Risk Management And Insurance

PrinciPles of risk ManageMent and insurance

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George E. Rejda

Michael J. McNamara

William H. Rabel

Principles of risk ManageMent and insurance

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v

contents Preface xiii About the authors xx

chaPter 1 risk and its treatMent 1 Definitions of Risk 2 Chance of Loss 4 Peril and Hazard 4 Classification of Risk 5 Major Personal Risks and Commercial Risks 7 Burden of Risk on Society 12 Techniques for Managing Risk 13

Summary 17 ■ Key Concepts and Terms 18 ■ Review Questions 19 ■ Application Questions 19 ■ Internet Resources 20 ■ Selected References 21 ■ Notes 21

Case Application 17

Insight 1.1: What Are Your Chances of Not Being Able to Earn an Income? Calculate Your Personal Disability Quotient 9

Insight 1.2: Careers in Risk Management and Insurance 16

chaPter 2 Insurance and risk 22 Definition of Insurance 23 Basic Characteristics of Insurance 23 Law of Large Numbers 24 Characteristics of an Ideally Insurable Risk 25 Two Applications: The Risks of Fire and Unemployment 27 Adverse Selection and Insurance 29 Insurance and Gambling Compared 29 Insurance and Hedging Compared 29 Types of Insurance 30 Benefits of Insurance to Society 34 Costs of Insurance to Society 35

Summary 40 ■ Key Concepts and Terms 40 ■ Review Questions 41 ■ Application Questions 41 ■ Internet Resources 41 ■ Selected References 42 ■ Notes 42

Case Application 39

Insight 2.1: The Lies Told to Auto Insurers 36 Insight 2.2: Shocking Cases of Insurance Fraud 37

Appendix: Basic Statistics and the Law of Large Numbers 44 Probability and Statistics 44 Law of Large Numbers 45 Notes 46

chaPter 3 introduction to risk ManageMent 47 Meaning of Risk Management 48 Objectives of Risk Management 49 Steps in the Risk Management Process 49 Benefits of Risk Management 60 Personal Risk Management 61

Summary 63 ■ Key Concepts and Terms 64 ■ Review Questions 64 ■ Application Questions 64 ■ Internet Resources 65 ■ Selected References 66 ■ Notes 66

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Case Application 62

Insight 3.1: vermont Leads U.S. Captive Domiciles 54 Insight 3.2: Why Do Employers Self-Fund Their Health Plans? 55

chaPter 4 enterPrise risk ManageMent 68 Enterprise Risk Management 70 Benefits of Enterprise Risk Management Programs 77 Insurance Market Dynamics 78 Loss Forecasting 81 Financial Analysis in Risk Management Decision Making 84 Other Risk Management Tools 86

Summary 89 ■ Key Concepts and Terms 90 ■ Review Questions 91 ■ Application Questions 91 ■ Internet Resources 91 ■ Selected References 92 ■ Notes 92

Case Application 89

Insight 4.1: Weather Futures and Options: Financial Tools That Provide a Means of Transferring Risk Associated with Adverse Weather Events 82

chaPter 5 tyPes of insurers and Marketing systeMs 94 Overview of Private Insurance in the Financial Services Industry 95 Types of Private Insurers 96 Agents and Brokers 101 Types of Marketing Systems 104

Summary 109 ■ Key Concepts and Terms 109 ■ Review Questions 109 ■ Application Questions 110 ■ Internet Resources 110 ■ Selected References 111 ■ Notes 112

Case Application 108

Insight 5.1: Show Me the Money—How Much Can I Earn as an Insurance Sales Agent? 103

chaPter 6 insurance coMPany oPerations 113 Insurance Company Operations 114 Rating and Rate Making 114 Underwriting 115 Production 118 Claims Settlement 119 Reinsurance 121 Investments 127 Other Insurance Company Functions 129

Summary 130 ■ Key Concepts and Terms 131 ■ Review Questions 131 ■ Application Questions 132 ■ Internet Resources 132 ■ Selected References 133 ■ Notes 134

Case Application 130

Insight 6.1: Home Owner’s Failure to Cooperate Yields Denied Claim 121 Insight 6.2: Be a Smart Consumer—Check the Claims Record of Insurers Before You Buy 122

chaPter 7 financial oPerations of insurers 135 Property and Casualty Insurers 136 Life Insurance Companies 141 Rate Making In Property and Casualty Insurance 143 Rate Making in Life Insurance 147

Summary 148 ■ Key Concepts and Terms 149 ■ Review Questions 150 ■ Application Questions 150 ■ Internet Resources 151 ■ Selected References 151 ■ Notes 151

Case Application 148

Insight 7.1: How Profitable Is the Property and Casualty Insurance Industry? 142

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chaPter 8 governMent regulation of insurance 153 Reasons for Insurance Regulation 154 Historical Development of Insurance Regulation 155 Methods For Regulating Insurers 157 What Areas are Regulated? 158 State Versus Federal Regulation 164 Current Issues in Insurance Regulation 167 Insolvency of Insurers 170 Market Conduct Regulation 172

Summary 174 ■ Key Concepts and Terms 175 ■ Review Questions 175 ■ Application Questions 176 ■ Internet Resources 176 ■ Selected References 177 ■ Notes 177

