Property & Casualty Insurance License Exam Manual PDF

Property & Casualty Insurance 1st Edition, Revised License Exam Manual  1st Edition, Revised Property and Casualty Insurance License Exam Manual Property and Casualty Insurance LEM 1eRev.indb...

Property & Casualty Insurance 1st Edition, Revised License Exam Manual  1st Edition, Revised Property and Casualty Insurance License Exam Manual Property and Casualty Insurance LEM 1eRev.indb 1 5/9/2014 12:41:00 PM  At press time, this edition contains the most complete and accurate information currently available. Owing to the nature of license examinations, however, information may have been added recently to the actual test that does not appear in this edition. Please contact the publisher to verify that you have the most current edition. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought. PROPERTY AND CASUALTY INSURANCE LICENSE EXAM MANUAL, 1ST EDITION, REVISED ©2010 Kaplan, Inc. All rights reserved. The text of this publication, or any part thereof, may not be reproduced in any manner whatsoever without written permission from the publisher. If you find imperfections or incorrect information in this product, please visit www.kfeducation.com and submit an errata report. Published in April 2010 by Kaplan Financial Education. Revised April 2016. Printed in the United States of America. ISBN: 978-1-4277-2506-6 / 1-4277-2506-3 PPN: 1000-0557 P&C LEM - TP-CR.indd 2 4/7/2016 1:21:01 PM  Contents Introduction ix U n i t 1 Principles of Insurance 1 Objectives of this Course 2 Elements of Insurability 5 Risk, Exposure 2 Other Insurance Terms 8 Managing Risk 3 Unit Test 10 Insurance 4 Answers and Rationales to Unit Test 12 Law of Large Numbers 5 U n i t 2 The Insurance Contract 15 Elements of a Valid Contract 16 Unit Test 22 Characteristics of an Insurance Answers and Rationales Contract 18 to Unit Test 23 Parts of the Insurance Contract: Declarations, Insuring Agreements, Conditions, Exclusions, and Definitions 20 U n i t 3 Insurance Company Organization and Regulation 25 Types of Insurance Organizations 26 Regulation 38 Lines of Insurance 28 Unit Test 49 Insurance Company Answers and Rationales Organization 30 to Unit Test 52 iii Property and Casualty Insurance LEM 1eRev.indb 3 5/9/2014 12:41:01 PM  iv Contents U n i t 4 The Insurance Transaction 55 Application 56 Representations and Warranties 62 Binders 56 Waiver and Estoppel 62 Underwriting the Policy 57 Cancellation and Nonrenewal 62 Rating the Policy 60 Unit Test 65 Certificate of Insurance 61 Answers and Rationales to Unit Test 67 Misrepresentation, Concealment, and Fraud 61 U n i t 5 Introduction to Property Insurance 69 Standardized Policies 71 Exclusions and Limitations 75 How the Remainder of the Course Conditions 77 Is Organized 71 Unit Test 87 Declarations 72 Answers and Rationales Insuring Agreement 74 to Unit Test 89 U n i t 6 Introduction to Liability Insurance 93 Liability Losses 94 Vicarious Liability 99 Negligence 95 Liability Insurance 99 Defenses Against Negligence 97 Unit Test 106 Absolute/Strict Liability 98 Answers and Rationales to Unit Test 108 U n i t 7 Dwelling Insurance 111 The Dwelling Policy 112 Dwelling Policy Endorsements 130 Basic Form (DP-1) 113 Unit Test 134 Broad Form (DP-2) and Answers and Rationales Special Form (DP-3) 122 to Unit Test 137 Dwelling Forms Comparison 128 Property and Casualty Insurance LEM 1eRev.indb 4 5/9/2014 12:41:01 PM  Contents v U n i t 8 Homeowners Insurance 141 The Homeowners Policy 143 Homeowners Forms Comparison 169 Section I—Property 145 Unit Test 170 Section II—Liability 160 Answers and Rationales Homeowners Endorsements 166 to Unit Test 173 U n i t 9 Personal Auto Insurance 177 Introduction 178 Parts E and F—Conditions 195 Organization and Eligibility 180 Underinsured Motorists Coverage 197 Definitions 180 Personal Auto Policy Part A—Liability Coverage 182 Endorsements 197 Part B—Medical Payments No-Fault Insurance 198 Coverage 187 Assigned Risk Plans 199 Part C—Uninsured Motorists Coverage 188 Unit Test 200 Part D—Coverage for Damage to Answers and Rationales Your Auto 191 to Unit Test 203 U n i t 1 0 Miscellaneous Personal Insurance 207 Introduction 209 Personal Watercraft Insurance 216 Flood Insurance 209 Personal Umbrella Insurance 218 Earthquake Insurance 212 Fair Plans 219 Mobile Home Insurance 213 Unit Test 221 Personal Inland Marine Answers and Rationales Insurance 213 to Unit Test 223 U n i t 1 1 The Commercial Package Policy 227 Introduction 228 Unit Test 233 Eligible Coverages 228 Answers and Rationales to Unit Test 234 Common Policy Declarations 230 Common Policy Conditions 230 Property and Casualty Insurance LEM 1eRev.indb 5 5/9/2014 12:41:01 PM  vi Contents U n i t 1 2 The Businessowners Policy 237 Introduction 238 Endorsements 263 Eligibility, Policy Organization 239 Comparison of Commercial Package Policy and Businessowners Property Coverage 241 Policy 265 Liability and Medical Expenses Unit Test 2664 Coverage 256 Answers and Rationales Conditions 262 to Unit Test 268 U n i t 1 3 Commercial Property Insurance 271 Commercial Property Coverage Extra Expense and Legal Liability Part 273 Coverage Forms 289 Building and Personal Property Causes of Loss Forms 290 Coverage Form 275 Endorsements 298 Builders Risk Coverage Form 283 Unit Test 299 Condominium Coverage Forms 285 Answers and Rationales Business Income Coverage to Unit Test 303 Forms 286 U n i t 1 4 Ocean and Inland Marine Insurance 307 Ocean Marine Insurance 310 Nonfiled Forms 328 Inland Marine Insurance 313 Unit Test 332 Filed Forms 316 Answers and Rationales to Unit Test 335 Property and Casualty Insurance LEM 1eRev.indb 6 5/9/2014 12:41:01 PM  Contents vii U n i t 1 5 Commercial General Liability Insurance 