Lesson 1 of Insurance: Principles of Insurance

Question 1

Insurance!

Answer 1

• Insurance is used as a protection against financial loss.
• Insurance is only used to protect against “Pure Risks.”
  • Planners need to address risk exposure in the client plan.
  • Pure risks simply create either a financial loss or no loss.
  • For example: house fires, auto accidents, and personal illness.
• Insurance involves the transfer of loss and the sharing of losses with others.
• Identify and transfer risk where possible.
  • Home, liability, auto, life, disability, health, business, pet ownership

Question 2

Types of Risk!

Answer 2

• Pure
• Speculative
• Subjective
• Objective

Question 3

Pure Risk

Answer 3

• With Pure Risk, there is a chance of loss or no loss.
• For example:
  • Death
  • Auto accidents
  • House fire

Question 4

Speculative Risk

Answer 4

• With speculative risk, there is a chance of profit, loss, or no loss.
  • Speculative Risk is generally undertaken by entrepreneurs.
  • Speculative risk is generally voluntary risk and not insurable.

Question 5

Subjective Risk

Answer 5

• Subjective risk differs based upon an individual’s perception of risk.
• FOR EXAMPLE:
  • Tom movies to Dunwoody, Georgia. His neighbors told him that the police department has a reputation for writing speeding tickets. As a result, Tom buys a radar detector because he perceives there to be a significant risk of getting a speeding ticket.

Question 6

Objective Risk

Answer 6

• Objective Risk does not depend on an individual’s perception but is measurable and quantifiable.
• Objective Risk measures the variation of an actual loss from expected loss.
• FOR EXAMPLE:
  • Statistics published for the number of speeding tickets written per driver living in a city would confirm or disprove the subjective risk perceived by Tom in the previous example.

Question 7

Understanding Risk!

Answer 7

• Probability of Loss
• Severity
• Law of Large Numbers

Question 8

Probability of Loss

Answer 8

• The probability of a loss incurring is the “chance” of a loss incurring.
• It is the measure of the long-run frequency with which an event occurs.
• The probability of a loss is a useful measure for the insurer because it quantifies the expected cost of claims.
• A higher probability of loss may result in a decline of coverage.

Question 9

Severity

Answer 9

• Severity is the actual dollar amount of the loss.
• Severity is more important than the probability of a loss.
• EXAMPLE:
  • Building a house on the beach increases the probability of a loss occurring due to a hurricane. If the house of built on the beach and it cost $750,000 for the land and $250,000 to build the house, the maximum severity of a loss due to a hurricane would be $250,000 or the cost to build the house.

Question 10

Law of Large Numbers

Answer 10

• The Law of Large Numbers specifies that when more units are exposed to a similar loss the PREDICTABILITY of such a loss to the entire pool increases.
• The more exposures, the more likely that the result will equal true results and thus will be predictive of future results.
• The Law of Large Numbers helps to reduce objective risk.

Question 11

Causes of Insured Loss

Answer 11

Perils

Hazard:

• Moral
• Morale
• Physical

Adverse Selection

Question 12

Perils

Answer 12

Perils are the actual cause of a loss.

FOR EXAMPLE:

• Fire
• Wind
• Tornado
• Earthquake
• Burglary
• Collision

Question 13

Hazard

Answer 13

A hazard is a condition that increases the likelihood of a loss occurring.

There are three types of hazards:

• Moral
• Morale
• Physical

Question 14

Moral Hazard

Answer 14

• A moral hazard is a character flaw.
• A character flaw would lead to filing a false claim.
• FOR EXAMPLE:
  • A famous running back for Ohio State claimed his car was broken into and $10,000 worth of CDs were stolen. There certainly wasn’t $10,000 worth of CDs in his car and thus is an example of false claim.

Question 15

Morale Hazard

Answer 15

Morale Hazard is the indifference created because a person is insured.

FOR EXAMPLE:

• Beth goes to the convenience store to get milk for her baby. Beth leaves her keys in the car and leaves the car running while goes into the store, not concerned that her car may get stolen because she has car insurance.

