Fundamentals of Risk and Insurance

Chapter 1The Problem of Risk

1. The concept of riskRisk: a condition in which there

is a possibility of an adverse deviation from a desired outcome that is expected or hoped for

Peril: a cause of a lossHazard: a condition that may create or increase the chance of a loss arising from a given peril

Three categories of hazards:Physical hazardsMoral hazardMorale hazard

2. Classifications of riskPure risk and speculative riskPure risk: the situations that

involve only the chance of loss or no loss

Speculative risk: a situation in which there is a possibility of loss, but also a possibility of gain

Chapter 2 Introduction to risk management

1. Risk managementRisk management is a scientific

approach to dealing with pure risks by anticipating possible accidental losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur

2. Risk management toolsInclude two broad approaches:(1) Risk control focuses on

minimizing the risk of lossA. Risk avoidanceB. Risk reduction: loss prevention &

loss control(2) Risk financing focuses on

finding funds to meet losses

(2) Risk financing focuses on finding funds to meet losses

A. Risk retention (assumption)Intentional and unintentionalB. Risk transferInsurance, hedging

Assume all risks that are not significant in relation to the company’s financial strength

Insure all risks not assumed

3. Risk management process

(1) Determination of objectives(2) Identification of risks(3) Evaluation of risks(4) Considering alternatives and

selecting the risk treatment device

(5) Implementing the decision(6) Evaluation and review

Determination of objectivesPost-loss objectives

Pre-loss objectives

Survival Economy

Continuity of operations Reduction in anxiety

Earning stability Meeting externally imposed obligations

Continued growth Social responsibility

Social responsibility

Chapter 3The insurance device1. The nature and functions of

insurance(1) Risk sharing and risk transferA. Transferring or shifting risk from

one individual to a groupB. Sharing losses, on some equitable

basis, by all members of the group

(2) Insurance defined from the viewpoint of the individual

Insurance is an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) that would exist if it were not for the insurance

(3) Risk reduction through pooling

The law of large numbersThe larger the sample, the more accurate

will be the estimate of the probabilityOnce the estimate has been made, it must

be applied to a sufficient large number of exposure units to permit the underlying probability to work itself out

To make the estimate more accurate, we use variance and standard deviation

The integration of inevitability and chance

Each insured, and each class of insureds should bear the mathematically fare share of the insurance pool’s losses and expenses(4) Insurance defined from the

viewpoint of societyInsurance is an economic device for

reducing and eliminating risk through the process of combining a sufficient number of homogeneous exposures into a group to make the losses predictable for the group as a whole

(5) Elements of an insurable risk

A. There must be a sufficient large number of homogeneous exposure units to make the losses reasonably predictable

B. The loss produced by the risk must be definite and measurable

C. The loss must be fortuitous or accidental

D. The loss must not be catastrophic

(6) The fields of insurance

A. Private (Voluntary) insuranceLife insuranceHealth insuranceProperty and liability insuranceIncluding named-peril coverage and open-

peril coverageB. Social insurance

Chapter 5 the private insurance industry1. Insurers classification by legal form of ownershipA. Capital stock insurance companiesB. Mutual insurance companiesC. Reciprocals or interinsurance exchangeD. Lloyd’s associationsE. Health expense associationsF. Government insurers

2. Marketing systems

The insurance occupationsAgentBrokerUnderwriterLoss adjusteractuary

(1) Life insurance distribution system

A. General agentsB. Branch office system—branch

manager

(2) Property and liability distribution system (refer to the book)

A. Independent agents (U.S.A.)B. Direct writers

Chapter 6 regulation of the insurance industryRegulation represents the rules

by which the game is played

The government as market regulator: to protect the weak group

1. The why of government regulation of insurance

(1) Rationale for regulation of the insurance industry

A. Vested-in-the-public-interestSolvencyComplex nature of insurance

contractsB. Destructive-competition Due to the unique nature of pricing

(2) Goals of insurance regulationsolvencyequity

2. Regulation todayThe current regulatory

structure:Legislative branchJudicial branchExecutive branch

3. Areas regulated

(1) Solvency regulationA. Licensing of companiesB. Reporting and financial analysisC. Risk-based capitalD. Examination of companiesE. Regulation of reservesF. Investments: admitted/nonadmitted assetsG. Dealing with insolvencies

(2) Market regulation

A. Unfair practicesB. Policy formsC. Competence of agentsD. Consumer complaints and assistance

(3) Regulation of ratesPrinciples:AdequacyNot be excessiveNot discriminate unfairlyWays for rate regulation:Prior approvalNo filingFile-and-useInformational filingFlex-rating

Chapter 7 functions of insurersRatemaking Methods:Judgment ratingSchedule ratingExperience rating: credibility factorRetrospective rating