339 Business Liability Exposures 341 Coverage C—Medical Payments 353 Commercial General Liability Coverage Part 342 Who Is an Insured 353 Occurrence and Claims-Made Limits of Insurance 355 Forms 342 Conditions 356 Definitions 346 Other Commercial General Coverage A—Bodily Injury and Liability Coverage Forms and Property Damage Liability 349 Endorsements 358 Coverage B—Personal and Unit Test 359 Advertising Injury Liability 351 Answers and Rationales Coverage A and B Supplementary to Unit Test 362 Payments 352 U n i t 1 6 Commercial Auto Insurance 367 Commercial Auto Coverage Motor Carrier Coverage Form 381 Part 369 Endorsements 382 Business Auto Coverage Form 369 Unit Test 385 Garage Coverage Form 378 Answers and Rationales Truckers Coverage Form 380 to Unit Test 388 U n i t 1 7 Commercial Crime Insurance 391 Types of Crime Forms 393 Other Crime Forms and Endorsements 405 Definitions 395 Fidelity Bonds 406 Insuring Agreements 397 Unit Test 408 Exclusions 400 Answers and Rationales Conditions 402 to Unit Test 410 Property and Casualty Insurance LEM 1eRev.indb 7 5/9/2014 12:41:01 PM  viii Contents U n i t 1 8 Workers’ Compensation 413 Workers’ Compensation Laws 414 Rating Workers’ Compensation Coverage 423 Funding 419 Unit Test 424 Workers’ Compensation and Employers Liability Policy 420 Answers and Rationales to Unit Test 425 Federal Workers’ Compensation Laws 423403 U n i t 1 9 Miscellaneous Commercial Insurance 427 Introduction 429 Commercial Umbrella Insurance 447 Farm Insurance 429 Surety Bonds 448 Boiler and Machinery Insurance 433 Surplus Lines 451 Aviation Insurance 443 Federal Terrorism Risk Insurance Act of 2002 451 Professional Liability Insurance 444 Unit Test 455 Employment Practices Liability Insurance 445 Answers and Rationales to Unit Test 458 Difference in Conditions Insurance 446 Glossary 463 Index 481 Property and Casualty Insurance LEM 1eRev.indb 8 5/9/2014 12:41:01 PM  Introduction Important: Check for Updates States sometimes revise their exam content outlines unexpectedly or on short notice. To see whether there is an update for this product because of an exam change, please go to www.kfeducation.com and check the Insurance Licensing Blog. If there is an update, it will be clearly noted in the blog entries. We suggest that you check for updates when you first receive the course, again during your study period, upon completion of your studies, and one last time just before you take your insurance license exam. Hints for Successful Exam Preparation An examination must be taken and passed before an insurance pro- ducer’s license is issued. This examination is designed to measure your basic knowledge of insurance coverages and practices to ensure that the public is served in a professionally responsible manner. The examination will also test your understanding of state laws and regulations pertaining to the insurance industry. The Licensing Examination All examination questions are four-part multiple-choice. The number of questions on the exam and the amount of time allowed to complete the exam varies depending on the state and the exam provider. Your exam may contain anywhere from 50–150 questions and have a time limit of 1–3 hours. Check with your state’s license exam administrator for details. Be sure to read each question carefully. While several of the possible answers may be partially correct, you must select the best answer to each question. Watch for words such as all, never, and always. They may help you eliminate some of the choices. There is no penalty for guessing. If you can narrow the choice of four answers down to three or even two logical possibilities, you have a good chance of making an educated guess and picking the right answer. Do not spend too much time on any one question. It is best to skip very difficult questions and return to them after you have completed all of the easier ones. Other questions on the exam may contain information that helps you answer more difficult questions. Study Techniques You may have a lot of experience taking training courses and their exami- nations or it may have been years since you’ve taken a course. Here are a couple tips we recommend to make your study most effective. ix Property and Casualty Insurance LEM 1eRev.indb 9 5/9/2014 12:41:01 PM  x Introduction Read the Entire Course Study the material in each unit until you understand it. A firm grasp of the material in the course is the best preparation for passing the exam. Look for Question Areas as You Read Each Assignment You can prepare for the exam by paying attention to the questions that appear throughout the course. They point to important areas that you should master. More importantly, study with the exam in mind. What questions would you put in the exam if you were creating it to test a student’s knowledge of the material? This exercise will help you master the important material in the course and pass the exam. Property and Casualty Insurance LEM 1eRev.indb 10 5/9/2014 12:41:01 PM  u n i t 1 Principles of Insurance 1 Property and Casualty Insurance LEM 1eRev.indb 1 5/9/2014 12:41:01 PM  2 Property and Casualty Insurance License Exam Manual ❚ 1.1. Learning Objectives After completing Unit 1—Principles of Insurance, you will be able to do the following: Define risk and describe various methods used to manage risk Explain the basic purpose of insurance Describe how the law of large numbers is used by the insurance industry Identify factors that determine whether a risk is insurable, including whether a risk is speculative or pure and whether insurable interest exists Explain the difference between a peril and a hazard Identify the different types of hazards ❚ 1.2. OBJECTIVES OF THIS COURSE Congratulations on your