Lesson 1 - Principles of Insurance

Question 1

Pure Risk

Answer 1

• With pure risk, there is a chance of loss or no loss. • For example: Death, auto accident, and house fire

Question 2

Subjective Risk

Answer 2

• Subjective risk differs based upon an individual’s perception of risk.
• For example: Tom recently moved 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 3

Speculative Risk

Answer 3

• 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 4

Objective Risk

Answer 4

• 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 drivers living in a city would confirm or disprove the subjective risk perceived by Tom in the previous example.

Question 5

Which of the following is an insurable risk?

a) Objective Risk.
b) Pure Risk.
c) Subjective Risk.
d) Speculative Risk.

Answer 5

Answer: B

Pure risk involves the risk of loss or no loss and is the only insurable risk.

Question 6

Exam Tip

Answer 6

Insurable Risks are CHAD - not Catastrophic, Homogeneous exposure units, Accidental, and measurable and Determinable

Question 7

Exam Tip

Answer 7

A legal contract requires COALL! -> Competent parties, Offer and Acceptance, Legal consideration, and Lawful purpose

Question 8

The Principle of Indemnity

Answer 8

• 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 9

Subrogation Clause

Answer 9

• The insured cannot receive compensation from both the insurer and a third party for the same claim.
• If the insured collects compensation from their insurance company, they loses 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 10

The Principle of Insurable Interest

Answer 10

• An insured must have an emotional or financial hardship resulting from damage, loss, or destruction. • Property and Liability Insurance – the insured must have insurable interest at time of policy inception and at time of loss.
• Life Insurance – the insured only needs an insurable interest at the time of policy inception.
• Life insurance policies are considered long-term investments

Question 11

Void

Answer 11

• 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 12

Voidable

Answer 12

• A voidable contract is a valid contract that allows cancelation by one of the parties however the other party is bound by the agreement.
- For example, if a minor enters into a contract to purchase a car the contract is valid but voidable by the minor (not a competent party). The car dealership, however, is bound by the contract.

Question 13

warranty

Answer 13

• A warranty is a promise made by the insured to the insurer.
• A breach of warranty is grounds for avoidance.

Question 14

representation

Answer 14

• Representations are statements made by the insured to the insurer during the application process. • They must be a material “misrepresentation” to void 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 15

concealment

Answer 15

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

Question 16

adhesion

Answer 16

• 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 or the insured.

Question 17

aleatory

Answer 17

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

Question 18

unilateral

Answer 18

• 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 the premiums. if the premiums are not paid, then there’s no promise by the insurer.

Question 19

conditional

Answer 19

• 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.

Question 20

CONTRACT RIGHTS AND PROVISIONS

Answer 20

• Waiver - Occurs when a party relinquishes a known right.
• Estoppel - Takes place when a party is denied assertion of a right to which they are otherwise entitled. Consider an insured who causes a car accident. The insured’s insurance 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.
• Waiver provisions (applies to insurance) - An insurer may seek to avoid liability associated with a loss due to their agents offering policy changes not authorized by the company.

Question 21

CONTRACTS: DISPUTE REMEDY

Answer 21

• Parol Evidence Rule - Once the contract is placed in written form all previous and prior understandings may not contradict the written contract. Essentially the parol evidence rule stipulates that the contract reflects the complete understanding of both parties.
• Reformation - Contractual remedy in which the contract is revised to express the original intent of all parties. • Rescission - Deems a contract void from inception.

Question 22

LAW OF AGENCY

Answer 22

Agent
• An agent is a legal representative of the insurer.
• An agent enters into agreements on behalf of the insurer.
General Agent - A general agent represents one insurer, such as a State Farm or Allstate insurance agent.
Independent Agent - An independent agent represents multiple, unrelated insurers.
Broker - A broker actually represents the policy owner, not the insurance company.

Question 23

Express Authority

Answer 23

• Given through an agency or written agreement.

- Insurer is responsible for acts of an agent based on express authority.