E in the end for IndifferencE and moralE.

Question 16

Physical Hazard

Answer 16

A physical hazard is a tangible condition that increases the probability of a peril occurring.

FOR EXAMPLE:

• Icy or wet roads
• Poor lighting
• Defective Equipment

EXAMPLE:

• Leaving a banana peel on the porch.

Question 17

Adverse Selection

Answer 17

Adverse selection

• is the tendency of a person with higher-than-average risks to purchase or renew insurance policies.

Premiums are dependent upon a balance between favorable and unfavorable risks in the pool.

Adverse Selection is managed through

• underwriting,
• denying insurance on the front end, and
• raising premiums on the back end.

Someone who would probably need insurance, like overweight disabled.

Question 18

EXAM QUESTION:

The underwriter of an insurance company is charged with the responsibility of achieving a profit within the risk parameter of the company. Which of the following is the underwriter’s greatest challenge?

A) Setting Premiums
B) Managing Adverse Selection
C) Making sure the profit margins are correct
D) Motivating salespeople

Answer 18

Answer: B

Managing adverse elections may be accomplished before the contract is issued by using credit scores, physicals, claims history, etc, or on the back end of the property, automobile health, and dental insurance by raising premiums.

Question 19

Insurable Losses!

Answer 19

Requisites for an Insurable Risk

Question 20

Requisites for an Insurable Risk

Answer 20

• A large number of similar (homogenous) exposure units. (Law of Large Numbers)
• Losses must be accidental from the insured’s viewpoint.
• Losses must be measurable and determinable so that the insurer can accurately forecast actual losses.
  • FOR EXAMPLE:
    
    • It’s easy to determine the value of a house or auto, but it’s difficult to determine the amount of cash in a wallet; therefore, coverage is limited.
• Losses must NOT pose a catastrophic risk for the insurer. (Insurance Company)
• An insurer cannot provide coverage that would cause it to become financially insolvent.
• Premiums must be affordable
• Cannot insure moral hazards because premiums would skyrocket.

Question 21

Exam Tip for Insurable Risks

Answer 21

Are CHAD

• Not catastrophic
• Homogenous exposure units,
• Accidental
• Measurable and Determimable.

Question 22

Exam Question

Which of the following is not a requisite for an insurable risk from an insurer’s perspective?

A) Law of Large Numbers
B) Losses must be accidental, measurable, and determinable
C) Losses must not pose a catastrophic risk for the insured.
D) The premiums must be affordable

Answer 22

Answer: C

Losses must not pose a catastrophic risk for the insurer. The insured wants to transfer catastrophic risks.

Question 23

Legal principles of all Contracts!

Answer 23

Elements of a Valid Contract

Question 24

Elements of a Valid Contract

Answer 24

One party must make an offer and the other party must accept the offer.

• The signing of an insurance application and paying the first premium can be considered an offer and acceptance.
• This would be considered a conditional receipt as long as the insured qualifies for the policy.
• Once the policy is actually delivered and the first premium is paid, the contract is fully in force.

There must be legal competency of all parties involved in a contract.

• Both parties must be 18 or older. Otherwise, the contract is voidable by the minor.

There must be legal considerations.

• Consideration is whatever is being exchanged.
• It can be money, services, or property.
• A promise to pay (insurer) and actual payment of a premium (insured).

The contract must pertain to a lawful purpose.

• Insurance contracts that promote actions that are illegal are invalid.

Question 25

EXAM TIP to Remember Elements of a Valid Contract

Answer 25

A legal contract requires COALL!

• Competent parties
• Offer and Acceptance
• Legal Consideration
• Lawful Purpose

Question 26

Legal Principles of Insurance Contract!

Answer 26

• The Principle of Indemnity
• Subrogation Clause
• The Principle of Insurable Interest
• Void versus Voidable

Question 27

The Principle of Indemnity

Answer 27

• An insured is only entitled to compensation to the extent of the insured’s financial loss.
• An insured cannot make a profit from an insurance contract.