decision to become a part of the challenging property-casualty insurance industry. As an insurance professional, you will have broad responsibilities to your company, the industry, and the public that you will serve. This course will prepare you to begin these new responsibilities with con- fidence. You will learn about the principles underlying insurance and how the insurance industry operates. You will become familiar with all of the major categories of property-casualty products, the kinds of situations they are designed to cover, and the characteristics that make them unique. Of course, no one training program will tell you everything you’ll ever want to know about insurance. Property-Casualty Concepts will give you the knowledge you need to take your first career steps and prepare you for the challenges and training opportunities that lie ahead. ❚ 1.3. RISK, exposure To understand what insurance is and how it works, you must first under- stand something about risk. Risk means the same thing in insurance that it does in everyday language. Risk is the chance or uncertainty of loss. For instance, the possibility that your house might be burglarized or that you might be hit by a car while crossing the street represents uncertainty of loss. Both are risks. Now notice that risk is not the loss itself but the uncertainty of loss. There are some losses that are certain to occur eventually, such as when a rug finally wears out after years of use or a car runs out of gas. Such losses are not risks because they represent a certainty, instead of an uncertainty, of loss. Property and Casualty Insurance LEM 1eRev.indb 2 5/9/2014 12:41:01 PM  Unit 1 Principles of Insurance 3 Another term that means almost the same thing as risk is exposure. An exposure is a condition or situation that presents a possibility of loss. For example, a home that is built on a flood plain is exposed to the possibility of flood damage. ❚ 1.4. MANAGING RISK We spend our entire lives coping with risk: crossing the street, going swim- ming, buying a new house, traveling by plane. These risks sometimes result in small losses, such as a stubbed toe or a lost pocket comb, that we accept as a normal part of life. But risks may also result in serious financial losses, such as when a house burns down or a person is injured in a car accident. The conse- quences of such serious financial losses can be quite severe and far reaching. People have developed several different methods for managing the risk of serious financial loss. One method is simply to avoid risk. For example, you can avoid the risk of being in an auto collision by never getting into a car. But it isn’t practical to avoid all risks. Fortunately, that isn’t the only method of managing risk. You can also control risk to some extent. For example, training workers in the safe use of welding tools can curtail the fre- quency of fires on the job. Risk control techniques that curtail loss frequency come under the heading of loss prevention. Or, installing a sprinkler system in a factory won’t prevent a fire from occurring, but it will limit the severity of any fire that does occur. Risk control techniques that limit loss severity come under the heading of risk reduction. In some cases, people simply retain a risk. That is, if any loss occurs, they will pay for it themselves. Sometimes people retain only a portion of a risk— the portion that remains after other means of managing the risk have been employed. If people are aware of a risk and decide to retain it (or a portion of it), then they do so intentionally. If people are not aware of a risk, they may retain it unintentionally, and they may be surprised if a loss occurs. The final method of managing risk is to transfer it. This option includes, but is not limited to, insurance. For example, a hold harmless agreement may shift liability from an owner or contractor to a tenant or subcontractor. (A hold harmless agreement is a contractual arrangement where one party assumes the liability of a situation and relieves the other party of responsibil- ity.) However, for many risks, the best way to transfer them is through insur- ance. We’ll focus on this way of handling the possibility of loss in the rest of this unit. Property and Casualty Insurance LEM 1eRev.indb 3 5/9/2014 12:41:01 PM  4 Property and Casualty Insurance License Exam Manual Exercise 1.A Match the method of managing risk on the left with its correct descrip- tion on the right. ____ 1. Avoid risk A. George always wears his seat belt in the car. ____ 2. Control risk B. Terry’s car is not insured. ____ 3. Retain risk C. Gretchen doesn’t own a car because she doesn’t know how to drive. Exercise answers can be found at the end of the Unit 1 answers and rationales. ❚ 1.5. INSURANCE You learned that one way of managing risk is to transfer it. This is what insurance does. The purpose of insurance is not to avoid or eliminate risk but to transfer risk. To see how it works, let’s look at the hypothetical town of Middlefield. Middlefield has 200 homes, each worth $100,000. Usually, one home in Middlefield burns to the ground each year. If the homeowner has to pay for the house, the owner will suffer a $100,000 loss. However, if that loss were divided among each of Middlefield’s homeowners, it would be only $500. Wouldn’t you agree to pay $500 knowing that if your house burned down, you would receive $100,000? This is basically how insurance works. Instead of paying each other, peo- ple pay insurance companies, thus transferring the risk and responsibility for paying for any losses that occur to the company in exchange for a premium. The insurance company accumulates these premiums to provide the funds to pay for losses. This means