Question 24

Implied Authority

Answer 24

• Authority that the public perceives, and a valid agency agreement exists.
• 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 25

Apparent Authority

Answer 25

• Apparent authority is when the insured believes that agent has authority to act on behalf of the insurer when in fact, no authority actually exists.
• Apparent authority could be inferred based on business cards or a sign on the wall, but the agency agreement actually expired.
• If an agent represents that insured can pay premium late, but is wrong, then the insurer is still responsibility.

Question 26

conditions

Answer 26

• Details the duties and rights of the insured and insurer.

Question 27

declarations

Answer 27

• Includes name of the insured, description of the property, amount of coverage, amount of premium, term of the policy, and inception/termination dates.

Question 28

exclusions

Answer 28

• This section outlines specifically 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.

Question 29

riders and endorsements

Answer 29

• 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.

Question 30

SIX STEPS OF RISK MANAGEMENT

Answer 30

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 probability of occurrence and potential loss. 4. Determine alternatives for managing risks, and select the most appropriate alternative 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 31

NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS (NAIC)

Answer 31

• 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 adopt.

Exam Tip
Be sure to know that the NAIC has no regulatory power over the insurance industry. Regulation occurs at the state leveL

Question 32

Legislative Branch

Answer 32

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

Question 33

Judicial Branch

Answer 33

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

Question 34

Executive or State Insurance Commissioner

Answer 34

• Administers, interprets, and enforces insurance laws. • The State Insurance Commissioner does NOT make law!

Question 35

Goals of State Insurance Regulation

Answer 35

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

Question 36

replacement cost

Answer 36

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

Question 37

actual cash value

Answer 37

• ACV is essentially replacement cost, less depreciation.
• ACV can impose serious financial burden on the insured.
• Almost all auto policies are 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?
Replacement Cost $6,000
Less: Depreciation <3,000>
Cash to Insured $3,000

Question 38

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 esti-mates 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 38

Answer: D $8,000 - (.40 x $8,000) = 8,000 - 3,200 = $4,800 If Brandon owed a $500 deductible, he would actually receive $4,800 - $500, or $4,300.

Question 39

Agreed-Upon Value

Answer 39

• Agreed-upon value is a value that is determined jointly by insured and insurer. • Agreed-upon value is typically used for art and antiques.

Question 40

Deductibles

Answer 40

• A stated amount the insured must pay before the insurer will make payments.
• Deductibles 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 41

Copayments

Answer 41

• 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 deductible.

Question 42

Coinsurance

Answer 42

• A 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 the lesser of: face value of policy, replacement cost, or actual expenditures.
• If coverage is less than the coinsurance requirement, then insurer pays the greater of actual cash value or the following formula:
(Face Value / Coinsurance) x Loss - Deductible Coinsurance = 80% x Replacement Cost

Question 43

Raj owns a house with a replacement value of $300,000 . He purchased $200,000 of homeowners insurance with a coinsurance requirement of 80% and a $500 deductible. Raj experiences a $40,000 loss. What will the insurance company pay?

Answer 43

Coinsurance Formula: [$200,000 / (0.80 x $300,000)] x $40,000
200,000 / 240,000 x 40,000 - 500 = $32,833

Question 44

Perils that Can Reduce/Eliminate the Ability to Earn

Answer 44

Dying Too Soon - 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.

Living Too Long - Superannuation is outliving the funds saved for retirement. - Annuities can mitigate the risk of superannuation.

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

Question 45

Perils that Can Destroy/Deplete Existing Assets

Answer 45

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

Legal Liability for Injuries Inflicted Upon Others - 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 can mitigate these risks.

Question 46

Company Selection

Answer 46

• 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 qualify rating. It is important to review the reports issued by multiple rating agencies before placing business with that carrier

Question 47

RISK MANAGEMENT GUIDELINES

Answer 47

• Avoidance for the most serious type of risks.
• Risk transfer is using insurance where the financial risk is severe but the 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 would include dings in your car, minor injuries/illnesses and deductibles.

Question 48

Ratings Agencies

Answer 48

A.M. Best’s - Highest Rating: A++ to A/A–Lowest Rating: C/C-to D
Moody’s - Highest Rating: Aaa to Aa1/Aa2 - Lowest Rating: B1/B2/B3 to Caa
Standard and Poor’s - Highest Rating: AAA to BBB - Lowest Rating: BB and lower CC