Question 28

Subrogation Clause

Answer 28

• The insured cannot receive compensation from both the insurer and a third-party claim.
• If the insured collects compensation from their insurance company, they lose the right to collect compensation from the third party.
  • The insurer “steps into the shoes” of the insured to recoup any restitution from the 3rd party or the 3rd party’s insurer.

Question 29

The Principle of Insurable Interest

Answer 29

• An insured must have an emotional or financial hardship from damage, loss, or destruction.
• Property and Liability Insurance
  • the insured must have an insurable interest at the time of policy INCEPTION and at the TIME OF LOSS
• Life Insurance
  • the insured only needs an insurable interest at the time of policy INCEPTION
  • Rule of Thumb: Insurable interest if Blood, Marriage or Business
• Life insurance policies are considered long-term investments.

Question 30

EXAMPLE of Life Insurance policy

Answer 30

Sally was married to Harry for 20 years. Sally was a stay-at-home mom for most of the marriage. Sally and Harry recently divorced. Although Sally may no longer have an insurable interest in Harry, if Sally had to surrender her life Insurance policy on Harry, it could cause financial hardship. She may not have any savings or personal retirement savings.

Sally would have Life Insurance, Insurale Interest because it is only for Time of Policy Inception. .

Question 31

Void Contract

Answer 31

• A void contract was never valid and thus never came into existence.
• It is not an enforceable contract since it lacks one of the four elements of COALL.
• FOR EXAMPLE:
  • A contract to sell heroin in the United States is a void contract since it is established for an unlawful purpose.

Question 32

Voidable Contract

Answer 32

A voidable contract

• is a valid contract that allows cancelation by one of the first parties however the other party is bound by agreement.

FOR EXAMPLE:

• If a minor enters into an agreement to purchase a car the contract is valid but voidable by the minor (not a competent party).
• The car dealership, however, bound by the contract.

Question 33

EXAM QUESTION

Mike is injured in an auto accident caused by Tim. Mike collects bodily injury payments from his insurance company and sues Tim to recover as well. Tim’s insurance company also pays Mike for the same injuries. Which of the following has been violated?

A) Subjective Risk
B) Adverse Selection
C) Adhesion
D) Subrogation

Answer 33

Answer: D

The subrogation clause in an insurance contract prevents from Mike collecting both his insurance company and a third party party in the same claim.

Question 34

The Principles of Good Faith!

Answer 34

• Warranty
• Representation
• Concealment

Question 35

Warranty

Answer 35

• A warranty is a promise made by the insured to the insurer.
• A breach of warranty is grounds for avoidance.
• EXAMPLE:
  • A college football player who is drafted in the first round typically agrees not to participate in activities that could result in physical injury, such as riding a motorcycle. Kellen Winslow, a first-round draft pick a few years ago agreed to such terms, but shortly into his contract, he was involved in a motorcycle accident. The injuries were so severe that he was unable to play for an entire year. Because he violated a warranty in his contract, the team was entitled to recoup a portion of his $6 million signing bonus.

Question 36

Representation

Answer 36

Representations are statements made by the

• insured to the insurer during the application process.

There must be a MATERIAL “misrepresentation” to

• avoid an insurance contract.

Misrepresenting age on a life insurance application is

• not material misrepresentation and the insurer will simply adjust your death benefit up or down based on your actual age.

Question 37

Concealment

Answer 37

• When the insured is silent about a fact that is material to the risk.

Question 38

EXAM QUESTION

Dave is 42 years old and applying for a life insurance policy, In order to receive a lower premium, Dave indicates that he is 34 on the insurance application. Which of the following is the insurance company to do when they determine Dave’s right age?

A) Avoid the contract
B) Void the contract
C) Pay Dave’s beneficiary a lesser face value that is based on the premiums paid and Dave’s correct age.
D) Refund the premiums and deny any claim by Dave’s beneficiary.

Answer 38

Answer: C

Misstating age is a misrepresentation but not a material misrepresentation and the insurance company will still pay the beneficiary. The amount will just be reduced based on the actual premiums paid by the insured and the insured’s correct age.