that even though people don’t pay each other directly, they still share in the cost of each other’s losses. Property and Casualty Insurance LEM 1eRev.indb 4 5/9/2014 12:41:01 PM  Unit 1 Principles of Insurance 5 So, a formal definition of insurance would be a contract or device for transferring risk from a person, business, or organization to an insurance com- pany that agrees, in exchange for a premium, to pay for losses through an accumulation of premiums. ❚ 1.6. LAW OF LARGE NUMBERS Overall, we’re a pretty safe group of people. Everyone doesn’t have a loss all the time. For this reason, by predicting the number of losses that will occur, an insurance company can provide large amounts of insurance for rela- tively little money. To help them predict their losses accurately so they can charge the proper premiums needed to accumulate adequate funds, insurance companies rely on the law of large numbers. The law of large numbers says that the more examples used to develop any statistic, the more reliable the statistic will be. Consider these statistics. Four out of five homes have defective wiring. To determine this, 15 homes were checked. Three out of four automobiles will suffer some form of tire damage each year. Five million auto owners were surveyed. The law of large numbers tells us that the tire statistic will be more accu- rate than the wiring statistic in predicting what will happen in the future because the tire statistic is based on many more examples. ❚ 1.7. ELEMENTS OF INSURABILITY 1.7.1. Pure Risk, Speculative Risk Although theoretically almost anyone could purchase insurance to cover almost any risk, there are certain rules that establish a practical basis regard- ing who can be insured and for what. For instance, insurance cannot be used to handle speculative risks. Spec- ulative risks are risks in which there exists both the possibility of gain and the possibility of loss. A poker game is an example of a speculative risk. Insur- ance can be used to manage only pure risks, which involve only the possibil- ity of loss. A person can buy insurance to protect against loss if a fur coat is stolen (pure risk) but not to protect against loss if the price of stock goes down (speculative risk). Property and Casualty Insurance LEM 1eRev.indb 5 5/9/2014 12:41:01 PM  6 Property and Casualty Insurance License Exam Manual Exercise 1.B For each of the examples listed below, indicate whether it is a pure risk (P) or a speculative risk (S). ____ 1. Harry feels lucky, so he buys a lottery ticket at the neighborhood convenience store. ____ 2. Joan hopes her fur coat is safe at the storage ware- house. ____ 3. The lightning rods aren’t up on Frank’s new house yet, and a severe thunderstorm has been predicted. ____ 4. Donna purchases several shares of stock in a computer company. Exercise answers can be found at the end of the Unit 1 answers and rationales. 1.7.2. Insurable Interest A basic rule concerning who can be insured states that before you can benefit from insurance, you must have a chance of financial loss or a financial interest in the property. This is called an insurable interest. You have an insurable interest in your own home but not your neighbor’s home. Property and Casualty Insurance LEM 1eRev.indb 6 5/9/2014 12:41:02 PM  Unit 1 Principles of Insurance 7 1.7.3. Other Elements of Insurable Risks There are additional rules that govern what risks are considered suitable subjects for insurance. Risks that do not meet these criteria are probably bet- ter handled using an alternate method of risk management. The risk of loss must be definite as to time and place and difficult to counterfeit or falsify. Death is probably the best example of a definite loss. The risk must be unexpected. In fact, as we mentioned earlier, if the results are expected, it does not qualify as a risk. The risk of a train wreck could be insured, whereas the risk that your suitcase will eventually wear out is not really a risk at all and, therefore, is not insurable. The risk must be large enough to create a financial hardship for the indi- vidual involved. A financially insignificant risk, such as the chance that you might lose a pair of inexpensive sunglasses, is not insurable. The loss must be calculable. In addition to requiring adequately large risks, only risks for which the cost of loss is calculable may be insured. Risks that involve loss that can’t be assigned a financial value are unin- surable. The cost of the insurance must be affordable to the insured. If the risk is so severe that it requires the insurance company to charge prohibitively high premiums to accumulate enough money to pay losses, it is not an insurable risk. Even if the person purchasing the insurance could afford to pay it, the cost should be only a fraction of the value of the item itself. There must be a large number of persons with a similar potential loss available for the insurance so that overall, losses become predictable. The law of large numbers applies here. To accumulate adequate funds to pay losses, the insurance company must be able to predict losses. Accu- rate predictions are possible only when there are sufficient numbers of potential insureds with a similar chance of loss. The loss must not happen to a large number of insureds at the same time. Although insurance companies do want to insure a large number of per- sons, if a great number of these insureds were to suffer a loss at the same time, it would be catastrophic for the insurance company. For instance, suppose an insurance company were to insure every home in a single town. A rapidly spreading fire could destroy the entire town. So instead of insuring every person in a single town, a company will want to insure several people in many towns. This is known as spread of risk. The greater the spread of risk, the less likely that there will be a catastrophic loss for the insurance company. Property and Casualty Insurance LEM 1eRev.indb 7 5/9/2014 12:41:02 PM  8 Property and Casualty Insurance License Exam Manual ❚ 1.8. OTHER INSURANCE TERMS 1.8.1. Peril You’ve learned that risk is the uncertainty of loss. A peril is the cause of loss. Fire and collision are both examples of perils. 