FIN 3305 Exam 2 Flashcards
1
Q
Describe Risk Transfer by Insurance
A
- Risk transfer by insurance is a financial intermediation device in which individuals or entities (insureds) transfer a risk of loss to another party (the insurer) in exchange for a payment less than the expected loss (premium)
- And the insurer combines or pools the risks together
2
Q
What value does insurance provide? (6 values)
A
- Less need for individuals/firms to fully pre-fund losses (reserve) (without insurance, we would need to save large amounts for eventual losses)
- Because reserves are lower, more capital is available for investment
- Reduced cost of capital due to increased capital flows
- Having insurance lowers an insured’s credit risk
- Insurers incentivize loss control (via premium discounts, warranties, etc.)
- Creates stability in society by preserving wealth and preventing bankruptcy
3
Q
Define Risk Pooling (loss sharing)
A
- Sharing of losses by large number of those exposed to a risk
- Insurer acts as intermediary in assembling a pool of risks
- Money collected from all is used to cover financial losses of the few who suffer loss
- Effect is reduction of risk of loss for individual members in the risk pool
4
Q
Risk reduction through pooling: The independent losses case
A
- Weighted average “(probability)(dollar amount)” to determine the “Expected Loss”
- Calculate variance
- Standard Deviation = square root of variance
5
Q
Describe what happens to expected loss and standard deviation whenever risk is pooled.
A
- Expected loss remains the same ($500); Pooling does not change the expected payout
- Standard deviation went down (from 1000 to 707); Pooling makes outcomes per person more predictable for the insurer (Don’t know which insureds will suffer loss, but the overall loss in predictable)
6
Q
What happens if the numbers of people in the pool increases infinitely?
A
Standard Deviation would approach 0
- Low of large numbers
- The greater the number of exposures, the more closely will actual results approach probable results expected from an infinite number of exposures
- As a sample of observations increases in size, the relative variation around the mean decreases
- The probability distribution of losses per person would approach the normal distribution
- While there is substantial variability in losses at the individual loss exposure level, once the risks are pooled together, the risk to the insurer, as shown by this reduced variability, is reduced
- Pooling and law of large numbers allows more accurate prediction of, and pricing for, losses due to risks
7
Q
What are the parameters for the law of large numbers to be effective?
A
- Loss exposures must have approximately the same probability of loss
- Loss exposures must be independent
8
Q
Describe the first parameter of the law of large numbers (Same probability of loss)
Who in an insurance firm carries out this process?
A
- Risk Classification (underwriting) - Insurers sort risk exposures into classes based on probability of loss
- Common Classes - Age, gender, health status, location, building use
- Classification depends on information: application, government records, wearables
9
Q
What is the goal of risk classification?
A
The goal of risk classification is to avoid adverse selection
10
Q
What is adverse selection?
A
- Tendency of persons or entities with higher-than-expected losses to seek insurance at the price charged to those with average losses
- Problem is insureds often have superior knowledge about risk exposure than the insured
11
Q
What are some ways adverse selection is avoided?
A
- Exclusions for coverage of intentional actions
- Suicide
- Criminal behavior - Comprehensive information gathering
- application questions
- other sources: credit, driving, medical records - Avoiding or adjusting for inadvertent incentives
- more lenient underwriting standards for certain
conditions than competition
12
Q
Independent Loss Exposures: What is the issue with positive correlation?
A
- The magnitude of risk reduction due to pooling is lower when losses are positively correlated
Are losses positively correlated?
- common root cause (illness, natural disaster)
- Common factors (inflation)
There is zero risk reduction if losses are perfectly positively correlated
13
Q
What effect does diversification have on independent loss exposures?
A
Diversification helps reduce correlation and increase independence of losses
- Diversification means selecting risks that are unlikely to share many of the same characteristics. Factors like geography, profession, and business activities are examples of distinctive characteristics
- There is some tension between the concept of selecting risks with the same probability of loss and diversification. The relevant factors may change depending upon the characteristics most significant to the potential loss.
