Ch. 2 - Nature of Insurance

What is the fundamental purpose of insurance?

To transfer and spread the risk of financial loss from an individual to a large group, so that the unpredictable loss of a few is paid for by the predictable contributions of many.

Define insurance as a contract.

A contract (policy) whereby one party (the insurer) indemnifies or guarantees another (the insured) against loss from a specified contingent event or peril, in exchange for consideration (premium).

Define the term 'insurer.'

The party that agrees to pay for losses and provide benefits — the insurance company. Also called the principal.

Define 'insured' vs 'policyowner.'

Insured: the person whose life or health is covered by the policy. • Policyowner: the person who owns the policy and holds all contractual rights. They are often, but not always, the same person.

STOCK insurance company — key features.

Owned by STOCKHOLDERS. Issues NON-PARTICIPATING policies. Profits are paid to stockholders as taxable dividends. Policyowners do not share in profits and do not vote.

MUTUAL insurance company — key features.

Owned by its POLICYOWNERS. Issues PARTICIPATING policies. Policyowners receive policy dividends (return of overcharged premium, not taxable as income) and have the right to vote for the board of directors.

Are policy dividends from a mutual insurer taxable?

No. They are legally considered a RETURN OF EXCESS PREMIUM (an overcharge refund), not income. However, interest earned on dividends left on deposit IS taxable.

Are policy dividends guaranteed?

No. Dividends can never be guaranteed. Illustrating them as guaranteed is an unfair trade practice.

What is demutualization?

The process of a mutual insurance company converting into a stock insurance company. (The reverse — stock to mutual — is called mutualization.)

FRATERNAL BENEFIT SOCIETY — key features.

A nonprofit charitable/benevolent organization that sells insurance ONLY to its members. Must have a representative form of government and a lodge system. Common examples: Knights of Columbus, Modern Woodmen.

RECIPROCAL insurance exchange — key features.

An unincorporated group where members (subscribers) insure each other, sharing risk. Managed by an ATTORNEY-IN-FACT. Each member is both insurer and insured.

LLOYD'S ASSOCIATION (Lloyd's of London) — what is it?

Not an insurer itself — a marketplace/association that provides the facilities for individual underwriters ('names' or syndicates) to write insurance. Each member is individually liable. Known for unusual and hard-to-place risks.

RISK RETENTION GROUP (RRG) — what is it?

A liability insurance company owned by its members, who must be engaged in similar businesses or activities. Formed under federal law to self-insure their common liability exposure.

What is a SELF-FUNDED (self-insured) plan?

An employer sets aside its own funds to pay employee claims rather than purchasing insurance. Often paired with stop-loss coverage and administered by a TPA.

DOMESTIC insurer — definition.

An insurer domiciled (incorporated) in THIS state. In California, a company incorporated in California is a domestic insurer.

FOREIGN insurer — definition.

An insurer incorporated in ANOTHER U.S. STATE (or U.S. territory/D.C.) but doing business in this state. Example: a New York company operating in California.

ALIEN insurer — definition.

An insurer incorporated in ANOTHER COUNTRY. Example: a company incorporated in Canada or Japan doing business in California.

Memory trick: Domestic / Foreign / Alien.

Domestic = Domiciled here (this state) • Foreign = another state (Foreign to this state, still USA) • Alien = Another country (think 'from another planet')

ADMITTED (authorized) insurer — definition.

An insurer that has received a Certificate of Authority from the state Insurance Commissioner and is legally authorized to transact insurance in that state.

NON-ADMITTED (unauthorized) insurer — definition.

An insurer NOT approved by the state and without a Certificate of Authority. It has not been approved to do business in the state, and its policyholders are not protected by the state guaranty association.

What is surplus lines insurance?

Coverage placed with a non-admitted insurer because the risk cannot be placed with an admitted carrier. Must be transacted through a specially licensed surplus lines broker.

What is a Certificate of Authority?

The license issued by the Insurance Commissioner permitting an insurer to transact insurance business in that state. Without it, an insurer is non-admitted.

What is the purpose of a state Guaranty Association?

To protect policyholders and claimants of an INSOLVENT insurer by paying covered claims up to statutory limits. Funded by assessments on ADMITTED insurers. Only admitted insurers' policyholders are protected.