Case Application 174

Insight 8.1: The Pros and Cons of Credit-Based Insurance Scores 173

chaPter 9 fundaMental legal PrinciPles 179 Principle of Indemnity 180 Principle of Insurable Interest 183 Principle of Subrogation 185 Principle of Utmost Good Faith 185 Requirements of an Insurance Contract 187 Distinct Legal Characteristics of Insurance Contracts 189 Law and the Insurance Agent 190

Summary 192 ■ Key Concepts and Terms 194 ■ Review Questions 194 ■ Application Questions 194 ■ Internet Resources 195 ■ Selected References 195 ■ Notes 195

Case Application 192

Insight 9.1: Corporation Lacking Insurable Interest at Time of Death Can Receive Life Insurance Proceeds 184

Insight 9.2: Auto Insurer Denies Coverage Because of Material Misrepresentation 186

Insight 9.3: Insurer voids Coverage Because of Misrepresentations in Proof of Loss 187

chaPter 10 analysis of insurance contracts 196 Basic Parts of an Insurance Contract 197 Definition of “Insured” 199 Endorsements and Riders 200 Deductibles 200 Coinsurance 203 Coinsurance in Health Insurance 205 Other-Insurance Provisions 205

Summary 207 ■ Key Concepts and Terms 208 ■ Review Questions 208 ■ Application Questions 208 ■ Internet Resources 209 ■ Selected References 210 ■ Notes 210

Case Application 207

Insight 10.1: How to Save Money on Car Insurance 202

chaPter 11 life insurance 211 Premature Death 212 Financial Impact of Premature Death on Different Types of Families 213 Amount of Life Insurance to Own 214 Types of Life Insurance 219 Variations of Whole Life Insurance 225 Other Types of Life Insurance 233

Summary 236 ■ Key Concepts and Terms 238 ■ Review Questions 238 ■ Application Questions 238 ■ Internet Resources 240 ■ Selected References 241 ■ Notes 241

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Case Application 236

Insight 11.1: Cash-value Life Insurance as an Investment—Don’t Ignore Two Points 224

Insight 11.2: Be a Savvy Consumer—Four Life Insurance Policies to Avoid 234

chaPter 12 life insurance contractual Provisions 243 Life Insurance Contractual Provisions 244 Dividend Options 250 Nonforfeiture Options 251 Settlement Options 254 Additional Life Insurance Benefits 258

Summary 263 ■ Key Concepts and Terms 264 ■ Review Questions 265 ■ Application Questions 265 ■ Internet Resources 266 ■ Selected References 267 ■ Notes 267

Case Application 263

Insight 12.1: Is This Death a Suicide? 246

Insight 12.2: Selection of the Best Dividend Option in a Participating Whole Life Policy 252

Insight 12.3: Accelerated Death Benefits: A Real-Life Example 261

Insight 12.4: What Is a Life Settlement? Examples of Actual Cases 262

chaPter 13 Buying life insurance 268 Determining the Cost of Life Insurance 269 Rate of Return on Saving Component 272 Taxation of Life Insurance 274 Shopping for Life Insurance 275

Summary 279 ■ Key Concepts and Terms 279 ■ Review Questions 279 ■ Application Questions 280 ■ Internet Resources 280 ■ Selected References 281 ■ Notes 281

Case Application 278

Insight 13.1: Be Careful in Replacing an Existing Life Insurance Policy 272

Appendix: Calculation of Life Insurance Premiums 282 Net Single Premium 282 Net Annual Level Premium 284 Gross Premium 285 Policy Reserves 285

Case Application 286

Key Concepts and Terms 286 ■ Notes 286

chaPter 14 annuities and individual retireMent accounts 287 Individual Annuities 288 Types of Annuities 289 Taxation of Individual Annuities 296 Individual Retirement Accounts 297

Summary 303 ■ Key Concepts and Terms 304 ■ Review Questions 305 ■ Application Questions 305 ■ Internet Resources 305 ■ Selected References 306 ■ Notes 306

Case Application 1 302

Case Application 2 303

Insight 14.1: Advantages of an Immediate Annuity to Retired Workers 290

Insight 14.2: Optional variable Annuity Benefits to Meet Specific Needs 293

Insight 14.3: Ten Questions to Answer Before You Buy a variable Annuity 298

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chaPter 15 individual health insurance coverages 307 Defects in the Healthcare System in the United States 308 Basic Provisions of the Affordable Care Act 312 Individual Medical Expense Insurance 318 Managed Care Plans 322 Health Savings Accounts 322 Long-Term Care Insurance 323 Disability-Income Insurance 327 Individual Health Insurance Contractual Provisions 330

Summary 332 ■ Key Concepts and Terms 334 ■ Review Questions 334 ■ Application Questions 335 ■ Internet Resources 335 ■ Selected References 336 ■ Notes 337

Case Application 332

Insight 15.1: Health Insurance Options for College Students Under the Affordable Care Act 315

chaPter 16 eMPloyee Benefits: grouP life and health insurance 338 Meaning of Employee Benefits 339 Fundamentals of Group Insurance 340 Group Life Insurance 342 Group Medical Expense Insurance 343 Managed Care Plans 344 Affordable Care Act and Group Medical Expense Insurance 348 Key Features of Group Medical Expense Insurance 350 High-Deductible Health Plan With Savings Option 351 Recent Developments in Employer-Sponsored Health Plans 352 Group Medical Expense Contractual Provisions 355 Group Dental Insurance 357 Group Disability-Income Insurance 358 Cafeteria Plans 358

