Nature of Insurance PDF

CHAPTER 2 NATURE OF INSURANCE, RISK, PERILS, AND HAZARDS **Adverse Selection:  **This is broadly defined as selection against the company or the tendency of people with higher risks to seek/continue insurance to a greater extent than those with little or less risk. In other words, adverse selection...

CHAPTER 2 NATURE OF INSURANCE, RISK, PERILS, AND HAZARDS **Adverse Selection:  **This is broadly defined as selection against the company or the tendency of people with higher risks to seek/continue insurance to a greater extent than those with little or less risk. In other words, adverse selection occurs when the percentage of poor risks among those covered by issued policies exceeds the ratio predicted by the actuaries when they designed the policies. This also consists of the tendency of policy owners to take advantage of favorable options in insurance contracts. **Hazard:  **This is any factor, condition, or situation that creates an increased possibility that a peril (a cause of a loss) will actually occur. **Homogeneous Exposure Units:  **These are similar "objects of insurance" that are exposed to the same group of perils. An "object of insurance" can be a person, a business, or a piece of property. Each "unit" represents one of many similar risks that are undertaken to be insured by an insurance company. **Indemnify:  **This is the act of restoring insureds to the financial condition that existed prior to a loss. **Indemnity:  **This is the amount needed to restore an individual to the financial condition he was in before he suffered a loss.  An indemnity can be a reimbursement or a fixed dollar amount. **Indemnity Contract:  **This is a contract that attempts to return the insured to her original financial position. **Law of Large Numbers:  **This is a fundamental principle of insurance. The larger the number of individual risks that are combined into a group, the more certainty there is in predicting the degree or amount of loss that will be incurred in any given period. **Loss:  **The insurance industry defines the word "loss" as the unintentional decrease in the monetary value of an asset due to a peril. **Loss Exposure:  **This is the risk of a possible loss. **Loss Exposure Unit:  ** This refers to each individual, organization, or asset that's exposed to the potential of financial loss due to a defined peril. When loss exposure units are aggregated together, the maximum potential loss expresses the overall **loss exposure**. **Moral Hazard:  **This is the type of hazard that exists because of the effect of an insured's personal reputation, character, associates, personal living habits, or degree of financial responsibility. This also includes criminal activity. **Morale Hazard:  **This is a hazard that arises from an insured's indifference to loss because of the existence of insurance. Morale hazards are often associated with having a careless attitude. **Peril:  **A peril is the immediate, specific event that causes loss and gives rise to risk. **Physical Hazard:  **This is a physical or tangible condition that exists in a manner which makes a loss more likely to occur. **Primary Insurance Company:  **This phrase has the following meanings: - When more than one policy covers the same claim, the term "primary insurance company" refers to the first policy to pay. - As it relates to reinsurance, the primary insurance company writes a policy to cover a risk in the marketplace. This primary insurer then surrenders a portion of the risk to a reinsurer and the reinsurer assumes the excess risk for a reinsurance premium. **Pure Risk:  **This is a type of risk that involves the chance of loss only; there's no opportunity for gain. Pure risks are the only form of insurable risks. **Reinsurance:  **This is the acceptance by one or more insurers---referred to as reinsurers---of a portion of the risk underwritten by another insurer that has contracted with an insured to provide coverage for the total value of a loss exposure. **Reinsurer:  **This is an insurance company that assumes a portion of the risk underwritten by a primary insurance company. **Risk:  **This is the uncertainty regarding loss. Risk is the probability of a loss occurring for an insured or prospect. **Risk Avoidance:  **This occurs when individuals evade risk entirely. It's the act of NOT participating in an activity that could possibly cause a loss. **Risk Management:  **This is the process of analyzing exposures that create risk and then designing programs to address them. **Risk Reduction:  **This is the risk management strategy that focuses on taking actions which decrease the chances of a loss occurring. It also refers to action taken to lessen the severity of a loss if one occurs. **Risk Retention:  **This is the act of analyzing the loss exposure presented by a risk and determining that the potential loss is acceptable. Risk retention is often associated with **self-insurance**. **Risk Selection:  **This is not a risk management technique that's used by consumers. Instead, "risk selection" describes the insurance company's process for determining whether to cover a new loss exposure. If done correctly, the ratio of losses to premium should reflect what actuaries predicted when they created the product, established the price, and