Module 1 - Managing RIsk

Question 1

Define and provide examples of speculative risk and pure risk

Answer 1

Speculative risk is assumed as a conscious choice and involves three possible outcomes: loss, gain or no damage. Purchasing stocks or purchasing land to hold for possible future development are examples of speculative risk events.

Pure risk is related to events outside of the risk taker’s control and is the opposite of speculative risk, with loss as the only possible outcome. Examples of pure risk events include premature death, identity theft, and career-ending disabilities.

Question 2

List the four techniques for managing risk

Answer 2

Transferring risk
Reducing (or mitigating) risk
Retaining risk
Avoiding risk

Question 3

Transferring risk

Answer 3

An individual or business can transfer the risk of financial consequences from any loss through eiter insurance or noninsurance arrangements. With insurance, the insured transfers a defined risk of a loss to the insurer in exchange for a premium through a two-party contract.

A noninsurance transfer of risk can be achieved through a hold harmless agreement or contract clause (also called an “indemnity” agreement or clause) that exempts a party from liability it would otherwise be responsible for.

Question 4

Reducing (or mitigating) risk

Answer 4

Loss prevention and loss reduction are two loss control techniques. Loss prevention attempts to reduce the possibility or frequency of loss for any risk that cannot be avoided. Loss reduction attempt to control the severity and financial impact of losses once they have occurred. Loss reduction activities to not involve the avoidance or prevention of losses.

Question 5

Retaining risk

Answer 5

Risk retention is the active decision to accept the responsibility or liability for financing losses associated with specific risks if they occur. I.e. the individual or plan sponsor is said to self-insure against the risk. Loss financing methods do not affect the frequency or severity of a loss; they indicate how an individual or plan sponsor will pay for it.

Question 6

Avoiding risk

Answer 6

The objective of risk avoidance is to eliminate the likelihood a risk will occur. An individual or business can avoid risk by either refusing to assume it initially or by abandoning a risk it is currently exposed to. Risk avoidance can be achieved through elimination, substitution or separation. Substitution involves replacing the risk (or a factor that influences its likelihood of occurring) for another. Separation involved separating potentially hazardous combinations of activities/products.

Question 7

Provide examples of risks that may be suitable for self-insurance (4)

Answer 7

1. High frequency/low severity losses (e.g. antibiotics)
2. Losses that can be absorbed as normal, everyday expenses (e.g. dental checkups)
3. Losses that are uninsurable, such as reputation damage arising from poor benefits administration practices that could result in nonpayment of otherwise valid claims
4. Amounts of insured losses up to a specific threshold (e.g. self insure up to $25k in health care claims and buy insurance for above that threshold)

The possibilities for risk retention are unlimited. Generally, high-severity losses should not be retained.

Question 8

Briefly describe the personal risks covered by insurance

Answer 8

Personal risk arises from the possibilities of death, poor health and outliving one’s savings. Life and health insurance companies sell products that insure against financial losses that result from premature death and loss of income due to disability, illness and accident.

Question 9

Explain risk pooling

Answer 9

When the individuals exposed to a risk (ie facing the uncertainty of a particular economic loss) purchase an insurance contract to transfer the risk to the insurer. In doing so, these individuals agree to share losses on an equitable basis with a pool of thousands of individuals. With pooling, the risk of loss is transferred from one to many and is shared y all individuals in the pool. The insurer collects a fee (a “premium”) from each individual and pools the premiums to create a fund to pay future losses sustained.

Pooling assumes that insurers can calculate the loss rate the members of the pool will sustain. E.g. a few premature death loss costs are spread across all insured individuals.

Question 10

Explain the significance of the loss rate

Answer 10

It is significant since pooling assumes that insurers can calculate the loss rate the members of the pool will sustain. To predict the loss rate for a given group of insureds, the insurer must predict the number and timing of covered losses (eg disability or death) that will occur in that group.

Once the loss rate is known, insurers can determine the proper premium amount to charge each insured and spread the cost of losses across all members

Question 11

Explain the significance of the concept of the law of large numbers to risk management

Answer 11

Predictions of future losses are based on the concept that even though individual events such as the death of a particular person occur randomly, observation of past events can be used to determine the likelihood, or probability, that a given event will occur in the future.

The law of large numbers states that, typically, the more times a particular event is observed, the more likely it is that the observed results will approximate the true probability the event will occur. Insurers use this concept to predict the chance of loss and, in effect, make a potential, uncontrollable event predictable.

Question 12

Explain how insurers use mortality and morbidity tables

Answer 12

Insurers compile data on large numbers of people to identify patterns of losses. For many years, life and health insurance companies shave been recording the rate of occurrence of disability due to illness or accident among their insured population, as well as the number who have died and their ages of death. This information is compared with general population records, and insurers use these statistics to develop mortality and morbidity tables.

Mortality tables show the rate of deaths, by age, occurring in a defined population during a selected time interval Morbidity shows the rate of morbidity (or disability) by age among a given group of people. Insurers use these tables to predict the probable loss rates for given groups of insureds and to establish adequate premium rates.

Question 13

List the five characteristics of risk (i.e. a potential loss) that are useful in identifying the general kinds of losses that are insurable.