(2) Principle of the rate of premium

A. FairnessB. Solvency: avoid vicious

competitionC. Comparative stabilityD. Encouraging loss reduction

(3) Setting of the property premium rate

Rate of loss=compensation÷insurance amountCredibility factor: usual 10 percent(This is also the adjustment rate)Rate of property premium:Rate of lossX(1+10%)X(1+g) ÷(1+y) g: extra rate, y: investment gain.(4) Rate of life premium

Chapter 11 introduction to life insuranceLife insurance is a risk-pooling

planLife insurance does not violate the

requirements of an insurable risk, for it is not the possibility of death itself that is insured, but rather untimely death

Life insurance is not a contract of indemnity

1. Types of life insurance contractsTerm insurance(pure insurance protection)

Cash value insurance(protection and savings)

Term insurance Whole-life insuranceEndowment insuranceUniversal life insuranceAdjustable life insuranceVariable life insurance

(1) Reasons for difference in term and cash value insurance

(2) The level premium concept

2. Current life insurance products(1) Term insuranceRenewable termConvertible termAdvantages of term life insurance:

A. Greatest amount of protection for a given outlayB. meet temporary insurance needs

Disadvantage: adverse selection

(2) Whole life insuranceA. Straight whole lifeB. Limited-pay whole life(3) Universal life insuranceAdvantages of Universal Life InsuranceFlexibility of Premium PaymentsAbility to earn a great return when interest

rates riseFlexibility of death benefits

Universal life insurance:

People buy a term policy and invest an additional amount with the insurance company.

The minimum premium is to keep a term insurance in force.

The insured is allowed to determine the amount and frequency of the premium payments within limits.

A guaranteed rate is specified in the contract, while an excess interest rate is determined by a formula or by company declaration.

(4) Variable life insurance

A modification of universal life insuranceOne insured has two accounts: an insurance account and a separate account(5) Adjustable life insurance(6) Endowment life insurance(7) Participating and nonparticipating life insuranceThe dividends

3. General classifications of life insurance(1) Ordinary life insurance(2) Industrial life insuranceSmall amount but higher frequency of

premiums(3) Group life insuranceProvided to a well-defined group of people who

are associated for some purpose other than purchasing life insurance

Generally costs less than similar individually purchased insurance

(4) Credit life insurance

Chapter 13 The life insurance contract1. Inception of the life insurance

contractConditional binding receipt: usually

called a binder, which is the temporary life insurance contract after the payment of a premium.

The binder has the same legal effect as the formal insurance contract

2. General provisions of life insurance contracts

Entire contract clauseOwnership clauseBeneficiary clause: primary or contingentRevocable or irrevocableIncontestable clauseMisstatement of age clauseGrace periodReinstatement

Suicide clauseAviation exclusionsWar clause

3. Settlement options(1) Interest option(2) Installments for a fixed period(3) Installments of a fixed amount(4) Life income optionsStraight life incomeLife income with period certainLife income with refundJoint and survivor income

Example of payments under any one of the above life income options

Chapter 15 Disability income insurance

1. General nature of disability income insurance

Periodic payments to the person insured when he or she is unable to work because of injury or illness

Benefit eligibility presumes a loss of income

(1) Types of insurersProperty and liability insurers, life insurers and specialty health insurers

(2) Methods of marketingMainly sold on a group basis(3) Short-term versus long-term

disability coverageShort-term: up to 2 years with an

elimination period (waiting period)Long-term: from the date of disability to

retirement with an elimination period. It is a logical complement to life insurance

Chapter 16 coverage for medical expensesThe insurance product1. Traditional forms of medical expense

insurance:(1) Base plan coverageHospitalization, surgical expense coverage and

physician’s coverage are written togetherCovers the costs of both hospitalization and

outpatientFirst dollar coverage: base plan coverage

policies often have no-deductible provision

A. Hospitalization insuranceBlue Cross service plans provide a semiprivate room in a participating hospital for a stated number of days, rather than a cash benefit

Hospital expense policies offered by commercial insurers reimburse some or all of the cost of room and board when the insured is confined to a hospital

Policies of both Blue Cross and commercial insurance companies cover incidental hospital expenses

B. Surgical expense insurance Specify a maximum amount of coverage. If one patient needs more than one procedures, the most expensive treatment determines the payment