14
Q
Characteristics of the Ideal Insurable Risk
A
- The number of similar exposure units is large, and each is independent of any other (law of large numbers)
- The losses that occur are accidental or by chance (fortuitous losses)
- A catastrophic loss cannot occur (terrorism, pandemic)
- Losses are definite in time and measurable in loss size (pain and suffering damages, punitive damages in liability insurance)
- Severity of losses should be high compared to frequency (tendency to retain low severity losses eg. broken windows)
- The cost of coverage is economically feasible to provide and buy
15
Q
What are the four key insurance principles?
A
- Indemnity
- Insurable interest
- Subrogation
- Utmost good faith
16
Q
Indemnity Contract
A
The principle of indemnity means that the insurer agrees to pay no more or no less than the actual loss of the insured
17
Q
What concepts support indemnity?
A
Insurable interest, subrogation, actual cash value provision, “other insurance” provision
18
Q
Describe “Actual Cash Value”
A
- Typical property insurance allows the insured to recover “the actual cash value, not to exceed the replacement value”
- Actual cash value is equal to replacement cost minus physical depreciation, including obsolescence (ex. damage to a 10 year old roof would have a cash value equal to the replacement value of the roof minus 10 years of value due to normal wear and tear)
- Actual cash value can also incorporate “fair market value” (Cars)
- Many policies offer replacement cost for a higher premium
19
Q
Describe “Other insurance provision”
A
A provision in the insurance contract describing how coverage will be prorated or applied if there is other coverage available for the loss
20
Q
Insurable Interst
A
A financial interest in the life or property of insured
Property
- owner, lessor, creditor
Life
- your life, life of an immediate family member, creditor,
employer, business relationship
21
Q
Time of Insurable Interest
A
Property: At the time of loss
Life: At the inception of the policy
22
Q
Amount of Insurable Interest
A
Property: Up to the amount of the insured’s financial interest
Life: A valued policy - the value is agreed upon ahead of time by the parties since difficult to determine
23
Q
Subrogation
A
The insurer has the right to assume any claim the insured has against a third party to recover a loss
(insurer “steps into the shoes” of the insured for purposes of recovering any loss from a third party)
24
Q
Utmost Good Faith (uberriame fidei)
A
Both parties to an insurance contract are expected to act with the utmost good faith
- Most other contracts require only “good faith”
- Arose from the inequality of available information to the
insurance parties
Originally, statements of insured seeking coverage were treated as warranties - if not strictly true, the coverage could be voided
- present standard is that statements of the insured are
representations
- misrepresentation or concealment of a material fact can
cause the. contract to be voidable by the insurer
(smoking status, location of vehicles)
- certain warranties in property insurance are still
enforceable (existence of burglar alarms, sprinklers)
25
Requirements of a Contract
An insurance policy is a specific type of contract. For a contract to be legally enforceable, it must meet the following minimum requirements
1. There must be an offer and an acceptance
2. There must be consideration
3. The parties to the contract must be competent
4. Its purpose must be legal
26
Who makes the offer in the typical insurance transaction?
Application as an offer to purchase insurance
- Raises problem of time to underwrite from application information
- Significant terms such as the price and exact coverages are often unknown
Results in issuance of policy as a counteroffer or new offer to insured
27
What is the acceptance?
Often a temporary insurance agreement is made subject to revision from a final policy
- Binder in property and casualty insurance (agents often have binding authority)
- Conditional receipt or temporary insurance in life insurance
Acceptance of the final policy agreement is by payment of the premium
28
Define Consideration for both the insured and the insurer
Insured's consideration is the payment of the initial premium; Subsequent premiums are conditions to the continuance of coverage
Insurer's consideration is the agreement to insure
29
Competent Parties
What are conditions that might cause a party not to be competent to enter into a contract?
- Mental state (dementia, mental disability), intoxication, age (contracts entered into by minors are voidable)
*For insurers, failure to have an insurance license might make the contract issued voidable by the insured*
30
Legal Purpose
- Contract must be for performance of an activity not prohibited by law
- Insurance is a legal purpose
31
How are insurance and gambling different?
