Insurance Handbook 2010 PDF

Insurance Handbook A guide to insurance: what it does and how it works Insurance Handbook A guide to insurance: what it does and how it works ©2010 Insurance Information Institute. 978-0-932387-47-9 Insurance Information Institute 110 William Street New York, NY 10038 Tel. 212-346-5500. Fax. 212-732-1916. www.iii.org President – Robert P. Hartwig, Ph.D., CPCU – [email protected] Executive Vice President – Cary Schneider – [email protected] Senior Vice President – Public Affairs – Jeanne Salvatore – [email protected] Senior Vice President and Chief Economist – Steven N. Weisbart, Ph.D., CLU – [email protected] Research Vice President – Global Issues – Claire Wilkinson – [email protected] Publications Vice President – Publications and Information Services – Madine Singer – [email protected] Managing Editor – Neil Liebman – [email protected] Research and Production – Mary-Anne Firneno – [email protected] Director – Technology and Web Production – Shorna Lewis – [email protected] Production Assistant – Katja Charlene Lewis – [email protected] Information Specialist – Alba Rosario – [email protected] Special Consultant – Ruth Gastel, CPCU – [email protected] Media New York: Vice President – Media Relations – Michael Barry – [email protected] Vice President – Web and Editorial Services – Andréa C. Basora – [email protected] Vice President – Communications – Loretta Worters – [email protected] Web/Media Producer – Justin Shaddix – [email protected] West Coast: Insurance Information Network of California: Executive Director – Candysse Miller – [email protected] Tel. 213-624-4462. Fax. 213-624-4432. Northern California: Communications Specialist – Tully Lehman – [email protected] Tel. 925-300-9570. Fax. 925-906-9321. Representatives Davis Communications – William J. Davis, Atlanta – [email protected] Tel. 770-321-5150. Fax. 770-321-5150. Hispanic Press Officer – Elianne González, Miami – [email protected] Tel. 954-389-9517. Florida Representative – Lynne McChristian, Tampa – [email protected] Tel. 813-480-6446. Fax. 813-915-3463. Insurance Handbook A guide to insurance: what it does and how it works ©2010 Insurance Information Institu§te. 978-0-932387-47-9 To The Reader F or over 50 years, the Insurance Information Institute (I.I.I.) has provided information to help consumers, reporters, insurance companies and researchers understand how insurance works and what it does. The Insurance Handbook is the latest addition to I.I.I.’s vast arsenal of resources, including books, brochures, newsletters and videos. Long a primary source of information, analysis and referral on property/casualty insurance issues, the I.I.I. has broadened its reach over the years. Today, the I.I.I. is also a leading source for clear, comprehensive information on annuities, retirement and other life/health insurance concerns. The Insurance Handbook reflects this diversity of subjects and issues. The book begins with basic information on the various types of insurance, including auto, home, life, annuities and long-term care. A glossary section contains over 500 entries, including over 100 life insurance definitions provided by LOMA, a worldwide association of life and financial services companies. A directory lists a wide range of insurance organizations, including national, state and specialty associations. Issues briefs provide overviews of the trends and developments shaping the insurance industry from natural catastrophes to terrorism to workplace safety. The Handbook is designed to be used in conjunction with the Institute’s other information resources: our Web site (www.iii.org), which provides comprehensive information on all aspects of insurance, and our various publications, including the Insurance Fact Book, the Financial Services Fact Book and A Firm Foundation: How Insurance Supports the Economy. Its scope and clarity make it an ideal source for a wide variety of audiences, including: Reporters Public policymakers Regulators Students Insurance company employees Academics We believe this Handbook will prove a source of vital information to the media and others who have long relied on the I.I.I.’s spokespersons and resources for creditable, timely information. We appreciate your comments. Robert Hartwig, Ph.D., CPCU President Insurance Information Institute Contents Insurance Basics..............................................................................1 Overview 1 Auto Insurance 3 Homeowners Insurance 5 Business Insurance 10 Life Insurance 16 Annuities 19 Long-Term Care Insurance 22 Disability Insurance 24 Insurance Topics........................................................................... 27 Captives and Other Risk-Financing Options 29 Catastrophes: Insurance Issues 32 Cellphones and Driving 34 Climate Change: Insurance Issues 35 Credit Scoring 39 Earthquakes: Risk and Insurance Issues 43 Financial and Market Conditions 45 Flood Insurance 47 Insurance Fraud 50 The Liability System and Medical Malpractice Insurance Issues 52 Microinsurance 54 No-Fault Auto Insurance and Other Auto Liability Systems 55 Regulation 57 Reinsurance 60 Residual Markets 62 Terrorism Risk and Insurance 69 Workers Compensation 73 Glossary......................................................................................... 78 Directories...................................................................................128 Property/Casualty Insurance Industry Organizations 128 Life/Health Insurance Industry Organizations 132 Financial Services Industry Organizations 134 Agents and Brokers 141 Regulatory/Legislative Organizations 142 Educational Organizations 143 Specialty Organizations 145 Actuarial/Accounting 145 Adjusters 146 Alternative Markets 146 Auto/Auto Insurance 146 Automation and Claims Services 147 Aviation 147 Community Development 147 Crime/Fraud 147 Crop Insurance 148 Flood Insurance 149 International 149 Legal Issues and Services 152 Marine and Ground Transportation 152 Medical Malpractice/Professional Liability 153 Nuclear Insurance 153 Professional 153 Property Insurance Plans 154 Reinsurance 154 Risk Management 154 Safety/Disaster Mitigation 155 Surety, Financial Guaranty and Mortgage 157 Title Insurance 158 Weather 158 Workers Compensation 158 Research and Ratings Organizations 159 Alphabetical Index of Associations..........................................162 State Organizations...................................................................166 Brief History................................................................................190 I.I.I. Resources.............................................................................193 I.I.I. Member Companies............................................................195 I.I.I. Staff............................................................... Inside back cover s u r ance In i c s B a s Overview The insurance industry safeguards the assets of its policyholders by transferring risk from an individual or business to an insurance company. Insurance compa- nies act as financial intermediaries in that they invest the premiums they collect for providing this service. Insurance company size is usually measured by net premiums written, that is, premium revenues less amounts paid for reinsurance. There are three main insurance sectors: property/casualty, life/health and health insurance. Property/casualty (P/C) consists mainly of auto, home and commer- cial insurance. Life/health (L/H) consists mainly of life insurance and annuity products. Health insurance is offered by private health insurance companies and some L/H and P/C insurers, as well as by government programs such as Medicare. Regulation All types of insurance are regulated by the states, with each state having its own set of statutes and rules. State insurance departments oversee insurer sol- vency, market conduct and, to a greater or lesser degree, review and rule on requests for rate increases for coverage. The National Association of Insurance Commissioners develops model rules and regulations for the industry, many of which must be approved by state legislatures. The McCarran-Ferguson Act, passed by Congress in 1945, refers to continued state regulation of the insurance industry as being in the public interest. Under the 1999 Gramm-Leach-Bliley Financial Services Modernization Act, insurance activities—whether conducted by banks, broker-dealers or insurers—are regulated by the states. However, there have been, and continue to be, challenges to state regulation from some seg- ments of the federal government as well as from some financial services firms. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 1 Insurance Basics Overview Accounting Insurers are required to use statutory accounting principles (SAP) when filing annual financial reports with state regulators and the Internal Revenue Service. SAP, which evolved to enhance the industry’s financial stability, is more conservative than the generally accepted accounting principles (GAAP), established by the inde- pendent Financial Accounting Standards Board (FASB). The Securities and Exchange Commission (SEC) requires publicly owned companies to report their financial results using GAAP rules. Insurers outside the United States use standards that dif- fer from SAP and GAAP. As global markets developed, the need for more uniform accounting standards became clear. In 2001 the International Accounting Standards Board (IASB), an independent international accounting standards setting organiza- tion, began work on a set of standards, called International Financial Reporting Standards (IFRS) that it hopes will be used around the world. Since 2001 over 100 countries have required or permitted the use of IFRS. In 2007 the SEC voted to stop requiring non-U.S. companies that use IFRS to re-issue their financial reports for U.S. investors using GAAP. In 2008 the National Association of Insurance Commissioners began to explore ways to move from statutory accounting principles to IFRS. Also in 2008, the FASB and IASB undertook a joint project to develop a common and improved framework for financial reporting. Distribution Property/casualty and life insurance policies were once sold almost exclusively by agents—either by captive agents, representing one insurance company, or by independent agents, representing several companies. Insurance companies selling through captive agents and/or by mail, telephone or via the Internet are called “direct writers.” However, the distinctions between direct writers and independent agency companies have been blurring since the 1990s, when insur- ers began to use multiple channels to reach potential customers. In addition, in the 1980s banks began to explore the possibility of selling insurance through independent agents, usually buying agencies for that purpose. Other distribu- tion channels include sales through professional organizations and through workplaces. 2 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Auto Insurance Auto Insurance Basics Auto insurance protects against financial loss in the event of an accident. It is a contract between the policyholder and the insurance company. The policyhold- er agrees to pay the premium and the insurance company agrees to pay losses as defined in the policy. Auto insurance provides property, liability and medical coverage:  Property coverage pays for damage to, or theft of, the car.  