Question 39

Distinguishing Characteristics of Insurance Contracts!

Answer 39

• Adhesion
• Aleatory
• Unilateral
• Conditional

Question 40

Adhesion

Answer 40

• An insurance policy is basically “take it or leave it.” There are no negotiations over terms and conditions.
• As a result, any ambiguities in an insurance contract are found in favor of the insured.

Question 41

Aleatory

Answer 41

• The money exchanged may be unequal.
• In other words, there’s a small premium, but the insured may receive a large benefit.

Question 42

Unilateral

Answer 42

• Only one promise is made by the insurer which is to pay in the event of a loss.
• The insured is not obligated to pay premiums.
• If the premiums are not paid, there there’s just no promise by the insurer.

Question 43

Conditional

Answer 43

• The insured must abide by the terms and conditions of the insurance contract. If the terms and conditions are not followed, the insurer may not pay a claim.

EXAMPLE:

• After a heavy rainstorm, Eric notices a small leak in his ceiling. Eric places a small plastic cup underneath the leak and decides that he will call his roofer upon returning from a three-week vacation that he starts tomorrow. Upon his return, the small leak turned into a large leak to the point where his ceiling in the living room and attached garage collapsed on his car, ruined his entertainment center and electronic equipment causing $30,000 in damage. The insurance adjuster determines that Eric did not take appropriate steps to minimize the loss when he first discovered the leak and denies Eric’s insurance claim. Eric has violated a condition of the contract.

Question 44

EXAM QUESTION

Randy’s house slid down a hill in California after a heavy storm and is a total loss. The relevant part of the insurance contract states “Earthquake is a general exclusion.” Which party is likely to win in court and why?

A) The insurance company because of the stated exclusion.
B) Randy because the contract is adhesive.
C) The insurance company because homeowner’s policies does not cover mudslides.
D) Randy because of the aletory principal.

Answer 44

Answer: B

Randy will win because ambiguities are decided in favor of the insured under principal of adhesion.

Question 45

Contract Rights and Provisions!

Answer 45

• Waiver
• Estoppel
• Waiver Provisions (applies to insurance)

Question 46

Waiver

Answer 46

• Occurs when a party relinquishes a known right.
• Give up the right

Question 47

Estoppel

Answer 47

• This takes place when a party is denied an assertion of a right to which they are otherwise entitled.

EXAMPLE:

• Consider an insured who causes a car accident. The insured agent says ‘Your auto insurance premiums won’t increase because of one accident.”. The insurer could be “estopped” from raising premiums at the next opportunity because of the informal agreement between the insured and insurance agent.

Question 48

Waiver provisions (applies to insurance)

Answer 48

• An insurer may seek to avoid liability associated with a loss due to their agents offering policy changes not authorized by the company.

Question 49

Contracts: Dispute Remedy!

Answer 49

• Parol evidence rule
• Reformation
• Rescission

Question 50

Parol Evidence Rule

Answer 50

• Once the contract is placed in written form, all previous and prior understandings may NOT contradict the written contract.
• Essentially the parol evidence stipulates that the contract reflects the complete understanding of both parties.

Question 51

Reformation

Answer 51

• Contractual remedy in which the contract is revised to express the original intent of all parties.

Question 52

Rescission

Answer 52

• Deems a contract void from inception.
• Inception - is like the starting point.

Question 53

Agent!

Answer 53

• An agent is a legal representative of the insurer.
• An agent enters into agreements on behalf of the insurer.
• Three types of Agents:
  • General
  • Independent
  • Broker

Question 54

General Agent

Answer 54

• A general agent represents one insurer,
• such as a State Farm or Allstate insurance agent.

Question 55

Independent Agent

Answer 55

• An independent agent represents multiple, unrelated insurers.

Question 56

Broker

Answer 56

• A broker usually represents the policy owner, not the insurance company.

Question 57

Types of Authority!

Answer 57

An agent’s authority to legally bind the insurer arises from three types of authority.