UCR chargesC. Physician’s expense insurance(2) Major Medical InsuranceMajor medical policies have a substantial

deductible provisionMajor medical policies have a participation

provisionMajor medical policies have a high limit of

liabilitySee the example

2. Exclusions under health insurance policies (12 exclusions)

3. Coordination of benefitIn the double-income family, one or both

partners may be covered under two policiesThe coordination of benefit is to eliminate

double payment when two policies existAn individual’s policy applies before the

spouse’s policyChildren are covered under the policy of the

parent whose birthday is earliest in the year

Chapter 19 the automobile and its legal environmentAutomobile coverage is a type of

property insurance with the apparent elements of life insurance

The purchase of the automobile coverage is not a mere personal choice, instead, it is a social obligation

1. A brief overview of automobile coverages(1) Automobile liability insurance (also called the third party liability), which covers the injuries to other persons and damages to caused Single limit of liabilitySplit limits of liabilityInsureds---the named insured and her consentients Exclusions

(2) Medical payments coverageIt is written with a maximum limit per person per accident

(3) Physical damage coverage, also called damage to the auto

Insures against loss of the policyholder’s own automobile

The coverage is written under two insurance agreements: A. other than collision B. collision

Exclusions

(4) Uninsured motorists coverage

Purpose: protect people from the loss of accident caused by another uninsured motoristUninsured motorist: Drivers without insurance Drivers with less insurance than the minimum required by the state law Hit-and –run Drivers Drivers with coverage provided by insolvent insurers

2. The no-fault concept

No-fault vs. tort systemThe no-fault insurance provides one more option to the insureds so that it is more flexibleUnder the no-fault system, there is no attempt to fix blame or to place the burden of the loss on the party causing itAll parties receive compensation from their own insurer, regardless of who caused the accidentNo-fault insurance is to speed the compensation in less serious traffic accidents

(1) Pure no-fault proposalsthe tort system would be abolished for bodily injuries arising from auto accidents

(2) Modified no-fault proposalsTort action would be retained for losses

above the amount recovered under first-party coverage

(3) Expanded first-party coverageNo exemption from tort liabilityMost important, the responsibility of the

negligent driver is retained by permitting subrogation by the insurer paying the first-party benefits

3. Cost of automobile insurance

Most automobile rating systems begin with three basic factors

A. Age and sex of the driverB. Use of the automobileC. The driver’s recordIn China, the region in which the

automobile is used is also considered

Poor vs. rich, plain vs. mountainous

Chapter 20 commercial property insuranceCan be classified into 7 broad

categories:1. Commercial property insurance2. Boiler and machinery insurance3. Transportation insurance4. Crime insurance5. Commercial liability insurance6. Commercial automobile insurance7. Workers compensation and employers’

liability insurance

Commercial Package Policy:Insureds must purchase at least two of the package’s components, and as many as they need1. Commercial property direct

loss coverage(1) Building and Personal Property

FormA. Property Covered:BuildingYour Personal PropertyPersonal Property of others

B. Perils insuredbasic form, broad form, special form

C. Other provisions:property excluded from coverage,

deductibles, actual cash valueD. Coinsurance Guard against the possible

intentional inadequate coverage

E. Reporting form coverage

Reporting forms are designed to meet the needs of business firms whose stocks of merchandise fluctuate over time

The insured must report 100 percent of the values of the property insured. Late reports or underreporting of values, intentional or otherwise, may result in a penalty at the time of a loss

2. Commercial property coverage for indirect loss

Commercial property forms do not provide coverage for the indirect loss resulting from damage to the insured property.

Such protection must be obtained under a separate form for an additional premium

(1) Business interruption insurance

Business income formsBusiness income coverage (and extra expense)Business income coverage (without extra

expense)

If the business is interrupted, payment is made for the loss of business income, defined as the net profit that would have been earned and the necessary expenses that continue during the period of restoration

(2) Contingent business interruption and extra expenses

A. Contributing propertyB. Manufacturing propertyC. Recipient propertyD. Leader property

3. Transportation coverages(1) Ocean marine insuranceA. Hull insuranceProtects the owner of a vessel against loss to

the ship itselfThe coverage is written on an open-perils

basisB. Cargo insuranceMain form of ocean marine insurance, written

separately from hull insuranceC. Freight insuranceD. Protection and indemnity

Perils insured---open perils agreementValuation

Average conditions: particular average & general average

(2) Inland marine insuranceNot limited to the transportation in the

rivers6 forms of coverage

4. Insurance against dishonesty

(1) Employee crime coverageAlso called fidelity bondsA. Schedule bondsCover the specific person or position

that is listed in the policyB. Blanket bondsCover all the employees, regardless

of position

(2) Nonemployee crime coverageprotect against burglary, robbery, theft, forgery, some of which with evidenceChapter 21 commercial

liability insurance1. Employers liability and

workers compensationTo protect both the employees

and the employerThe largest firms self-insure

(1) Workers compensation insurance

A. The insuring agreement obligates the insurer to pay the benefits for which the insured is liable under the workers compensation law