- Insurance is designed to protect against the financial consequences of a risk that the insured already has (insurable interest)
- Gambling creates a new risk for the gambler on the outcome of some event
32
4 Characteristics of Insurance Contracts
1. Aleatory: The values exchanged may not be equal
- How many have never made an insurance claim?
- How many have had a large claim?
2. Conditional: insureds must perform certain acts to be indemnified
- report losses within a certain time, provide proof of loss
3. Unilateral: Only the insurer makes a legally enforceable promise
- If insured doesn't perform their duties, contract just gets
voided
4. Contracts of Adhesion: Any ambiguity in contract language will be decided in favor of the insured
- insurers (and their lawyers) have the advantage in writing
the contract
33
Agents and Brokers
Agents
- Represent the insurer
- Typically arrange insurance for individuals and small businesses
- Have authority from the insurer to bind coverage (exception: life insurance)
Brokers
- Represent the insured
- Typically arrange insurance for medium/large businesses
- Do not have authority to bind coverage
34
What are the 5 major elements of the insurance contract?
1. Declarations
2. Insuring Agreement
3. Exclusions
4. Conditions
5. Endorsements and Riders
35
Limits of Liability
The maximum amount payable for a specific loss
36
Limits of Liability on Property Insurance
May be modified by actual cash value, replacement cost, or amount of insurable interest due to principles of indemnity
37
Limits of Liability on Health Insurance
Affordable care act has eliminated most medical expense limitations
38
Limits of Liability on Life Insurance
Valued policy - amount is agreed to by the parties
39
Limits of Liability on Liability Insurance
May be a dollar limitations on amount of liability paid but cost of defense is in addition to limit
40
Retained Losses
Deductibles, coinsurance, copayments, elimination periods
These all affect the cost of the insurance. The more responsibility an insured accepts for the loss through these mechanisms lowers the premium
41
Insuring Agreement for Property Damage
We will pay for direct physical loss of or damage to covered property at the premises described in the Declarations caused by or resulting from any covered cause of loss
42
Insuring Agreement for General Liability Insurance
We will pay those sums that the insured becomes legally obligated to pay as damages because of "bodily injury" or "property damage" to which insurance applies
43
Insuring Agreement - 2 Types of Perils
1. Named-Perils Policy - Covers only losses caused by perils listed in the policy
2. Open-Perils Policy (all risk) - Covers losses caused by all perils except those excluded
44
Exclusions
In contrast to the insuring agreement, this is a list of things that are NOT covered
- Perils (e.g. war)
- Types of losses (indirect loss, intentional loss)
- Types of property (cash)
- Locations (certain countries)
**The Exclusions sections is NOT a comprehensive list of all things not covered; Even the insuring agreement may exclude coverage by saying "We cover X, but do not cover Y"**
45
Why are some perils excluded?
Reason for Exclusion:
1. Uninsurable (does not meet requisites of insurable risk; war, earthquake, maintenance)
2. Should be covered under a different policy (maintain principle of indemnity; damage to insured's vehicle excluded under homeowner's policy)
3. Poses a risk that is not priced in the policy (premiums would be inaccurate; Personal auto policies exclude business activities (ex. rideshare)
46
Conditions
Provisions of a policy that describe the duties of the parties. Conditions must be fulfilled for the contract to continue in force; We will focus on conditions affecting the insured
47
What are some conditions in insurance contracts that affect the insured?
