FIN 230 Exam 2

Hard fraud

Premeditated, planned, deliberate fraud. Usually complex schemes, the most costly and widespread form, often run by fraud rings (same people who commit identity theft). Ex: Brake-check staged accidents, arson for insurance money, faking a death to collect life insurance.

Soft fraud (opportunistic fraud)

Stretching the truth or telling "white lies" on a legitimate claim or application to gain more. Most common type = exaggerating an injury to stay out of work longer. Ex: Claiming stolen property is worth more than it was, or claiming artwork you never owned was stolen.

Four elements of fraud

1) Someone makes a statement in support of an insurance claim. 2) The statement contains false information. 3) The statement is material (insurer relies on it). 4) The statement is made with intent to defraud the insurer.

Materiality

A statement is material if it causes the insurer to rely on it and do something it otherwise would not have done (such as pay a claim).

Fraud Triangle

Three conditions that lead to fraud: Perceived Need (pressure), Opportunity, and Rationalization. The center of the triangle is Ethical Risk.

Fraud Triangle: Perceived Need

The incentive or pressure to commit fraud. Ex: Greed, debt, bad credit, financial losses, unexpected financial need, addiction.

Fraud Triangle: Opportunity

The ability to commit fraud. Ex: Weak internal controls, no audit trail, a position of trust. This is the one side employers can control.

Fraud Triangle: Rationalization

The justification for one's actions. Ex: "I'll only do it once," "I'm entitled to it because I was passed over for a raise," "If I don't, someone else will."

Why fight insurance fraud

1) Corporate and civic duty to report. 2) Financial gain and recovery. 3) Government requirements (42 states have mandatory reporting laws). 4) Reduce costs (lower premiums and healthcare costs).

Special Investigation Unit (SIU)

Insurer unit staffed with people who have law enforcement experience and insurance knowledge. Investigates suspicious claims, works with local/state/federal law enforcement, and trains claims staff to spot red flags. Ex: Comparing bills across body shops to find outlier shops.

Ratemaking

The pricing of insurance and calculation of premiums. Done by actuaries using modeling, past loss experience, and industry statistics. Sets overall rates for each class of customers.

Rate

The price per unit of insurance. Ex: Like construction cost per square foot.

Exposure unit

The unit of measurement used in insurance pricing. In property insurance, usually $100 of property value. Ex: A $100,000 home = 1,000 exposure units.

Premium formula

Premium = Rate x Exposure units.

Premium adequacy

Total premiums must be enough to pay all claims AND expenses (salaries, adjusters, marketing) during the policy period, plus profit.

Actuary

Professional who determines rates and reserves, certifies financial statements, helps with product development, does catastrophe modeling, and partners with management on planning.

Reserves

Money set aside to pay anticipated claims. Loss reserves are for pending losses and are held as a company liability.

Loss frequency

How OFTEN losses occur (number of accidents divided by number of units analyzed). Ex: 5.5% probability of loss = 0.055 accidents per policy.

Loss severity

How COSTLY each loss is on average (total dollar losses divided by number of accidents). Ex: $5,000 average cost per loss.

Average loss (expected loss)

Loss frequency x Loss severity. Starting point for calculating a premium.

Factors affecting claim frequency and severity

Marketing strategy (target segment), choice of which applicants to insure, how claims are reviewed and paid, and trends (prices, consumer behavior, inflation, natural disasters).

Loss adjustment expense (LAE)

All the costs of investigating, verifying, documenting, and paying a claim. Rising LAE raises premiums. More efficient insurers can charge lower premiums.

Combined ratio

(Paid losses + loss adjustment expense + underwriting expenses) divided by premiums. The percentage of each premium dollar spent on claims and expenses. A decrease means results are improving. An increase means they are deteriorating.

Combined ratio vs. ratemaking

Combined ratio is retrospective (looks back at past results). Ratemaking is prospective (forward looking).

Ratemaking vs. underwriting

Actuaries (ratemaking) set overall rates for classes of customers. Underwriters apply guidelines to individual applications. Analogy: the person who creates the menu and prices vs. the chef who prepares the dish.

Underwriting

The process of selecting, classifying, and pricing applicants for insurance, following the company's statement of underwriting policy (acceptable classes of business, amounts that can be written).