Answer 13

1. The loss must occur by chance
2. The loss must be definite (in terms of time and amount)
3. The loss must be financially significant (otherwise admin costs associated with providing coverage for minor losses would drive the cost of insurance too high)
4. The probable rate of loss must be predictable
5. The potential loss must not be catastrophic to the insurer

Question 14

Provide examples of a contract of indemnity and a valued contract, noting the differences between the two types

Answer 14

Depends how the contract addresses the amount payable for a covered fee. In a contract of indemnity, the amount payable is based on the actual amount of financial loss incurred at the time of the loss (subject to any maximum amount stared in the contract). Prescription drug coverage and property and liability insurance are examples of contracts of indemnity.

In a values contract the amount payable when a loss occurs is an example of a valued contract, and “face value” describes the amount of insurance \

Question 15

Explain the significance of adverse selection in the pricing of insurance

Answer 15

The tendency to select insurance based on likelihood of loss and is the primary reason that insurers carefully review each application to assess how much risk they will assume if they issue the policy.

Question 16

Briefly describe the role of the underwriter

Answer 16

Insurance company professionals responsible for evaluating risk are called “underwriters”. Underwriters measure risk exposure, decide whether to accept the risk and insure and applicant, determine how much insurance coverage to provide and determine the premium to charge. The function of the underwriter is to protect the insurance company’s book of business from risks they believe will result in a loss and to issue policies at a premium commensurate with the exposure a risk presents. Each insurer has its own underwriting guidelines to help its underwriters determining whether to accept the risk

Question 17

Provide examples of how physical hazards and moral hazards impact the likelihood an individual will suffer a loss

Answer 17

A physical hazard is a physical characteristic or condition of the proposed insured that may increase the the possibility of a loss. For example, a proposed insured with a history of heart attacks has a physical hazard that increases the likelyhood of a loss.

A moral hazard occurs when the reputation, financial position, or criminal record of a proposed insured indicates that the individual may act dishonestly in an insurance transaction in such a way as to increase the possibility of a loss.

Question 18

Explain why risk class is integral to setting equitable insurance prices

Answer 18

The factors that insurers use to classify risks are generally objective, clearly related to the cost of providing coverage, practical to administer, consistent with applicable law and designed to protect the long-term viability of the insurance program. The information used to evaluate an applicant depends on the type of insurance coverage being requested.

Individuals with similar risk characteristics are grouped to determine average experience, and these averages are applied to individuals for the purpose of setting prices. After identifying the risks a proposed insured presents, the underwriter applies the inurers underwriting guidelines to classify them in an appropriate risk class. Risk classes are used to determine the equitable premium rate for the requested coverage.

Question 19

Identify risk classes generally used in life insurers’ underwriting guidelines to categorize proposed insureds for the purpose of determining equitable premium rates for requested coverage

Answer 19

1. Declined risk (proposed insureds are considered to present a risk that is too great for the insurer to cover)
2. Substandard risk (impaired) (Proposed insureds who have significantly greater-than-average likelihood of loss but are still insurable.
3. Standard risk (likelyhood of loss that is not significantly greater than average)
4. Preferred risk (significantly less-than-average likelihood of loss.

Question 20

Purpose of a group benefits plan

Answer 20

Any plan is any type of plan that provides benefits to plan members as one group, independent of government-sponsored benefits. The plan sponsor is the organization that provides the plan to the group. Can also be sponsored by other entities as well (e.g. employee benefit trusts for employees working for multiple employers under the terms of a collective agreement, alumni, professional associations, banks providing protection to their borrowers).

Main purpose is to protect plan members from the possible financial consequences of various risks, such as death, serious illness, and accidents. Plans provide a critical component to individual wellbeing, as government sponsored plans provide limited coverage to individuals, and making costs more predictable

Question 21

Contrast an individual insurance policy with a group insurance policy

Answer 21

Individual insurance policy (or contract) is purchased on an individual basis for protection against the financial hazards of death, accident and sickness, covering only one person and in some cases members of their family as well. Policy owner is the individual.

Group insurance policy provides mass protection against the financial hazards of death, accident and sickness, usually without requiring individual evidence of insurability. It insures classes of people rather than specific individuals. They are simply defined as members of a class. A group insurance policy is issued to a plan sponsor for the benefit of its plan members. Owner is the plan sponsor.

Question 22

Contrast individual life insurance and group life insurance in terms of underwriting guidelines

Answer 22

Individual life insurance underwriting requires the proposed insured to meet the insurer’s underwriting requirements for evidence of insurability. In contrast, group insurance underwriting focuses on characteristics of the group and does not usually require each proposed group-insured member to provide individual evidence of insurability. Nevertheless, the goal of group underwriting is the same as individual - to determine whether a group of people presents an average risk and whether the group’s loss experience will be predictable and acceptable to the insurer.

