2. Insurance Planning. 1. Principles of Insurance Flashcards
Module Introduction
Supreme Court Justice Black wrote regarding the 1943 South-Eastern Underwriters Association decision, “Perhaps no modern commercial enterprise directly affects so many persons in all walks of life as does the insurance business. Insurance touches the home, the family, and the occupation or business of almost every person in the United States.” The purchase of insurance is among the most important and essential transactions made by individuals and businesses.
The Principles of Insurance module will explain the financial and legal aspects of insurance and will present basic insurance terminology. The module also gives a brief description of risk management with an emphasis on risk response.
The online portion of this module takes the average student approximately two hours to complete.
Upon completion of this module you should be able to:
* State the financial and legal definitions of insurance
* Define “insured,” “insurer,” “premium” and “policy”
* Describe different types of losses
* Distinguish among a loss, a hazard, and a peril
* State the law of large numbers and what is meant by “adverse selection,” and
* Differentiate among the types of risk responses.
Module Overview
Throughout human history, unexpected economic losses have occurred. To prevent the occurrence of economic loss, it is important to understand the principles of insurance, various aspects of insurance, and the terminology associated with insurance. Underlying all insurance products is the mathematical foundation known as the law of large numbers, which explains how losses can be predicted. This module concludes by outlining the risk management process and describes the different types of risk responses.
When reviewing the insurance modules, remember that insurance is regulated at the state level, and that the information provided in these modules is not state specific. This information is intended to provide you with the tools needed to evaluate various policies and issues as they relate to specific-state rules and regulations.
To ensure that you have an understanding of the principles of insurance, the following lessons will be covered in this module:
* Insurance Fundamentals
* Insurance Terminology
* Risk Management
Section 1 – Insurance Fundamentals
Experts do not always agree on the definition of “risk management” and other insurance terms. Questions involving definitions of insurance terms have required thousands of court cases and can involve hundreds of millions of dollars. In fact, just defining the word “insurance” is an issue courts have dealt with for decades.
The definitions that are presented within this module are generally accepted and lay the foundation for material covered throughout the course. This module will present both financial and legal definitions of insurance. Additionally, common insurance terminologies such as “insured,” “insurer,” “premium,” and “insurance policy” will be defined.
To ensure that you have an understanding of insurance fundamentals, the following topic will be covered in this lesson:
* Definitions of Insurance
After completing this lesson, you should be able to:
* Describe financial and legal aspects of insurance
* Distinguish between various rights and duties of the insured and the insurer, and
* Recall the meaning of “exposure to loss.”
What is the Financial Definition of Insurance?
Insurance is a financial arrangement that redistributes the costs of unexpected losses.
Insurance involves the transfer of potential losses to a group of individuals exposed to the same risk through what is referred to as an insurance “pool.” Members contribute financial consideration to fund the pool based upon the combined predicted losses divided by the number of members. As covered losses occur, members receive funds from the pool to replace the economic loss sustained.
Certainty of financial payment from a pool with adequate resources and accurate predictability of losses are the hallmarks of the insurance transaction.
The following example of how insurance works is based on a community comprised of 180 homes, each worth $180,000. Without insurance, any individual homeowner may face a substantial loss. However, if they all agree to share equally in any losses, the risk to each is only $1,000 per loss.
What is the Legal Definition of Insurance?
Insurance is a contractual arrangement whereby one party agrees to compensate another party for losses, in exchange for consideration paid (i.e., the premium).
Insurance law is a branch of contract law. The insurance policy, like all contracts, is an arrangement creating rights and corresponding duties for the parties that are involved. In analyzing an insurance contract, you should remember that a right created for one party represents a duty (obligation) for the other party.
In an insurance contract, the party agreeing to pay for the losses is known as the __ ____??____ __.
* insurer
* insured
* premium
* beneficiary
insurer
* In an insurance contract, the party agreeing to pay for the losses is known as the insurer.
* The insured is the party whose loss causes the insurer to make a claims payment.
* The premium is the payment received by the insurer.
* The beneficiary is the recipient of the claim payment.
Define Exposure To Loss
The insured’s possibility of loss is called his exposure to loss. If the insured purchases an insurance policy, he transfers the exposure to loss to the insurer.