set the underwriting criteria. **Risk Sharing (Risk Pooling or Loss Sharing):  **This is the risk management technique that manages an individual's risk by sharing the possibility of loss with others and spreading the cost over a large number of individuals. This technique transfers risk from an individual to a group. **Risk Transfer:  **This is the act of exchanging the responsibility for a significant potential loss (risk) to another party in exchange for a smaller, preset cost or premium. **Self-Insurance:  **This is a risk retention process. A self-insuring individual or organization maintains monetary reserves to cover potential costs in the event of a financial loss occurring. **Speculative Risk:  **This is a type of risk that involves the chance of both loss and gain; it's not insurable. [Most accident, health, property, and casualty insurance contracts are contracts of ]**indemnity**[. Their purpose is to reimburse for a loss. In contrast, life insurance policies are valued contracts because they pay a predetermined amount regardless of the actual loss that was incurred.] LAW OF NUMBERS Predicting the level of future losses expected across a large group is also referred to as the "spread of risk," or more commonly referred to as risk spreading. This principle of actuarial science states that [the larger the number of risks insured in the same risk pool, the more predictable losses become]---at least in the aggregate. Although an insurance company can use the Law of Large numbers to predict the total amount of expected loss in the risk pool, there's no way to predict which specific individual will suffer financial loss. ADVERSE SELECTION\  In the purest sense, adverse selection means that one party in a business transaction has superior accurate information over another party. [Insurance underwriting is designed to ensure that insurance carriers are fairly compensated for the actual risks they undertake when issuing insurance contracts]. Therefore, the premium for a high-risk person or property is greater than the premium for a lower risk. Some risks are avoided by an insurance carrier altogether because the company may choose not to select risks that run against its own best interest. Adverse selection occurs when a company takes on risk without being accurately compensated for the actual amount they must ultimately pay in claims. To be profitable and stay in business, companies must avoid adverse selection. A [profitable distribution of exposure] exists when the number of preferred risks is balanced with poor risks, and the number of average risks is in the middle. [Sound, competent underwriting may reduce the chance of adverse selection. Insuring large groups of individuals (i.e., group life insurance) may also reduce this danger]. [A **peril** is the immediate, specific event that causes a loss]. As noted in the following list, different lines of insurance cover different perils. - Property insurance covers losses caused by such perils as fire, lightning, windstorm hail, earthquake, and vandalism. - Liability insurance covers an insured's legal responsibility to indemnify a third-party that's harmed due to the insured's negligence. - Accident and health insurance covers losses caused by illnesses and accidents. - For life insurance and annuities, the covered peril is mortality. Life insurance protects against premature death; however, annuities provide a measure of protection when death is delayed, and the insured would otherwise outlive his assets. - Typically, insurance policies define the perils being protected against in one of two ways: Specified (Named) Perils and Special (Open) Perils**.** - Insurance contracts that individually cover **Specified or Named Perils **list those specific perils that they cover. If a loss is caused by a peril that's not listed within the insurance policy, then the loss is not covered. *For example, a life insurance policy may specifically name coverage for only accidental death. A health insurance policy may explicitly only cover cancer. A property policy may explicitly cover only loss that's caused by fire and lightning. Again, a named perils policy identifies the perils that are covered under the policy. By doing so, a named-peril policy defines the covered losses narrowly*. **Special or Open Peril** insurance policies don't name the perils that they cover. Instead, these policies begin by stating that they cover all direct causes of loss and then list all of the perils that they exclude from coverage. Since an open peril policy stipulates the causes of loss that are not covered under the policy, the policy will therefore cover any peril that's not explicitly identified as being excluded from coverage. *For example, comprehensive medical insurance and standard life insurance will typically cover medical bills and pay death claims related to perils other than those expressly excluded*. **Direct losses** occur when a person or property is damaged, destroyed, or killed by a peril without any *intervening cause*. The peril in question is the proximate cause of the direct loss.  An **indirect loss** is also referred to as "**Consequential Loss" **because the loss is a consequence of, or results from, a direct loss. This distinction is most relevant for property and casualty insurance. A loss can also be defined as either an accident or an occurrence.  