保險學 insurance

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1

Principles of Risk Management andInsurance

Major Reference

GEORGE E. REJDA 7th Edition (2011)

E-mail: [email protected]

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PART TWOLaw And the Insurance Contract

Chapter 5 Legal Principles in InsuranceChapter 6 Analysis of Insurance Contracts

PART SIXThe Private Insurance Industry

Chapter24 Types of Private Insurers and Marketing Systems

Chapter25 Functional Operations of Private Insurance

Chapter26 Financial Operations of Private Insurers

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Copyright 2011 Pearson Education. All Rights Reserved

Chapter 5

Legal Principlesin Insurance

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4

Agenda

Principle of Indemnity

Principle of Insurable Interest

Principle of Subrogation

Principle of Utmost Good Faith

Requirements of an Insurance Contract

Distinct Legal Characteristics of Insurance

Contracts Law and the Insurance Agent

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The insurer agrees to pay no more thanthe actual amount of the loss

Purpose:

To prevent the insured from profiting from aloss

To reduce moral hazard

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In property insurance, indemnification is based onthe actual cash value of the property at the time ofloss

There are three main methods to determine actualcash value:

Replacement cost less depreciation

Fair market value is the price a willing buyer would pay awilling seller in a free market

Broad evidence rule means that the determination of ACVshould include all relevant factors an expert would use todetermine the value of the property

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There are some exceptions to the principle ofindemnity:

A valued policy

pays the face amount of insurance if a total lossoccurs

Some states have a valued policy law thatrequires payment of the face amount of insuranceto the insured if a total loss to real propertyoccurs from a peril specified in the law

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Replacement cost insurance

means there is no deduction for depreciationindetermining the amount paid for a loss

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()

60%

60%

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A life insurance contractis a valued policy that

pays a stated sum to the beneficiary upon theinsureds death

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A life insurance contract

It is difficult to determine accurately the valueof a human life, and the amount paid maysubstantially exceed the economic value of theinsureds life. The human life value approach

gives a crude estimate of how much a person'slife is worth, but few people insure their livesfully, and all losses are total.

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The insured must stand to lose financially if aloss occurs

An insurable interest is required in every insurance

contract in order to prevent gambling, to reduce moral

hazard, and to measure the amount of the insureds lossin property insurance.

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Purpose:

To prevent gambling

To reduce moral hazard

To measure the amount of loss

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(2)Examples of an Insurable Interest

1.Property and liability Insurance

A.Ownership of property

owners of property will lose financially if their property isdamaged or destoryed

B.Potential legal liability

The firm may be legally liable for damage to customers goods

cause by the firms negligenceC.Secured creditors

A commercial bank that lends money to buy a house has an

insurable interest in the property of mortgage

.

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D.Contractual right

a business firm that contracts to purchase goods from abroad on

the condition that they arrive safely has an insurable interest in the

goods.

2.Life Insurance

A.Family or Marriage

a husband can purchase a life insurance policy on his wifes life

and be named as beneficiary.

B.Pecuniary interest

Even when there is no relationship by blood or marriage, one

person may be financially harmed by the death of another.

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16

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A.

B.

(Mortgagee)

C.

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D.

( )

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E.

(Invoice Value)(

)

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A.

()

B.

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1.

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2.

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3.

4.

(434 )

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1.

(

1122,1123)

(1114)

A.

1001111611003

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B.

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( )

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2.

3.

4.

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5.

6.

1114

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1115

1117

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When must insurable interest exist?

Property insurance: at the time of the loss

Reasons:

A. most property insurance contracts are contracts of indemnity.

B. you may not have an insurable interest in the property when the

contract is first written but may expect to have an insurable

interest in the future, at the time of possible loss.

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Life insurance: only at inception of thepolicy

Reasons:

A. life insurance is not a contract of indemnity but is a valued policy that pays a stated sum upon the insureds

death.

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Life insurance: only at inception of the

policyReasons:

B. the beneficiary has only a legal claim to receive the policy

proceeds, the beneficiary does not have a show that a loss

has been incurred by the insureds death.

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(Proceed)

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Insurer is entitled to recover from anegligent third party any loss paymentsmade to the insured.

Substitution of the insurer in place of theinsured for the purpose of claiming indemnityfrom a third person for a loss covered byinsurance.

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Purposes: To prevent the insured from collecting

twice for the same loss

To hold the negligent person responsible

for the loss

To hold down insurance rates

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Importance of Subrogation

The insurer is entitled only to the amount ithas paid under the policy

The insured cannot impair the insurerssubrogation rights

Subrogation does not apply to life insuranceand to most individual health insurancecontracts

The insurer cannot subrogate against itsown insureds

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A higher degree of honesty is imposed onboth parties to an insurance contract thanis imposed on parties to other contracts

148

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Supported by three legal doctrines:

Representations

are statements made by the applicantfor insurance

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A contract is voidable if the representation ismaterial, false, and relied on by the insurer

An innocent misrepresentation of a material fact,if relied on by the insurer, makes the contractvoidable

Representation

(voidable)

1.materialif the insurer knew the true facts, the policy

not have been issued or it would have been issued on different

terms

2.falsestatement is not true or is misleading

3.relied on by the insurer

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A concealment

is intentional failure of the applicant forinsurance to reveal a material fact to theinsurer

1.the concealed fact was known by the insured to be material

2.the insured intended to defraud the insurer

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A warranty

is a statement that becomes part of theinsurance contract and is guaranteed by themaker to be true in all respects

Statements made by applicants are consideredrepresentations, not warranties

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To be legally enforceable, an insurancecontract must meet four requirements:

Offer and acceptance

of the terms of the contract

In most cases, the applicant for insurance makes the offer, and thecompany accepts or rejects the offer.