B. There are no exclusions under the coverage and no maximum limit on the insurer’s liability

C. It makes the insurer directly and primarily liable to employees who are entitled to benefits

D. The insurer’s obligation to employees is not affected by any default of the insured

E. The insurer’s liability to the employees is governed by the workers compensation law, the insurer’s obligation to the employer is governed by the policy terms

(2) Employer liability insuranceIf an injured employee brought suit,

the legal principles generally favored the employer

2. General liability insurance

Protect the firm against the peril of legal liability that involves injuries to persons other than employees of the insured

(1) General liability exposureEvery business firm is subject to one or a

combination of the following liability exposures

A. Ownership and maintenance of premises

B. Conduct of business operationsC. Products: Negligence, breach of warranty, strict

liabilityD. Completed operationsE. Contingent liabilityF. Contractual liability

3. Commercial automobile insurance

Four commercial automobile forms:Business auto coverageGarage coverageTruckers coverageMotor carriers coverage

(1) Business auto coverage formSimilar in all the aspects with that of

the personal auto policy

(2) Garage coverage form

To provide comprehensive liability coverage for garages, sales agencies, repair shops, service stations, storage garages and public parking places

Hazards covered:Premises and operationsProducts and completed operationsAutomobile liability

(3) Truckers coverage form

A modified version of the Business Auto Coverage Form designed to meet the special needs of truckers.

Extend the coverage from the licensed truckers to the independent owner-operators

4. Aviation insurance

Purchased by the owners and operators of aircraft, airport operators, and by companies building and supplying parts for aircraft, but not passengers

Including planes, helicopters, hot air balloons, hang gliders and space satellites

(1) Aircraft liability insurance

A. Passenger B. Bodily injury excluding passengersC. Property damage liability (2) Hull coverageThe core problem facing aviation insurers is the weakening of law of large numbers

Chapter 22 surety bonds and credit insuranceBoth are designed to protect against financial losses from default by someone on whom the insured depends1. Surety bondsIt is reserved for the nonfidelity field

One party (the surety) agrees to be held responsible to a second party (the obligee) for the obligations of a third party (the principal)The principal buys the surety bond. The surety lends its name and credit to guarantee the obligation of the principal. If the principal fails to perform, the surety is responsible to the obligee for the amount of the bond.

(1) Suretyship distinguished from insuranceA. The most frequently stated distinction is

that a surety bond is a three-party contract, whereas the insurance policy is a two-party contract

B. The most important distinction is one of the basic philosophy regarding losses. In the insurance field, the insurer generally expects losses. In the surety field, no losses are expected.

C. Whereas actuarial science is the basis for insurance rates, the fee for a surety bond is a payment for investigation and certification

The main categories of surety bonds:Contract bondsCourt bondsLicense and permit bondsPublic official bondsMiscellaneous bonds

2. Credit insurancePurchased by the creditor

It is sold only to manufacturers and wholesalers, which protects against loss resulting from the inability to collect accounts due to insolvency or unwillingness or inability to pay by the purchasers

Back coverage policies: cover losses arising out of defaults during the policy period

Forward coverage policies: cover losses stemming from sales during the policy period

(1) Types of policiesA. Extraordinary coverageGenerally purchased by companies that

deal with a limited number of buyers.It is issued after an investigation of the

individual debtors and acceptance of each one by the insurer.

The insurer is permitted to cancel coverage as to future shipments to any debtor.

B. General coverageIt includes protection on all policyholder’s customers with a credit rating

Investigation of the individual customers is not needed because the coverage on each account is determined by a table of mercantile ratings, selected by the insured and incorporated into the contract.

Only debtors whose credit rating comes within the limitations of the ratings adopted by the insured are covered.

(2) Coinsurance and the normal loss

The insured shall assume two proportions of each net loss:

A. Coinsurance percentage (10% or 20%)

B. Annual deductible (known as the primary loss or normal loss)

It is calculated from the previous experience of the firm insured or as a percentage of the firm’s net sales from tables that express bad debt ratios for various industries

Loss settlement is made on an annual basis, with the coinsurance percentage applied to each loss before the application of the normal loss deductible

(3) Collection serviceThe collection service is one of the most

attractive aspects of credit insuranceIf the insured is required or permitted to turn

past due accounts over to the insurer, accounts that are overdue a stated period under the original terms of sale are turned over to the insurer for collection. If the insurer succeeds, a small service charge is made for the collection. If it is unsuccessful, the account becomes a loss under the policy.

3. Credit enhancement insurance

Also called financial guarantee, is a combination of suretyship and insuranceThe insurer “insures” the purchaser of bonds and other debt instruments that the debt will be paid and substitutes its financial strength for the financial strength of the borrower