Principles of Insurance

Question 1

Law of Large Numbers

Answer 1

The mathematical foundation of insurance known as the Law of Large Numbers, explains how losses can be predicted.

Question 2

Savings feature of life insurance

Answer 2

Interest credited to policy cash values is typically tax deferred. This fact enhances the attractiveness of the contract as a savings vehicle.

Question 3

What are conditions for Self-Insurance

Answer 3

To self insure a firm must set up a sound program with the following requirements.

Law of Large Numbers - The firm should be big enough to combine sufficiently large numbers of exposure units so as to make a loss predictable.
Be financially dependable - The firm should be able to accumulate funds to meet losses that may occur. Also, the firm needs to cover losses if they occur more frequently than predicted.
Geographic distribution of risk in the event of a catastrophe.

Question 4

Direct loss

Answer 4

Direct losses are the immediate, or first, result of an insured peril. For example, if a fire destroys a home, the loss of the home is the direct loss.

Question 5

Indirect loss

Answer 5

Indirect losses, also called consequential losses (such as loss of use), are a secondary result of an insured peril. If a tornado destroys a restaurant, the property damage is the direct loss. The loss of income during the period when the business is being reestablished is the indirect loss.

Question 6

Hazard

Answer 6

Hazards are conditions that increase the probability of loss from a peril, by increasing either the frequency or the severity of potential losses. For example, every home faces the peril of destruction by fire. Storing oily rags near the home’s furnace would be an example of a hazard. There are 4 types of hazards.

Physical Hazards - involve physical characteristics such as type of construction, location, occupancy of building, having frayed wires on plugs, steep stairs with no railing, or smoking in bed.

Moral Hazards - involve dishonest tendency such as exaggerating losses in a theft claim or auto insurance fraud (e.g. two cars intentionally bump each other with many passengers claiming injury).

Morale Hazards - involve an increase in losses due to knowledge of insurance coverage such as having a different attitude toward a loss because the loss will be covered by an insurance company (e.g. leaving a car unlocked, ordering unnecessary medical tests, or a jury’s tendency to grant larger amounts of money in situations where an insurer will have to pay).

Legal Hazards - involve increased frequency and severity of losses such as legislative action (e.g. ADA requirements or mandated insurance coverages).

Question 7

Peril

Answer 7

A peril is defined as the cause of the loss. For example, fires, tornadoes, heart attacks, and criminal acts constitute perils.

Question 8

Proximate cause

Answer 8

The proximate cause of a loss is the first peril in a chain of events resulting in a loss. Without proximate cause, the loss would not have occurred.

Question 9

Risk

Answer 9

Risk may be defined as the variation in possible outcomes of an event based on chance. This definition of risk is a useful one because it focuses attention on the degree of risk in given situations.

Question 10

Degree of risk

Answer 10

The degree of risk is a measure of the accuracy with which the outcome of an event based on chance can be predicted.

Question 11

Pure risk

Answer 11

Pure risk refers to possibilities that can result in only loss or no change. Insurance deals with pure risk that exists only when a chance of loss/no loss is possible. Man-made speculative risks such as the stock market and gambling are not suitable for coverage.

Question 12

Speculative risk

Answer 12

Speculative risk refers to those exposures to price change that may result in gain or loss. Most investments, including stock market investments, are classified as speculative risks.

Question 13

Law of Large Numbers

Answer 13

Insurance pools reduce risk by applying a mathematical principle called the law of large numbers. Simply put, the law states that the greater the number of observations of an event based on chance, the more likely the actual result will approximate the expected result.

Question 14

Adverse selection

Answer 14

When one party to a transaction has more relevant information or more control of outcomes than another party to the transaction, the party with superior information or control can take advantage of the situation. Insurance scholars call the possession of asymmetric information adverse selection.

Adverse selection is also defined as the actions of individuals acting for themselves or others, who are motivated directly or indirectly to take financial advantage of a risk classification system. For example, adverse selection occurs when people who know their health is deteriorating try to purchase health insurance to cover the cost of a needed operation. Another example would involve a person trying to purchase fire insurance immediately after an arsonist threatened his property.

Question 15

Risk Management process

Answer 15

The risk management process involves the identification, measurement and treatment of property, liability and personal loss exposures.

Establish risk management objectives
Gather information
Analyze information
Develop the risk management plan
Implement the risk management plan
Monitor and revise the risk management plan.