(Binder)

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Consideration

the values that each party exchange

The value that each party gives to the other.

A. Insured's consideration generally is payment of the first

premium.

B. Insurer's consideration is the promise to perform the contract.

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Legally competent parties, with legal capacityto enter into a binding contract

This means the parties must have legal capacity to enter into abinding contract.

Minorsnormally are not legally competent to enter

into binding insurance contracts.

The insurer generally must be licensed

to sell insurance, and

the insurance sold must be within the scope.

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The contract must exist for a legal purpose

An insurance contract that encourages or promotes something

illegal or immoral is contrary to the public interest and cannot be

enforced

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Distinct Legal Characteristics ofInsurance Contracts

Aleatory

: values exchanged are not equal

Unilateral: only the insurer makes a legally

enforceable promise

Conditional: policyowner must comply with

all policy provisions to collect for a coveredloss

Personal: property insurance policy cannot

be validly assigned to another party withoutthe insurer's consent

Contract of adhesion: since the insured

must accept the entire contract as it is written,any ambiguities are construed against theinsurer

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Aleatory

: values exchanged are not equal

(Commutative

Contract)

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Unilateral

: only the insurer makes a legallyenforceable promise

(Bilateral Contract)

most commercial contract are bilateral contract in nature. Each

party makes a legally enforceable promise to the other party.

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Conditional

: policyowner must comply with all policyprovisions to collect for a covered loss

That is, the insurers obligation to pay a claim depends onwhether the insured or the beneficiary has comply with all

policy conditions.

Conditions are provisions inserted in the policy that qualify or

place limitations on the insurers promise to perform.

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Personal

which means the contract is between the insured and the insurer.

property insurance policy cannot be validly assigned to another party

without the insurer's consent.

Thus, the insurers consent is normally required before a propertyinsurance policy can be validly assigned to another party.

(character)

(moral)

(credit)

(assignment)

because the assignment does

not usually alter the risk or increase the probability of death

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Contract of adhesion

: since the insured must accept the entirecontract as it is written, any ambiguities are

construed against the insurer the insured must accept the entire contract, with all its terms andconditions.

(endorsement)

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Law and the Insurance Agent

An agent is someone who has the authority to acton behalf of a principal (the insurer)

Several laws govern the actions of agents and theirrelationship to insureds

There is no presumption of an agency relationship An agent must be authorized to represent the principal

Authority is either express, implied, or apparent

Knowledge of the agent is presumed to be knowledge ofthe principal with respect to matters within the scope ofthe agency relationship

Insurers can place limitations on the power of agents byadding a nonwaiver clause to the application or policy

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Waiver

is defined as the voluntary

relinquishment of a known legal right

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Estoppel

occurs when a representation of fact made byone person to another person is reasonably reliedon by that person to such an extent that it wouldbe inequitable to allow the first person to denythe truth of the representation

(

)

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Key Concepts and Terms

Actual Cash Value

Aleatory Contract

Binder

Broad Evidence Rule

Commutative Contract

Concealment

Conditional Contract

Conditional PremiumReceipt

Consideration

Contract of Adhesion

Estoppel

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Express Powers

Fair Market Value

Implied Powers

Innocent Misrepresentation

Legal Purpose

Legally Competent Parties

Material Fact

Offer and Acceptance

Pecuniary Interest

Personal Contract

Principle of indemnity

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Chapter 6

Analysis ofInsurance

Contracts

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Agenda

Basic parts of an insurance contract

Definition of the Insured

Endorsements and Riders

Deductibles

Coinsurance

Other-insurance provisions

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Basic Parts of an Insurance Contract

Declarations

are statements that provide information aboutthe particular property or activity to be insured

Usually the first page of the policy

In property insurance, it contains name of the insured,location of property, period of protection, amount ofinsurance, premium and deductible information

Insurance contracts typically contain a page orsection of definitions

For example, the insured is referred to as you

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The insuring agreement

summarizes the major promises of the insurer

The two basic forms of an insuring agreement inproperty insurance are:

Named perils policy

where only those perils specifically named in the policyare covered

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The insuring agreement

summarizes the major promises of theinsurer

All-risks policy

where all losses are covered except those lossesspecifically excluded

May also be called an open-perils policy or specialcoverage policy

Insurers have generally deleted the word all frompolicies

All-risks coverage has fewer gaps, and theburden of proof is placed on the insurer to deny aclaim

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Insurance contracts contain three majortypes of exclusions

1.Excluded perils

e.g., flood, intentional act In a homeowners policy, the perils of flood, earth movement, and

nuclear radiation or radioactive contamination.