Underwriting guidelines differ by insurer

Ex: One insurer declines homes with heavy clutter (poor maintenance means higher fire/damage risk). Ex: Cancels after more than one non-weather claim in 3 years (suggests poor maintenance). Ex: Cancels second homes not occupied every 30 days (undetected pipe bursts/flooding).

Principles of underwriting

1) Make an underwriting profit. 2) Select insureds per company standards. 3) Reduce adverse selection. 4) Maintain equity among policyholders (one group should not unduly subsidize another).

Adverse selection

The tendency of people with a higher-than-average chance of loss to seek insurance at standard rates. Ex: A heavy smoker buying health insurance at standard rates, so the rest of the pool covers the cost.

Group underwriting

Individual characteristics are NOT judged. The group is evaluated as a whole and everyone in the group gets coverage. Ex: Employer health plan.

Individual underwriting

Based on the individual's specific factors ("all about you"). Ex: Your own auto policy.

Factors used in underwriting

Marital status, living arrangements, geographic area (redlining), credit score (strong correlation between low credit scores and likelihood of filing a claim).

Redlining

An insurer designates a geographical area where it decides not to sell. Ex: Insurers avoiding Florida (hurricanes) or California (wildfires). Illegal as unfair discrimination when it targets areas like low-income zip codes.

Independent agent

Sells policies from several insurance carriers. Acts as a middleman, works primarily on behalf of the insurer (earns commission from insurer), and offers personalized service such as filing claims for you.

Exclusive (captive) agent

Can only write for their own company. Commissions are lower than independent agents because the insurer pays some expenses. Ex: State Farm, Nationwide, Farmers.

Direct writer

Salaried employees with no commission incentive. Ex: GEICO, USAA. Allstate has both direct writers and independent agents.

Broker

Acts as the insured's legal agent and works on behalf of the client. Used more in commercial insurance, liability, employee benefits, and marine insurance. In some states brokers must be agents of an insurer.

Unfair claims practices

Refusing to pay without a reasonable investigation, not attempting prompt/fair/equitable settlements, and offering low settlements to force insureds to sue. Typically state statutes require claims be settled within 30 days.

Staff claim adjuster

Employed by the insurer (desk or field job) and handles "daily claims."

Independent adjuster

Handles claims for an insurer for a fee. Used where the insurer has no office and for catastrophe (CAT) claims.

Third-party administrator (TPA)

Handles claims for self-insured companies, keeps claim records, does statistical analysis, and is used in catastrophes.

Public adjuster

Hired by the POLICYHOLDER and works for them. Prepares the claim, negotiates a settlement, and is paid a percentage of the claim.

Reinsurance

Insurance bought by insurance companies. The reinsurer takes part of the risk and part of the premium from the primary (ceding) company. Reinsurers reimburse the insurer and do NOT pay policyholder claims directly.

Why reinsurance is used

Increase underwriting capacity, stabilize profits, reduce the unearned premium reserve, protect against catastrophic loss, exit a line or territory, and get underwriting advice on unfamiliar lines.

Unearned premium reserve

Premium collected in advance but not yet earned until the policy period expires. It is set aside because it may need to be refunded. Reinsurance frees up this reserve.

Facultative reinsurance

Optional, case-by-case reinsurance for a SINGLE risk, used when an application exceeds the insurer's retention limit. Ex: Very large, prominent building.

Treaty reinsurance

Primary insurer agrees to cede business and reinsurer agrees to accept it, for the ENTIRE book of business. Can be proportional or non-proportional.

Securitization of risk

Transferring insurable risk to capital markets by creating a financial instrument (futures contract or catastrophe bond). Think of it as bundling and repackaging risk. Similar to ABS and MBS in banking.

Catastrophe bond

A securitization where investors get face value plus interest if no catastrophe occurs. Investors like them because they do not correlate with the stock market (diversification).

State guaranty fund

Every state, DC, and Puerto Rico has a guaranty association and every insurer must belong to the one in each state where it operates. Payer of last resort when an insurer fails. Funded through assessments on insurance companies. Illinois (liquidations on or after 1/1/2011) pays up to the policy limit capped at $500,000 for most claims. NO limit on workers' comp claims. Unearned premium refund up to $10,000 with a $100 deductible.