Question 16

Responses to risk

Answer 16

Risk Avoidance
Risk Reduction
Risk Transfer
Risk Retention
Risk Diversification

Question 17

Absolute liability

Answer 17

Absolute liability — is a liability without regard to negligence or fault (e.g., worker’s compensation).

Question 18

Aleatory contract

Answer 18

Aleatory contract — if no loss occurs, the insurer will pay nothing. Alternatively, the insurer may, if a loss occurs, pay more than the premiums that it has collected.

Question 19

Collateral source rule

Answer 19

Collateral source rule — holds that damages assessed against a negligent party should not be reduced simply because the injured party has other sources of recovery available (such as insurance or employee benefits).

Question 20

Contract of adhesion

Answer 20

Contract of adhesion — an insurance contract is a contract of adhesion, meaning the insurance company prepares the entire contract. The insured can accept or reject the contract, but the insured cannot modify, alter, or negotiate the contract. Thus, there are no modifications that can be made by the consumer, who must take it or leave it.

Question 21

Contract of indemnity

Answer 21

Contract of indemnity — insurance is a contract of indemnity and must meet the following criteria:

There must be an insurable interest. For property, the interest must exist both at the inception of the contract and at the time of loss.

There must be a determinable actual cash value. The amount recovered cannot exceed the cash value of the loss.

There must be subrogation. The insurance company must have the right to collect from a negligent third party that caused the loss.

Most property, liability, and health insurance contracts are contracts of indemnity, which means that a policy owner is entitled to payment only to the extent of financial loss or legal liability.

Question 22

Contract of utmost good faith

Answer 22

Contract of utmost good faith — consists of the following three doctrines that relate to insurance:

Misrepresentation — if the insured made a false statement, the insurance contract may be voided.

Warranties — a breach of warranty may cause an insurance contract to be voidable. A warranty is a statement that is made part of the policy.

Concealment — failure of the insured to disclose material facts concerning the subject matter of the insurance and may cause an insurance contract to be voidable.

Question 23

Dynamic risks

Answer 23

Dynamic risks — result from a changing economy (e.g., changes in business cycle, consumer taste). Insurance does not cover these risks.

Question 24

Estoppel

Answer 24

Estoppel — occurs when one party is not allowed to assert a right due to having misled someone, and action is required by the other party.

Question 25

Fundamental risk

Answer 25

Fundamental risk — impersonal, and usually a group risk (e.g., a recession or an earthquake). The loss affects large segments of the society at the same time.

Question 26

Group insurance

Answer 26

Group insurance — provides coverage to more than one person under a single contract issued to someone (usually the employer) other than the persons insured. The contract, referred to as a master contract, provides benefits to a group of individuals who have a specific relationship to the policy owner. Employees covered under the contract receive certificates of insurance as evidence of their coverage.

Question 27

Joint and several liability

Answer 27

Joint and several liability — negligence caused by one or two or more parties. Each party may be held fully liable. The party paying more than its own legal share can seek contribution from the other joint tortfeasors who have not paid their proportional share.

Question 28

Particular risk

Answer 28

Particular risk — is a personal and individual risk, such as the burglary of someone’s home. It affects only individuals or small groups of individuals at the same time, rather than a large segment of society.

Question 29

Res ipsa loquitur

Answer 29

Res ipsa loquitur — means “the thing speaks for itself.” It is a doctrine of law of negligence that is concerned with the circumstances and the types of accidents that afford reasonable evidence if a specific explanation of negligence is not available (e.g., a plane crash). The negligence does not have to be proven by the injured party.

Question 30

Strict liability

Answer 30

Strict liability — is a liability for damage resulting from some extraordinary dangerous activity or other statutorily defined activities. Negligence does not have to be proved; however, defenses may be allowed to refute or lessen liability.

Question 31

Tort

Answer 31

Tort — an infringement on the rights of another. The wrongdoer is a tortfeasor and creates a right for the damaged party to bring a civil action. Tort can result in two forms of injury: bodily injury and property damage. Note that a general tort liability other than an intentional tort can be waived in bankruptcy. The elements that must be proven to establish tort liability for negligence are:

There must be a duty owed by the defendant.
There must be a breach of that duty.
There must be damage or loss suffered by the plaintiff.
The breach of duty must be the proximate cause of the damage.