In property and liability insurance, most insurance contract

exclude coverage for acts of war.

The war exclusion clause is important today because of the

terrorist attack on the United States on September 11, 2001.

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2.Excluded losses

certain types of losses may be excluded.

e.g., a professional liability loss is excludedin the homeowners policy

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3.Excluded property

in a homeowners policy, certain types of personalproperty are excluded, such as cars, planes, animals,

birds, and fish.

in a liability insurance policy, property of others in thecare, control, and custody of the insured is usually

excluded.

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Why are Exclusions Necessary?

1.Some perils are not commerciallyinsurable

e.g., catastrophic losses due to war

2.Extraordinary

hazards are present e.g., using the automobile for a taxi

3.Coverage is provided by other contracts

e.g., use of auto excluded onhomeowners policy

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Why are Exclusions Necessary?

4.Moral hazard problems

e.g., coverage of money limited to $200in homeowners policy

5.Attitudinal hazard problems e.g., individuals are forced to bear losses

that result from their own carelessness

6.Coverage not needed by typical insureds

e.g., homeowners policy does not coveraircraft

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Conditions

are provisions in the policy that qualify or

place limitations on the insurers promise toperform

If policy conditions are not met, insurercan refuse to pay the claim

Insurance policies contain a variety ofmiscellaneous provisions

e.g., cancellation, subrogation, graceperiod, misstatement of age

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1.Give notice of loss ()

2.Preserve and protect property from

further loss or damage ()

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3.Repair before Evaluation()

(

)

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(4)Miscellaneous provision

In Property and Liability Insurance

1.Cancellation clause

()

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(4)Miscellaneous provision

In Property and Liability Insurance

2.Appraisal

Arbitration

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3.Assignment()

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4.Other Insurance

Other Insurance

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Double Insurance

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Double Insurance

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Double Insurance

1.

2.

3.

4.

5.

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5.Subrogation

()

i f

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Subrogation

1.

2.

3.

4.

i f C

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(5).In Life and Health Insurance1.Grace Period

B i P f I C

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2.Reinstatement Clause

()

B i P t f I C t t

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96.7.18

B i P t f I C t t

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3.Misstatement of age

D fi iti f I d

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Definition of an Insured

An insurance contract must identify thepersons or parties who are insured under thepolicy The named insuredis the person or persons

named in the declarations section of the policy

The first named insured has certain additional rightsand responsibilities that do not apply to other namedinsureds

A policy may cover other parties even though theyare not specifically named

e.g., the homeowners policy covers resident relativesunder age 24 who are full-time students away fromhome

Additional insuredsmay be addedusing an endorsement

D fi iti f I d

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Definition of an Insured

1.

2.

E d t d Rid

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In property and liability insurance, anendorsement

is a written provision that adds to, deletesfrom, or modifies the provisions in the

original contract e.g., an earthquake endorsement to a homeowners

policy

Earthquake Endorsement

E do e e t d Ride

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In life and health insurance, a rider

is a provision that amends or changesthe original policy

e.g., a waiver-of-premium rider on a lifeinsurance policy

waiver-of-premium rider


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(3)

Purpose

1. to add, delete, or modify provisions in the original contract

2.Riders may increase or decrease benefits or amounts of

insurance.

3.Riders may add coverage for new perils or losses

(4)()

An endorsement attached to a contract generally takes precedence

over any conflicting terms in the contract.

Deductibles

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Deductibles

A deductible

is a provision by which a specified amountis subtracted from the total loss paymentthat otherwise would be payable

A deductible is not used in life insurance because the insureds

death is always a total loss

.

Deductibles

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Deductibles

The purpose of a deductible is to:

Eliminate small claims that are expensive to handleand process

Reduce premiums paid by the insured

Under the large loss principle, insurance should pay for

high severity losses; small losses can be budgeted out ofthe persons income

Reduce moral hazard and attitudinal hazard

Some dishonest insureds may deliberately() cause a loss to profit from

insurance. Deductibles encourage people to be more careful with respect to

the protection of their property and prevention of a loss.

Deductibles

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Deductibles

With a straight deductible

, the insured must pay a certain amountbefore the insurer makes a loss payment

e.g., an auto insurance deductible

The insured must pay a certain number of dollars of loss.

1

5

2

Deductibles

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Deductibles

An aggregate deductible

means that all losses that occur during aspecified time period are accumulated tosatisfy the deductible amount

(

)

Deductibles in Health Insurance

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A calendar-year deductible

is a type of aggregate deductible that isfound in basic medical expense and majormedical insurance contracts


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A corridor deductible

is a deductible that can be used tointegrate a basic medical expense planwith a supplemental major medical

expense plan


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An elimination (waiting) period

is a stated period of time at thebeginning of a loss during which noinsurance benefits are paid


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An elimination (waiting) period

Elimination periods are commonly used in disability income

insurance contracts.