1. Notice and Proof of Loss
2. Protection of Property after a loss (make necessary repairs)
3. Examination (insurance company can examine scene)
4. Cooperation of the Insured (insured must cooperate)
48
Clauses Limiting Amounts Payable
Limits, deductibles, coinsurance, time limitations
49
Policy Limits
No insurance policies are unlimited - the contract specifies the maximum amount that will be paid
50
Policy Limits - Aggregate Dollar Limit
The most the policy will pay in total for a single occurrence
- Liability policies have separate per-occurrence and aggregate limits for the policy period (ex. $1M limit per occurrence, but a $3M limit per year for all occurrences
51
Policy Limits - Sublimits
Certain perils or property types may have smaller limits
- $200 sublimit for cash
- $2,000 sublimit for loss by theft of firearms
52
Deductibles
Specified dollar amounts to be borne by the insured before the insurer begins paying a claim
53
Straight Deductible
A deductible that applies per loss
54
Aggregate Deductible
A deductible that applies over all losses during a policy year, rather than a per-loss basis (common in health insurance)
55
Disappearing Deductible
A deductible that decreases as the size of the loss increases
56
Coinsurance in Property Insurance
- Insured must bear a portion of loss ONLY when underinsured (limits are less than the required amount of insurance)
- For commercial insurance, it is common to insure for less than the total property value, as total losses are rare
- The insurer specifies the amount of coverage required by setting coinsurance %, which is expressed as a % of property value
57
Time Limitations of Insurance
- Insurance contracts specify a period of time when coverage is in place
- Policies which provide a stream of payments (ex. disability insurance) often have a "waiting period" before benefits begin
- The policy will not pay until after the insured has been
disabled for 30 days
- This can be thought of as deductible which uses time.
rather than money
- Such policies also typically have a time limit after which
benefits are no longer paid
58
Rider
Usually used with life insurance policies to add an additional benefit
59
Endorsement
Endorsement usually used with property and casualty policies to change the terms of the policy
- May add a benefit or change limitations
- Also used with life insurance policies to amend something
in the application
60
Typical Business Insurance Coverages
1. Commercial Property Coverage
2. Consequential Property Coverage - Business income insurance
3. Commercial General Liability
4. Specialized Property Coverages (crime, cyber)
61
Building and Personal Property (BPP) Form
"Buildings"
Buildings - Those listed on the dec page, additions/extensions/fixtures, permanently attached machinery or equipment, and service equipment
62
Building and Personal Property (BPP) Form
"Business Personal Property"
Personal property owned by the insured and usual to the occupancy of the insured (excluded property includes motor vehicles)
63
Building and Personal Property (BPP) Form
"Personal Property of Others"
- Improvements and betterments made to a leased building
- Personal property of others in the insured's control (ex. held for repair)
64
Describe the difference between "specific" coverage and "blanket" coverage
Coverage may be "specific" (property is listed and specifically insured) or "blanket" (property at multiple locations is listed as a single item)
65
Three Options for Cause of Loss in Building and Personal Property Insurance
1. Basic Form - A named perils form with 11 named perils
2. Broad Form - A named perils form with 14 named perils
3. Special Form - An "all perils" form with exclusions
66
Property Insurance Coverages
- Basic Form covers only causes 1-11
- Water damage does not include floods
- "Collapse" is also covered whether due to the named perils, weight of people o personal property, weight of water, or defective materials
- Broad form would have higher premium than basic
- One advantage of special form is coverage for theft (but excludes employee theft or mysterious disappearance)
67
Property Not Covered - Important Items
- Currency, money, food stamps
- electronic data
- cost to restore information on records
68
Replacement Cost New (RCN)
Value of the lost or destroyed property if it were bought new or rebuilt on the day of the loss
- A policy written on an RCN definition should have higher policy dollar limits than an ACV policy
- A policy written on an RCN definition will be more expensive than an ACV policy
69
Limits of Insurance
- Business policies have maximum dollar limitations on various coverages
- The lower the maximum limits, the less expensive the policy
- Coinsurance provisions require insureds to maintain insurance with a dollar limit of at least a certain percentage (usually 80%) of the value of the property
70
Business Owner's Policy (BOP)
- Standalone policy, not part of CPP
- Designed for small to medium sized businesses
- Covers property, liability, and medical payments
- Can endorse coverage for earthquakes, spoilage, utility services, and computer
70
Insurance-to-Value Requirement
To get full replacement cost coverage, insurance limit must be at least 80% of replacement cost at time of loss
71
Difference in Conditions (DIC) Insurance
Adds all-risk coverage to basic cause of loss form in BPP
- Large deductible, no coinsurance
- Can be expanded to cover earthquake, flood, and other
perils
72
Optional Property Coverages
1. Commercial crime and fidelity
- Primarily intended for employee theft
- Also offers coverage for forgery, fraudulent transfers,