Liability coverage pays for the policyholder’s legal responsibility to others for bodily injury or property damage.  Medical coverage pays for the cost of treating injuries, rehabilitation and sometimes lost wages and funeral expenses. Most states require drivers to have auto liability insurance before they can legal- ly drive a car. (Liability insurance pays the other driver’s medical, car repair and other costs when the policyholder is at fault in an auto accident.) All states have laws that set the minimum amounts of insurance or other financial security drivers have to pay for the harm caused by their negligence behind the wheel if an accident occurs. Most auto policies are for six months to a year. A basic auto insurance policy is comprised of six different kinds of coverage, each of which is priced separately (see below). 1. Bodily Injury Liability This coverage applies to injuries that the policyholder and family members list- ed on the policy cause to someone else. These individuals are also covered when driving other peoples’ cars with permission. As motorists in serious accidents may be sued for large amounts, drivers can opt to buy more than the state- required minimum to protect personal assets such as homes and savings. 2. Medical Payments or Personal Injury Protection (PIP) This coverage pays for the treatment of injuries to the driver and passengers of the policyholder’s car. At its broadest, PIP can cover medical payments, lost wages and the cost of replacing services normally performed by someone injured in an auto accident. It may also cover funeral costs. 3. Property Damage Liability This coverage pays for damage policyholders (or someone driving the car with their permission) may cause to someone else’s property. Usually, this means damage to someone else’s car, but it also includes damage to lamp posts, tele- phone poles, fences, buildings or other structures hit in an accident. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 3 Insurance Basics Auto Insurance 4. Collision This coverage pays for damage to the policyholder’s car resulting from a col- lision with another car, an object or as a result of flipping over. It also covers damage caused by potholes. Collision coverage is generally sold with a deduct- ible of $250 to $1,000—the higher the deductible, the lower the premium. Even if policyholders are at fault for an accident, collision coverage will reimburse them for the costs of repairing the car, minus the deductible. If the policyholder is not at fault, the insurance company may try to recover the amount it paid from the other driver’s insurance company, a process known as subrogation. If the company is successful, policyholders will also be reimbursed for the deduct- ible. 5. Comprehensive This coverage reimburses for loss due to theft or damage caused by something other than a collision with another car or object, such as fire, falling objects, missiles, explosions, earthquakes, windstorms, hail, flood, vandalism and riots, or contact with animals such as birds or deer. Comprehensive insurance is usu- ally sold with a $100 to $300 deductible, though policyholders may opt for a higher deductible as a way of lowering their premium. Comprehensive insur- ance may also reimburse the policyholder if a windshield is cracked or shattered. Some companies offer separate glass coverage with or without a deductible. States do not require the purchase of collision or comprehensive coverage, but lenders may insist borrowers carry it until a car loan is paid off. It may also be a requirement of some dealerships if a car is leased. 6. Uninsured and Underinsured Motorist Coverage Uninsured motorist coverage will reimburse the policyholder, a member of the family or a designated driver if one of them is hit by an uninsured or a hit-and- run driver. Underinsured motorist coverage comes into play when an at-fault driver has insufficient insurance to pay for the other driver’s total loss. This cov- erage will also protect a policyholder who is hit while a pedestrian. 4 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Homeowners Insurance Homeowners Insurance Basics Homeowners insurance provides financial protection against disasters. It is a pack- age policy, which means that it covers both damage to property and liability, or legal responsibility, for any injuries and property damage policyholders or their families cause to other people. This includes damage caused by household pets. Damage caused by most disasters is covered but there are exceptions. Standard homeowners policies do not cover flooding, earthquakes or poor maintenance. Flood coverage, however, is available in the form of a separate policy both from the National Flood Insurance Program (NFIP) and from a few private insur- ers. Earthquake coverage is available either in the form of an endorsement or as a separate policy. Most maintenance-related problems are the homeowners’ responsibility. A standard homeowners insurance policy includes four essential types of coverage. They include: 1. Coverage for the Structure of the Home This part of a policy pays to repair or rebuild a home if it is damaged or destroyed by fire, hurricane, hail, lightning or other disaster listed in the policy. It will not pay for damage caused by a flood, earthquake or routine wear and tear. Most standard policies also cover structures that are not attached to a house such as a garage, tool shed or gazebo. Generally, these structures are cov- ered for about 10 percent of the total amount of insurance on the structure of the home. 2. Coverage for Personal Belongings Furniture, clothes, sports equipment and other personal items are covered if they are stolen or destroyed by fire, hurricane or other insured disaster. Most companies provide coverage for 50 to 70 percent of the amount of insurance on the structure of a home. This part of the policy includes off-premises coverage. This means that belongings are covered anywhere in the world, unless the poli- cyholder has decided against off-premises coverage. Expensive items like jewelry, furs and silverware are covered, but there are usually dollar limits if they are sto- len. To insure these items to their full value, individuals can purchase a special personal property endorsement or floater and insure the item for its appraised value. Trees, plants and shrubs are also covered under standard homeowners insur- ance—generally up to about $500 per item. Perils covered are theft, fire, light- ning, explosion, vandalism, riot and even falling aircraft. They are not covered for damage by wind or disease. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 5 Insurance Basics Homeowners Insurance 3. Liability Protection Liability coverage protects against the cost of lawsuits for bodily injury or prop- erty damage that policyholders or family members cause to other people. It also pays for damage caused by pets. The liability portion of the policy pays for both the cost of defending the policyholder in court and any court awards—up to the limit of the policy. Coverage is not just in the home but extends to anywhere in the world. Liability limits generally start at about $100,000. However, experts recommend that homeowners purchase at least $300,000 worth of protection. An umbrella or excess liability policy, which provides broader coverage, includ- ing claims for libel and slander, as well as higher liability limits, can be added to the policy. Generally, umbrella policies cost between $200 to $350 for $1 mil- lion of additional liability protection. Homeowners policies also provide no-fault medical coverage. In the event that someone is injured in a policyholder’s home, the injured person can sim- ply submit medical bills to the policyholder’s insurance company. In this way expenses are paid without a liability claim being filed. This coverage, however, does not pay the medical bills for the policyholder’s own family or pets. 4. Additional Living Expenses This pays the additional costs of living away from home if a house is inhabit- able due to damage from a fire, storm or other insured disaster. It covers hotel bills, restaurant meals and other extra living expenses incurred while the home is being rebuilt. Coverage for additional living expenses differs from company to company. Many policies provide coverage for about 20 percent of the insurance on a house. The coverage can be increased for an additional premium. Some companies sell a policy that provides an unlimited amount of loss-of-use cover- age, but for a limited amount of time. Additional living expense coverage also reimburses homeowners who rent out part of their home for the rent that would have been collected from a ten- ant if the home had not been destroyed. Types of Homeowners Insurance Policies There are several types of homeowners insurance policies that differ in the amount of insurance coverage they provide. The different types are fairly standard through- out the country. However, individual states and companies may offer policies that are slightly different or go by other names such as “standard” or “deluxe.” People who rent the homes they live in have specific renters policies. 6 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Homeowners Insurance The various types of homeowners insurance policies are listed below. HO-3: This is the most common policy and protects the home from all perils except those specifically excluded. HO-1: Limited coverage policy This “bare bones” policy provides coverage against the first 10 disasters. It is no longer available in most states. HO-2: Basic policy A basic policy provides protection against all 16 disasters. There is a version of HO-2 designed for mobile homes. HO-8: Older home Designed for older homes, this policy usually reimburses for damage on an actual cash value basis, which means replacement cost less depreciation. Full replacement cost policies may not be available for some older homes. HO4: Renter Created specifically for people who rent the home they live in, this policy protects personal possessions and any parts of the apartment that the policyholder owns, such as newly installed kitchen cabinets, against all 16 disasters. H0-6: Condo/Co-op A policy for people who own a condo or co-op, it provides coverage for belongings and the structural parts of the building that they own. It protects against all 16 disasters. What Type of Disasters Are Covered? Most homeowners policies cover the 16 disasters listed below. Some “bare bones” policies only cover the first 10: Fire or lightning Windstorm or hail Explosion Riot or civil commotion Damage caused by aircraft Damage caused by vehicles I.I.I. Insurance Handbook www.iii.org/insurancehandbook 7 Insurance Basics Homeowners Insurance Smoke Vandalism or malicious mischief Theft Volcanic eruption Falling object Weight of ice, snow or sleet Accidental discharge or overflow of water or steam from within a plumbing, heating, air conditioning, or automatic fire-protective sprinkler system, or from a household appliance Sudden and accidental tearing apart, cracking, burning, or bulging of a steam or hot water heating system, an air conditioning or automatic fire- protective system Freezing of a plumbing, heating, air conditioning or automatic, fire- protective sprinkler system, or of a household appliance Sudden and accidental damage from artificially generated electrical current (does not include loss to a tube, transistor or similar electronic component) Standard Homeowners Policy Exclusions Standard homeowners policies exclude coverage for flood, earthquake, war, nuclear accident, landslide, mudslide, sinkhole. Some of these exclusions are discussed below. 