties can be considered grounds for voiding the policy or a return of premium.

  • Because of such a strict definition, statements made by applicants for life and health insurance policies, for example, are usually not considered warranties, except in cases of fraud.

• Concealment

  • Concealment is the legal term for the intentional withholding of information of a material fact that is crucial in making a decision.

  • In insurance, concealment is the withholding of information by the applicant that will result in an imprecise underwriting decision.

  • Concealment may void a policy.

• Fraud

  • Fraud is the intentional misrepresentation or intentional concealment of a material fact used to induce another party to make or refrain from making a contract, or to deceive or cheat a party.

  • Fraud is grounds for voiding an insurance contract.

• Waiver and Estoppel

  • Waiver is the voluntary act of relinquishing a legal right, claim or privilege.

• Estoppel is a legal process that can be used to prevent a party to a contract from re-asserting a right or privilege after that right or privilege has been waived.

  • Estoppel is a legal consequence of a waiver.

What two elements are necessary for a life insurance contract to have a legal purpose?

Insurable interest and consent

When does an insurance policy go into effect?

When the policy is delivered and the premium is paid

A person who does not lock the doors to their house shows an indifferent attitude. This person presents what type of hazard?

Morale

Insurance is a contract that protects the insured from what?

Loss

Whose responsibility is it to determine that all the questions on an insurance application are answered?

The agent's

What entities make up the Medical Information Bureau?

Insurers

What are the strategies used by underwriters to prevent adverse selection?

Restriction of coverage, refusal to accept a risk, and accepting a risk at a higher rate

What type of risk is insurable?

Pure

For the purpose of insurance, what is risk?

Uncertainty of loss

When would a misrepresentation on an insurance application be considered fraud?

When it is intentional and material

What document is required for an insurance company to transact insurance?

Certificate of Authority

Who is responsible for making sure that an applicant receives the new insurance policy once it's issued?

The agent

The insurer organized to return a profit to the stockholders is what type of insurer?

Stock company

An insurance policy paid a nontaxable dividend to the insured one year, and nothing the next. From what type of insurer did the insured purchase the policy?

Mutual

Conditions that increase the chance of a loss are known as what?

Hazards

An applicant conceals relevant health information on the application. The applicant presents what type of hazard?

Moral

If an agent fails to obtain the applicant's signature on the insurance application, what must the insurer do?

Send the application back to the applicant for signature

When agents act within the scope of their contract, their actions will be assumed to be the acts of whom?

Insurer

What type of insurer is formed under the laws of another country?

Alien

What are the four elements of an insurance contract?

Agreement (offer and acceptance), consideration, competent parties, and legal purpose

What is the term for the causes of loss insured against in an insurance policy?

Peril

In insurance, when is the offer usually made on a contract?

When the insurance application is submitted

Whom does an insurance agent represent?

Insurance company

An insurance company that is formed under the laws of another state is known as what type of insurer?

Foreign

In the agent/insurer relationship, who is considered the principal?

Insurer

A situation in which a person can only experience a loss and no gain presents what type of risk?

Pure risk

Who owns stock companies?

Stockholders

In forming an insurance contract, when does an acceptance usually occur?

When the insurer approves a prepaid application

The type of insurance company organized to return any surplus money to its policyholders is known as what?

Mutual company

What is a warranty in an insurance contract?

An absolutely true statement upon which the validity of the insurance contract is based

The reduction, decrease, or disappearance of value of the person or property insured in a policy is known as what?

Loss

Insurers are classified according to their domicile. What are the three types of insurers?

Domestic, foreign, and alien

When risks with higher probability of loss are seeking insurance more often than other risks, this is knows as what?

Adverse selection

What are the three types of agent authority?

Express, implied and apparent

The requirement that agents must account for and promptly remit all insurance funds collected is knows as what type of agent responsibility?

Fiduciary

When a change needs to be made on the application for insurance, which is the best method for correcting the information?

Complete a new application or ask the applicant to initial the correction on the original application

If an insurer meets the state's financial requirements and is approved to transact business in the state, it is considered what type of insurer?

Authorized or admitted

An insurance company is domiciled in California and transacts insurance in Nevada. What is this insurer's classification in Nevada?

Foreign

What is the best way to handle incomplete insurance applications?

Return the application to the applicant for completion

What are the three types of hazards?

Physical, moral and morale

Wagering on a sporting event is known as what type of risk?

Speculative

What are the five characteristics of an ideally insurable risk?

Loss must be 1) due to chance, 2) definite and measurable, 3) statistically predictable, 4) not catastrophic, and 5) Coverage cannot be mandatory.

What do individuals use to transfer their risk of loss to a larger group?

Insurance

According to the Law of Agency, a principal is represented by whom?

Agent or producer