For example, disability-income contracts that replace part of

a disabled workers earnings typically have elimination

periods of 30, 60, 90 days or even longer.

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(Insurable value)

(Actual cash value)

=(Replacement cost)

(Accumulated depreciation)

(1)Full Insurance

1,500,000

1,500,000

300,000

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(2)Under Insurance

1,500,000

1,000,000

300,000

(

)

=

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(3)Over Insurance

1,500,000

2,500,000

300,000

1.()

2.()

Coinsurance

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Coinsurance

A coinsurance clause

in a property insurance contract encourages theinsured to insure the property to a statedpercentage of its insurable value

If the coinsurance requirement is not met at thetime of the loss, the insured must share in theloss as a coinsurer

recoveryofAmountLossxrequiredinsuranceofAmount

carriedinsuranceofAmount

Coinsurance

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Coinsurance

1,500,000

600,000

80 coinsurance clause

1,200,000

300,000

(x)

=

600,000 (1500,000 x 80 ) X 300,000

= 150,000

Coinsurance

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Coinsurance

The purpose of coinsurance

is to achieve equity in rating

A property owner wishing to insure for a totalloss would pay an inequitable premium if otherproperty owners only insure for partial losses

If the coinsurance requirement is met, theinsured receives a rate discount, and thepolicyowner who is underinsured is penalizedthrough application of the coinsurance formula

Exhibit 6.1 Insurance to Full Value

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Exhibit 6.1 Insurance to Full Value

Exhibit 6.2 Insurance to Half Value

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Exhibit 6.2 Insurance to Half Value

Coinsurance

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Coinsurance

Coinsurance problem

1.Inflation can result in a serious coinsurance penalty if the amountof insurance is not periodically increased for inflation.

2.Insured may incur a coinsurance penalty if property valuesfluctuate widely during the policy period

3.If a small loss occurs, the insured may incur financial hardship ifhe or she is required to take a physical inventory of the undamaged

and damaged goods

Coinsurance in Health Insurance

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Health insurance policies frequently contain apercentage participation clause

The clause requires the insured to pay acertain percentage of covered medicalexpenses in excess of the deductible

80-20 Coinsurance clause

80

20

Coinsurance in Health Insurance

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The purpose is

to reduce premiums

and prevent overutilization of policy

benefits

Other-insurance Provisions

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Other insurance Provisions

The purpose of other-insurance provisions is toprevent profiting from insurance and violation ofthe principle of indemnity


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Other insurance Provisions

Under a pro rata liability provision, eachinsurers share of the loss is based on theproportion that its insurance bears to the totalamount of insurance on the property

(1)Pro rata liability

1:500,000A

300,000

B

100,000

C

100,000

100,000

Company A:300,000500,000 x 100,000 = 60,000

Company B:100,000500,000 x 100,000 = 20,000

Company C:100,000500,000 x 100,000 = 20,000

Total loss payment = 100,000


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Under contribution by equal shares, each insurer sharesequally in the loss until the share paid by each insurer

equals the lowest limit of liability under any policy, oruntil the full amount of the loss is paid

(2)Contribution by Equal Shares

1.Amount of loss = 150,000 amount of insurance contribution by equal shares total paid

Company A 100,000 50,000 50,000

Company B 200,000 50,000 50,000

Company C 300,000 50,000 50,000

2.Amount of loss = 500,000

amount of insurance contribution by equal shares total paid

Company A 100,000 100,000 100,000

Company B 200,000 100,000 +100,000 200,000

Company C 300,000 100,000 +100,000 200,000

Exhibit 6.3 Pro Rata Liability Example

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6 3 o a a ab y a p e

Exhibit 6.4 Contribution by Equal Shares(E ample 1)

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(Example 1)

Exhibit 6.5 Contribution by Equal Shares(Example 2)

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(Example 2)


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Under a primary and excess insurance provision, the

primary insurer pays first, and the excess insurerpays only after the policy limits under the primarypolicy are exhausted

(3)Primary and Excess Insurance

The primary insurer pays first, and the excess insurer pays only afterthe policy limits under the primary policy are exhausted.

Primary insurerExcess insurer

Primary insurer

APrimary insurer500,000B

Excess insurer

300,000

600,000

A500,000

B 100,000


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The coordination of benefits provision

in group health insurance is designed toprevent overinsurance and the duplication

of benefits if one person is covered undermore than one group health insurance plan

e.g., two employed spouses are insured asdependents under each others group healthinsurance plan


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Aggregate Deductible

All-Risks Policy

Calendar Year Deductible

Coinsurance Clause

Contribution By Equal Shares


Equity in Rating

Exclusions

Insuring Agreement

Large Loss Principle

Named Insured

Named perils Policy


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Coordination of benefits Provision

Corridor Deductible

Declarations

Elimination(Waiting)Period

Other Insurance Provision

Percentage Participation Clause

Primary and excess insurance

Pro rata Liability

Straight deductible

Chapter 24

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Chapter 24

Types of PrivateInsurers andMarketing

Systems

Agenda

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g

Overview of Private Insurance in theFinancial Services Industry

Types of Private Insurers

Agents and Brokers Types of Marketing Systems

Group Insurance Marketing

Overview of Private Insurance in theFinancial Services Industry

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Financial Services Industry

The financial services industry consists of:

Commercial banks

Savings and loan institutions

Credit unions

Life and health insurers Property and casualty insurers

Mutual Funds

Securities brokers and dealers

Private and state pension funds Government-related financial institions

Exhibit 24.1 Assets of Financial ServicesSectors 2007 ($billions)

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Sectors, 2007 ($billions)

Overview of Private Insurance inthe Financial Services Industry

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the Financial Services Industry

Changes in the financial services industryinclude:

Consolidations

The number of firms has declined due to mergers and

acquisitions

Convergence

Existing financial institutions now sell a wide varietyof financial products that earlier were outside theircore business area


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Size of the insurance market, 2007

Life and health insurers: 1009

These insurers sell life and health insuranceproducts, annuities, mutual funds, pension plans,

and related financial products

Property and casualty insurers: 2723

These insurers sell property and casualty insuranceand related lines, including marine coverages andsurety and fidelity bonds

Exhibit 24.2 Top Twenty U.S. Life/HealthInsurance Groups by Revenues 2007 ($ millions)

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Insurance Groups by Revenues, 2007 ($ millions)

Exhibit 24.3 Top Twenty U.S. Property/ CasualtyCompanies by Revenues 2007 ($millions)

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Companies by Revenues, 2007 ($millions)


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Insurers can be classified by theirorganizational form:

Stock insurers

Mutual insurers

Reciprocal exchanges

Lloyds of London

Blue Cross and Blue Shield Plans

Health maintenance organizations (HMOs) Other types of private insurers


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A stock insurer is a corporation owned bystockholders

Objective: earn profit for stockholders

Increase value of stock

Pay dividends

Stockholders elect board of directors

Stockholders bear all losses

Insurer cannot issue an assessable policy


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A mutual insurer is a corporation owned by the policyowners

Policyowners elect board of directors, who have effectivemanagement control

May pay dividends to policyowners, or give a rate reduction inadvance

There are three main types of mutual insurers: An advance premium mutual is owned by the policyowners; there are

no stockholders, and the insurer does not issue assessable policies

An assessment mutual has the right to assess policyowners anadditional amount if the insurers financial operations are unfavorable

A fraternal insurer is a mutual insurer that provides life and health

insurance to members of a social or religious organization


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The corporate structure of mutual insurersis changing due to:

An increase in company mergers

Demutualization, in which a mutual company is

converted into a stock insurer by: Pure conversion

Merger

Bulk reinsurance

The creation of mutual holding companies A holding company is a company that directly or

indirectly controls an authorized insurer

Exhibit 24.4Mutual Holding Company Illustration

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Lloyds of Londonis not an insurer, but a societyof members who underwrite insurance insyndicates

Membership includes corporations, individual members

(Names), and Scottish limited partnerships New individual members, or Names, who belong to the

various syndicates now have limited legal liability

Corporations with limited legal liability and limited liabilitypartnerships can also join Lloyds of London

Lloyds is licensed only in a small number of jurisdictionsin the U.S.


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A reciprocal exchange is an unincorporatedmutual

The reciprocal is managed by an attorney-in-fact

In a pure reciprocal exchange, insurance isexchanged among the members; each memberof the reciprocal insures the other members

A separate account is kept for each member

A modified reciprocal exchange is similar to anadvance premium mutual

No individual accounts


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Blue Cross and Blue Shield Plans are generallyorganized as nonprofit, community oriented plans

Blue Cross plans provide coverage for hospital services

Blue Shield plans provide coverage for physicians and

surgeons fees Most plans have merged into one entity

Many sponsor HMOs and PPOs

Some plans have converted to a for-profit status to raisecapital and become more competitive


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A Health Maintenance Organization (HMO)provides comprehensive health careservices to its members

Broad health care services are provided for a

fixed prepaid fee

Cost control is emphasized

Choice of health care providers may berestricted

Less costly forms of treatment are oftenprovided


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A captive insurer is an insurer owned by a parentfirm for the purposes of insuring the parent firmsloss exposures

More than 5100 captives exist today

Savings Bank Life Insurance refers to lifeinsurance that is sold by mutual savings banks,over the phone or through Web sites

Agents and Brokers

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An agent is someone who legally representsthe principal and has the authority to act onthe principal's behalf

(Insurance Agent)

Authority may be:

Expressed

Implied

Apparent

The principal is responsible for all acts of anagent when the agent is acting within thescope of authority

Agents and Brokers

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A property and casualty agent has thepower to bind the insurer

A binderprovides temporary insurance

until the policy is actually written A life insurance agent normally does not

have the authority to bind the insurer

The applicant for life insurance must be

approved by the insurer before theinsurance becomes effective

Agents and Brokers

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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 businessis placed

does not have the authority to bind the insurer

(Insurance Broker)

A surplus lines broker is licensed to place business witha nonadmitted insurer

Surplus lines refer to any type of insurance for which thereis no available market within the state, and coverage mustbe placed with a nonadmitted insurer