1. Floods Flood damage is excluded under standard homeowners and renters insurance poli- cies. Flood coverage, however, is available in the form of a separate policy both from the National Flood Insurance Program (NFIP) and from a few private insurers. Additional information on flood insurance can be found on the FloodSmart.gov Web site or by calling 888-379-9531. For coverage over and above the $250,000 limit for property and $100,000 for contents provided by the NFIP, excess flood insurance is available from private insurance companies. (See Topic on Flood Insurance on page 47 for further information.) Tsunamis cause flood damage and are therefore only covered by a flood policy. 2. Earthquakes Earthquake coverage can be a separate policy or an endorsement to a home- owners or renters policy. It is available from most insurance companies. In 8 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Homeowners Insurance California, it is also available from the California Earthquake Authority, a pri- vately funded, publically managed organization. In earthquake prone states like California, the policy comes with a high deductible. 3. Damage Resulting from “Faulty, Defective or Inadequate” Maintenance, Workmanship, Construction or Materials Defective products can include construction materials. An insurance policy will not cover damage due to lack of maintenance, mold, termite infestation and infestation from other pests. It is the policyholder’s responsibility to take rea- sonable precautions to protect the home from damage. Levels of Coverage There are three coverage options. 1. Actual Cash Value This type of coverage pays to replace the home or possessions minus a deduc- tion for depreciation. 2. Replacement Cost This type of coverage pays the cost of rebuilding or repairing the home or replacing possessions without a deduction for depreciation. 3. Guaranteed/Extended Replacement Cost An extended replacement cost policy pays a certain percentage, generally 20-25 percent, over the coverage limit to rebuild the home in the event that materials and labor costs are pushed up by a widespread disaster, for example. For exam- ple, if homeowners take out a policy for $100,000, they can get up to an extra $20,000 or $25,000 of coverage. Some companies offer a guaranteed replacement cost policy, which pays whatever it costs to rebuild the home as it was before the fire or other disaster, even if it exceeds the policy limit. This gives protection against sudden increases in construction costs due to a shortage of building materials after a widespread disaster or other unexpected situations. It generally does not cover the cost of upgrading the house to comply with current building codes. However, an endorsement (or an addition to) the policy called Ordinance or Law can help pay for these additional costs. Guaranteed and extended replacement cost policies are more expensive; but can offer excellent financial protection against disasters. This type of coverage, however, may not be available in all states or from all companies. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 9 Insurance Basics Business Insurance Business Insurance Basics Most businesses need to purchase at least the following four types of insurance: 1. Property Insurance Property insurance compensates a business if the property used in the business is lost or damaged as the result of various types of common perils, such as fire or theft. Property insurance covers not just a building or structure but also the contents, including office furnishings, inventory, raw materials, machinery, computers and other items vital to a business’s operations. Depending on the type of policy, property insurance may include coverage for equipment break- down, removal of debris after a fire or other destructive event, some types of water damage and other losses. Business Interruption Insurance Also known as business income insurance, business interruption insurance is a type of property insurance. A business whose property has sustained a direct physical loss such as fire damage or a damaged roof due to a tree falling on it in a windstorm and has to close down completely while the premises are being repaired may lose out to competitors. A quick resumption of business after a disaster is essential. That is why business interruption insurance is so important. There are typically three types of business interruption insurance. A business can purchase any one or combination of these. Business Income Coverage: Compensates for lost income if a company has to vacate its premises due to disaster-related damage that is covered under the property insurance policy. Business income insurance covers the profits the company would have earned, based on financial records, had the disaster not occurred. The policy also covers operating expenses, such as electricity, that continue even though business activities have come to a temporary halt. Extra Income Coverage: Reimburses the company for a reasonable sum of money that it spends, over and above normal operating expenses, to avoid having to shut down during the restoration period. Contingent Business Interruption Insurance: Protects a businessowner’s earnings following physical loss or damage to the property of the insured’s suppliers or customers, as opposed to its own property. Damage due to floods, earthquakes and acts of terrorism are generally not covered by standard business property insurance but can be purchased through various markets. 10 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Business Insurance Protection Against Flood Damage Property insurance policies usually exclude coverage for flood damage. Businesses should find out from their local government office or commercial bank whether their business is located in a flood zone and whether their loca- tion has been flooded in the past. Flood insurance is available through the fed- eral government’s National Flood Insurance Program (www.FloodSmart.gov), which is serviced by private carriers, and from a few specialty insurers. Protection Against Earthquake Damage Coverage for earthquake damage is excluded in most property insurance poli- cies, including businessowners package policies. Businesses in an earthquake- prone area will need a special earthquake insurance policy or commercial prop- erty earthquake endorsement. Protection Against Terrorist Attack Losses Under the Terrorism Risk Insurance Act of 2002 and its extensions, only busi- nesses that purchase optional terrorism coverage are covered for losses arising from terrorist acts. The exception is workers compensation, which covers work- related injuries and deaths including those due to acts of terrorism. 2. Liability Insurance Any enterprise can be sued. Customers may claim that the business caused them harm as the result of, for example, a defective product, an error in a service or disregard for another person’s property. Or a claimant may allege that the busi- ness created a hazardous environment. Liability insurance pays damages for which the business is found liable, up to the policy limits, as well as attorneys’ fees and other legal defense expenses. It also pays the medical bills of any peo- ple injured by, or on the premises of, the business. A Commercial General Liability (CGL) insurance policy is the first line of defense against many common claims. CGL policies cover claims in four basic categories of business liability: Bodily injury Property damage Personal injury (including slander or libel) Advertising injury (damage from slander or false advertising) In addition to covering claims listed above, CGL policies also cover the cost of defending or settling claims. General liability insurance policies always state the maximum amount that the insurer will pay during the policy period. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 11 Insurance Basics Business Insurance There are two major forms of liability insurance policies a business can select: occurrence and claims made. Both types of policies have their advantages. Occurrence Policy: An occurrence policy covers a business for harm to others caused by incidents that occurred while a policy is in force, no matter when the claim is filed. For example, a person might sue a business in 2010 for an injury stemming from a fall in 1999. The policy that was in place when the incident occurred (i.e. 1999) will apply, even if the company now has a policy in place with higher limits. Occurrence coverage may not be available in some states or for some industries or professions. Claims Made Policy: A claims made policy covers the business based on the policy that is in force when the claim is made, regardless of when the incident occurred. In the above example, the limits in the policy in effect in 2010 would apply. Businesses with claims made policies can purchase optional “tail coverage.” Tail coverage enables a business to report claims after the policy has ended for alleged injuries that occurred while the policy was in effect. 3. Commercial Vehicle Insurance A commercial auto policy provides coverage for vehicles that are used primar- ily in connection with commercial establishments or business activities. The insurance pays any costs to third parties resulting from bodily injury or property damage for which the business is legally liable up to the policy limits. While the major coverages are the same, commercial auto policies differs from a personal auto policy in a number of technical respects. They may have higher limits and/or provisions that cover rented and other non-owned vehicles, including employees’ cars driven for company business. Several insurers offer business auto policies geared to owners of small businesses or specific types of businesses. 