Summary 360 ■ Key Concepts and Terms 361 ■ Review Questions 362 ■ Application Questions 362 ■ Internet Resources 363 ■ Selected References 364 ■ Notes 364

Case Application 360

Insight 16.1: History of Health Maintenance Organization 346 Insight 16.2: Basic Characteristics of the Small Business Health Options Program (SHOP) 349

chaPter 17 eMPloyee Benefits: retireMent Plans 365 Fundamentals of Private Retirement Plans 366 Types of Qualified Retirement Plans 370 Defined-Benefit Plans 370 Defined-Contribution Plans 373 Section 401(K) Plan 374 Section 403(B) Plan 377 Simplified Employee Pension (SEP) 377 Simple Ira Plan 377 Profit-Sharing Plans 378 Saver’s Credit 379 Retirement Plan Security 379 Funding Agency and Funding Instruments 379 Problems and Issues In Qualified Retirement Plans 380

Summary 382 ■ Key Concepts and Terms 383 ■ Review Questions 384 ■ Application Questions 384 ■ Internet Resources 384 ■ Selected References 385 ■ Notes 385

Case Application 382

Insight 17.1: Six Common 401(k) Mistakes 375

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chaPter 18 social insurance 387 Social Insurance Programs 389 Old-Age, Survivors, and Disability Insurance (OASDI) 390 Types of Benefits 391 Medicare 397 Problems and Issues 401 Unemployment Insurance 404 Workers’ Compensation 407

Summary 411 ■ Key Concepts and Terms 412 ■ Review Questions 412 ■ Application Questions 413 ■ Internet Resources 414 ■ Selected References 414 ■ Notes 415

Case Application 411

Insight 18.1: Postponing Social Security Benefits—Key Factors to Consider 394 Insight 18.2: Try Your Hand at Social Security Reform 403

chaPter 19 the liaBility risk 417 Basis of Legal Liability 419 The Law of Negligence 419 Imputed Negligence 421 Res Ipsa Loquitur 422 Specific Applications of the Law of Negligence 422 Current Tort Liability Problems 425

Summary 434 ■ Key Concepts and Terms 435 ■ Review Questions 435 ■ Application Questions 436 ■ Internet Resources 437 ■ Selected References 437 ■ Notes 438

Case Application 434

Insight 19.1: Judicial Hellholes 2017–2018 428

chaPter 20 auto insurance 440 Overview of Personal Auto Policy 441 Part A: Liability Coverage 443 Part B: Medical Payments Coverage 447 Part C: Uninsured Motorists Coverage 449 Part D: Coverage For Damage to Your Auto 453 Part E: Duties After an Accident or Loss 459 Part F: General Provisions 460 Insuring Motorcycles and Other Vehicles 461

Summary 461 ■ Key Concepts and Terms 462 ■ Review Questions 462 ■ Application Questions 463 ■ Internet Resources 465 ■ Selected References 465 ■ Notes 465

Case Application 461 Insight 20.1: Private Passenger Auto Insurance Remains Unprofitable for Many Insurers 442 Insight 20.2: In 5 States, 20% or More of Drivers Have No Insurance; Countrywide Average

Increases 449 Insight 20.3: The Four Types of Rental Car Insurance, Explained 455

chaPter 21 auto insurance (Continued) 467 Approaches for Compensating Auto Accident Victims 468 Auto Insurance for High-Risk Drivers 478 Cost of Auto Insurance 479 Shopping for Auto Insurance 483 Auto Insurance Emerging Issues 485

Summary 487 ■ Key Concepts and Terms 488 ■ Review Questions 488 ■ Application Questions 489 ■ Internet Resources 489 ■ Selected References 490 ■ Notes 490

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Case Application 487

Insight 21.1: Filing an Auto Claim with the Other Party’s Insurance Company 472 Insight 21.2: Protect Yourself: Insuring Your Teen Driver 481 Insight 21.3: Distracted Driving 486

chaPter 22 hoMeowners insurance, section i 492 Overview of Homeowners Insurance 493 The Homeowners 3 Policy: Persons Insured 498 The Homeowner 3 Policy: Section I Coverages 498 The Homeowners 3 Policy: Section I Perils Insured Against 504 The Homeowners 3 Policy: Section I Exclusions 507 The Homeowners 3 Policy: Section I Conditions 508 The Homeowners 3 Policy: Section I and II Conditions 514

Summary 515 ■ Key Concepts and Terms 516 ■ Review Questions 516 ■ Application Questions 517 ■ Internet Resources 518 ■ Selected References 519 ■ Notes 519

Case Application 515

Insight 22.1: Your Renters Insurance Guide: What to Look for When Shopping for Renters Insurance 496

Insight 22.2: How to Create a Home Inventory 509 Insight 22.3: The Big Gap between Replacement Cost and Actual Cash value Can Empty Your