extortion
2. Inland Marine
- Covers property transported by rail or truck
3. Ocean Marine
- Covers property transported by water
4. Boiler and Machinery Coverage
- Covers damages from explosions or sudden breakdowns
of boiler and other machinery
73
Business Income Coverage (Business Interruption Coverage) (BIC)
- Previous coverages were for direct loss or damage to property. BIC is designed to cover consequential losses - losses incurred as a consequence of loss or damage to property
- Must be caused by "a direct physical loss or damage to property"
- Generally, replaces an amount of expected net income including replacing any net loss
74
Business Income Coverage - Coinsurance
- Policies incorporate a coinsurance clause requiring the business to insure a specified % of its profits + operating expenses
- Insured will only collect a pro-rata portion of losses if underinsured
- Coinsurance and limits should be based on maximum probable loss, expected length of interruption, seasonality of business
75
Extended Period-of-Indemnity Endorsement
Extends period of loss to include time to return to normal business operations (gives additional time to regain lost market share, etc)
76
Business Income - Insurance-to-value
Alternative to coinsurance; Insured buys a specific $ amount of coverage based on estimated income for a period of time with a monthly reimbursement limit
77
Commercial General Liability Insurance (CGL)
Three Types of Coverage
1. Bodily Injury and Property Damage - Covers liability to others for bodily injury and property damage due to the insured's activities
2. Personal and Advertising Injury Liability - Covers non-physical injuries (interesting exclusions: intentional or criminal acts, contractual liability, intellectual property infringement, insureds in media and internet-type businesses)
3. Medical Payments - Primarily intended as no-fault medical coverage for persons injured on the insured's premises
78
Commercial General Liability (CGL) Coverage Examples
Covers bodily injury or property damages resulting from conditions of the premises, business operations, products, completed operations, and some intentional torts.
- Customer slip-and-fall at the insured's store (premises coverage)
- Vendor exposed to caustic chemicals at insured's factory (premises)
- Insured (a plumber) starts a fire at customer's home when brazing pipes (business operations)
- Child injured by product manufactured by insured (product liability)
- Insured improperly installs their machinery and causes a fire at a customer's facility (completed operations coverage)
- Insured sued for libel by competitor because of advertising campaign (advertising liability- an intentional tort)
79
Insuring Clause
80
Supplementary Payment Provisions
- Covers expenses incurred by the insured including defense costs (defense costs may be covered within policy limits or in addition to policy limits)
- Sometimes courts require that defendant post a bond to guarantee he/she will not dispose of property subject to confiscation if the case is lost. Insurer agrees to pay the premium on those bonds
- Insurer has right to require the insured to appear in court and otherwise cooperate in defense of each case
81
Definition of "Insured"
- The firm itself
- All partners, officers, directors, and proprietors
- Employees while performing duties related to the business
- Other parties - such as partners in a joint venture - also may be named
82
Commercial General Liability Exclusions
16 standard exclusions, including:
- Intentional or expected injury
- Aircraft, auto, or watercraft (liability intended to be covered in other contracts)
- Product recall (lawsuit for damages is covered, cost of recall must be insured separately)
- Pollution
- Damage to property belonging to, or rented to, or in the care, custody, or control of the insured
83
Limits of Liability
Many policies have occurrence limits and aggregate annual limits
- $1M per occurrence, $3M aggregate
- Separate limits for (1) general liability, (2) products and completed operations liability, (3) personal and advertising liability, (4) medical payments, and (5) damage to premises rented to you
- Overall annual aggregate applies to all coverages except for (2), which has its own annual aggregate limit
84
Claims-made vs occurrence
Claims Made:
- Policy at the time that "claim" happens is the one that provides coverage
- "Retroactive date" sets earliest allowable date for occurrences (often set to be when insurance was first purchased)
- Potential for gap in coverage if occurrence happened before retroactive date
Occurrence:
- Policy at the time that "occurrence" happened is the one that provides coverage
- Good for insureds, but important to keep all policies forever
- Challenge for insurers, who may get a claim decades after writing the policy
85
Extended Reporting Period (for claims-made coverages)
Basic Extended Reporting Period
Allows reporting of an occurrence near the end of the policy period, then extends reporting period for claims related to the occurrence. Usually automatic if a claims-made policy is cancelled or non-renewed
- As long as an occurrence is reported to the insurer within 60 days of the policy expiration date, coverage is provided for associated claims that are made for the following 5 years
86
Extended Reporting Period (for claims-made coverages)
Supplemental Tail
Endorsement to expiring claims-made policy which provides "forever" coverage for events that occurred between the retro date and the expiration date (one time premium up to 200% of original policy premium)
87
When is the occurrence?