4. Workers Compensation Insurance Employers have a legal responsibility to their employees to make the workplace safe. However, despite precautions, accidents can occur. To protect employers from lawsuits resulting from workplace accidents and to provide medical care and compensation for lost income to employees hurt in workplace accidents, in almost every state businesses are required by law to buy workers compensa- tion insurance. Workers compensation insurance covers workers injured on the job, whether they are hurt on the workplace premises or elsewhere, or in auto accidents while on business. It also covers work-related illnesses. Workers com- 12 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Business Insurance pensation provides payments to injured workers, without regard to who was at fault in the accident, for time lost from work and for medical and rehabilitation services. It also provides death benefits to surviving spouses and dependents. Each state has different laws governing the amount and duration of lost income benefits, the provision of medical and rehabilitation services and how the sys- tem is administered. For example, in most states there are regulations that cover whether the worker or employer can choose the doctor who treats the injuries and how disputes about benefits are resolved. Workers compensation insurance must be bought as a separate policy. In-home business and businessowners policies (BOPs) are sold as package poli- cies but do not include coverage for workers’ injuries. Other Types of Business Coverages The first four coverages discussed below are different types of liability insurance policies available to businesses. The fifth is a form of life insurance. There are also specialized liability policies geared to specific types of businesses. 1. Errors and Omissions Insurance/Professional Liability Some businesses involve services such as giving advice, making recommenda- tions, designing things, providing physical care or representing the needs of others, which can lead to being sued by customers, clients or patients claiming that the business’ failure to perform a job properly has injured them. Errors and omissions or professional liability insurance covers these situations. The policy will pay any judgment for which the insured is legally liable, up to the policy limit. It also provides legal defense costs, even when there has been no wrong- doing. 2. Employment Practices Liability Insurance Employment practices liability insurance covers, up to the policy limits, dam- ages for which an employer is legally liable such as violating an employee’s civil or other legal rights. In addition to paying a judgment for which the insured is liable, it also provides legal defense costs, which can be substantial even when there has been no wrongdoing. 3. Directors and Officers Liability Insurance Directors and officers liability insurance protects directors and officers of corpo- rations or nonprofit organizations if there is a lawsuit claiming they managed the business or organization without proper regard for the rights of others. The policy will pay any judgment for which the insured is legally liable, up to the I.I.I. Insurance Handbook www.iii.org/insurancehandbook 13 Insurance Basics Business Insurance policy limit. It also provides for legal defense costs, even where there has been no wrongdoing. 4. Umbrella or Excess Policies As the name implies, an umbrella liability policy provides coverage over and above a business’s other liability coverages. It is designed to protect against unusually high losses, providing protection when the policy limits of one of the underlying policies have been used up. For a typical business, an umbrella poli- cy would provide protection beyond Its general liability and auto liability poli- cies. If a company has employment practices liability insurance, directors and officers liability, or other types of liability insurance, the umbrella could provide protection beyond those policy limits as well. Cost depends on the nature of the business, its size, the type of risks the business faces and the ways the business implements risk reduction. 5. Key Person Life Insurance The loss of a key person can be a major blow to a small business if that person is the founder of the business or is the key contact for customers and suppliers and the management of the business. Loss of the key person may also make the running of the business less efficient and result in a loss of capital. Losses caused by the death of a key employee are insurable. Such policies compensate the business against significant losses that result from that person’s death or disabil- ity. The amount and cost of insurance needed for a particular business depends on the situation and the age, health and role of the key employee. Key employ- ee life insurance pays a death benefit to the company when the key employee dies. The policy is normally owned by the company, which pays the premiums and is the beneficiary. The monies from key person insurance can be used to buy back shares in a company from the estate of the deceased, pay a head hunt- ing firm to find a suitable replacement and cover costs or expenses while the business adjusts to the loss. Package Policies Commercial insurers sell coverages separately and/or offer policies that combine protection from most major property and liability risks in one package. Package policies are created for types of businesses that generally face the same kind and degree of risk. 1. Packages for Small Businesses Smaller companies often purchase a package policy known as the Business- 14 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Business Insurance owners Policy, or BOP. A BOP is recommended for most small businesses (usual- ly 100 employees or less), as it is often the most affordable way to obtain broad coverage. BOPs are “off the shelf” policies combining many of the basic coverag- es needed by a typical small business into a standard package at a premium that is generally less than would be required to purchase these coverages separately. Combining both property and liability insurance, a BOP will cover a business in the event of property damage, suspended operations, lawsuits resulting from bodily injury or property damage to others, etc. BOPs do not cover professional liability, auto insurance, workers compensation or health and disability insur- ance. Small businesses will need separate insurance policies to cover professional services, vehicles and employees. 2. Commercial Multiple Peril Policies Larger companies might purchase a commercial package policy or customize their policies to meet the special risks they face. Commercial multiple peril poli- cies, often purchased by corporations, bundle property, boiler and machinery, crime and general liability coverage together. Larger firms employee a risk man- ager to help determine the company’s exposure to certain risks. 3. In-Home Business Policies There are several insurance options designed to address the special needs of home businesses. Homeowners Policy Endorsement: Homeowners may be able to add a simple endorsement or rider to their existing homeowners policy to increase coverage. In-Home Business Policy: An in-home business policy provides more comprehensive coverage for business equipment and liability than a homeowners policy endorsement. Many insurance companies offer insurance policies specifically tailored to small business. Businessowners Policy (BOP): The home business might be eligible for The Businessowners Policy (BOP), see above. The key to whether a business owner is eligible for a BOP is the size of the premises, the limits of liability required, the type of commercial operation it is and the extent of its off-premises servicing and processing activities. A BOP, like an in-home business policy, covers business property and equipment, loss of income, extra expense and liability; however, the BOP provides these coverages on a much broader scale. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 15 Insurance Basics Life Insurance Life Insurance Basics Many financial experts consider life insurance to be the cornerstone of sound financial planning. It can be an important tool in the following situations: 1. Replace Income for Dependents If people depend on an individual’s income, life insurance can replace that income if the person dies. The most common example of this is parents with young children. Insurance to replace income can be especially useful if the government- or employer-sponsored benefits of the surviving spouse or domestic partner will be reduced after he or she dies. 2. Pay Final Expenses Life insurance can pay funeral and burial costs, probate and other estate admin- istration costs, debts and medical expenses not covered by health insurance. 3. Create an Inheritance for Heirs Even those with no other assets to pass on, can create an inheritance by buying a life insurance policy and naming their heirs as beneficiaries. 4. Pay Federal “Death” Taxes and State “Death” Taxes Life insurance benefits can pay for estate taxes so that heirs will not have to liq- uidate other assets or take a smaller inheritance. Changes in the federal “death” tax rules through January 1, 2011 will likely lessen the impact of this tax on some people, but some states are offsetting those federal decreases with increas- es in their state-level estate taxes. 5. Make Significant Charitable Contributions By making a charity the beneficiary of their life insurance policies, individuals can make a much larger contribution than if they donated the cash equivalent of the policy’s premiums. 6. Create a Source of Savings Some types of life insurance create a cash value that, if not paid out as a death benefit, can be borrowed or withdrawn on the owner’s request. Since most people make paying their life insurance policy premiums a high priority, buying a cash-value type policy can create a kind of “forced” savings plan. Furthermore, the interest credited is tax deferred (and tax exempt if the money is paid as a death claim). 16 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Life Insurance Types of Life Insurance There are two major types of life insurance: term and whole life. 1. Term Life Term insurance is the simplest form of life insurance. It pays only if death occurs during the term of the policy, which is usually from one to 30 years. Most term policies have no other benefit provisions. There are two basic types of term life insurance policies: level term and decreasing term. Level term means that the death benefit stays the same throughout the duration of the policy. Decreasing term means that the death benefit drops, usually in one-year incre- ments, over the course of the policy’s term. 2. Whole Life/Permanent Life Whole life or permanent insurance pays a death benefit whenever the policy- holder dies. There are three major types of whole life or permanent life insur- ance—traditional whole life, universal life, and variable universal life, and there are variations within each type. In the case of traditional whole life, both the death benefit and the premi- um are designed to stay the same (level) throughout the life of the policy. The cost per $1,000 of benefit increases as the insured person ages, and it obviously gets very high when the insured lives to 80 and beyond. The insurance com- pany keeps the premium level by charging a premium that, in the early years, is higher than what is needed to pay claims, investing that money, and then using it to supplement the level premium to help pay the cost of life insurance for older people. By law, when these “overpayments” reach a certain amount, they must be available to the policyholder as a cash value if he or she decides not to continue with the original plan. The cash value is an alternative, not an additional, ben- efit under the policy. In the 1970s and 1980s, life insurance companies intro- duced two variations on the traditional whole life product: universal life insur- ance and variable universal life insurance. Some varieties of whole life/permanent life insurance are discussed below. Universal Life: Universal life, also known as adjustable life, allows more flexibility than traditional whole life policies. The savings vehicle (called a cash value account) generally earns a money market rate of interest. After money has accumulated in the account, the policyholder will also have the option of altering premium payments—providing there is enough money in the account to cover the costs. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 17 Insurance Basics Life Insurance Variable Life: Variable life policies combine death protection with a savings account that can be invested in stocks, bonds and money market mutual funds. The value of the policy may grow more quickly, but involves more risk. If investments do not perform well, the cash value and death benefit may decrease. Some policies, however, guarantee that the death benefit will not fall below a minimum level. Variable Universal Life: This type of policy combines the features of variable and universal life policies, including the investment risks and rewards characteristic of variable life insurance and the ability to adjust premiums and the death benefit that is characteristic of universal life insurance. 18 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Annuities Annuities Basics Annuities are financial products intended to enhance retirement security. An annuity is an agreement for one person or organization to pay another a series of payments. Usually the term “annuity” relates to a contract between an indi- vidual and a life insurance company. There are many categories of annuities. They can be classified by: Nature of the underlying investment: fixed or variable Primary purpose: accumulation or pay-out (deferred or immediate) Nature of payout commitment: fixed period, fixed amount or lifetime Tax status: qualified or nonqualified Premium payment arrangement: single premium or flexible premium An annuity can be classified in several of these categories at once. For example, an individual might buy a nonqualified single premium deferred variable annuity. In general, annuities have the following features: 1. Tax Deferral on Investment Earnings Many investments are taxed year by year, but the investment earnings—capital gains and investment income—in annuities are not taxable until the investor withdraws money. This tax deferral is also true of 401(k)s and IRAs; however, unlike these products, there are no limits on the amount one can put into an annuity. Moreover, the minimum withdrawal requirements for annuities are much more liberal than they are for 401(k)s and IRAs. 2. Protection from Creditors People who own an immediate annuity (that is, who are receiving money from an insurance company), are afforded some protection from creditors. Generally the most that creditors can access is the payments as they are made, since the money the annuity owner gave the insurance company now belongs to the company. Some state statutes and court decisions also protect some or all of the payments from those annuities. 3. A Variety of Investment Options Many annuity companies offer an array of investment options. For example, individuals can invest in a fixed annuity that credits a specified interest rate, similar to a bank Certificate of Deposit (CD). If they buy a variable annuity, their money can be invested in stocks, bonds or mutual funds. In recent years, annuity companies have created various types of “floors” that limit the extent of investment decline from an increasing reference point. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 19 Insurance Basics Annuities 4. Taxfree Transfers Among Investment Options In contrast to mutual funds and other investments made with aftertax money, with annuities there are no tax consequences if owners change how their funds are invested. This can be particularly valuable if they are using a strategy called “rebalancing,” which is recommended by many financial advisors. Under rebal- ancing, investors shift their investments periodically to return them to the proportions that represent the risk/return combination most appropriate for the investor’s situation. 5. Lifetime Income A lifetime immediate annuity converts an investment into a stream of pay- ments that last until the annuity owner dies. In concept, the payments come from three “pockets”: The original investment, investment earnings and money from a pool of people in the investors group who do not live as long as actuarial tables forecast. The pooling is unique to annuities, and it is what enables annu- ity companies to be able to guarantee a lifetime income. 6. Benefits to Heirs There is a common apprehension that if an individual starts an immediate lifetime annuity and dies soon after that, the insurance company keeps all of the investment in the annuity. To prevent this situation individuals can buy a “guaranteed period” with the immediate annuity. A guaranteed period commits the insurance company to continue payments after the owner dies to one or more designated beneficiaries; the payments continue to the end of the stated guaranteed period—usually 10 or 20 years (measured from when the owner started receiving the annuity payments). Moreover, annuity benefits that pass to beneficiaries do not go through probate and are not governed by the annuity owner’s will. Types of Annuities There are two major types of annuities: fixed and variable. Fixed annuities guar- antee the principal and a minimum rate of interest. Generally, interest credited and payments made from a fixed annuity are based on rates declared by the company, which can change only yearly. Fixed annuities are considered “general account” assets. In contrast, variable annuity account values and payments are based on the performance of a separate investment portfolio, thus their value may fluctuate daily. Variable annuities are considered “separate account” assets. There are a variety of fixed annuities and variable annuities. One example, the equity indexed annuity, is a hybrid of the features of fixed and variable 20 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Annuities annuities. It credits a minimum rate of interest, just as other fixed annuities do, but its value is also based on the performance of a specified stock index—usu- ally computed as a fraction of that index’s total return. In December 2008 the Securities and Exchange Commission voted to reclassify indexed annuities (with some exceptions) as securities, not insurance products. Annuities can also be classified by marketing channel, in other words whether they are sold to groups or individuals. Annuities can be deferred or immediate. Deferred annuities generally accu- mulate assets over a long period of time, with withdrawals usually as a single sum or as an income payment beginning at retirement. Immediate annuities allow purchasers to convert a lump sum payment into a stream of income that the policyholder begins to receive right away. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 21 Insurance Basics Long-Term Care Insurance Long-Term Care Insurance Basics Long-term care insurance pays for services to help individuals who are unable to perform certain activities of daily living without assistance, or require supervi- sion due to a cognitive impairment such as Alzheimer’s disease. Features of Long-Term Care Policies The best policies pay for care in a nursing home, assisted living facility, or at home. Benefits are typically expressed in daily amounts, with a lifetime maxi- mum. Some policies pay half as much per day for at-home care as for nursing home care. Others pay the same amount, or have a “pool of benefits” that can be used as needed. Criteria for the Beginning of Payments The policy should state the various conditions that must be met. They can include: 1. The Inability to Perform Two or Three Specific “Activities of Daily Living” Without Help These include bathing, dressing, eating, toileting and “transferring” or being able to move from place to place or between a bed and a chair. 2. Cognitive Impairment Most policies cover stroke and Alzheimer’s and Parkinson’s disease, but other forms of mental incapacity may be excluded. 3. Medical Necessity or Certification by a Doctor that Long-Term Care is Necessary Most policies have a “waiting period” or “elimination” period. This is a period that begins when an individual first needs long-term care and lasts as long as the policy provides. During the waiting period, the policy will not pay benefits. The policy pays only for expenses that occur after the waiting period is over, if the policyholder continues to need care. In general, the longer the waiting period, the lower the premium for the long-term care policy. Benefit periods for long-term care may range from two years to a lifetime. Premiums can be kept down by electing coverage for three to four years—longer than the average nursing home stay—instead of a lifetime. Most long-term care policies pay on a reimbursement (or expense-incurred) basis, up to the policy limits. In other words, if the policy has a $150 per day benefit, but the policyholder spends only $130 per day for a home long-term care provider, the policy will pay only $130. The “extra” $20 each day will, in 22 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Long-Term Care Insurance some policies, go into a “pool” of unused funds that can be used to extend the length of time for which the policy will pay benefits. Other policies pay on an indemnity basis. Using the same example as above, an indemnity policy would pay $150 per day as long as the insured needs and receives long-term care ser- vices, regardless of the actual outlay. Inflation protection is an important feature, especially for people under the age of 65, who are buying benefits that they may not use for 20 years or more. A good inflation provision compounds benefits at 5 percent a year. Without inflation protection, even 3 percent annual inflation will, over 24 years, reduce the purchasing power of a $150 daily benefit to the equivalent of $75. Six Other Important Policy Provisions 1. Elimination Period Under some policies, if the insured has qualifying long-term care expenses on one day during a seven-day period, he or she will be credited with having satisfied seven days toward the elimination period: i.e., the time between an injury and the receipt of payments. This type of provision reflects the way home care is often delivered—some days by professionals and some days by family members. 2. Guaranteed Renewable Policies These must be renewed by the insurance company, although premiums can go up if they are increased for an entire class of policyholders. 3. Waiver of Premium This provision ensures that no further premiums are due once the policyholder starts to receive benefits. 4. Third-Party Notification This provision stipulates that a relative, friend or professional adviser will be notified if the policyholder forgets to pay a premium. 5. Nonforfeiture Benefits These benefits keep a lesser amount of insurance in force if the policyholder lets the coverage lapse. This provision is required by some states. 