Why exclusions exist

1) Some perils are not commercially insurable (Ex: war). 2) Extraordinary hazards (Ex: using your car as a taxi or Uber). 3) Coverage provided by other contracts (Ex: autos excluded from homeowners). 4) Moral hazard (Ex: homeowners limits money to $200). 5) Attitudinal hazard (Ex: you bear losses from your own carelessness). 6) Coverage not needed by typical insureds (Ex: aircraft).

Property coinsurance clause

Rewards insuring to a stated percentage of value. Formula: (Insurance carried / Insurance required) x Loss = Recovery. If the requirement is not met at the time of loss the insured shares the loss beyond the deductible and acts as a coinsurer. Ex: Have $80,000, should have $100,000, loss $43,000. Insurer pays 80/100 x $43,000 = $34,400.

Health insurance cost-sharing example

$20,000 claim, $500 deductible, 20% cost share, $5,000 out-of-pocket max. After the $500 deductible your 20% share is 20% of $19,500 = $3,900. You pay $4,400 total, insurer pays $15,600. This stays under the out-of-pocket maximum so the cap is not hit.

Paul v. Virginia (1869)

"Issuing a policy is not a transaction of commerce." Landmark states' rights case that removed insurance from Congress and made states responsible for regulation and taxation. Overturned by the Supreme Court in 1944 which confused the issue and led to the McCarran-Ferguson Act.

Risk treatments

Accept (retain), Mitigate (reduce), Transfer (Ex: buy insurance), Avoid (do not do the activity).

Peril vs. hazard

Peril = the CAUSE of loss (Ex: fire). Hazard = a condition that INCREASES the chance or severity of loss (Ex: oily rags).

Fortuitous loss

Loss that is unforeseen, unexpected, and outside the insured's control. A requirement for insurable risk.

Indemnification

Restoring the insured to their pre-loss financial position with no profit from the loss.

Moral hazard vs. morale (attitudinal) hazard

Moral hazard = dishonesty that raises the chance of loss (Ex: arson or inflated claims). Morale hazard = carelessness or indifference because you are insured (Ex: leaving doors unlocked).

Risk retention

Keeping some or all of a risk yourself instead of transferring it. Ex: a deductible.

Tort

A civil wrong that causes harm to another, the basis for liability claims.

Negligence and proximate cause

Negligence = failing to act as a reasonable person would. Proximate cause = the act that is the direct, foreseeable cause of the harm.

Res ipsa loquitur

"The thing speaks for itself." Negligence is inferred from the nature of the accident itself. Ex: a surgical tool left inside a patient.

Respondeat superior

Employers are liable for acts of employees done within the scope of their employment.

Material fact

A fact that would influence the insurer's decision to issue a policy or pay a claim.

Methods of insurance regulation

Legislation, state insurance departments, and courts.

Rate regulation: modified prior approval

Changes based solely on emerging experience do not need approval.

Rate regulation: flex rating

Approval is only needed if the rate change exceeds a set threshold.

Rate regulation: other types

State-made rates (state sets them), no filing, commercial lines (often lighter regulation). Life insurance rates are regulated indirectly through minimum reserves.

Why regulators check rates

Prevent excessive rates and excessive profit, prevent rates too low (insurer sells many policies but cannot pay claims), and prevent unfair discrimination.

Reasons to be denied car insurance (assigned risk)

Major driving convictions (DUI/DWI, hit-and-run), multiple accidents or tickets or claims, little or no driving experience. The state assigns the driver to an insurer doing business there.

Licensing of insurers

States set formation and licensing rules including minimum capital and surplus. Domestic = domiciled in the state. Foreign = chartered in another state. Alien = chartered in another country.

McCarran-Ferguson Act (1945)

Clarified that states should keep regulating and taxing insurance (in the public's best interest). Promoted competition by letting companies exchange loss data. Allowed standard policy language.

Federal vs. state regulation

Federal advantages: uniformity, international flavor, systemic risk management, efficiency, states do not always protect enough, regulators too often side with industry. State advantages: more responsive, avoids cost of a dual system, concern about federal quality, NAIC promotes uniformity.

Contract parts (Chapter 10)

Declarations, insuring agreement, exclusions, conditions, endorsements and riders, deductibles, coinsurance, and other-insurance provisions.

Definitions section

Insurance contracts define terms. Ex: the insured is referred to as "you."