When meeting with a client, you can ask questions such as: “What risks do we face and what is our exposure?” Exposure refers to the units that are exposed to risk. In other words, the owner of four houses could be said to be exposed to four chances of loss by fire, theft, or windstorm damage, while a single homeowner has one exposure.
Define Self-Insurance
Self-Insurance means that a firm or other organization may decide to deal with its own risks. They decide to operate much like a commercial insurance company and will engage in the same types of activities as a commercial insurer. When these activities involve the operation of the law of large numbers and predictions regarding future losses, they are commonly referred to as self-insurance.
To self-insure a firm must set up a sound program with the following requirements.
* Law of large numbers: The firm should be big enough to combine sufficiently large numbers of exposure units so as to make a loss predicable.
* Financial Reliability: The firm should be able to accumulate funds to meet losses that may occur. Also, the firm needs to cover losses if they occur more frequently than predicted.
* Geographic distribution: Dispersion of risk in the event of a catastrophe.
Often the context in which the word “self-insurance” is used would be better described as risk retention. There are some important advantages and disadvantages of retaining risk through self-insurance.
Section 1 – Insurance Fundamentals Summary
Insurance is a financial arrangement for redistributing the costs of unexpected losses requiring a legal contract, called a “policy,” whereby an insurer agrees to compensate an insured for unexpected losses.
In this lesson, we have covered the following:
Definitions of Insurance:
* Financial: Insurance is a financial arrangement that redistributes the costs of unexpected losses.
* Legal: Insurance is a contractual arrangement whereby one party agrees to compensate another party for losses.
* Exposure to loss: The insured’s possibility of loss.
* Self-insurance: The firm or individual decides to deal with potential risks and losses using its own funds.
Which of the following is NOT considered an element of the financial definition of insurance?
* Certainty of financial payment from a pool.
* Proper redistribution of losses.
* Accurate predictability of losses.
* Rights and duties of the two parties.
Rights and duties of the two parties.
* Rights and duties of the two parties is not considered an element of the financial definition of insurance.
* Certainty of financial payment from a pool attracts more members to join a particular insurance pool while accurate predictability of losses helps the pool to redistribute losses properly among its members.
* Proper redistribution of losses is also a hallmark of insurance transactions.
An insurance system redistributes the costs of losses from the unfortunate few members experiencing them to all the members of the insurance system who pay premiums.
* False
* True
True
* An insurance system redistributes the costs of losses from the unfortunate few members experiencing them to all the members of the insurance system who pay premiums.
What is exposure to loss?
* Probability of loss.
* Possibility of loss.
* Cause of loss.
* Attitude of indifference to loss.
Possibility of loss.
* We consider the insured’s possibility of loss as his exposure to loss. The insured transfers the exposure to loss to the insurer by purchasing an insurance policy.
Section 2 – Insurance Terminology
Insurance can protect the home, the family, and the occupation or business of almost every person in the United States, because many different types of losses can occur, directly or indirectly. A peril, like a hurricane, is a cause of loss. A hazard, like poor building construction, is a condition that increases the probability of loss.
The uncertainty concerning a loss is called a risk. Insurance pools reduce risk by applying a mathematical principle called the law of large numbers. Some insureds take advantage of the concept of adverse selection. Adverse selection raises serious ethical and moral questions.
To ensure that you have an understanding of insurance terminology, the following topics will be covered in this lesson:
* Loss
* Chance of Loss
* Perils
* Hazards
* Proximate Cause
* Risks
* Law of Large Numbers
* Adverse Selection
After completing this lesson, you should be able to:
* Describe the various types of losses
* Differentiate between various types of perils and hazards
* Identify different kinds of risks
* State the law of large numbers, and
* Verify whether a particular insured’s action involves adverse selection.
Define Loss
The word “loss,” as it is commonly used, means being without something previously possessed such as “loss of memory” and “loss of time.”
When the word is used in insurance, however, it takes on a more limited meaning. It is called insurable loss.
AUDIO EXAM TIP:
Define Peril
A peril is defined as the cause of the loss. For example, fires, tornadoes, heart attacks, and criminal acts constitute perils.
Insurance policies provide financial protection against losses caused by perils. Insurers call policies that specifically identify a list of covered perils specified-perils contracts.
The alternative format is to cover all losses except those specifically excluded. Insurers call this type of policy an open-perils contract.