Wallet 511

chaPter 23 hoMeowners insurance, section ii 520 Personal Liability Insurance and Medical Payments to Others Coverage 521 Section II Exclusions 524 Section II Additional Coverages 527 Section II Conditions 528 Endorsements to a Homeowners Policy 529 Cost of Homeowners Insurance 532 Suggestions for Buying a Homeowners Policy 534

Summary 537 ■ Key Concepts and Terms 537 ■ Review Questions 537 ■ Application Questions 538 ■ Internet Resources 539 ■ Selected References 539 ■ Notes 540

Case Application 536

Insight 23.1: Dog Bites Hurt, So Do Lawsuits 522 Insight 23.2: Five Insurance Mistakes to Avoid . . . (and Still Save Money) 535

chaPter 24 other ProPerty and liaBility insurance coverages 541 ISO Dwelling Program 542 Mobile Home Insurance 544 Inland Marine Floaters 544 Watercraft Insurance 545 Government Property Insurance Programs 547 Title Insurance 552 Personal Umbrella Policy 553

Summary 557 ■ Key Concepts and Terms 558 ■ Review Questions 558 ■ Application Questions 559 ■ Internet Resources 560 ■ Selected References 560 ■ Notes 561

Case Application 557

Insight 24.1: Dispelling Myths about Flood Insurance 551 Insight 24.2: The vitals on Title Insurance 553 Insight 24.3: 10 Real Examples of Umbrella Insurance Claims 555

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chaPter 25 coMMercial ProPerty insurance 563 Commercial Package Policy 564 Building and Personal Property Coverage Form 565 Reporting Forms 569 Business Income Insurance 570 Other Commercial Property Coverages 573 Transportation Insurance 577 Businessowners Policy (BOP) 581

Summary 584 ■ Key Concepts and Terms 585 ■ Review Questions 585 ■ Application Questions 586 ■ Internet Resources 587 ■ Selected References 588 ■ Notes 588

Case Application 583

Insight 25.1: Examples of Equipment Breakdown Claims: Recent Paid Claims 575

chaPter 26 coMMercial liaBility insurance 590 General Liability Loss Exposures 591 Commercial General Liability Policy 593 Employment Practices Liability Insurance 599 Workers Compensation Insurance 600 Commercial Auto Insurance 602 Aircraft Insurance 605 Commercial Umbrella Policy 606 Cyber Liability Insurance 608 Businessowners Policy 608 Professional Liability Insurance 610 Directors and Officers Liability Insurance 611

Summary 613 ■ Key Concepts and Terms 614 ■ Review Questions 615 ■ Application Questions 615 ■ Internet Resources 616 ■ Selected References 617 ■ Notes 617

Case Application 613

Insight 26.1: General Liability Lawsuit Examples 593 Insight 26.2: Beyond Prevention: Workers Compensation Insurance 601 Insight 26.3: 10 Most Common and Costliest Small Business Claims 609

chaPter 27 criMe insurance and surety Bonds 619 The ISO Commercial Crime Insurance Program 620 Commercial Crime Coverage Form (Loss-Sustained Form) 621 Financial Institution Bonds 627 Surety Bonds 628

Summary 631 ■ Key Concepts and Terms 632 ■ Review Questions 632 ■ Application Questions 633 ■ Internet Resources 634 ■ Selected References 634 ■ Notes 634

Case Application 631

Insight 27.1: Crime Prevention Tips for Small Businesses 623

Insight 27.2: ISO’s Crime Changes: Keeping Pace with our Digital World 625

Appendix A: Personal Auto Policy 636

Appendix B: Homeowners 3 (Special Form) 651

Glossary 676

Index 695

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x i i i

The first edition of this text appeared 37 years ago in 1982. The basic objective was to write an intellectually stimulating and visually attractive text from which students could learn and professors could teach. The fundamental objective for this edi- tion remains the same. This edition provides students with an in-depth treatment of major risk manage- ment and insurance topics in a visually attractive and user-friendly product with no prerequisites. The 14th edition is unique in this respect. Students can imme- diately apply the basic principles in this text to their own personal risk management and insurance pro- grams to deal with major risks that create great eco- nomic insecurity.

CONTENT CHANGES IN THE 14TH EDITION Thoroughly revised and updated, the 14th edition pro- vides a comprehensive analysis of major life and health insurance contracts and property and liability insurance coverages, which readers have come to expect from Principles of Risk Management and Insurance. Key content changes in this edition include the following:

• Enterprise risk management. Chapter 4 provides a revised and expanded treatment of enterprise risk management.

• Changes in marketing practices. Chapter 5 cov- ers significant changes in marketing practices. In particular, the fields of wholesale insurance and surplus lines insurance have been evolving rap- idly, which has led to a new classification sys- tem for intermediaries in those areas. Wholesale insurance refers to property/casualty interme- diaries who obtain business only from “retail” agents and brokers and do not deal with the public. The Wholesale and Specialty Insurance Association has been formed to provide a single

voice for intermediaries in the field. In addition, Chapter 5 deals with shifts in consumer prefer- ences that have produced changes in life insur- ance marketing and financial planning.

• Government regulation. Chapter 8 adds new mate- rial to enhance the understanding of state insurance regulation. Additional insights have been added deal- ing with insurance regulation following the severe 2008 financial debacle and economic downswing.