An **accident** is an unforeseen, unexpected, unintended, and sudden event that occurs at a specific time and specific place.  An **occurrence** can be any event that causes a loss. Occurrences include accidents, injuries, illnesses, as well as losses that are caused by repeated or continuous exposure to conditions over time. *For example, if an individual needs a knee replacement from being involved in a car accident, there are likely some witnesses who saw the accident and, in theory, could provide the exact time and location of the accident that caused the injury. Now, let's assume the individual needs a knee replacement due to years of intense physical activity. In this case, there are no witnesses who could provide the [specific time and location] of the occurrence that resulted in the need for the individual's knee replacement.\ * *\[EXAM TIP: Every accident is an occurrence, but not every occurrence is an accident.\]* **Loss Exposure: **Loss exposure is the risk of a possible loss. Basically, it's any situation that presents the possibility of a loss. **Homogeneous Exposure Units: **Homogeneous exposure units are similar objects of insurance that are exposed to the same group of perils. The larger the number of homogeneous units (similar risks), the easier it becomes to predict loss. A loss exposure consists of loss exposure units. A **hazard** increases the possibility that a peril (a cause of a loss) will occur. Examples of hazards include icy roads, driving while intoxicated, and improperly stored toxic waste. There are three types of hazards---*physical hazards, moral hazards,* and *morale hazards*. All of these hazards result from conditions relating to the insured. **Physical Hazards    **Physical hazards are physical or tangible conditions that exist in a manner which makes a loss more likely to occur. Physical hazards can be seen, touched, tasted, smelled, or tripped over, thereby causing loss.* *Poor health and ice on roads are examples of physical hazards. *For example, let's assume that an individual leaves a full can of gasoline near the furnace in his basement. In this case, there's a greater likelihood that an explosion will occur than if the individual had left the gas can in his garage*. **Moral Hazards    **Moral hazards make the loss more likely to occur due to the dishonest character of the insured, who may be more disposed to either engage in criminal activity or cause a loss because of negative habits. The chance of loss increases because of who the insured is. In other words, the chance of loss is greater due to the individual character of the insured. Properly defined, a moral hazard occurs when the insured is much more intentioned and conscious of participating in wrongdoing that's more likely to lead to a loss. *For example, a dishonest person is more likely to lie to an insurance company---both on an application and when submitting a claim for loss, thereby creating a higher likelihood of engaging in insurance fraud. Drug use and alcohol abuse are commonly associated with moral hazards*. **Morale Hazards    **Morale hazards result from the personal or subjective thought process of the insured. In other words, they arise from a state of mind that's related to the indifference of an insured to whatever loss may occur. The insured unintentionally creates a loss situation on an unconscious level. In essence, they just don't care about loss prevention since the property is insured. *For example, Alex leaves his car running unattended and the doors unlocked to heat it on a cold winter morning. This act makes it more likely that his car will be easily stolen by a car thief who's looking for such vehicles. On some unintentional mental level, the insured simply doesn't care that this kind of loss may occur, probably because the vehicle is insured. Reckless driving, jumping off a cliff, stealing, racing motorcycles, and a careless lifestyle are often associated with morale hazards*. **Speculative Risk    **Speculative risk is a risk that presents the chance for both loss and gain. [Speculative risks are not insurable]. **Pure Risk    **Pure risks present a potential for loss only and no possibility of gain. [Only pure risks are insurable]. ELEMENTS OF AN INSURABLE RISK - **An insurable loss must be due to chance (accidental)** -- "Chance" means that it's outside an insured's control. In this sense, the individual insured (loss exposure unit) that suffers the loss is randomly selected. This characteristic helps insurers avoid adverse selection. *For example, an insured catches a cold*. - **An insurable loss must be definite and measurable** -- "Definite and measurable" means that the time, place, amount, and whether the claim is payable can be documented. *For example, the insured's automobile accident occurred at 2:00 p.m. on Friday and caused \$2,000 in damage*. - **An insurable loss must be predictable** -- The term "predictable" means that the (estimated) average frequency and severity of future losses can be calculated. There must be a sufficient number of homogeneous loss exposure units to effectively allow insurers to apply law of large numbers. *For example, 18% of accidents involve distracted driving*. - **An insurable loss