6. Restoration of Benefits This provision ensures that maximum benefits are put back in place if the policyholder receives benefits for a time, then recovers and goes for a specified period (typically six months) without receiving benefits. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 23 Insurance Basics Disability Insurance Disability Insurance Basics Disabling injuries affect millions of Americans each year. Disability insurance, which complements health insurance, helps replace lost income if an individual is unable to work due to a disability. There are three basic ways to replace income. 1. Employer-Paid Disability Insurance This is required in most states. Most employers provide some short-term sick leave. Many larger employers provide long-term disability coverage as well, typi- cally with benefits of up to 60 percent of salary lasting for a period of up to five years until the age of 65, and in some cases extended for life. 2. Social Security Disability Benefits This is paid to workers whose disability is expected to last at least 12 months and is so severe that no gainful employment can be expected. 3. Individual Disability Income Insurance Policies Other limited replacement income is available for workers under some circum- stances from workers compensation (if the injury or illness is job-related), auto insurance (if disability results from an auto accident) and the Department of Veterans Affairs. For most workers, even those with some employer-paid cover- age, an individual disability income policy is the best way to ensure adequate income in the event of disability. Workers who buy a private disability income policy can expect to replace from 50 percent to 70 percent of income. Disability benefits paid out on individual disability policies are not taxed; benefits from employer-paid policies are subject to income tax. Types of Disability Insurance There are two types of disability policies: Short-term disability and Long-term disability. Short-term policies have a waiting period of 0 to 14 days with a maximum benefit period of no longer than two years. Long-term policies have a waiting period of several weeks to several months with a maximum benefit period ranging from a few years to a lifetime. Disability policies have two different protection features: noncancelable and guaranteed renewable. Noncancelable means that the policy cannot be canceled by the insurance company, except for nonpayment of premiums. This gives the policyholder the right to renew the policy every year without an increase in the premium or a reduction in benefits. Guaranteed renewable gives the policyhold- er the right to renew the policy with the same benefits and not have the policy 24 24 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Insurance Basics Disability Insurance canceled by the company. However, the insurer has the right to increase premi- ums as long as it does so for all other policyholders in the same rating class. There are several options and factors to consider when purchasing a disabil- ity policy. 1. Additional Purchase Options The insurance company gives the policyholder the right to buy additional insur- ance at a later time. 2. Coordination of Benefits The amount of benefits policyholders receive from their insurance companies is dependent on other benefits they receive because of the disability. The policy specifies a target amount the policyholder will receive from all the policies com- bined and will make up the difference not paid by other policies. 3. Cost of Living Adjustment (COLA) The COLA increases disability benefits over time based on the increased cost of living measured by the Consumer Price Index. Policyholders will pay a higher premium if they select the COLA. 4. Residual or Partial Disability Rider This provision allows workers to return to work part-time, collecting part of their salaries and receiving a partial disability payment if they are still partially disabled. 5. Return of Premium This provision requires the insurance company to refund part of the premium if no claims are made for a specific period of time declared in the policy. 6. Waiver of Premium Provision This clause means that the policyholder does not have to pay premiums on the policy after he or she is disabled for 90 days. Factors Affecting the Choice of a Disability Policy 1. Definition of Disability Some policies pay benefits if workers are unable to perform the customary duties of their own occupation. Others pay only if workers are unable to perform any job suitable for their level of education and experience. Some policies define disability in terms of workers’ occupations for an initial period of two or three years and then continue to pay benefits only if they are unable to perform any occupation. “Own occupation” policies are more desirable, but more expensive. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 25 Insurance Basics Disablity Insurance 2. Benefit Period The benefit period is the amount of time policyholders will receive monthly benefits during their lifetimes. Experts usually recommend that the policy pay benefits until at least age 65, at which point Social Security disability will take over. Young people may consider buying a policy offering lifetime benefits because it will still be relatively inexpensive. 3. Replacement Percentage A policy that will replace from 60 percent to 70 percent of total taxable earnings is advisable. A higher replacement percentage, if available, is more expensive. Other sources of income should be evaluated before deciding how much disabil- ity coverage is needed. 4. Coverage for Disability Resulting from Either Accidental Injury or Illness An accident-only policy is less expensive but does not provide adequate protec- tion. Ideally, both accident and illness coverage should be purchased. 5. A Cost-of-Living Increase in Benefits Policies may not pay benefits for a decade or more and should keep pace with increases in the cost of living. (Some companies also offer “indexed” benefits, keeping pace with inflation after benefit payments begin.) 6. A Policy Paying “Residual” or Partial Benefits This type of policy is available so that people can work part-time and still receive a benefit making up for lost income. A standard feature in some policies, and added by a rider to others, a residual benefits policy pays partial benefits based on loss of income without an initial period of total disability. 7. Transition Benefits Offered by some companies, it can offset financial loss during a post-disability period of rebuilding a business or professional practice. 8. Ongoing Coverage A noncancelable policy will continue in-force as long as the premiums are paid; neither the benefit nor the premium can change. A guaranteed renewable policy keeps the same benefits but may cost more over time since the insurer can increase the premium if it is increased for an entire class of policyholders. 9. Financial Stability Check the financial stability of insurers through an agent or a ratings firm. 26 I.I.I. Insurance Handbook www.iii.org/insurancehandbook c s Topi These Topics are adapted from papers regularly updated at www.iii.org/issues_updates. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 27 28 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Updates at www.iii.org/issues_updates Insurance Topics Captives and Other Risk-Financing Options Captives and Other Risk-Financing Options Traditionally, businesses and other organizations have handled risk by transfer- ring it to an insurance company through the purchase of an insurance policy or, alternatively, by retaining the risk and allocating funds to meet expected losses through an arrangement known as “self insurance,” in which firms retain rather than transfer risk. During the liability crisis of the 1980s, when businesses had trouble obtain- ing some types of commercial insurance coverage, new mechanisms for transfer- ring risk developed, facilitated by passage of the Product Liability Risk Retention Act of 1981. These so-called alternative risk transfer (ART) arrangements blend risk transfer and risk retention mechanisms and, together with self insurance, form the alternative market. Captives—a special type of insurance company set up by a parent company, trade association or group of companies to insure the risks of its owner or own- ers—and risk-retention groups—in which entities in a common industry join together to provide members with liability insurance—were the first mecha- nisms to appear. Other options, including risk retention pools and large deduct- ible plans, a form of self insurance, followed. ART products, such as catastrophe bonds, weather derivatives and micro- insurance programs are also emerging as an alternative to traditional insurance and reinsurance products. Alternative Market Mechanisms I. Captives Wholly owned captives are companies set up by large corporations to finance or administer their risk financing needs. If such a captive insures only the risks of its parent or subsidiaries it is called a “pure” captive. Captives may be established to provide insurance to more than one entity. An association or group of companies may band together to form a captive to provide insurance coverage. Professionals—doctors, lawyers, accountants—have formed many captives over the years. Captives may, in turn, use a variety of reinsurance mechanisms to provide the coverage. In particular, many offshore captives use a “fronting” insurer to provide the basic insurance policy. Fronting typically means that underwriting, claims and administrative functions are handled in the United States by an experienced commercial insurance company, since a captive generally will not want to get involved directly in running the insurance operation. Also, fronting allows a company to show it has an insur- I.I.I. Insurance Handbook www.iii.org/insurancehandbook 29 Insurance Topics Updates at www.iii.org/issues_updates Captives and Other Risk-Financing Options ance policy with a U.S.-licensed insurance company, which it may need to do for legal and business reasons. The rent-a-captive concept was introduced in Bermuda 20 years ago and remains a popular alternative market mechanism. Rent-a-captives serve busi- nesses that are unable to capitalize a captive but are willing to assume a portion of their own risk and share in the underwriting profits and investment income. Generally sponsored by insurers or reinsurers, which essentially “rent out” their capital for a fee, the mechanism allows users to obtain some of the advantages of a captive without having the expense of setting up a single parent captive and meeting minimum capital and surplus requirements. Captives have been expanding into the employee benefits arena since 2003, the year in which the Department of Labor gave final approval to Archer Daniels Midland Co.’s plan to use its Vermont captive to reinsure group life insurance benefits. While the leading domicile for captives in the U.S. is Vermont, offshore captives covering U.S. risks are predominantly located in Bermuda, where they enjoy tax advantages and relative freedom from regulation. The Cayman Islands, Guernsey, the British Virgin Islands, Luxembourg and Barbados are also significant centers for captives. Vermont is the leading domicile for captives in the United States. II. Self Insurance Self insurance can be undertaken by single companies wishing to retain risk or by entities in similar industries or geographic locations that pool resources to insure each other’s risks. The use of higher retentions/deductibles is increasing in most lines of insur- ance. In workers compensation many companies are opting to retain a larger portion of their exposure through policies with large deductible amounts of $100,000 or higher. Large deductible programs, which were first introduced in 1989, now account for a sizable portion of the market. III. Risk Retention Groups A risk retention group (RRG) is a corporation owned and operated by its mem- bers. It must be chartered and licensed as a liability insurance company under the laws of at least one state. The group can then write insurance in all other states. It need not obtain a license in a state other than its chartering states. 