Exposure Doctrine
Loss occurs when someone is "exposed" to the product
88
When is the occurrence?
Manifestation Doctrine
Loss occurs only once the disease or injury is discovered
89
When is the occurrence?
Tripple Trigger
Loss occurs during exposure, while substance is "in residence" but not yet causing harm, OR when disease/injury manifests
Triple trigger is broadest coverage for the insured but can create problems if the insured self-insures or switches coverage over time
90
Commercial Umbrella Liability Policy
- Standard limit for CGL is $1M
- Umbrella coverage provides liability coverage for amounts above the CGL limit
- No medical payments coverage
91
Other Liability Coverages
1. Business Automobile Liability
2. Professional Liability
3. Employment Practices Liability
4. Cyber Risk
92
Errors and Omissions (E&O) Insurance
- General liability excludes errors made by a professional in performing their professional duties
- E&O insurance only covers professional liability, not general liability
- Medical malpractice, lawyers, architects, engineers, accountants, may seek this kind of insurance
93
Employment Practices Liability (EPL)
- Protects businesses against lawsuits alleging sexual harassment, wrongful termination, retaliation, and discrimination
- Covers the firm itself, directors, officers, managers, and employees
- Also provides defense and covers defense costs (within policy limits)
- Does not cover: intentional or dishonest acts, punitive damages or civil fines, downsizing/closing/reorganization, or class-action lawsuits
94
Losses Covered by Cyber Insurance
Security (data) breach, extortion threats, replacement or restoration of electronic data, and public relations expense
95
Significant Exclusions of Cyber Insurance
- Damages for pain and suffering, mental anguish
- Slowdown of computer system, disruption of internet service
- Patent violations
- Expense to upgrade or repair a computer system
- Any previously known claims
- Payment card industry fines
*Cost of defense is included in limitation of liability amount (unusual for liability policies which typically pay all cost of defense)
96
Insurance Company Classifications
Life and Health Insurers
- Licensed specifically to issue life, health, disability, accident, annuities, long-term care insurance
- If they market property and casualty insurance, it is through a p&c subsidiary
97
Insurance Company Classifications
Property and Casualty Insurers
- Licensed specifically to issue insurance coverages for property damage, loss of value, and liability
- If they offer life and health insurance, it is through a l&h subsidiary
98
Insurance Classifications
Personal Insurance
Insurance that is purchased by individuals and families for their risk needs. Such insurance includes life, health, disability, auto, homeowner, and long-term care
99
Insurance Classifications
Commercial Insurance
Generally refers to property and casualty insurance for businesses and other organizations
100
Insurance Classifications
Individual Insurance
Refers to the type of insurance a policy covering one person, one family, or one entity (can be personal or commercial)
101
Insurance Classifications
Group Insurance
Refers to the type of insurance contract issued to an entity on behalf of its employees or members
- It covers multiple insureds under one umbrella contract
- Used more frequently for life and health coverages but sometimes for property and casualty
- Often used for personal insurance needs of a group of people but also exists for groups of businesses for commercial insurance needs
102
Insurance Company Ownership
Stock Company
The insurer is owned by stockholders like a standard corporation and there is no relationship between policies issued and ownership
103
Insurance Company Ownership
Mutual Company
The insurer is owned by its policyholders with each policy granting insurance and ownership privileges
104
Steps for selecting a risk management technique
1. Avoid risks if possible
2. Implement appropriate loss control measures
3. Select the optimal mix of risk retention and risk transfer