Question 32

Unilateral contract

Answer 32

Unilateral contract — an insurance contract is a unilateral contract. Only the insurer promises to do anything, as there is no promise for the insured to pay the premium.

Question 33

Insurable risks

Answer 33

Insurable risks — not all insurers are willing to accept all the risks that others may wish to transfer to them. Although the following four characteristics are not needed to have an insurable risk, these elements represent an insurable risk:

There must be a sufficiently large number of homogeneous exposure units to make the losses reasonably predictable.
The loss produced by the risk must be definite and measurable (for example, being able to tell when the loss occurs and the value insured).
The loss must be fortuitous or accidental.
The loss must not be catastrophic.

Question 34

Benefit Coverage of Long Term Disability

Answer 34

The policies offered by many companies provide:

A choice of elimination (waiting) periods (0 to 365 days) before benefits.
A schedule of maximum daily benefits and length of benefit periods. The schedule of the benefit periods offered might range from two to five years. Very few insurers offer a lifetime benefit period, which is an expensive option.
A maximum lifetime approach to defined benefit payments. Thus, if the benefit amount is $250 per day and the benefit period is four years, the maximum lifetime payout would be $250 times 365 days times 4 years, for a total of $365,000. This $365,000 pool of money can be used for covered services in whatever way desired, subject to the daily maximum.
Some companies pay a set amount monthly, as with disability income insurance. Thus, the policy may agree to pay $5,000 per month or a per day amount such as $265 regardless of actual charges.
Community-based care can be less expensive than nursing home care (if they need less than 24-hour care). The maximum daily benefit is often 50 percent of the maximum daily benefit for nursing home care. The length of the benefit period is often the same for both coverages, but some policies require a different waiting period.

Question 35

Disability Insurance components

Answer 35

The elimination period (waiting period)
The benefit period
The monthly indemnity amount

Question 36

Elimination period

Answer 36

The elimination period is also called a waiting period and refers to the number of days at the start of disability during which no benefits are paid.

It is a limitation on benefits, somewhat like a deductible in medical expense and property insurance policies.
It is meant to exclude the inconsequential illness or injury that disables the insured for only a few days and that is more economically met from personal funds.
Elimination periods range from 30 days to one year, with three months being a common elimination period.
Premiums are lower for policies with longer elimination periods.
The major insurers allow for a temporary break in the elimination period. Thus, the insured is not penalized for any brief attempt to return to work before the elimination period has expired at the start of disability.

Question 37

The benefit period

Answer 37

The benefit period is the longest period of time for which benefits are paid under the disability policy. Usually, the benefit period is the same for sickness and injury and is available for durations of two or five years, to age 65, and for life, provided continuous, total disability begins before a specified age, e.g. age 55. The longer the benefit period, the higher the premium.

Question 38

Commercial Insurance

Answer 38

Business firms and homeowners need property insurance. When businesses purchase insurance, it is called commercial insurance. Historically, businesses had to purchase several different insurance policies to weave together a complete insurance program.

Question 39

Risk Management Information Systems

Answer 39

Many risk managers now use Risk Management Information Systems (RMIS) to do the following:

Record, track and analyze losses
Maintain records of plant, property, and equipment and record how they are protected from loss
Perform statistical analysis of past losses and to forecast losses

Question 40

Taxation on Death Benefits

Answer 40

Death benefits received by beneficiaries are generally income tax free and may be subject to estate tax. The death benefit can be used to pay for:

Final illness costs not covered by medical insurance.
Repayment of all outstanding debt, most notably home mortgage.
Costs associated with funeral, burial, or cremation.
Short-term living expenses until the surviving spouse can downsize or find employment.
Funding for college costs.
Bequests to family and/or friends.

Question 41

Disability Income Insurance

Answer 41

As you determine the proper amount of coverage, reduce the total benefit with other benefits such as worker’s compensation benefits and Social Security benefits. No benefit is available if you are currently unemployed or retired.

Question 42

Open and Named Perils

Answer 42

When considering insurance for both real and personal property, you should understand the difference between open-peril and named-peril policies.

Open perils — Also known as all-risks policies, covers all losses to covered property unless the loss is specifically excluded.
Named perils — Also known as specified-perils policies, contains a list of the covered perils. If a peril is not listed, losses resulting from that peril are not covered.