• Express Authority
• Implied Authority
• Apparent Authority

Question 58

Express Authority

Answer 58

• Given through an agency or written agreement.
• Insurer is responsible for acts of an agent based on express authority.

Question 59

Implied Authority

Answer 59

The authority that the public perceives, and a valid agency agreement exists.

• This stems directly from the Expressed Authority granted by an agreement, and it’s what the client sees when the authority is granted. (Cannot exist without Express Authority).

Example:

• The actual delivering of an insurance contract and accepting a premium is an example of implied authority.
• Insurer is still responsible even if a client is misled.

Question 60

Apparent Authority

Answer 60

Apparent Authority is when the

• insured believes the agent has the authority to act on behalf of the insurer when in fact, no authority actually exists.
• This stems directly from when there is NO Expressed Authority granted. Even though the client sees the collateral, this is only apparent authority, as the representative should not have the marketing pieces. (Cannot exist if there is EXPRESS AUTHORITY)
• The apparent authority could be inferred based on business cards or a sign on the wall, but the agency agreements actually expired.
• If an agent represents that insured can pay the premium late but is wrong, then the insurer is still responsible.

Question 61

Example of Authority

Answer 61

• Jason walks into Tom’s insurance company office looking for auto insurance. Tom has a business card, stationery and a sign on the front door reading, “Mega Insurance Company?” Jason believes Tom has the authority to write an insurance policy based upon “Implied Authority” from the business cards, stationery, and office door sign.
• Tom pulls out his agency agreement with Mega Insurance Company which gives Tom “Express Authority” to write policies on behalf of Mega Insurance Company. Jason decides to pay Tom $1,000 for a new auto policy.
• Unfortunately, Tom’s agency agreement was terminated the prior day. Because of “Apparent Authority,” Mega Insurance Company will have to honor Jason’s auto policy, even though Tom was not authorized to write the auto policy.

Question 62

Exam Question

Scott is 22 and just started his first job with Rest in Peace Life Insurance Company. Scott is scheduled to take the state insurance exam at 9:00 a.m. on Saturday. The exam is computerized and if passed, automatically issues the State License. Scott has an important appointment with his Uncle Carlos at 1:00 p.m. on Saturday to sell Carlos $10M of universal variable life insurance. On Friday, just before 5:00 p.m. Scot’s boss gives him a wrapped gift and tells him not to open it until after he passes the exam, which she is confident he will do. Scott goes ahead and opens the present on Friday night and calls his friends to celebrate getting his “Rest in Peace” business cards. Scott goes out with his friends Friday night, gets drunk, and misses the Saturday exam. However, he goes to Carlos’ house, takes his application, and gets a check from Carlos for the first year premium. Unfortunately, Carlos is hit by lightening while playing golf Saturday afternoon and dies. Which of the following is correct?

A) Carlos’ beneficiary will collect $10M because of explicit authority and that the check was given to the agent.

B) The policy is not issued because Scott is not licensed to sell life insurance.

C) Carlos’ beneficiary will not receive anything because the check, while issued, was given to an unlicensed agent.

D) Presuming Carlos meets normal underwriting standards, his beneficiary will collect $10M under apparent authority.

Answer 62

Answer: D

Even though not licensed, Scott can still bind “Rest In peace” because he should not have applications and business cards.

Question 63

Important Features of Insurance Contracts!

Answer 63

• Conditions
• Declarations
• Exclusions
• Riders and Endorsements

Question 64

Conditions

Answer 64

Details the duties and rights of the

• insured and
• insurer

Question 65

Declarations

Answer 65

Includes:

• The name of the insured
• description of the property
• amount of coverage
• amount of premium
• term of the policy
• Inception/termination dates

Question 66

Exclusions

Answer 66

Section outlines specifically cover what will not be covered

• Exclusions may exclude perils such as war, earth movement, and flood
• Exclusions can also exclude the cost of a private hospital room when a semi-private will do.
• Exclusions may exclude specific items such as cash, collectibles, or business property.
• This helps keep premiums down.