Question 23

Describe the role of a third party administrator (TPA) in Canadian group benefits

Answer 23

A TPA is an organization that can perform some or most of the administrative functions that a benefit plan requires and that typically delivers insurance products created by insurers. TPAs cannot offer insured products but can offer products for which underwriting services are not required. However, TPAs can create bread-based offerings by combining their own administrative services with benefit products and services from one, two or more insurance carriers and specialty providers (such as an EAP). A service agreement with the plan sponsor identifies the scope of a TPA s services, which may include maintaining plan member data, creating consolidated premium bills if multiple insurers are involved, handling employee inquiries, providing access to non-insurance benefit products etc.

Question 24

Contrast what is required of parties to a group insurance policy to form a valid contract in accordance with contract law with those for an individual insurance policy (4)

Answer 24

To form a valid group insurance contract under contract law, the policyholder and insurance must:
1. Mutually agree to the contract terms
2. Have contractual capacity
3. Exchange legally adequate consideration
4. Form the contract for a lawful purpose.

Individual and group insurance address the first three requirements similarly. However, in an individual policy the lawful purpose requirement is my by the presence of an insurable interest, while in group contracts it is met by the policyholder entering into a contract to provide a benefit to covered group members.

Question 25

Describe the parties to a group insurance master contract/policy

Answer 25

The parties to a master contract/policy are the insurer and the group policyholder. The policyholder is the employer or plan sponsor organization that enters into the group insurance contract. The policyholder signs the master contract/policy, decides what types of group insurance coverage to purchase, negotiates terms of the contract with the insurer, makes decisions regarding amendments, administers the plan, and collects and remits all premiums.

Question 26

10 major elements in a group insurance master policy

Answer 26

1. Benefits schedule outlining type and level of coverage provided
2. Definitions
3. Eligibility for insurance
4. Effective date of insurance
5. Termination of insurance
6. Benefit provisions for each covered benefit
7. Payment of claims
8. Administration of the policy
9. Payment of premiums
10. General provisions (e.g. conforming to legislation and disclosure provisions)

Question 27

Contrast the ownership rights of the parties to a group insurance contract with those under individual insurance policies.

Answer 27

A group policyholder does not have the same ownership rights under a master contract that an individual policy owner has, because some of those rights are granted to the insured group members. For example, it is the group member, not the group policyholder, who names the beneficiary of the policy. Note that when someone purchases individual life insurance, they are generally both the policy owner and the individual insured by the life insurance policy. Occasionally, it makes sense for an individual to buy an individual policy to insure someone else and name themselves as the beneficiary (e.g. when two people have a shared interest in a business). That type of policy has special requirements.

Question 28

Identify the main types of insurable groups (4)

Answer 28

(a) Single employer groups (groups of employees who work for one company)

(b) Multi-employer groups (groups of employees who work for many companies) and who are typically members of a union in a particular industry and/or area.

(c) Association groups (groups of employees who work for employers that are members of an association or a group of individuals who are members of an association)

(d) Creditor groups (groups of individuals who borrow from banks and other money-lending institutions)

Question 29

Explain factors that impact how insurers typically establish group insurance premium rates

Answer 29

Insurers typically establish group insurance premium rates on a case-by-case basis, with the objective of setting premiums that will be adequate to pay the promised benefits and cover the associated administrative expenses. In addition to the characteristics of the group and the type of benefits covered, underwriters take into consideration the pattern of the group’s own claims experience.

Question 30

Identify group characteristics considered by group underwriters when assessing whether a specific group will experience a predictable average loss rate.

Answer 30

1. The purpose of the group
2. The size of the group
3. The demographic makeup of the group
4. The geographic location of the group
5. The flow of new members into the group
6. The stability of the group
7. The occupational activities of the group
8. The required participation rates.
9. Determination of benefit levels.

Question 31

Explain the rationale behind each of the fundamental principles of group insurance underwriting and the implications when a group insurance contract deviates from them.

Answer 31

(a) Employees must be permanent employees and be actively at work to be eligible for coverage.
(b) Choices/amount of coverage must be restricted.
(c) For contributory plans, plan members’ contributions must be deducted from their pay.
(d) Plan sponsor must contribute at least some of the cost of the overall plan.
(e) The risk must be spread.

A group insurance contract that deviates from any of these five principles will include compensatory plan provisions for the added risk to the insurer. The premiums will generally also be higher than normal to reflect this additional risk.

Question 32

Justify why groups such as those found in clubs and lodges and groups of individuals participating in mass-marketing insurance plans do not meet the fundamental principles of group insurance underwriting applied to single employer sponsored plans.

Answer 32

In clubs and lodges, such as the Legions or Kiwanis clubs, there is no requirement for members to be actively at work for coverage to commence, no automatic mechanism to collect premiums equivalent to payroll deduction and no plan sponsor contribution, and individuals may decide to join the organization merely to obtain the insurance. This contravenes the fundamental principle of restricted individual choice.

Mass-marketed insurance plans such as those offered by university/college alumni associations, professional associations or retiree organizations usually have elements of both group and individual insurance, and the participating group is therefore best classified as an association of individuals (or affinity group) without necessarily involving a true association. While it contravenes most principles of a more typical group insurance program, most importantly it contravenes the first principle of being actively at work. For example, there is no requirement to be actively at work to participate in a university/college alumni-sponsored life insurance program.