Can a producer use Guaranty Association membership to sell insurance?

No. Advertising or using the existence of the Guaranty Association as an inducement to purchase insurance is prohibited and is an unfair trade practice.

Name the major insurer financial rating organizations.

A.M. Best, Standard & Poor's (S&P), Moody's, Fitch, and Weiss. They evaluate an insurer's financial strength and claims-paying ability.

What is meant by an insurer's 'financial strength rating'?

An independent assessment of the insurer's ability to meet its future obligations to policyholders — NOT a rating of its investment attractiveness or service quality.

PRIVATE vs GOVERNMENT insurers.

Private: commercial companies (stock, mutual, fraternal, etc.). • Government: programs the private market can't efficiently cover — Social Security, Medicare, Medicaid, workers' compensation funds, federal flood and crop insurance.

Define reinsurance.

Insurance for insurers. The CEDING company transfers all or part of a risk to a REINSURER (assuming company) to limit its loss exposure and increase capacity.

Ceding company vs. reinsurer.

Ceding company: the original/primary insurer that transfers the risk away. • Reinsurer (assuming insurer): the company accepting the transferred risk.

Treaty vs. facultative reinsurance.

Treaty: an automatic, blanket agreement — the reinsurer must accept all risks within the defined terms. • Facultative: negotiated case-by-case; each risk is optional and separately evaluated.

Why do insurers use reinsurance?

To increase underwriting capacity, stabilize loss experience, protect against catastrophic loss, and reduce required reserves.

What is retention (in a reinsurance context)?

The amount of risk the ceding insurer keeps for its own account before reinsurance applies.

CAREER (captive) agency system — describe.

Agents represent ONE insurer exclusively (or primarily). Also called the exclusive agency system. Includes general agency and managerial/branch office systems.

INDEPENDENT agency system — describe.

Agents/brokers represent MULTIPLE insurers, own their book of business and expirations, and are compensated by commission. Also called the American Agency System.

Direct response marketing — describe.

The insurer sells directly to the consumer without an agent, using mail, television, internet, or telephone. Lower acquisition cost, no field underwriting.

What is a general agent (GA)?

An independent contractor authorized by an insurer to recruit, train, and supervise agents within a territory, and to sell the insurer's products.

Agent vs. broker — the key distinction.

An AGENT legally represents the INSURER. • A BROKER legally represents the INSURED/applicant. • This determines whose knowledge and acts are imputed to whom.

In California, what term does the Insurance Code use for a licensee who sells insurance?

'Producer' is the general industry term; California licenses 'insurance agents' and 'brokers,' with a Life Agent license covering life, accident and health products.

What does 'transacting insurance' include?

1) Solicitation • 2) Negotiations preliminary to execution • 3) Execution of a contract of insurance • 4) Transaction of matters arising out of the contract (e.g., claims). A license is required for any of these.

What is the McCarran-Ferguson Act (1945)?

Federal law establishing that STATE regulation of insurance is in the public interest — insurance is regulated primarily by the states, with federal antitrust law applying only where state law does not regulate.

What is the NAIC?

The National Association of Insurance Commissioners — an organization of state insurance regulators that develops MODEL LAWS and uniform standards. The NAIC has NO direct regulatory authority; states must adopt its models to give them force.

Who regulates insurance in California, and how does that person take office?

The California Insurance Commissioner, who is ELECTED by the voters to a four-year term (a distinguishing feature — in most states the commissioner is appointed).

What is the participating vs non-participating policy distinction?

Participating: policyowner shares in insurer surplus via dividends (typically mutual companies). • Non-participating: no dividends paid to policyowners (typically stock companies).

What is an insurance 'policy'?

The written contract issued by the insurer to the policyowner setting forth the terms of the insurance agreement — the physical evidence of the transfer of risk.

What is the difference between a life insurance company's general account and separate account?

General account: supports guaranteed products; insurer bears investment risk. • Separate account: supports variable products; the CONTRACT OWNER bears investment risk. Selling separate-account products requires a securities registration in addition to a life license.

Why must an agent selling variable products hold a securities license?

Variable products are considered SECURITIES as well as insurance because the owner bears the investment risk. FINRA registration (Series 6 or 7) plus a state life license is required.