• Estate tax law. Policyholders with large taxable estates often purchase life insurance for federal estate tax purposes. Chapter 13 deals with impor- tant considerations in purchasing life insurance for federal estate tax purposes. Updates have been added to reflect recent changes in the federal es- tate tax law.

• Poor performance of health care delivery system. When compared to advanced foreign nations, the United States scores last or low on most measure- ments of health care delivery systems and health insurance. Chapter 15 provides an updated anal- ysis of the broken and flawed health care delivery system in the United States.

• Evaluation of the Affordable Care Act. Chapters 15 and 16 provide a current analysis of the Af- fordable Care Act (ACA) and an evaluation of its effectiveness in reducing the number of unin- sured individuals and family members. The 14th edition analyzes the most egregious defects now found in the current ACA program.

• Update on developments in employer-sponsored group health insurance plans. Employers con- tinue to struggle with the rapid increase in group health insurance premiums and continue to seek new solutions for holding down costs. Chapter 16 is an update on current trends in group health insurance and proposals to slow health care cost increases.

• Changes in group life and health insurance. Chapter 16 also deals with changes in group life

Preface

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x I v P R E F A C E

and health insurance and the market for group health insurance. For example, high-deductible health insurance plans combined with health sav- ings accounts are making substantial gains in the preferred provider organization (PPO) market.

• Obsolescence of certain retirement plans. Chapter 16 recognizes that certain older retirement plans such as money purchase retirement plans and Keogh plans for the self-employed have become obsolete and are being replaced by other options.

• Coverage of new Personal Auto Policy (PAP). The Insurance Services Office (ISO) has released a new version of the Personal Auto Policy. The 2018 PAP is discussed in Chapter 20. The pol- icy was revised to address car sharing and ride sharing (for example, Uber and Lyft) exposures. Additional changes in the 2018 PAP are also dis- cussed.

• Cyber insurance. Computer hackers have been successful in accessing the credit card records and other personal information of millions of individuals. Cyber security remains an impor- tant financial concern for business firms and public entities because of data breaches and malware. Chapter 25 provides an updated treat- ment of cyber property insurance. Chapter 26 provides an updated treatment of cyber liability insurance.

IDENTIFICATION AND TREATMENT OF MAJOR RISKS A primary objective of the text is to identify major risks in our economy and the various techniques for treating risk. Since the last edition of the text appeared, several tragedies have occurred that vividly show the deadly presence of risk in our society. In August 2017, Hurricane Harvey caused $125 billion in damage, record rainfall and catastrophic flooding in Texas and Louisiana, and 107 confirmed deaths. Harvey was the second most-costly hurricane in the United States since 1900. Shortly thereafter, in October 2017, a deranged gunman rained gunfire on people attending an out- door concert across the street from the Mandalay Bay Resort and Casino in Las Vegas, Nevada, killing 58 people and wounding and injuring more than 800 people from gunfire and panic.

In addition to catastrophic tragedies at the national level, the media routinely report events that clearly show the destructive presence of risk at the local level. Examples abound. An employee in a liquor store is shot and killed by a customer seeking cash and alcohol; a house fire leaves a family homeless; a tor- nado destroys a large part of a small town; a drunk driver fails to stop at a red light and smashes into another motorist; a plant explosion kills two people and injures several employees; and a blinding snow- storm and ice-packed interstate highway cause a chain- like accident and collision damage to 10 cars. As a result, victims and families experience catastrophic financial losses, intense emotional pain and suffering, serious physical and mental injuries, and often death. To say that we live in a risky and very dangerous envi- ronment is an enormous understatement.

OVERVIEW OF THE 14TH EDITION The 14th edition of this text discusses the aforemen- tioned risks and other insurance issues, as well. The text is designed for a beginning undergraduate course in risk management and insurance with no prerequi- sites. Topics discussed include basic principles in risk management and insurance, introductory and advanced topics in traditional risk management, newer enterprise risk management concepts, func- tional and financial operations of insurers, legal prin- ciples, life and health insurance, property and liability insurance, employee benefits, Social Security, and social insurance programs. In addition, the 14th edi- tion is a user-friendly text for students who can apply basic concepts immediately to their own personal risk management and insurance programs.

SOLVING TEACHING AND LEARNING CHALLENGES By its very nature, the introductory course in risk management and insurance involves the teaching of highly complex technical concepts that can present certain teaching and learning challenges to both pro- fessors and students. To deal with technical problems and complexity, the authors have designed the text to reflect a basic principle in education—repetition is the

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P R E F A C E x v

mother of learning. The 14th edition reflects this important principle in the following ways:

1

“When we take a risk, we are betting on an outcome that will result from a decision we have made, though we do not know for certain what the outcome will be.”

Peter L. Bernstein Against the Gods: The Remarkable Story of Risk

Risk and Its Treatment

After studying this chapter, you should be able to

1.1 Explain the historical definition of risk.

1.2 Explain the meaning of loss exposure.

1.3 Understand the following types of risk:

– Pure risk

– Speculative risk

– Diversifiable risk

– Nondiversifiable risk

– Enterprise risk

– Systemic risk

1.4 Identify the major pure risks that are associated with great economic insecurity.

1.5 Show how risk is a burden to society.

1.6 Explain the major techniques for managing risk.

Learning Object ives

1 CHAPTER

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• Learning objectives. Each chapter has spe- cific learning objectives, which give students an overview of the subject matter and list the important concepts students are expected to know.