Exam Tip: CFP Board often tests the concepts of loss and peril by presenting scenarios in which a specific loss occurrs. Remember that the cause of the loss is the peril.
Audio:
* Peril - highly testable
* Peril is an actual cause of loss
* Could be fire, windstorm, flood, lightning, theft, smoke
* Insure against losses caused by those perils
* One type of home insurance is written on a specifiied perils basis. Only perils covered are specifically listed in the contract.
* Versus open perils contracts - all perils are covered, unless it’s specifically excluded. Better for the client. Will cover more things. More expensive.
Define Insurable Loss, Direct, and Indirect Losses
A typical insurable loss is an undesired, unplanned reduction of economic value arising from chance. We call losses not resulting from chance depreciation expenses. Therefore, depreciation cannot be insured against, as such loss is guaranteed to occur, rather than being left to chance.
Insurable losses are categorized as direct or indirect losses.
Direct losses are the immediate, or first, result of an insured peril.
* Example: If a fire destroys a home, the loss of the home is the direct loss.
Indirect losses, also called consequential losses (such as loss of use), are a secondary result of an insured peril.
* Example: If a tornado destroys a restaurant, the property damage is the direct loss. The loss of income during the period when the business is being reestablished is the indirect loss.
There must be a direct loss before an indirect loss. Property insurance policies are specific when providing coverage for direct or indirect losses, or for both.
Define Chance of Loss, A Priori chance of loss and Ex-Post chance of loss
The chance of loss is the probability of loss.
The concept of chance of loss refers to a fraction. The numerator is either the actual or the expected number of losses. The denominator represents the number exposed to loss. The chance of loss in a given case may or may not be known accurately before a loss occurs.
If we are referring to the predicted chance of loss, we divide the expected number of losses by the number of exposed units. This fraction is called a priori chance of loss.
If we are looking back in time, we can divide the actual number of losses by the total number of exposures. This fraction is called the actual or ex-post chance of loss.
If each house in an insurance pool represents one exposure to loss, and we expect three houses out of 1,000 houses in an insurance pool to be destroyed by fire, what would be the expected chance of loss?
* 0.3
* 0.03
* 0.003
* 0.0003
0.003
* If we expect three houses out of 1,000 houses in an insurance pool to be destroyed by fire, the expected chance of loss is 3/1000 or 0.003.
Define Hazards
Hazards are conditions that increase the probability of loss from a peril, by increasing either the frequency or the severity of potential losses.
* For example, every home faces the peril of destruction by fire. Storing oily rags near the home’s furnace would be an example of a hazard.
The hazard increases the chances of the peril occurring. If an insured materially increases a hazard, the insurer may suspend the insurance coverage.
Hazards can be separated into four categories:
1. Physical Hazards: Involve physical characteristics such as type of construction, location, occupancy of building, having frayed wires on plugs, steep stairs with no railing, or smoking in bed.
2. Moral Hazards: Involve dishonest tendency such as exaggerating losses in a theft claim or auto insurance fraud (e.g., two cars intentionally bump each other with many passengers claiming injury).
3. Morale Hazards: Involve an increase in losses due to knowledge of insurance coverage such as having a different attitude toward a loss because the loss will be covered by an insurance company (e.g., leaving a car unlocked, ordering unnecessary medical tests, or a jury’s tendency to grant larger amounts of money in situations where an insurer will have to pay).
4. Legal Hazards: Involve increased frequency and severity of losses such as legislative action (e.g., ADA requirements or mandated insurance coverages).
Exam Tip: It is important to distinguish between a peril and a hazard. As we’ve mentioned, the peril is the occurrance for which we insure. There are circumstances that are often controllable by an insured, that increase the likelihood of loss but are not the specific cause of the loss. These circumstances are called hazards.
If a property owner burns down a building to collect the insurance claim, the fire causes the damage and is considered the peril, while the owner’s behavior is considered a __ ____??____ __.
* morale hazard
* moral hazard
* risk
* claim
moral hazard
* If someone burns down a building to collect the insurance, their actions are considered a moral hazard.
Define Speculative Risks
Speculative risk refers to those exposures to price change that may result in gain or loss.