Marketing Systems in Life Insurance

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An agency building system is a system by which an insurerbuilds its own agency force by recruiting, financing, training,and supervising new agents

General agency system

The general agent is an independent contractor who represents only oneinsurer, and receives a commission based on the amount of businessproduced

Insurer provides some financial assistance, but the general agent isresponsible for recruiting, training, and motivating new agents

Managerial system

Branch offices are established in various areas

The branch manager is responsible for hiring and training new agents,and receives a commission from the insurer

Insurer pays expenses of the branch office

Marketing Systems in Life Insurance

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A nonbuilding agency system is a marketing systemby which an insurer sells its products throughestablished agents

A personal-producing general agent is a successfulagent who is hired primarily to sell insurance under a

contract

Under a direct response system, insurance is solddirectly to customers without the services of an agent

Marketing Systemsin Property and Liability Insurance

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The independent agency

is a business firmthat usually represents several unrelated insurers

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

Agency owns the expirations or renewal rights to thebusiness

Under the exclusive agencysystem, the agent

represents only one insurer or group of insurersunder common ownership

Agents do not usually own the expirations or renewalrights to the policies

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

Marketing Systemsin Property and Liability Insurance

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A direct writer is an insurer in which the salespersonis an employee of the insurer, not an independentcontractor.

Employees are usually compensated on a salary plusarrangement

A direct response insurer sells directly to theconsumer by television or some other media

Used primarily to sell personal lines of insurance

Many property and casualty insurers use multiple

distribution systems

Group Insurance Marketing

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Many insurers use group marketingmethods to sell individual insurancepolicies to:

Employer groups

Labor unions

Trade associations

Some property and liability insurers usemass merchandising plans to market their

insurance Employees pay for insurance by payroll

deduction

Chapter 25

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FunctionalOperations ofPrivate Insurers

Agenda

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147

Rating and Ratemaking Underwriting

Production

Claim settlement Reinsurance

Investments

Rating and Ratemaking

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Ratemaking

refers to the pricing ofinsurance and the calculation of insurancepremiums

A rate is the price per unit of insurance

An exposure unit is the unit of measurement used ininsurance pricing

Total premiums charged must be adequate forpaying all claims and expenses during the policy

period Rates and premiums are determined by an actuary,

using the companys past loss experience andindustry statistics

unitsexposureratepremium *

Underwriting

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Underwriting refers to the process of

selecting, classifying, and pricing applicantsfor insurance

A statement of underwriting policy

establishes policies that are consistent with

the companys objectives, such as Acceptable classes of business

Amounts of insurance that can be written

A line underwriter makes daily decisions

concerning the acceptance or rejection ofbusiness

Underwriting

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Important principles of underwriting:

The primary objective of underwriting is to attain anunderwriting profit

The second principle is to select prospectiveinsureds according to the companys underwritingstandards

The purpose of underwriting standards is to reduceadverse selection against the insurer

Adverse selectionis the tendency of people with ahigher-than-average chance of loss to seek insuranceat standard rates. If not controlled by underwriting,

this will result in higher-than-expected loss levels.

Underwriting should also maintain equity among thepolicyholders

One group of policyholders should not unduly subsidizeanother group

Underwriting

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Underwriting starts with the agent in the field Information for underwriting comes from:

The application

The agents report

An inspection report

Physical inspection

A physical examination and attending physicians report

MIB report

After reviewing the information, the underwriter can:

Accept the application

Accept the application subject to restrictions ormodifications

Reject the application

Production

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Production

refers to the sales andmarketing activities of insurers

Agents are often referred to as producers

Life insurers have an agency or sales department

Property and liability insurers have marketingdepartments

An agent should be a competent professionalwith a high degree of technical knowledge ina particular area of insurance and who alsoplaces the needs of his or her clients first

Claim Settlement

The objectives of claims settlement

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The objectives of claims settlementinclude:

Verification of a covered loss

Fair and prompt payment of claims

Personal assistance to the insured

Some laws prohibit unfair claims practices,such as:

Refusing to pay claims without conducting areasonable investigation

Not attempting to provide prompt, fair, andequitable settlements

Offering lower settlements to compelinsureds to institute lawsuits to recover

amounts due

Claim Settlement

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The claim process begins with a notice of loss

Next, the claim is investigated

A claims adjustor determines if a covered loss has

occurred and the amount of the loss The adjustor may require a proof of loss

before the claim is paid

The adjustor decides if the claim should be

paid or denied Policy provisions address how disputes may be

resolved

Reinsurance

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Reinsurance

is an arrangement by which the primaryinsurer that initially writes the insurancetransfers to another insurer part or all of thepotential losses associated with such

insurance The primary insurer is the ceding company

The insurer that accepts the insurance from theceding company is the reinsurer

The retention limitis the amount of insurance

retained by the ceding company

The amount of insurance ceded to the reinsurer isknown as a cession

Reinsurance

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Reinsurance is used to: Increase underwriting capacity

Stabilize profits

Reduce the unearned premium reserve

The unearned premium reserve represents theunearned portion of gross premiums on alloutstanding policies at the time of valuation