Question 67

Riders and Endorsements

Answer 67

Riders and endorsements are written additions to an insurance contract.

• They make it possible to customize an insurance contract for items that may be limited in coverage under the normal terms and conditions of a contract.
• Riders and endorsements take precedence over conflicting terms in policy.
• Ensure it states if a rider was elected, and what is attributable to that rider (dollars and benefits)
• Take Precedence to terms and conditions.

Question 68

Regulating the Insurance Industry!

Answer 68

• Regulation is done at the State level, NOT at the Federal^ level.
• IRS, SEC, and ERISA have oversight (when applicable)
• Subheaders:
  • Legislative Branch
  • Judicial Branch
  • Executive or State Insurance Commissioner
  • Goals of State Insurance Regulation

^ IRS, SEC and ERISA have oversight (when applicable)

Question 69

Legislative Branch

Answer 69

• Provides for licensing of agents
• enacts laws and requirements for doing business in a particular state.

Question 70

Judicial Branch

Answer 70

• The judicial branch rules on the constitutionality of laws passed by the legislative branch.
• They also render decisions and interpretations regarding policy terms.

Question 71

Executive or State Insurance Commissioner

Answer 71

• Administers, interprets, and enforces insurance laws.
• Is a member of NAIC
• The State Insurance Commissioner does NOT make law!

Dictate how insurance is transacted within their state.

Question 72

Goals of State Insurance Regulation

Answer 72

• Protect the insured
• Maintain and promote competition
• Maintain solvency of insurers

Question 73

Valuation of Insured Losses!

Answer 73

• Replacement Cost
• Actual Cash Value (ACV)
• Agreed Upon Value

Question 74

Replacement Cost

Answer 74

• Replacement cost is the current cost of replacing property with new materials of like kind.

For Purposes of Exam - This is a GOOD THING

On exam scenario based: Get Endorsement for REPLACEMENT COST.

Question 75

Actual Cash Value (ACV)

Answer 75

• ACV is essentially replacement cost, less depreciation.
• ACV can impose serious financial burden on the insured.
• Almost all auto policies are ACV.

For Purposes of Exam - this is NOT GOOD

Question 76

Agreed Upon Value

Answer 76

• A value that is determined jointly by the insured and insurer.
• Typically used for art and antiques.

Question 77

Example of Actual Cash Value (ACV)

Kevin buys a plasma television for $8,000. Three years later it’s stolen and it’s 50% depreciated. The same plasma television is now selling for $6,000, how much does Kevin receive from his insurance company?

Answer 77

Replacement Cost = $6,000
Less: Depreciation (6,000*.50) = <3,000>
Cash to Insured = $3,000

$8,000 is not important to this question at all.

Question 78

Exam Question of Actual Cash Value

Brandon purchased a home theater system for $10,000 two years ago. The replacement cost is $8,000. The home theater system was destroyed in a fire. Brandon’s insurance company estimates that the home theater system was 40% depreciated. How much will Brandon receive if the home theater system is covered under actual cash value?

A) $2,000
B) $2,700
C) $3,200
D) $4,800

Answer 78

Answer: D

$8,000 - (.40 X $8,000) = 8,000 - 3,200 = $4,800
If Brando owed a $500 deductible, he would actually receive

4,800 - 500 = $4,300

Question 79

Important Features of Insurance Contracts!

Answer 79

• Deductibles
• Copayments
• Coinsurance

Question 80

Deductibles

Answer 80

• A stated amount the insured must pay before the insurer will make payments.
• Deductibles will help eliminate small claims and reduce premiums.
• They are used mainly for property, health, and auto policies.
• Deductibles are a form of RETAINING risk.

Question 81

Copayments

Answer 81

• Copayments are in addition to deductibles and are common with health insurance.
• Insured pays a portion of the losses incurred.
• Typically a health insurance policy will contain a $500 deductible and an 80/20 copayment clause.
  • Insured is responsible for 20% of expenses above deductibles.