cannot be catastrophic** -- The term "catastrophic" is from the perspective of the insurer. This is meant to indicate that it's too big and uncertain to be insured. The loss exposure must be reasonable. *For example, a war, a nuclear disaster, or a \$1 trillion life insurance policy is not reasonable loss exposure*. - **The number of loss exposures (units) to be insured must be substantial --** The carrier's actuaries must be able to apply the law of large numbers to help the insurance company predict loss. - **The premium cost must be economically feasible -- **A premium is "feasible" when it's affordable. Also, the premium must be small in comparison to the loss exposure being insured. *For example, a healthy 45-year-old male could probably qualify for a 20-year term life insurance policy with a \$250,000 face amount for less than \$500 per year*. **1. Standard Risks:** Standard risks are considered to have an average potential for loss. Standard risks are typically insured in return for a predetermined standard premium. 2.    **Substandard Risks: **Substandard risks are judged to be a poor risk for an insurance company and have a higher-than-average potential for loss. Substandard risks may be insured for an increased premium, covered with a lower benefit, or declined altogether. 3.    **Preferred Risks:** Preferred risks are judged to be a better than average risk for an insurance company. Preferred risks have a lower potential for loss. Insurers offer coverage to preferred risks for a lower-than-average premium. The process of analyzing exposures that create risk and designing programs to handle them is referred to as **risk management**. Risk management may be accomplished by \(1) detecting the potential loss exposure; \(2) selecting a method or tool in order to reduce risk; \(3) executing a course of action; and \(4) periodically reviewing the measures taken. The risk may be reduced or managed by purchasing an insurance contract. **Risk-sharing** spreads risk among multiple parties. Each party assumes a portion of the risks that are covered by the arrangement. **Reciprocal insurance companies** (e.g., USAA in San Antonio, TX)---also referred to as **inter-insurance exchanges**---are one type of risk sharing arrangement. **Risk transfer** features a legal contract that transfers risk from one party to another. In general, insurance contracts are risk transfer arrangements. They transfer the risk of loss defined in the policy to the insurer in exchange for a known fee or premium. **Risk Avoidance    [Risk avoidance]**[ means that risk can be avoided by eliminating an activity or condition that exposes a person to a type of loss or specific perils.] *For example, if a person doesn't go skydiving, she has no risk of dying in a skydiving accident*. **Risk Reduction    [Risk reduction]**[ is the process by which a person takes deliberate actions to reduce the likelihood of a loss, or the severity of a loss if it should occur.] *For example, installing smoke alarms and a sprinkler system reduces the risk of death and will reduce the amount of property loss in a building fire*. **Risk retention** is a conscious strategy in which a person maintains a certain amount of reserves to address unexpected expenses that are caused by insurable losses. Some forms of risk retention are limited, such as the deductibles in a health insurance plan or personal automobile insurance. Some large companies that have highly predictable patterns of loss also self-insure. *For example, a person with a \$1,000 deductible on her automobile insurance policy retains \$1,000 of any risk if her car is damaged in an accident*. It's essential to know that "self-insurance" is much different than "no insurance." The former is a planned strategy that's based on holding reserves and self-financing losses. The latter is simply a refusal to acknowledge the reality of risk and the possibility of financial loss. *\[EXAM TIP: One way to remember these methods of handling risk is to use the acronym STARR (shared, transferred, avoided, reduction, and retention).\]* Another risk management tool available is loss prevention. Loss prevention involves taking actions to eliminate damage or loss. In fact, it's a method used to identify and analyze risk and to control losses. **The Nature of Insurance** - An insurance policy is the transfer of risk from one party to another in exchange for a fee (premium) using a legal contract. - Insurance companies take one person's risk of loss and spread it among all parties who are participating in the insurer's risk pool, as evidenced by the payment of premiums. - The "**Principle of Indemnification**" is financial. Any insurance contract that's based on this principle intends to restore insureds to their original financial position after they suffer losses. - The same principle stipulates that insureds will not profit or gain from their loss. In other words, they will not receive more than they lost. - The amount needed to restore the insured's financial status can be referred to as an **indemnity.