Insuring agreement

States what the insurer promises to cover. Read it alongside the words "excluded" and "limited" which narrow the coverage.

Three types of exclusions

Excluded perils (Ex: flood or intentional act), excluded losses (Ex: professional liability loss in a homeowners policy), excluded property (Ex: pets are not personal property).

War exclusion (CGL policy)

Bodily injury or property damage due to war is excluded. War includes civil war, insurrection, rebellion, or revolution.

Miscellaneous policy provisions

Cancellation, subrogation, grace period, misstatement of age.

First named insured

Has extra rights and responsibilities that other named insureds do not. The named insured is whoever is in the declarations.

Who else may be an insured

Homeowners policy covers resident relatives under age 24 who are full-time students away from home. Additional insureds can be added by endorsement.

Endorsement example

Earthquake endorsement to a homeowners policy.

Large loss principle

Insurance should pay for high severity losses. Small losses can be budgeted from income. This supports using deductibles.

Deductible tradeoff example

Option A: $500 deductible and $1,200 premium. Option B: $1,000 deductible and $800 premium. B costs you $500 more at claim time but saves $400 per year ($33.33/month). Break even = $500 / $33.33 = 15 months. Never take a higher deductible than you can afford.

Coinsurance purpose

Equity in rating. Owners insuring to the required percentage get a rate discount and underinsured owners are penalized through the formula. Ex: House A insured $150,000 and House B $250,000 with the same $50,000 loss would recover the same without coinsurance even though A pays less premium.

Health coinsurance example

Percentage participation clause. Ex: Insured pays 25% and insurer pays 75% of covered expenses above the deductible.

Coordination of benefits example

$60,000 bill. Primary: $500 deductible and 10% coinsurance so patient share is $500 + (59,500 x 10%) = $6,450 and primary pays $53,550. Secondary: $750 deductible and 20% coinsurance so secondary patient share is $750 + (5,700 x 20%) = $1,890 and secondary pays $4,560. Patient ends up paying $1,890.

Legal defense and supplementary payments

Insurer provides defense and pays all legal defense costs for covered claims. Supplementary payments: bail bond up to $250, premiums on appeal bonds, interest accruing after a judgment, loss of earnings up to $200 per day, and other reasonable expenses.

Parts of the Personal Auto Policy

Part A Liability, Part B Medical Payments, Part C Uninsured Motorists, Part D Damage to Your Auto, Part E Duties After an Accident or Loss.

Liability coverage: extra persons covered

Also covers any person or organization legally responsible for an insured's use of a covered auto and for the named insured's or family's use of a non-owned auto or trailer.

Additional liability exclusions

Vehicles used in the auto business or any other business, vehicles under special nuclear energy contracts, and vehicles owned by or furnished for regular use of a family member.

Rideshare insurance

Hybrid policy covering personal use plus the time a driver is logged into a rideshare app but not covered by Uber or Lyft. Delivery drivers (Grubhub, Instacart, Uber Eats) also need it to avoid a gap.

TNC coverage gap

Transportation Network Companies carry commercial auto, liability, and collision coverage (some with $1 million primary liability limit). Extended excess policies are mostly secondary and lack first-party coverage such as comprehensive and collision.

Financial responsibility law: other states

If another state has higher required limits than your declarations, your PAP automatically provides the higher limits when you have an accident there.

Pro rata vs. excess

If more than one liability policy applies, the insurer pays its pro rata share for an OWNED vehicle. Its coverage is excess over other insurance for a NON-OWNED vehicle.

Ways to prove financial responsibility

1) Auto liability policy with minimum limits. 2) Posting a bond or depositing the required amount. 3) Qualifying as a self-insurer. Problem: minimum limits are low and protection against irresponsible drivers is limited.

Compulsory insurance law pros and cons

Pro: requires proof of coverage BEFORE an accident (before licensing or registering). Cons: critics say it does not reduce uninsured drivers and computer tracking systems have not been effective.

UM advantage and disadvantage

Advantage: faster settlement than a tort lawsuit. Disadvantage: minimum limits are low so the victim may not be fully compensated.

UM exclusions (slide list)

No UM coverage on the vehicle, primary coverage under another policy, insured settles a claim without insurer consent, public or livery conveyance, workers' comp benefits apply, no reasonable belief of permission.