1.8.2. Hazard Now that you understand the difference between risk and peril, let’s dis- cuss another important term: hazard. A hazard is anything that increases the chance of loss. Suppose Georgia was injured when a furnace exploded as the result of a poorly tightened gas connection. The peril was explosion; the hazard was a poorly tightened gas connection. 1.8.2.1. Physical, Morale, and Moral Hazards There are three different types of hazards. A physical hazard is a hazard that arises from the condition, occupancy, or use of the property itself. An example of a physical hazard is a skateboard left on the porch steps. The second type of hazard is called a morale hazard. This means that an individual, through carelessness or by irresponsible actions, can increase the possibility for a loss. An example of a morale hazard is a person who drives a car carelessly because he knows a loss will be insured if an accident occurs. The third type of hazard, closely related to the morale hazard, is the moral hazard. A moral hazard means that a person might create a loss situation on purpose just to collect from the insurance company. An example of a moral hazard is a prearranged, faked theft of an older vehicle so the owner could collect the insurance money and buy something new. Property and Casualty Insurance LEM 1eRev.indb 8 5/9/2014 12:41:02 PM  Unit 1 Principles of Insurance 9 Exercise 1.C Read through the examples that follow and mark each as a physical, morale, or moral hazard. 1. Jerry is having serious business difficulties. He plans to burn down the building in which his business operates so he can collect on the insurance. _______________________________________________________ 2. Bill leaves his car unlocked whenever he goes shopping. He figures that the car is insured and there is no reason to worry. _______________________________________________________ 3. The Starfire Equipment Company, which is occupied in a very old building, has had several serious fires in the last two years. An inspector says that a worn-out furnace may have caused the fires. _______________________________________________________ Exercise answers can be found at the end of the Unit 1 answers and rationales. Property and Casualty Insurance LEM 1eRev.indb 9 5/9/2014 12:41:02 PM  10 Property and Casualty Insurance License Exam Manual U nit T est Throughout this course, as you complete each unit, you will have a chance to review what you have learned by working through some review exercises. After you have completed them, be sure to review any that you missed and, if necessary, reread the appropriate section of the text. Note that unit review questions are drawn from all 4. LaTonya purchases a house from John. She topics discussed in a particular unit. Students who are borrows $75,000 from First City Bank which, taking this course to prepare for producer licensing along with her $25,000 down payment, equals the exams may see questions on topics that were not $100,000 purchase price of the home. Who has an included on their state exam syllabuses. If you wish to insurable interest in this home? tailor your review to your particular state’s licensing A. LaTonya exam, we recommend that you purchase Kaplan’s B. John Property and Casualty InsurancePro QBank™. Go to C. LaTonya’s son, who would like to inherit the www.kfeducation.com for details. home some day D. First City Bank 1. Match each word below with its appropriate definition. 5. Describe four of the criteria a risk must meet to be 1. Risk ____ A. Increases the chance of loss insurable. 2. Insurance ____ B. A means of transferring the risk A. _____________________________________ of loss _____________________________________ 3. Peril ____ C. The chance of loss _____________________________________ 4. Hazard ____ D. The cause of loss B. _____________________________________ _____________________________________ 2. Which of the following represent pure risks? _____________________________________ A. Terry places a bet on the outcome of a C. _____________________________________ basketball game. _____________________________________ B. Margaret’s dog is temperamental. She’s afraid _____________________________________ it will bite a neighbor someday, and she will be D. _____________________________________ held responsible. _____________________________________ C. Both A and B. _____________________________________ 3. The law of large numbers 6. Highpoint Industries has an automatic sprinkler A. prohibits insurance with extremely high system installed in its office building. This is an premiums example of which risk management method? B. states that there must be an adequate spread of A. Avoidance risk for insurance to be effective B. Reduction C. states that the more examples used to develop C. Control a statistic, the more reliable the statistic will be 7. Benson Pharmaceutical Company decides not to manufacture a new drug after determining that it has serious potential side effects. This is an example of which risk management method? A. Transfer B. Retention C. Avoidance Property and Casualty Insurance LEM 1eRev.indb 10 5/9/2014 12:41:02 PM  Unit 1 Principles of Insurance 11 8. Since she has always been in good health, Donna 10. Veronica forgets to lock her