105
Steps for selecting a risk management technique
1. Avoid Risks if Possible
Avoidance reduces risk to zero
Potential issues:
- some risks cannot be avoided (government-imposed risks,
natural disasters, risks required to conduct normal business)
- Opportunity cost
- Avoiding one risk may create/increase another
106
Steps for selecting a risk management technique
2. Implement appropriate loss control
- Loss control always used in conjunction with retention/transfer
- Loss control reduces frequency and/or severity, which affects the financing decision
- Important to properly analyze the expected effects of loss control
107
Steps for selecting a risk management technique
3. Select optimal mixture of retention/transfer
- Retention is optimal for low-severity risks (ok if frequency is high, that helps make better predictions)
- Transfer optimal for low-frequency, high-severity risks
- If frequency and severity are both high, use risk avoidance if possible (retention involves high bankruptcy risk and transfer is expensive); Loss control may help
108
Guidelines for Using Different Risk Management Techniques
109
Selecting Retention Amounts
***Buying Insurance with a deductible involves both retention and transfer***
- High deductibles = lower premiums
- Ideally, deductibles should be the largest amount a person/firm can afford
- Modeling future losses will help determine optimal deductible levels
110
Self Insurance - Calculated Risk Retention
- Need large number of exposure to take advantage of law of large numbers
- Take precautions to reduce likelihood of simultaneous destruction
- Good data is important for modeling
- Self-insurance plans should have quality management/administration
- Firm (and managers) must be financially prepared for large losses
111
Advantages of Self-Insurance
- Lower insurance expenses (no insurer profit margin, no premium tax)
- Cash flow benefits (hold assets until claims instead of paying premiums in advance
- Claims-conscious management
112
Disadvantages of Self-Insurance
- More feasible for larger firms
- Amounts reserved are not tax-deductible, unlike insurance premiums
- If amounts reserved earn less than a normal return on capital, then have opportunity cost
- Major claims must be borne by ER (possible to buy "excess" coverage)
- No services normally provided by insurer (loss control, program admin)
113
Excess Insurance
Coordinates with self-insurance to protect against catastrophic claims
114
Specific Excess Insurance
- Self-insured ER absorbs the first $X on any loss (similar to straight deductibles)
- Excess insurer only pays individual claims that exceed $X
115
Aggregate Excess Insurance
- Self-insurance ER states an "attachment point" of total claims where excess insurer begins to pay
- Operates like an aggregate deductible
116
Captive Insurance Company
- An insurance company that provides insurance coverages to its non-insurance company parent and affiliated companies
- It is a form of risk retention since the parent company retains financial responsibility for the company insuring the risk
- Used by over 90% of fortune 500 companies
117
Advantages of Captive Insurer
- Amounts to cover anticipated claims losses which the parent would otherwise establish as a non-deductible reserve are converted to deductible premium expenses
- Premium is cheaper because does not include profit margin and acquisition costs (marketing)
- Coverages can be precisely matched to needs. Don't have to accept the commercial insurer's standard coverage
- Can create coverage for any risk
- Can use captive coverage to negotiate less expensive commercial coverage by using captive coverage to cover higher deductibles or lower liability limits
- Allows access to reinsurance market
- Handling your own claims
- Can create better internal awareness of risk management
118
Disadvantages of Captive Insurer
- Set up time and resources
- Administration and management of claims can be costly
- Potential for catastrophic loss
- Only feasible for large companies with many exposures
- Difficult to get money back once paid to a captive