** The act of restoring is considered **indemnifying**. - The '**law of large numbers**' states that the greater the number of homogenous loss exposures, the more accurate the prediction of the aggregate risk within an insurance pool. - **Adverse selection** is the tendency for higher-than-average risks to seek out insurance more frequently than lower risks. **Perils, Loss, and Hazards** - A **peril **is the immediate and specific cause of a loss. - Insurance policies that cover **Specified or Named Perils **will individually list the perils that they cover. If the peril that causes a loss is not listed, then the loss is not covered. - Insurance policies that use a** Special or Open Peril** definition of covered perils will cover losses that result from any cause (peril) which is not explicitly excluded in the policy. - A **loss** is an unintended (by the insured) loss of financial or monetary value. - The event that causes a loss is referred to as an **Occurrence. **An occurrence takes place at a specific time or place or develops over time before it makes itself known. - An **accident **is a type of occurrence but is unexpected and unintended. An accident happens at a specific time and place and causes a measurable loss. - Other occurrences such as illnesses, repetitive motion injuries, or exposure to toxins may cause an identifiable loss, but it's not possible to determine the exact moment that the loss occurred. - A **direct loss** occurs when people are harmed, or a covered peril damages property. - An **Indirect Loss** or "**Consequential Loss" **results from a direct loss, such as the loss of revenue when a business shuts down to rebuild after a fire. Disability insurance also covers a consequential loss---the loss of income when a person cannot work because of an illness or injury (direct loss). - **Loss exposure** is the risk of a possible loss. Basically, any situation that presents the possibility of a loss. In some cases, the term is used to refer to a loss exposure unit. - **Homogeneous exposure units** are individual entities that are exposed to the same group of perils. Their similarities allow them to be grouped together so that the same actuarial assumptions can be applied when pricing coverage. - A **hazard **is a physical condition, a way of acting, or a way of thinking that increases the likelihood that a loss will occur. - **Physical hazards** are physical or tangible conditions that make a loss more likely to occur, such as the increased risk of disability if a person has chronic back problems. - **Moral hazards** make the loss more likely to occur due to the dishonest character of the insured or harmful acts that are done intentionally. Cigarette smoking is an example of a legal action that's considered a moral hazard. Falsifying the circumstances of an automobile insurance claim to avoid paying a deductible or being held liable is both illegal and evidence of a moral hazard. - **Morale hazards **arise from a state of mind that's indifferent to the possibility of loss because of the existence of insurance. **Risk** - **Risk **is the uncertainty regarding the occurrence of a loss. - **Speculative risks** are not insurable as they result in financial gains as well as losses. - **Pure risks** are insurable because there's only the potential for loss. - In general, insurable risk must include all of the following elements: - An insurable loss must be due to chance (accidental), which means the cause must be outside an insured's control. - An insurable loss must be definite and measurable, which means the time, place, and amount are known. - An insurable loss must be predictable (calculable). There must be a sufficient number of homogeneous loss exposures. - An insurable loss cannot be catastrophic. If the potential loss is too large or unpredictable, an insurer cannot financially survive after paying a claim. - An insured consumer must have a substantial loss exposure to make the option of buying insurance economically reasonable. - The premium cost must be affordable. - The following are the three basic risk classifications: - **Standard risks** have an average potential for loss. - **Substandard risks** have a higher-than-average potential for loss. - **Preferred risks** have a lower-than-average potential for loss. - Risk managers analyze existing loss exposures and create programs that manage the risk using one or more of the following risk management tools: - **Risk avoidance** eliminates situations that expose a person to risk. - **Risk reduction** accepts the existence of a risk but takes actions to reduce the likelihood or severity of a loss*.* - **Loss prevention** is a form of risk reduction. The insured takes actions that eliminate damage or loss. - **Risk retention** occurs when a person accepts a degree of risk and creates a reserve to pay for it if needed. - **Risk transfer** is the practice of transferring risk from one party to another and is the basis of insurance. - **Risk-sharing** spreads risk among multiple parties that each assumes a portion of the covered losses. - **Risk pooling **spreads risk by distributing the anticipated cost of future losses among many individuals. - Risk pooling transfers the risk of loss from an individual to a group. - **Reinsurance **is a form of risk transfer between insurance companies. - The ceding primary insurer transfers excess risk (risk in excess of its retention limit for a single exposure) to a reinsurance carrier that assumes the risk after receiving a premium from the primary carrier.