30 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Updates at www.iii.org/issues_updates Insurance Topics Captives and Other Risk-Financing Options IV. Risk Purchasing Groups Like risk retention groups (RRGs), purchasing groups must be made up of per- sons or entities with like exposures and in a common business. However, where- as RRGs are liability insurance companies owned by their members, purchasing groups purchase liability coverage for their members from admitted insurers, surplus lines carriers or RRGs. Laws in some states prohibit insurers from giv- ing groups formed to purchase insurance advantages over individuals. However, purchasing groups are not subject to so-called “fictitious group” laws, which require a group to have been in existence for a certain period of time or require a group to have a certain minimum number of members. The Risk Retention Act of 1986 specifically provided for purchasing groups to be created to pur- chase liability insurance for members of the sponsoring groups. V. Catastrophe Bonds and other Alternative Risk Transfer (ART) Products A number of alternative risk transfer (ART) products, such as insurance-linked securities and weather derivatives have developed to meet the financial risk transfer needs of businesses. One such product, catastrophe (cat) bonds, risk- based securities sold via the capital markets, developed in the wake of hurri- canes Andrew and Iniki in 1992 and the Northridge earthquake in 1994—mega- catastrophes that resulted in a global shortage of reinsurance (insurance for insurers) for such disasters. Tapping into the capital markets allowed insurers to diversify their risk and expand the amount of insurance available in catas- trophe-prone areas. Zurich Financial’s Kamp Re was the first major catastrophe bond to be triggered. The $190 million bond was triggered by 2005’s Hurricane Katrina, and resulted in a total loss of principal. Catastrophe bonds are now a multibillion dollar industry. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 31 Insurance Topics Updates at www.iii.org/issues_updates Catastrophes: Insurance Issues Catastrophes: Insurance Issues The term “catastrophe” in the property insurance industry denotes a natural or man-made disaster that is unusually severe. An event is designated a catastrophe by the industry when claims are expected to reach a certain dollar threshold, currently set at $25 million, and more than a certain number of policyholders and insurance companies are affected. The magnitude of the damage caused by Katrina and the potential dam- age Hurricane Rita might have caused had it not weakened from an intense Category 5 hurricane has triggered a reexamination, not just among insurers and reinsurers but also among public policy and political leaders, of how the United States deals with the financial consequences of such massive property damage and personal loss. Disaster losses along the coast are likely to escalate in the coming years, in part because of huge increases in development. One catastrophe modeling company predicts that catastrophe losses will double every decade or so due to growing residential and commercial density and more expensive buildings. Data from the Census Bureau, collected by USA Today, show that in 2006, 34.9 million people were seriously threatened by Atlantic hurricanes, compared with 10.2 million in 1950. Before the 2005 hurricane season, Hurricane Andrew ranked as the single most costly U.S. natural disaster. Man-made catastrophes such as the attacks on the World Trade Center can also cause huge losses. The attacks led Congress to pass the Terrorism Risk Insurance Act (TRIA) in November 2002. Since then, TRIA has been reauthorized twice. The latest reauthorization, passed at the end of 2007, extends the law to 2014. TRIA provides a federal backstop for commercial insurance losses from terrorist acts, making it easier for insurers to calculate their maximum losses for such a catastrophe and thus to underwrite the coverage, see the topic on Terrorism Risk and Insurance. The typical homeowners insurance policy covers damage from a fire, windstorms, hail, riots and explosions—as well as other types of loss such as theft and the cost of living elsewhere while the structure is being repaired or rebuilt after being damaged. Commercial property insurance policies generally cover the same causes of loss with some variation, depending on the coverages selected. Flood and earthquake damage are excluded under homeowners poli- cies—separate policies are available—but are covered under the comprehensive portion of the standard auto policy, which more than 75 percent of drivers who buy auto liability insurance purchase. The insurance industry tracks catastrophes to monitor claim costs, assign- 32 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Updates at www.iii.org/issues_updates Insurance Topics Catastrophes: Insurance Issues ing a number to each catastrophe. Each claim arising from the event is tagged so that total industrywide losses can be tabulated. The term catastrophe is often used in the property insurance industry in a narrow way to mean a catastrophic event that exceeds a dollar threshold in claims payouts. This figure has changed over the years with inflation and the increase in development of areas subject to natural disasters. Starting in 1997 the catastrophe definition was raised from $5 million to $25 million in insured damage. There have been four catastrophes that fall into the megacatastrophe catego- ry, greatly exceeding the $25 million threshold. The first two, Hurricane Andrew (1992) and the Northridge earthquake (1994), were both watershed events in that they were far more destructive than most experts had predicted a disaster of this type would be. The third, the terrorist attack on the World Trade Center in 2001, altered insurers’ attitudes about man-made risks worldwide. Hurricane Katrina (2005), the fourth catastrophe, is not only the most expensive natural disaster on record but also an event that intensified discussion nationwide about the way disasters, natural and man-made, are managed. It also focused attention on the federal flood insurance program, see the topic on Flood Insurance. I.I.I. Insurance Handbook www.iii.org/insurancehandbook 33 Insurance Topics Updates at www.iii.org/issues_updates Cellphones and Driving Cellphones and Driving Increased reliance on cellphones has led to a rise in the number of people who use the devices while driving. There are two dangers associated with driving and cellphone use, including text messaging. First, drivers must take their eyes off the road while dialing. Second, people can become so absorbed in their conversations that their ability to concentrate on the act of driving is severely impaired, jeopardizing the safety of vehicle occupants and pedestrians. Since the first law was passed in New York in 2001 banning hand-held cellphone use while driving, there has been debate as to the exact nature and degree of hazard. The latest research shows that while using a cellphone when driving may not be the most dangerous distraction, because it is so prevalent it is by far the most common distraction in crashes and near crashes. Research: Studies about cellphone use while driving have focused on several different aspects of the problem. Some have looked at its prevalence as the lead- ing cause of driver distraction. Others have looked at the different risks associat- ed with hand-held and hands-free devices. Still others have focused on the seri- ousness of injuries in crashes involving cellphone users and the demographics of drivers who use cellphones. Of increasing concern is the practice of texting. In January 2010 the National Safety Council (NSC) released a report that estimates that at least 1.6 million crashes (28 percent of all crashes) are caused each year by drivers talking on cellphones (1.4 million crashes) and texting (200,000 crashes). The estimate is based on data of driver cellphone use from the National Highway Traffic Safety Administration and from peer-reviewed research that quantifies the risks using cellphones and texting while driving. In July 2009 Virginia Tech Transportation Institute released a study show- ing that the risk of texting while driving is far greater than previous estimates showed and far exceeds the hazards associated with other driving distractions. Researchers used cameras in the cabs of trucks traveling long distances over a period of 18 months and found that the collision risk became 23 times higher when the drivers were texting. The research also measured the time drivers stopped looking at the road and used their eyes to send or receive texts. Drivers generally spent nearly five seconds looking at their devices before a crash or near crash, a period long enough for a vehicle to travel more than 100 yards at typical highway speeds. 