front door when she decides to cancel her health insurance policy. leaves for work. Later that day, a thief enters her This is an example of which risk management apartment and steals her television. method? A. What was the peril? A. Retention _____________________________________ B. Control _____________________________________ C. Avoidance B. What was the hazard? _____________________________________ 9. Determine the peril involved in each of the _____________________________________ following losses. A. Mr. Reed’s home was destroyed in a fire. _____________________________________ _____________________________________ B. Suzanne’s house was damaged in a flood. _____________________________________ _____________________________________ C. Jim’s automobile collided with Sue’s. _____________________________________ _____________________________________ Property and Casualty Insurance LEM 1eRev.indb 11 5/9/2014 12:41:02 PM  12 Property and Casualty Insurance License Exam Manual A nswers and R ationales T O U N I T T E S T 1. 4 A.; 2 B.; 1 C.; 3 D. Risk is the chance or 6. B A sprinkler system can reduce the severity uncertainty of loss. Insurance is a contract of fires, but it does not prevent them or device for transferring the risk of loss altogether or reduce the number that from a person, business, or organization occur. to an insurance company that agrees, in exchange for a premium, to pay for losses 7. C By not producing the drug, Benson avoids through an accumulation of premiums. the risk of being sued by consumers who A peril is the cause of loss. A hazard is are injured by the drug. something that increases the chance of loss. 8. A By not carrying health insurance, Donna is retaining the risk of financial loss from 2. B A pure risk is one that involves only the unexpected medical expenses. possibility of loss. Choice A is an example of a speculative risk in which there exists 9. A peril is the cause of loss. In these both the possibility of gain and the exercises, the perils are: A. Fire; B. Flood; possibility of loss. C. Collision. 3. C The law of large numbers says that the 10. A peril is the cause of loss. In question A, more examples used to develop a statistic, the peril is theft. A hazard is something the more reliable the statistic will be. that increases the chance of loss. In Insurers use the law of large numbers to question B, the hazard is leaving the door predict the number of losses that will occur unlocked. so they can charge the correct premium. 4. A and D are correct. Insurable interest exists when there is an actual economic interest in the safety or preservation of the subject of the insurance from loss or destruction or financial damage or impairment. LaTonya has an insurable interest in the home because she owns it. First City Bank has an insurable interest as long as it carries a mortgage on the home. 5. Any four of the following: Insurable interest; pure risk, not speculative; loss must not happen to a large number of insureds at the same time; risk of loss must be definite; loss would cause financial hardship; cost of loss is calculable; cost of insurance covering the risk is affordable; large number of persons with similar potential for loss. Property and Casualty Insurance LEM 1eRev.indb 12 5/9/2014 12:41:02 PM  Unit 1 Principles of Insurance 13 unit 1 e x ercise A nswers Exercise 1.A Exercise 1.C 1. C 1. Moral 2. A 2. Morale 3. B 3. Physical Exercise 1.B 1. S 2. P 3. P 4. S Property and Casualty Insurance LEM 1eRev.indb 13 5/9/2014 12:41:02 PM Property and Casualty Insurance LEM 1eRev.indb 14 5/9/2014 12:41:02 PM  u n i t 2 The Insurance Contract 15 Property and Casualty Insurance LEM 1eRev.indb 15 5/9/2014 12:41:02 PM  16 Property and Casualty Insurance License Exam Manual ❚ 2.1 Learning Objectives After completing Unit 2—The Insurance Contract, you will be able to do the following: Describe the elements of a legally valid contract and how those elements apply in an insurance transaction Identify special characteristics associated with insurance contracts, including the principle of indemnity Explain the role of the five sections found in most insurance policies: declarations, insuring agreements, conditions, exclusions, and defini- tions Describe how insurance policies may be organized Explain the purpose of endorsements ❚ 2.2 ELEMENTS OF A VALID CONTRACT Now that you’re familiar with some of the principles of insurance, let’s look more closely at the insurance contract itself. You’re probably familiar with the term contract. A contract is a legal agree- ment between two competent parties that promises a certain performance in exchange for a certain consideration. When an insurance company agrees to pay for an insured’s losses in exchange for a certain premium, the two parties have entered into a contract. Although a contract of insurance may be oral, it is usually written in the form of an insurance policy. Property and Casualty Insurance LEM 1eRev.indb 16 5/9/2014 12:41:03 PM  Unit 2 The Insurance Contract 17 Insurance contracts, like all other contracts, must exhibit certain charac- teristics to be legally enforceable. These characteristics are: competent parties; legal purpose; offer and acceptance (agreement); and consideration. 2.2.1. Competent Parties A contract is not valid unless it is made between two parties who are considered competent under the law. In most cases, a person who is a minor, insane, or under the influence of alcohol or drugs is considered incompetent. 2.2.2. Legal Purpose The second requirement for a valid contract is that it be formed for a legal purpose. A contract that is against public policy (offensive to the best inter- ests of the public) or in violation of the law is not enforceable. 