Provide protection against a catastrophicloss

Retire from business or from a line ofinsurance or territory

Obtain underwriting advice on a line forwhich the insurer has little experience

Types of Reinsurance Agreements

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There are two principal forms of reinsurance: Facultative reinsuranceis an optional, case-by-case method that is used when the cedingcompany receives an application for insurance thatexceeds its retention limit

Facultative reinsurance is often used when the primaryinsurer has an application for a large amount ofinsurance

Treaty reinsurance means the primary insurerhas agreed to cede insurance to the reinsurer, andthe reinsurer has agreed to accept the business

All business that falls within the scope of the agreementis automatically reinsured according to the terms of thetreaty

Methods for Sharing Losses

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There are two basic methods for sharing losses: Under the Pro rata method, where the ceding company

and reinsurer agree to share losses and premiums basedon some proportion

Under the Excess method, where the reinsurer pays onlywhen covered losses exceed a certain level

Under a quota-share treaty, the ceding insurer and thereinsurer agree to share premiums and losses based onsome proportion

Under a surplus-share treaty, the reinsurer agrees toaccept insurance in excess of the ceding insurers

retention limit, up to some maximum amount An excess-of-loss treaty is designed for catastrophic

protection

A reinsurance pool is an organization of insurers thatunderwrites insurance on a joint basis

Types of Reinsurance

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1.Facultative reinsurance

2.Treaty reinsurance

undertre ty reinsur nce, if the business falls within thescope of the agreement, the primary company must cede

insurance to the reinsurer and the reinsurer must accept.


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B.Types of automatic treaties

(1)Quota share

(2) Surplus share

(One Line)(Lines)

20


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(3)Excess of loss

(4)Excess of loss ratio

=

=

Reinsurance Alternatives

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Some insurers use the capital markets asan alternative to traditional reinsurance

Securitization of risk

means that an insurable risk is

transferred to the capital marketsthrough the creation of a financialinstrument, such as a futures contract

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Investments

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Because premiums are paid in advance, they

can be invested until needed to pay claims andexpenses

Investment income is extremely important inreducing the cost of insurance to policyowners

and offsetting unfavorable underwritingexperience

Life insurance contracts are long-term; thus,safety of principal is a primary consideration

In contrast to life insurance, propertyinsurance contracts are short-term in nature,and claim payments can vary widelydepending on catastrophic losses, inflation,medical costs, etc

Exhibit 25.1 Growth of Life Insurers Assets

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Exhibit 25.2 Asset Distribution of LifeInsurers 2007

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Exhibit 25.3 Investments, Property/CasualtyInsurers, 2007 Investments by Type

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Other Insurance Company Functions

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The electronic data processing areamaintains information on premiums, claims,loss ratios, investments, and underwritingresults

The accounting department preparesfinancial statements and develops budgets

In the legal department, attorneys are usedin advanced underwriting and estateplanning

Property and liability insurers providenumerous loss control services

Chapter 26

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FinancialOperations ofPrivate Insurers

Agenda

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Property and Casualty Insurers Life Insurance Companies

Ratemaking in Property and CasualtyInsurance

Ratemaking in Life Insurance The Financial Crisis and Insurers

Financial Statements of Property andCasualty Insurers

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Balance Sheet: a summary of what acompany owns (assets) and what it owes(liabilities)

Total Assets = Total Liabilities + Owners Equity

Exhibit 26.1 ABC Insurance Company

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The primary assets for an insurancecompany are financial assets

Insurers liabilities include requiredreserves

A loss reserve is an estimated amount for: Claims reported and adjusted, but not yet paid

Claims reported and filed, but not yet adjusted

Claims incurred but not yet reported to thecompany


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Case reserves are loss reserves that areestablished for each individual claim

Methods for determining case reservesinclude:

The judgment method: a claim reserve isestablished for each individual claim

The average value method: an average value isassigned to each claim

The tabular method: loss reserves are

determined for certain claims for which theamounts paid depend on data derived frommortality, morbidity, and remarriage tables


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The loss ratio method establishesaggregate loss reserves for a specificcoverage line

A formula based on the expected loss ratio

is used to estimate the loss reserve The incurred-but-not-reported (IBNR)

reserve is a reserve that must beestablished for claims that have already

occurred but that have not yet beenreported


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The unearned premium reserve is a liabilityitem that represents the unearned portion ofgross premiums on all outstanding policies atthe time of valuation

Its purpose is to pay for losses that occur during thepolicy period

It is also needed so that refunds can be paid topolicyholders that cancel their coverage

It also serves as the basis for determining the

amount that must be paid to a reinsurer for carryingreinsured polices

The annual pro rata method is one method ofcalculating the reserve


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Policyholders surplus is the differencebetween an insurance companys assets andliabilities

The stronger a companys surplus position, the

greater is the security for its policyholders


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The income and expense statementsummarizes revenues and expenses paid overa specified period of time