Katerina, age 24, is a finance major at a large university. The placement director for the university has an annual job fair where recruiters from different business firms interview students for possible employment. Katerina signed up for an interview with a large multi-line insurance company to learn about job opportunities. The recruiter explained that job openings exist in several areas, and that the company hires new employees with a wide variety of educational backgrounds. Katerina is surprised to learn of the wide range of jobs in the insurance industry. The company has career openings in underwriting, sales, claims, actuarial, finance, information systems, accounting, legal, engineering, medicine, and in other areas as well.

To make insurance available to the public, insurers engage in a wide variety of specialized functions or operations. This chapter discusses the major functional operations of insurers, which include rate making, underwriting, production, claim settlement, reinsurance, and investments. Chapter 7 discusses the financial operations of insurers.

INSURANCE COMPANY OPERATIONS The most important operations of an insurance com- pany include the following:

■ Rate making ■ Underwriting ■ Production ■ Claims settlement ■ Reinsurance ■ Investments

Insurers also engage in other operations, such as accounting, legal services, loss control, and informa- tion systems. The sections that follow discuss each of these functional areas in some detail.

RATING AND RATE MAKING Rate making refers to the pricing of insurance and the calculation of insurance premiums. The premium paid by the insured is the result of multiplying a rate by the number of exposure units purchased and then adjust- ing the premium by various rating factors (a process called rating). A rate is the price per unit of insurance. An exposure unit is the unit of measurement used in insurance pricing, which varies by line of insurance. In life and in property insurance an exposure unit

normally is denominated in $1,000 of coverage. The premium is the rate per thousand multiplied by the number of exposure units and then modified to reflect economies of scale and other factors. For example, if Enrique buys $100,000 of life insurance and the rate is $7.31 per thousand his annual premium will be $731. The premium would be less than $731 if he bought $1 million, reflecting the fact that fixed costs are spread over ten times as many exposure units.

A similar approach is followed in liability insur- ance, but exposure units usually are expressed in denominations of $5,000, $10,000, or more. Rate making for all lines of insurance is discussed in greater detail in Chapter 7 and in the appendix of Chapter 11.

Insurance pricing differs considerably from the pricing of other products. When other products are sold, the company generally knows in advance the costs of producing those products, so that prices can be estab- lished to cover all costs and yield a profit. However, the insurance company does not know in advance what its actual costs are going to be. The total premiums charged for a given line of insurance may be inadequate for pay- ing all claims and expenses during the policy period. It is only after the period of protection has expired that an insurer can determine its actual losses and expenses. Of course, the insurer hopes that the premium it charges plus investment income will be sufficient to pay all claims and expenses and yield a profit.

1 1 4

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• Chapter discussion. Each chapter pres- ents text material designed to give stu- dents the knowledge needed to attain the learning objectives specified at the beginning of the chapter. Important material is often presented in italics for emphasis.

R E V I E W Q u E S T I O n S 1 0 9

deduction. Workers no longer employed can keep their insur- ance in force by paying premiums directly to the insurer.

■ Mass merchandising is a plan for selling individually underwritten property and casualty coverages to group members; individual underwriting is used; rate discounts may be given; employees typically pay for the insurance by payroll deduction; and employers do not usually con- tribute to the plans.

KEY CONCEPTS AND TERMS Advance premium mutual (97) Agent (102) Assessment mutual (97) Broker (102) Captive agent (105) Captive insurer (101) Career agents (105) Demutualization (98) Direct response system (108) Direct writer (107) Exclusive agency system (107) Fraternal insurers (97) Holding company (99) Independent agency system (107) Interinsurance exchange (100) Lloyd’s (99) Managed care plans (101) Managing general agent (MGA) (104) Mass merchandising (108) Multiple distribution systems (108) Multiple line exclusive agency system (105) Mutual holding company (99) Mutual insurer (97) Nonadmitted insurer (100) Personal-producing general agent (PPGA) (105) Personal selling distribution systems (105) Producers (101) Reciprocal exchange (100) Savings bank life insurance (SBLI) (101) Stock insurer (97) Surplus lines brokers (103)

REVIEW QUESTIONS 1. Describe the basic characteristics of stock insurers. 2. a. Describe the basic features of mutual insurers.

b. Identify the major types of mutual insurers.

SUMMARY ■ There are several basic types of insurers:

– Stock insurers

– Mutual insurers

– Lloyd’s

– Reciprocal exchange

– Blue Cross and Blue Shield Plans

– Health maintenance organizations (HMOs)

– Captive insurers

– Savings bank life insurance

■ An agent is someone who legally represents the insurer and has the authority to act on the insurer’s behalf. In contrast, a broker is someone who legally represents the insured.

■ Surplus lines refer to any type of insurance for which there is no available market within the state, and the coverage must be placed with a nonadmitted insurer. A nonadmitted insurer is a company not licensed to do business in the state. A surplus lines broker is a special type of broker who is licensed to place business with a nonadmitted insurer.