2.2.3. Offer and Acceptance The third element of a valid contract, offer and acceptance, means that the contract involves two parties: one who makes an offer and one who accepts it. This is also called agreement. An offer is a promise that requires an act or another promise in exchange. Acceptance occurs when the other party agrees to the offer or does what was proposed in the offer. Exercise 2.A Ted fills out an application for auto insurance and sends it to the XYZ Insurance Company, which agrees to provide the insurance to Ted. 1. Which party made an offer? A. Ted B. XYZ Insurance Company 2. Which party accepted the offer? A. Ted B. XYZ Insurance Company Exercise answers can be found at the end of the Unit 2 answers and rationales. Property and Casualty Insurance LEM 1eRev.indb 17 5/9/2014 12:41:03 PM  18 Property and Casualty Insurance License Exam Manual 2.2.4. Consideration The last requirement for a valid contract is that it involve consideration. Consideration is a thing of value exchanged for the performance promised in the contract. With insurance, the consideration that the insured gives is the premium payment. The consideration that the insurer gives is the promise to pay for certain losses suffered by the insured. ❚ 2.3 CHARACTERISTICS OF AN INSURANCE CONTRACT 2.3.1. Principle of Indemnity In addition to the characteristics an insurance contract shares with other valid contracts, it also has some special features of its own. Principle of Indemnity One of the most important characteristics of an insurance contract is that it is a contract of indemnity. The principle of indemnity states that when a loss occurs, an individual should be restored to the approximate financial condition he was in before the loss, no more and no less. Let’s consider two examples. The insured bought an automobile four years ago for $15,000. Today it is worth $6,000. According to the principle of indemnity, the insured should receive no more than $6,000 if the car is demolished. You lend your laptop computer to a friend, and it is destroyed in a fire at your friend’s house. Your friend offers to pay for the computer. You also have insurance that would cover the loss. According to the principle of indemnity, you should not be able to collect the full amount of this loss from both your friend and the insurance company. Property and Casualty Insurance LEM 1eRev.indb 18 5/9/2014 12:41:03 PM  Unit 2 The Insurance Contract 19 The principle of indemnity is closely related to both the requirement of an insurable interest and the exclusion of speculative risks that we discussed earlier. An insured may only be indemnified to the extent of his insurable interest. Insurance is not gambling—the insured doesn’t win or lose. The insured may only be returned to the approximate financial condition he occu- pied before the loss occurred. Suppose Harry Arne and his cousin each own 50% of a $160,000 duplex. Suppose Harry purchases $160,000 of insurance on the home. If it burns to the ground, Harry could not collect more than $80,000. 2.3.2. Personal An insurance contract does not insure property; it insures the person who owns the property. This means it is a personal contract. 2.3.3. Aleatory An insurance contract is aleatory, which means it is contingent on an uncertain event (a loss) that provides for unequal transfer of value between the parties. An insured can pay premiums for many years without having a covered loss. On the other hand, insureds who suffer a loss often get a great deal more from the insurance company than they’ve paid in premiums. 2.3.4. Adhesion When we say that insurance contracts are adhesion contracts, we mean that one party has greater power over the other party in drafting the contract. The provisions of the contract are prepared by one party—the insurer. The other party, the insured, does not take part in the preparation of the contract. Although the insured may request special provisions or coverages, it is the insurance company that ultimately draws up and issues the policy. A problem that sometimes arises in insurance contracts is ambiguity, which occurs when the insurer doesn’t make the terms and agreements of the policy perfectly clear. Since an insurance policy is an adhesion contract, the courts usually resolve any ambiguity in policy wording in favor of the insured. When doing so, the courts may rely on the doctrine of reasonable expecta- tions, which states that a policy includes coverages that an average person would reasonably expect it to include, regardless of what the policy actually provides. 2.3.5. Unilateral An insurance policy is a unilateral contract. Unilateral means one sided. An insurance policy is one sided because only the insurance company is legally bound to perform its part of the agreement. If an insured pays a premium and a loss occurs, the insurer is legally bound to pay for the loss under the terms of the policy. However, insureds are not legally obligated to pay premiums. If insureds stop paying premiums, the insurance company can cancel coverage, but it can’t take them to court for breaking the contract. On the other hand, Property and Casualty Insurance LEM 1eRev.indb 19 5/9/2014 12:41:03 PM  20 Property and Casualty Insurance License Exam Manual if an insured fails to comply with conditions and duties specified in the con- tract, the insurance company may deny an insured’s claim. 2.3.6. Contract of Utmost Good Faith Another characteristic of an insurance contract is that it is a contract of utmost good faith. The insurance company relies on the truthfulness and integrity of the applicant when issuing a policy. In return, the insured relies on the company’s promise and ability to provide coverage and pay claims. 