Insurance Concepts & Principles

Basic Insurance Concepts and Principles

• An Agent/Producer is a legal representative of an insurance company, including agents and brokers
• A Beneficiary is a person who receives the benefits of an insurance policy
• A Broker is an insurance producer not appointed by an insurer and represents the client
• Indemnity is the principle that the insured cannot recover more than the actual loss; insurance restores to the pre-loss position
• An Insurance Policy is a contract where an insurance company agrees to pay the insured or beneficiary for loss caused by specific events
• The Insured is the person covered by the insurance policy; this may or may not be the policy owner
• The Insurer is the company that issues an insurance policy
• The Law of Large Numbers states that the larger the number of people with similar exposure to loss, the more predictable the actual losses
• The PolicyOwner is the person entitled to exercise the rights and privileges in the policy
• A Premium is the money paid to the insurance company for the insurance policy
• Reciprocity/Reciprocal refers to a mutual interchange of rights and privileges

Insurance as a Transfer of Risk

• Insurance transfers risk of loss from an individual or business to an insurance company
• Insurance spreads the cost of unexpected losses to many individuals
• Without insurance, the cost of a loss would be borne solely by the individual who suffered the loss
• The cost of an insurance loss is transferred to the insurer and spread among other insureds

Life Insurance Parties

• PolicyOwner pays the premium to the insurance company
• The Insurance Company issues the policy to the policy owner and pays benefit to the beneficiary
• The Beneficiary receives the death benefit upon the insured's death

Risk Types

• Risk is the uncertainty or chance of a loss occurring
• Pure risk involves situations with only a loss or no change, with no opportunity for financial gain, and is insurable
• Speculative risk involves opportunities for loss or gain, such as gambling, and is not insurable
• Only pure risks are insurable

Causes of Loss

• Perils are the causes of loss insured against in an insurance policy
• Hazards are conditions or situations that increase the probability of an insured loss occurring
• Physical hazards are individual characteristics that increase the chances of loss
• Moral hazards are tendencies towards increased risk
• Morale hazards arise from a state of mind causing indifference to loss, like carelessness

Law of Large Numbers

• The Law of Large Numbers states that the larger the number of people with a similar exposure to loss, the more predictable actual losses will be.
• As the number of people in a risk pool increases, future losses become more predictable

Exposure and Insurance Rates

• Exposure is a unit of measure to determine rates for insurance coverage
• Factors considered in determining rates include age, medical history, occupation, and sex of the insured

Hazards, Perils, Loss, and Insurance

• Hazards are decisions/actions that increase the risk or probability of loss
• Perils are the causes of loss
• Loss is the reduction of value and the basis for a claim
• Insurance includes the transfer of loss and protection

Risk, Hazard and Peril

• Risk is a chance that a loss will occur
• A hazard increases the probability of loss
• A peril is the cause of loss

Adverse Selection and Risk

• Insurance companies protect themselves from adverse selection, insuring risks less prone to losses than average
• Critical risks involve exposures where possible losses could result in financial ruin
• Important risks involve exposures where losses lead to major changes in lifestyle
• Unimportant risks involve exposures where losses can be met without financial strain

Methods of Handling Risk

• Sharing involves a group with similar exposures sharing losses
• Transfer involves shifting the risk, so the loss is borne by another party
• Avoidance eliminates exposure to a loss
• Retention is the planned assumption of risk using deductibles, copayments, or self-insurance
  • to reduce expenses and improve cash flow
  • to increase control of claim reserving and claims settlements
  • to have funds for losses that cannot be insured
• Reduction lessens the possibility of a loss

Insurable Risks

• The loss must be due to chance (accidental) and outside the insured's control
• The loss must be definite and measurable in cause, time, place, and amount
• The loss must be statistically predictable to estimate future losses and set premium rates (using mortality/morbidity tables in life/health insurance)
• The loss cannot be catastrophic; insurers avoid risks that expose them to catastrophic losses and exclude coverage for wars or nuclear events
• The loss exposure must involve large homogeneous exposure units, grouped into classes with similar risks for insurers to predict losses
• Insurance must not be mandatory; insurers must not be required to issue a policy to each applicant and must have underwriting guidelines

Insurability of Losses

• The more predictable a loss, the more insurable it becomes
• The more unpredictable a loss, the less insurable it becomes
• Gambling loss or lottery outcomes are unpredictable, and not insurable.

Insurable Interest

• A valid insurable interest may exist between the policyowner and the insured when insuring:
  • The policyowner's own life
  • The life of a family member (spouse or close blood relative)
  • The life of a business partner, key employee, or someone with a financial obligation to the policy owner
• Insurable interest must exist at the time of application
• The policy owner must have insurable interest in the life of the insured

Indemnity (Reimbursement)

• Indemnity means an insured or beneficiary can collect only to the extent of the financial loss, not gain financially
• Insurance restores, but does not allow the insured to profit from the loss

Health Insurance example

• Brenda has a health policy for $20,000
• Her medical expenses totaled $15,000
• The policy will reimburse Brenda only for $15,000 (the amount of the loss), and not for $20,000 (the total amount of insurance).

Property Insurance Example

• Brenda has a homeowners policy for $200,000
• Her home was destroyed, and expenses totaled $150,000 to rebuild
• The policy will reimburse Brenda only for $150,000 (the amount of the loss), and not for $200,000 (the total amount of insurance).
• Indemnity means insureds cannot recover more than their loss

Utmost Good Faith

• Utmost Good Faith implies no fraud, misrepresentation, or concealment between parties
• Insurer and insured must rely on each other for relevant information
• The insured is expected to provide accurate information on the application
• The insurer must clearly and truthfully describe policy features and benefits, and must not conceal or mislead the insured