■ A managing general agent (MGA) is a specialized type of “wholesale” producer that, unlike the “retail” producer, is vested with underwriting authority from an insurer.

■ Life and health insurance companies use several distribu- tion systems to market their products. They include:

– Personal selling systems

– Financial institution distribution systems

– Direct response system

– Other distribution systems

■ Property and casualty insurance companies use several dis- tribution systems to market their products. They include:

– Independent agency system

– Exclusive agency system

– Direct writer

– Direct response system

– Multiple distribution systems

■ Many insurers use group insurance marketing methods to sell individual insurance policies to members of a group. Employees typically pay for the insurance by payroll

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• Chapter summary. Each chapter ends with a summary of the major concepts students should know so that the learning objectives listed at the beginning of the chapter can be attained.

A01_REJD0860_14_SE_FM.indd 15 09/01/19 3:31 AM

 

 

x v I P R E F A C E

• Key concepts and terms. Risk management and insurance has its own unique vocabulary and set of key concepts and terms. Instructors should inform students that these terms are clearly de- fined and easily accessible in the Glossary at the end of the text. If students do not understand the basic vocabulary, they will perform poorly.

R E V I E W Q u E S T I O n S 1 0 9

deduction. Workers no longer employed can keep their insur- ance in force by paying premiums directly to the insurer.

■ Mass merchandising is a plan for selling individually underwritten property and casualty coverages to group members; individual underwriting is used; rate discounts may be given; employees typically pay for the insurance by payroll deduction; and employers do not usually con- tribute to the plans.

KEY CONCEPTS AND TERMS Advance premium mutual (97) Agent (102) Assessment mutual (97) Broker (102) Captive agent (105) Captive insurer (101) Career agents (105) Demutualization (98) Direct response system (108) Direct writer (107) Exclusive agency system (107) Fraternal insurers (97) Holding company (99) Independent agency system (107) Interinsurance exchange (100) Lloyd’s (99) Managed care plans (101) Managing general agent (MGA) (104) Mass merchandising (108) Multiple distribution systems (108) Multiple line exclusive agency system (105) Mutual holding company (99) Mutual insurer (97) Nonadmitted insurer (100) Personal-producing general agent (PPGA) (105) Personal selling distribution systems (105) Producers (101) Reciprocal exchange (100) Savings bank life insurance (SBLI) (101) Stock insurer (97) Surplus lines brokers (103)

REVIEW QUESTIONS 1. Describe the basic characteristics of stock insurers. 2. a. Describe the basic features of mutual insurers.

b. Identify the major types of mutual insurers.

SUMMARY ■ There are several basic types of insurers:

– Stock insurers

– Mutual insurers

– Lloyd’s

– Reciprocal exchange

– Blue Cross and Blue Shield Plans

– Health maintenance organizations (HMOs)

– Captive insurers

– Savings bank life insurance

■ An agent is someone who legally represents the insurer and has the authority to act on the insurer’s behalf. In contrast, a broker is someone who legally represents the insured.

■ Surplus lines refer to any type of insurance for which there is no available market within the state, and the coverage must be placed with a nonadmitted insurer. A nonadmitted insurer is a company not licensed to do business in the state. A surplus lines broker is a special type of broker who is licensed to place business with a nonadmitted insurer.

■ A managing general agent (MGA) is a specialized type of “wholesale” producer that, unlike the “retail” producer, is vested with underwriting authority from an insurer.

■ Life and health insurance companies use several distribu- tion systems to market their products. They include:

– Personal selling systems

– Financial institution distribution systems

– Direct response system

– Other distribution systems

■ Property and casualty insurance companies use several dis- tribution systems to market their products. They include:

– Independent agency system

– Exclusive agency system

– Direct writer

– Direct response system

– Multiple distribution systems

■ Many insurers use group insurance marketing methods to sell individual insurance policies to members of a group. Employees typically pay for the insurance by payroll

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I n T E R n E T R E S O U R C E S 4 1

a. Identify the ideal requirements of an insurable risk. b. Which of the requirements of an insurable risk are

not met by the flood peril?

4. Private insurance provides numerous coverages that can be used to meet specific loss situations. For each of the following situations, identify a private insurance coverage that would provide the desired protection. a. Emily, age 28, is a single parent with two dependent

children. She wants to make certain that funds are available for her children’s education if she dies before her youngest child finishes college.

b. Danielle, age 16, recently obtained her driver’s license. Her parents want to make certain they are protected if Danielle negligently injures another motorist while driving a family car.

c. Jacob, age 30, is married with two dependents. He wants his income to continue if he becomes totally disabled and unable to work.

d. Tyler, age 35, recently purchased a house for $200,000 that is located in an area where tornadoes frequently occur. He wants to make certain that funds are available if the house is damaged or destroyed by a tornado.

e. Nathan, age 40, owns an upscale furniture store. He wants to be protected if a customer is injured while shopping in the store and sues him for the bodily injury.

INTERNET RESOURCES

■ The American Council of Life Insurers (ACLI) is a trade association with approximately 290 insurers operating in the United States and abroad. The ACLI promotes policies and legislation at the federal, state, and interna- tional levels that support the life insurance industry and the millions of families that rely on life insurance prod- ucts. The ACLI publishes important statistics on the life insurance industry and provides valuable consumer information on various life insurance and annuity prod- ucts. The publications include an annual Life Insurers Fact Book that provides timely and important industry statistics. Visit the site at ACLI.com.