34 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Updates at www.iii.org/issues_updates Insurance Topics Climate Change: Insurance Issues Climate Change: Insurance Issues There is now a consensus among the scientific community that the climate is changing, with potential risk to the global economy, ecology, and human health and well being. But how much of this is due to natural phenomena and how much to the effects of human activity is a matter of debate. Also unknown is the extent to which weather patterns have already been affected. As assumers of risk, insurers seek to mitigate potential losses every day through a process known as risk management. Since climate change could lead to losses on a scale never before experienced, insurers are not waiting for researchers to produce all the answers. A 2009 report by Ceres, a network of companies concerned about global warming, identified some 244 insurance- related organizations in 29 countries that were working in 2008 to find solu- tions to the threat posed by greenhouse gas emissions, up from 190 groups in 26 countries in 2007. Insurers are also redoubling their efforts in the more traditional areas of risk management, including alerting policyholders to the potential for lawsuits for failure to protect against or disclose possible harm to the environment. Meanwhile, society’s concern about climate change offers insurers new ave- nues for leadership and new opportunities for innovative products. Global Warming: When fossil fuels—coal, oil and natural gas—are burned to produce energy, so-called greenhouse gases, largely carbon dioxide, are emitted into the atmosphere where they trap heat. Forests and oceans can absorb some of the carbon. But to avoid the most catastrophic effects of what is predicted to occur, researchers say, carbon emissions must be greatly reduced, hence the push to reduce overall energy use, boost the use of energy from renewable sources such as solar heat and curb the use of paper and other products made from trees, which absorb carbon dioxide in the process of photosynthesis. Global warming has the potential to affect most segments of the insurance business, including life insurance if rising temperatures lead to an up-tick in death rates. Property losses of all kinds are most likely to increase, and there is the potential for much higher commercial liability losses if shareholders and consumers try to hold businesses responsible for changes to the environment. Insurers’ Contribution to Lowering Greenhouse Gases: Insurers, like compa- nies in other industries, are promoting strategies to lower greenhouse gas emis- sions. Some insurers have been warning public policy leaders and the general public about the threat of climate change for years, and others were among the I.I.I. Insurance Handbook www.iii.org/insurancehandbook 35 Insurance Topics Updates at www.iii.org/issues_updates Climate Change: Insurance Issues first to adopt public statements on the environment and climate change and to join business coalitions calling on the federal government to enact legislation to reduce greenhouse gases. Some, particularly reinsurers, are sponsoring research and working with others interested in the same kind of solutions, such as find- ing ways for individuals and society to adapt to extreme weather, particularly in developing countries. Many insurance companies are committed to reducing their own total greenhouse gas emissions and offsetting the remainder through contributions to reforestation and renewable energy projects. They also encourage their employ- ees to adopt “green” policies in their private lives. Some were involved in proj- ects to reduce greenhouse gases even before such efforts gained widespread pub- lic attention, and many are now reinforcing their policyholders’ desire to reduce their carbon footprints by offering them paperless billing and documentation. Some have upgraded the quality of their Web sites to encourage policyholders to transact business electronically. At least one auto insurer sells policies exclu- sively online. Insurers are also working on another front: seeking to reduce the incidence and cost of property damage caused by those events that still occur, despite soci- ety’s best efforts to reduce greenhouse gases. New Products and Business Opportunities: Without insurance the economy could not function. Insurers essentially enable new products and services to be created by assuming the risk of loss. Just as they quickly adapted existing liability insurance policies for horse-drawn carriages, or teams of horses, to auto- mobiles towards the end of the nineteenth century, so they are responding to climate change initiatives at the beginning of the twenty-first century. Opportunities exist on several fronts. First, there are new risks to insure, including new industries such as wind farms and other alternative fuel facilities, and emerging financial risks such as those involved in carbon trading. Insurance policies related to carbon trading protect those that invest in clean technol- ogy projects against failure of the project to deliver the agreed-upon emission rights. A number of companies are also offering their clients carbon project risk management consulting services. A carbon credit permits the holder to emit one ton of carbon. The Kyoto Protocol and other cap and trade systems now under discussion set ceilings for carbon output and allow those that produce less than the limit to sell credits to those that exceed it. Investors in clean technology projects such as reforestation and renewable energy buy the rights to credits and sell them in the international carbon trading market. Among the risks associated 36 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Updates at www.iii.org/issues_updates Insurance Topics Climate Change: Insurance Issues with purchasing carbon trading rights is that the technology/project designed to reduce carbon emissions will not meet expectations or that the company will become insolvent before it is able to fulfill its contract, leaving the investor without the necessary carbon offsets. Second, the need to curb global warming has spurred the creation of insur- ance policies that provide incentives to policyholders to contribute to these efforts. These include discounts on auto insurance policies for owning a hybrid car and for driving fewer miles and policies for green building construction. Auto Insurance Initiatives: Motor vehicles account for more than 25 percent of all U.S. greenhouse gas emissions. Insurance policies such as pay-as-you- drive, which factors mileage driven into the price of insurance, and hybrid car discounts could reduce that amount by more than 10 percent if broadly imple- mented, according to Ceres, a network of companies concerned about global warming. A study by the Brookings Institution suggests that if drivers paid by the mile, driving would drop by about 8 percent. There are two ways to reduce the greenhouse gas emissions associated with driving. One is to encourage people to purchase vehicles that emit less carbon dioxide into the environment and get more miles per gallon of gasoline. A number of companies offer discounts to people who drive hybrid vehicles— some believe that people who are socially responsible are also more responsible behind the wheel. The other way is to reward people for driving fewer miles, known as pay-as-you-drive (PAYD) auto insurance. Several insurers have devel- oped technology-based discount programs that provide financial incentives to drive fewer miles. Mileage information comes from a special device. In some, it is linked to the car’s odometer and in others it is a wireless sensor that can monitor speed as well as mileage. These programs are offered in a growing num- ber of states. In addition, California and several other states are encouraging the development of PAYD programs. Insurers are helping to promote sustainable building practices by offering green homeowners and commercial property policies. In addition, they are responding to the growing demand for assistance with energy and emissions- reduction projects with risk management services that address global warming. “Green” Building Insurance Coverage: Increasingly, homeowners at the lead- ing edge of the environmental sustainability movement are generating their own geothermal, solar or wind power and selling any surplus energy back to the local power grid. Several insurers are supporting this trend by offering a homeowners policy that covers both the income lost when there is a power I.I.I. Insurance Handbook www.iii.org/insurancehandbook 37 Insurance Topics Updates at www.iii.org/issues_updates Climate Change: Insurance Issues outage from a covered peril and the extra expense to the homeowner of buying electricity from another source. Policies generally cover the cost of getting back online, such as utility charges for inspection and reconnection. Some insurers offer homeowners insurance policies that, in the event of a fire or other disaster, allow policyholders to rebuild to environmentally respon- sible “green” standards, even if they had not purchased such a policy originally. Green standards, part of the sustainability movement, include energy conserva- tion benchmarks and the use of renewable construction materials. The Green Building Council introduced its Leadership in Energy and Environmental Design (LEED) certification program in 2001. According to Ceres, buildings account for more than one-third of greenhouse gas emissions and green building practices can reduce energy use and emissions by more than 50 percent. With green commercial building construction expected to rise significantly over the next few years, a growing number of insurers are offering green com- mercial property insurance policies and endorsements, some of which are direct- ed at specific segments of the business community such as manufacturers. The first green commercial policy was introduced in 2006. In general, the policies allow building owners to replace damaged buildings, whether or not they are already certified green, with green alternatives includ- ing energy efficient electrical equipment and interior lighting, water conserving plumbing, and nontoxic and low odor paints and carpeting. They also may pay for engineering inspections of heating, ventilation, air conditioning systems, building recertification fees, the replacement of vegetative or plant covered roofs and debris recycling. Some cover the income lost and costs incurred when alter- native energy generating equipment is damaged. 38 I.I.I. Insurance Handbook www.iii.org/insurancehandbook Updates at www.iii.org/issues_updates Insurance Topics Auto Credit Insurance Scoring Credit Scoring The goal of every insurance company is to correlate rates for insurance policies as closely as possible with the actual cost of claims. If insurers set rates too high they will lose market share to competitors who have more accurately matched rates to expected costs. If they set rates too low they will lose money. This con- tinuous search for accuracy is good for consumers as well as insurance compa- nies. The majority of consumers benefit because they are not subsidizing people who are worse insurance risks—people who are more likely to file claims than they are. The computerization of data has brought more accuracy, speed and effi- ciency to businesses of all kinds. In the insurance arena, credit information has been used for decades to help underwriters decide whether to accept or reject applications for insurance. New advances in information technology have led to the development of insurance scores, which enable insurers to better assess the risk of future claims. An insurance score is a numerical ranking based on a person’s credit history. Actuarial studies show that how a person manages his or her financial affairs, which is what an insurance score indicates, is a good predictor of insurance claims. Insurance scores are used to help insurers differentiate between lower and higher insurance risks and thus charge a premium equal to the risk they are assuming. Statistically, people who have a poor insurance score are more likely to file a claim. Insurance scores do not include data on race or income because insurers do not collect this information from applicants for insurance. The Poor Economy Has N

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