Most investments, including stock market investments, are classified as speculative risks. Other speculative risks result from the potential gains or losses associated with interest rate changes, price movements of foreign currencies, and price movements of agricultural and other commodities. With speculative risk, the risk is man-made and did not exist naturally. The individual’s goal is not merely to avoid loss, but rather to create risk in the hopes of actually gaining. Since insurance deals with pure risk that exists only when a chance of loss/no loss is possible, man-made speculative risks such as the stock market and gambling are not suitable for coverage.
Pure Risk + Speculative Risk = Risk
Practitioner Advice: Often clients say they don’t believe in buying insurance because they feel it is a “gamble.” This is odd, considering insurers do not take on speculative risk. When people say they won’t buy disability insurance because they have to become disabled in order to “win,” they miss the point of insurance. The risk of disability already exists whether you purchase insurance or not. You either can become disabled or not; there is no gain potential in becoming healthier because you have a policy. On the other hand, when you bet $100 in hopes of winning $1,000 if your favorite football team wins the Super Bowl, your chance of loss or gain did not exist prior to your bet. You created this risk.
Define Adverse Selection
When one party to a transaction has more relevant information or more control of outcomes than another party to the transaction, the party with superior information or control can take advantage of the situation. Insurance scholars call this possession of asymmetric information adverse selection.
Adverse selection is also defined as the actions of individuals acting for themselves or others, who are motivated directly or indirectly to take financial advantage of a risk classification system. For example, adverse selection occurs when people who know their health is deteriorating try to purchase health insurance to cover the cost of a needed operation. Another example would involve a person trying to purchase fire insurance immediately after an arsonist threatened his property.
The reason the term is called adverse selection is because the insurer is trying to select suitable people for coverage from an applicant pool that really doesn’t represent a fair cross-section of the population. This is because those at risk tend to apply in greater proportion to those who are at lower risk. Thus, there is a tendency to select for coverage a higher percentage of adverse candidates.
**Practitioner Advice: Though many new life and health insurance agents get very excited when they receive an unsolicited request to purchase an insurance policy, most seasoned agents remain cautious. Experience shows that such inquiries usually come with a higher risk of adverse selection. It is important to ask these individuals appropriate questions to properly assess their situations. More times than not, an agent will discover that the potential client was compelled into action due to a known change to his or her health.
**
Exam Tip: Adverse selection represents a real risk to an insurance company. Beyond knowing the definition of adverse selection, work towards recognizing a scenario where adverse selection could be present for an insurer.
Section 2 – Insurance Terminology Summary
In this lesson, we have covered the following:
* Two types of losses: Insurable losses and depreciation expenses. Insurable losses can be classified into direct losses and indirect losses. There must be a direct loss before an indirect loss.
* Chance of loss: The possibility of loss. It is the possibility or the chance of loss that creates the need for insurance.
* A peril: The cause of a loss. Hazards are conditions that increase either the frequency or the severity of losses. Two special types of hazards are moral and morale hazards.
- The law of large numbers: Allows only accurate predictions of group results, not of individual events. The law says the greater the number of observations of an event based on chance, the more likely the actual result will approximate the expected result.
- Adverse selection: Taking advantage of the possession of asymmetric information. Adverse selection raises serious ethical and moral questions, but it is an ever-present fact in the insurance market.
- Proximate cause of a loss: The first peril in a chain of events resulting in a loss.
- Risk: The uncertainty concerning a possible loss.
An insurable loss is:
* An event that has not been predicted.
* An exposure that cannot be easily measured before the event has occurred.
* An unexpected reduction of economic value.
* Being without something one has previously possessed.
An unexpected reduction of economic value.
* The word loss, as it is commonly used, means ‘being without something previously possessed.’ But its meaning, when used in the context of insurance, becomes limited.
* A typical insurable loss is an undesired, unplanned reduction of economic value arising from chance.
* For example, loss or damage to property or life due to fires, tornadoes, heart attacks, and criminal acts.
The definition of peril is:
* An event or condition that increases the chance of loss.
* The uncertainty concerning loss.
* A measure of the accuracy with which a loss can be predicted.
* The actual cause of the loss.
The actual cause of the loss.
* A peril is the actual cause of the loss. For example, fire, tornadoes, heart attack, and criminal acts.
* The event or condition that increases the chance of loss is a hazard.