Question 82

Coinsurance

Answer 82

• homeowners policy requires the insured to cover at least a stated percentage of the property value.
• If coverage meets or exceeds the coinsurance requirement (usually 80%), then the insurer pays less of the
  
  • face value of the policy,
  • replacement cost, or
  • actual expenditures.
• If coverage is less than the coinsurance requirement, the insurer pays
  
  • the greater of the actual cash value or the following formula

Coinsurance Requirement is 80% unless they say differently.

Question 83

Coinsurance Formula

Answer 83

• (Face Value ÷ Coinsurance) x Loss - Deductible
• Coinsurance = 80% x Replacement Cost

Face Value is the Amount of Coverage Purchased

Question 84

Coinsurance Example

Raj owns a house with a replacement value of $300,000 and is 50% depreciated. He purchased $200,000 of homeowners insurance with a coinsurance requirement of 80% and a $500 deductible. Raj experiences a $100,000 loss. What will the insurance company pay?

In this question, if they gave you value of land you would subtract the replacement cost or $300,000 by the value of land.

Answer 84

The Coverage is less than 80%. (200,000/300,000) = 66.6%

Greater of:

ACV
= (100,000 x 0.5)
= $$50,000

OR

[ $200,000 ÷ (0.8 x $300,000)] x $100,000 - $500

= 200,000 ÷ 240,000 x 100,000 - 500 = $82,833

They will pay $82,833.

Question 85

Individual Loss Exposures and Insurance Coverages!

Answer 85

Perils that can Reduce/Eliminate the Ability to Earn

• Dying too soon
• Living too long
• Disability

Perils that Can Destroy/Deplete Existing Assets

• Damage to property
• Legal liability for injuries inflicted upon others

Company Selection

• Industry Ratings

Question 86

Dying too soon

Answer 86

• Not able to meet financial obligations for your family such as education, debt repayment, or retirement.
• Life insurance can mitigate against the risk of dying too soon.

Question 87

Living too long

Answer 87

• Superannuation is outliving the funds saved for retirement
• Annuities can mitigate the risk of superannuation.

Question 88

Disability

Answer 88

• An unexpected illness or accident resulting in the inability to work.
• Disability insurance can mitigate this risk.

Question 89

Damage to property

Answer 89

• Natural disasters, accidents, and crime can damage property
• Both direct (loss of house due to fire) and indirect loss (hotel expenses while the house is being repaired) can be the result of damaged property.
• Homeowners, renters insurance, and a personal auto policy can mitigate these risks.

Question 90

Legal liability for injuries inflicted upon others

Answer 90

• Liability judgments and legal defense can be costly.
• Personal savings and other assets can be seized to satisfy judgments. Wages can be garnished if no assets are available to satisfy a judgment.
• A personal liability insurance policy mitigates these risks.

Question 91

Company Selection

Answer 91

Industry Ratings:

• the financial strength of insurers is vitally important to understand prior to obtaining coverage from them.
• Several companies publish reports on insurers covering a range of areas such as management, use of reinsurance, licenses, the nature of the operations, and an overall quality rating.
• It is important to review the reports issued by multiple rating agencies before placing business with that career.

Question 92

Rating Agencies!

Answer 92

Used to Help Planner Evaluate Insurance Companies.

• A.M. Best’s
• Moody’s
• Standard and Poor’s

Question 93

A.M. Best’s

Answer 93

• Highest rating: A++ to A/A-
• Lowest Rating: C/C- to D

Question 94

Moody’s

Answer 94

• Highest rating: Aaa to Aa1/Aa2
• Lowest Rating: B1/B2/B3 to Caa

Question 95

Standard and Poor’s

Answer 95

• Highest rating: AAA to BBB
• Lowest Rating: BB and Lower CC

Question 96

National Association of Insurance Commissioners (NAIC)!

Answer 96

• Provides a watch list of insurance companies based upon financial ratio analysis.
• Ratios measure the financial health of insurance companies.
• NAIC has NO regulatory power over the insurance industry, but is involved in accrediting state insurance regulatory offices.
• NAIC issues “model legislation” that state legislatures may or may not adapt.