The two principal sources of revenue are

premiums and investment income Earned premiums are those premiums for which the

service for which the premiums were paid (insuranceprotection) has been rendered

Expenses include the cost of adjusting claims,paying the insured losses that occurred,commissions to agents, premium taxes, andgeneral insurance expenses

Exhibit 26.2 ABC Insurance Company

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Measuring the Performance of Propertyand Casualty Insurers

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The loss ratio is the ratio of incurred losses and lossadjustment expenses to premiums earned

The expense ratio is equal to the companysunderwriting expenses divided by written premiums

The combined ratio is the sum of the loss ratio andthe expense ratio. A positive ratio indicates anunderwriting loss

EarnedPremiums

ExpensesAdjustmentLossLossesIncurredRatioLoss

WrittenPremiums

ExpensesngUnderwritiRatioExpense

Measuring the Performance of Propertyand Casualty Insurers

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The investment income ratio compares netinvestment income to earned premiums

The overall operating ratio is equal to the combinedratio minus the investment income ratio

This ratio measures the companys total performance(underwriting and investments)

PremiumsEarned

IncomeInvestmentNetRatioIncomeInvestment

Financial Statements ofLife Insurers

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The balance sheet The assets of a life insurer have a longer

duration, on average, than those of propertyand casualty insurers

Because many life insurance policies have asavings element, life insurers keep an interest-bearing asset called contract loans or policyloans

A life insurance company may have separateaccounts for assets backing interest-sensitiveproducts, such as variable annuities


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Policy reserves are a liability item on the balancesheet that must be offset by assets equal to thatamount

State laws specify the minimum basis for calculating policyreserves

The reserve for amounts held on deposit is aliability representing funds that are owed topolicyholders and to beneficiaries

The asset valuation reserve is a statutoryaccounting account designed to absorb asset valuefluctuations not caused by changing interest rates


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Policyholders surplus is less volatile in the lifeinsurance industry than in the property andcasualty insurance industry

Benefit payments, including death benefits

paid to beneficiaries and annuity benefits paidto annuitants, are the life insurers majorexpense

A life insurers net gain from operations equals

total revenues less total expenses,policyowner dividends, and federal incometaxes

Measuring the Performance of LifeInsurers

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A number of measures can be used togauge the performance of life insurers

Pre-tax or after-tax net income vs. totalassets

Rate of return on policyowners surplus


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State Laws Require: Rates should be adequate for paying all losses

and expenses

Rates should not be excessive, such that

policyholders are paying more than the actualvalue of their protection

Rates must not be unfairly discriminatory;exposures that are similar with respect to losses

and expenses should not be charged significantlydifferent rates


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Business Rate-Making Objectives include: Rates should be easy to understand.

Rates should be stable over short periods oftime

Rates should be responsive to changing lossexposures and changing economic conditions

Rates should encourage loss prevention


A rate is the price per unit of insurance

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A rate is the price per unit of insurance.

An exposure unit is the unit of measurementused in insurance pricing, e.g., a car-year

The pure premium is the portion of the rateneeded to pay losses and loss adjustment

expenses Loading is the amount that must be added to

the pure premium for other expenses, profit,and a margin for contingencies

The gross rate consists of the pure premiumand a loading element

The gross premium paid by the insured consistsof the gross rate multiplied by the number of

ex osure units


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There are three basic rate makingmethods in property and casualtyinsurance:

1. Judgment rating means that each

exposure is individually evaluated, andthe rate is determined largely by thejudgment of the underwriter

2. Class rating means that exposures with

similar characteristics are placed in thesame underwriting class, and each ischarged the same rate


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Class rates are determined using twobasic methods:

Under the pure premium method, the purepremium can be determined by dividing thedollar amount of incurred losses and loss-

adjustment expenses by the number ofexposure units

Under the loss ratio method, the actual lossratio is compared with the expected loss ratio,and the rate is adjusted accordingly


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3. Merit rating

is a rating plan bywhich class rates are adjusted upward ordownward based on individual lossexperience

Under a schedule rating plan, each exposure isindividually rated

A basis rate is determined for each exposure, whichis then modified by debits or credits depending onthe physical characteristics of the exposure

Commonly used in commercial property insurance


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Under experience rating

, the class ormanual rate is adjusted upward or downwardbased on past loss experience

The insurers past loss experience is used todetermine the premium for the next policy period

Under a retrospective rating

plan, theinsureds loss experience during the current policyperiod determines the actual premium paid for thatperiod

A provisional premium is paid at the beginning of the

policy period; the final premium is calculated at theend of the policy period

Commonly used in workers compensation insurance

Ratemaking in Life Insurance

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Life insurance actuaries use a mortality tableor individual

company experience to determine theprobability of death at each attained age

The annual expected value of death claimsequals the probability of death times theamount the insurer must pay if death occurs

The Financial Crisis and Insurers

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The recent financial crisis has affectedfinancial institutions in different ways

Banks were more negatively impacted as theyissued the sub prime mortgage loans

Insurers were not heavily involved in sub prime

lending Insurers did not securitize the bad mortgage loans

and mortgage debt was not a significant share ofinsurers investment portfolios

Insurers were most affected by the sharp decline

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