■ The American Insurance Association (AIA) is an impor- tant trade and service organization that represents more than 330 insurers. The site lists available publications, position papers on important issues in property and casualty insurance, press releases, insurance-related links, and names of state insurance commissioners. Visit the site at aiadc.org/aiapub/.

REVIEW QUESTIONS 1. Explain each of the following characteristics of a typi-

cal insurance plan. a. Pooling of losses b. Payment of fortuitous losses c. Risk transfer d. Indemnification

2. Explain the law of large numbers. 3. Pure risks ideally should have certain characteristics to

be insurable by private insurers. List the six character- istics of an ideally insurable risk.

4. Identify the approaches that insurers can use to deal with the problem of catastrophic loss exposures.

5. Why are most market risks, financial risks, production risks, and political risks considered difficult to insure by private insurers?

6. a. What is the meaning of adverse selection? b. Identify some methods that insurers use to control

for adverse selection. 7. What are the two major differences between insurance

and gambling? 8. What are the two major differences between insurance

and hedging? 9. a. Identify the major fields of private insurance.

b. Identify several property and casualty insurance coverages.

10. a. Explain the basic characteristics of social insurance programs.

b. Identify the major social insurance programs in the United States.

APPLICATION QUESTIONS

1. Compare the risk of fire with the risk of war in terms of how well they meet the requirements of an ideally insurable risk.

2. a. Private insurers provide social and economic bene- fits to society. Explain the following benefits of insurance to society. 1. Indemnification for loss 2. Enhancement of credit 3. Source of funds for capital accumulation

b. Explain the major costs of insurance to society.

3. Buildings in flood zones are difficult to insure by pri- vate insurers because the ideal requirements of an insurable risk are difficult to meet.

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• Review questions. The answers to review ques- tions at the end of each chapter enable students to answer the learning objectives listed at the begin- ning of each chapter.

11 0 C H A P T E R 5 / T y P E S O F I n S u R E R S A n D M A R k E T I n g S y S T E M S

b. Identify the marketing system that management is considering adopting.

2. Compare a stock insurer to a mutual insurer with respect to each of the following: a. Parties who legally own the company b. Right to assess policyholders additional premiums c. Right of policyholders to elect the board of directors

3. A luncheon speaker stated, “The number of life insur- ers has declined sharply during the past decade because of the increase in company mergers and acquisitions, demutualization of insurers, and formation of mutual holding companies.” a. Why have mergers and acquisitions among insurers

increased over time? b. What is the meaning of demutualization? c. Briefly explain the advantages of demutualization of

a mutual life insurer. d. What is a mutual holding company? e. What are the advantages of a mutual holding com-

pany to an insurer?

4. A newspaper reporter wrote, “Lloyd’s is an association that provides physical facilities and services to the members for selling insurance. The insurance is under- written by various syndicates who belong to Lloyd’s.” Describe Lloyd’s Corporation with respect to each of the following: a. Liability of individual members and corporations b. Types of insurance written c. Financial safeguards to protect insureds

5. Property and casualty insurance can be marketed under different marketing systems. Compare the independent agency system with the exclusive agency system with respect to each of the following: a. Number of insurers represented by the agent b. Ownership of policy expirations

INTERNET RESOURCES

■ American College of Financial Services is an accredited, nonprofit educational institution that provides graduate and undergraduate education, primarily on a distance- learning basis, to people in the financial services industry. The organization awards the professional Chartered Life Underwriter (CLU) designation, the Chartered Financial Consultant (ChFC) designation, and other professional designations. Visit the site at theamericancollege.edu.

3. The corporate structure of mutual insurers has changed over time. Briefly describe several trends that have had an impact on the corporate structure of mutual insurers.

4. Explain the basic characteristics of Lloyd’s Corporation. 5. Describe the basic characteristics of a reciprocal

exchange. 6. Explain the legal distinction between an agent and a

broker. 7. Explain the difference between a “retail” and “whole-

sale” intermediary and describe the two types of “whole salers.”

8. Describe briefly the following distribution systems in the marketing of life insurance.

a. Personal selling systems b. Financial institution distribution systems c. Direct response system d. Other distribution systems

9. Describe briefly the following distribution systems in the marketing of property and casualty insurance.

a. Independent agency system b. Exclusive agency system c. Direct writer d. Direct response system e. Multiple distribution systems

10. Who owns the policy expirations or the renewal rights to the business under the independent agency system?

11. What is a mass-merchandising plan in property and liability insurance?

APPLICATION QUESTIONS

1. A group of investors are discussing the formation of a new property and liability insurer. The proposed com- pany would market a new homeowners policy that combines traditional homeowner coverages with unem- ployment benefits if the policyholder becomes involun- tarily unemployed. Each investor would contribute at least $100,000 and would receive a proportionate inter- est in the company. In addition, the company would raise additional capital by selling ownership rights to other investors. Management wants to avoid the expense of hiring and training agents to sell the new policy and wants to sell the insurance directly to the public by selec- tive advertising in personal finance magazines. a. Identify the type of insurance company that best fits

the preceding description.