EXAM TIP:

• Be sure to know the NAIC has no regulatory power over the insurance industry.
• Regulation occurs at the state level.

Question 97

Steps in Risk Management

Answer 97

1. Determine the objectives of the risk management program.
2. Identify the risks to which the client is exposed.
3. Evaluate the identified risks as to the probability of occurrence and potential loss.
4. Determine alternatives for managing risks, and select the most appropriate for each.
5. Implement the program
6. Evaluate, monitor, and review (control).

EXAM TIP:

• D-I-E-D-I-E: Don’t insure everything (squared)

Question 98

Risk Management Guidelines!

Answer 98

• Avoidance for the most serious type of risks.
• Risk transfer is using insurance where the financial risk is severe and frequency is low.
• Retention or reduction is appropriate where the financial risk is low and frequency is high because it would be too expensive to insure.

EXAMPLES:

• Dings in your car, minor injuries/illnesses, and deductibles.

Question 99

Avoidance

Answer 99

Most serious type of risk.

• Severity: High
• Frequency: High

Example:

• Likelyhood of dying by dropping off of a plane is extremely high. So don’t do that.

Question 100

Risk Transfer (Insurance)

Answer 100

Financial loss could be severe but doesn’t happen often.

• Severity: High
• Frequency: Low

Example:

• Tree landing on your head

Question 101

Retention/Reduction

Answer 101

Minimal financial loss, too expensive to insure

• Severity: Low
• Frequency: High

Examples:

Risk Reduction: Wearing a Helmet

Retention: Deductibles

Question 102

Retention

Answer 102

Minor injuries, illnesses, car door dings
Healthcare policy deductible

• Severity: Low
• Frequency: Low

Question 103

Practice Question

Joe’s daughter is 16 years old and he recrntly bought her a 1970 VW Bug for $1,000. Which of the following risk management strategies should Joe use to manage the risk property loss due to a collision?

a) Risk Avoidance
b) Risk Reduction
c) Risk Transfer
d) Risk Retention

Answer 103

Answer: D

“Risk of Property Loss”

Law states you need liability loss not property loss.

$1,000 is the car not worth to get the transfer.

Question 104

Exam Tip

Answer 104

• Contextual variables within each question may change the order of importance.
• How to provide adequate protection while keeping premiums at a reasonable rate.

One key point to keep in mind:

• is the amount of emergency fund the client has available to self-insure, including covering deductibles.

Premiums at a REASONABLE RATE: The deudctible needs to be less than or equal to the deductible.

Question 105

Risk Management Guidelines Exam Question

Which of the following methods of dealing with risk does NOT match its action?

A) Risk Avoidance: Wearing a hard hat on a construction site.
B) Risk Reduction: Installing a sprinkler system in a building
C) Risk Transfer: Carrying automobile insurance
D) Risk Retention: Health insurance policy deductibles

Answer 105

A - Risk avoidance

Avoidance would mean not going anywhere near a construction site.

Question 106

General Insurance Underwriting!

Answer 106

Insurance companies issue one of four underwriting policy ratings for insureds:

• Preferred
• Standard
• Rated
• Decline

Factors effecting premiums

Question 107

Preferred

Answer 107

• This rating provides the lowest policy premiums.
• Insureds receiving this rating exceed the requirements for a standard rating.
• For life insurance, disability, and long-term care, these individuals have above-average ratings in underwriting factors.
• See factors affecting premiums.

Question 108

Standard

Answer 108

• This rating reflects an average risk for the insurance company.

Question 109

Rated

Answer 109

• There is a scale for rated policies.
• The scale represents health issues (for non-property and casualty policies),
  
  • the insurance company will accept a greater amount in premium in return for providing the insurance.

Question 110

Decline

Answer 110

• Insurance companies will not accept the risk of issuing a policy.

Question 111

Factors affecting premiums

Answer 111

• Health
• Family health history
• Risk factors (high-risk activities such as sky diving, scuba diving, etc)
• Credit rating
• Driving record