2.3.7. Conditional An insurance policy includes a number of conditions that both the insured and the insurer must comply with. For example, if a covered loss occurs, the insured must notify the insurer about the loss, and the insurer must use the valuation methods specified in the policy to settle the loss. For this reason, an insurance policy is a conditional contract. ❚❚ 2.4 PARTS OF THE INSURANCE CONTRACT: Declarations, ❚ insuring agreements, conditions, exclusions, and definitions Since an insurance policy is a legal contract, it must be very specific about the agreements between the insured and the insurer. To do this, most policies contain five parts: declarations, insuring agreements, conditions, exclusions, and definitions. The declarations, which are almost always on the first page of the policy, contain such information as the name of the insured, the address, the amount of coverage provided, a description of the property, and the cost of the pol- icy. The insuring agreements, the heart of the policy, state in general what is to be covered or, in other words, the losses for which the insured will be indemnified. This section also describes the type of property covered and the perils against which it is insured. The conditions state the ground rules for the policy. They describe the responsibilities and the obligations of both the insurance company and the insured. The exclusions describe the losses for which the insured is not covered. If an excluded loss occurs, the insured will not be indemnified. Finally, the definitions section clarifies the meanings of certain terms used in the policy. Property and Casualty Insurance LEM 1eRev.indb 20 5/9/2014 12:41:03 PM  Unit 2 The Insurance Contract 21 Exercise 2.B Read the following policy excerpts and label them as declarations, insur- ing agreements, conditions, exclusions, or definitions. 1. Named insured and mailing address: Leah Bachman, 11491 Bretson Road, Elysium, Anystate 01001 _______________________________________________________ 2. In this policy, property damage means physical injury to or destruction of property. _______________________________________________________ 3. This policy does not cover any loss caused by earthquake. _______________________________________________________ 4. This policy may be canceled if the insured does not pay premiums when due. ______________________________________________ 5. This policy covers personal property owned or used by the insured. _______________________________________________________ Exercise answers can be found at the end of Unit 2 answers and rationales. 2.4.1. Policy Organization Although all insurance contracts contain these elements, policies can be organized in a number of different ways. Some policies contain the declarations, insuring agreement, conditions, definitions, and exclusions all in one single, continuous page. Another format uses a policy jacket, also called a skeleton policy, that contains general conditions and the declarations. To complete the policy, a policy form or coverage form containing the insuring agreements, exclusions, definitions, and additional coverages must be attached. Still another format features a declarations page, a coverage form con- taining the coverages and certain exclusions, definitions and conditions, a separate general conditions form, and a causes of loss form listing the perils insured against and additional exclusions. Later in this course, you will have an opportunity to learn more about specific policies and see how they are constructed. Because our lives are subject to so many changes and because each policy- holder is different, it is often necessary to modify or change the original policy in some way, such as broadening coverage, restricting coverage, or changing the name of an insured. This is accomplished by adding an endorsement, which is attached to the policy itself. Property and Casualty Insurance LEM 1eRev.indb 21 5/9/2014 12:41:03 PM  22 Property and Casualty Insurance License Exam Manual U nit T est 1. For each of the following examples, write in 3. List the purpose of each part of an insurance which of the four elements of a valid contract is policy. missing: competent parties, legal purpose, offer and A. Declarations: __________________________ acceptance, or consideration. _____________________________________ A. Jack agrees to burn down Albert’s house for B. Insuring agreements: ____________________ $10,000.______________________________ _____________________________________ B. Susan’s insurance policy is canceled for C. Conditions: ___________________________ nonpayment of premium. _____________________________________ _____________________________________ D. Exclusions: ____________________________ C. JAG Insurance Company denies George’s _____________________________________ application for auto insurance. E. Definitions: ___________________________ _____________________________________ _____________________________________ D. Andrea, age 15, signs a lease for an apartment F. Endorsements: _________________________ in Highview Estates. _____________________________________ _____________________________________ 2. Match the following terms describing insurance contracts with the statements that explain them. 1. Conditional ____ A. Prepared by one party, with little or no opportu- nity for bargaining by the other party 2. Indemnity ____ B. Insurer relies on insured’s statements and insured relies on insurer’s ability to fulfill its promises 3. Personal ____ C. Dependent on an uncer- tain event 4. Aleatory ____ D. Insures a person 5. Adhesion ____ E. After a loss occurs, an individual is restored to the approximate finan- cial condition she was in before the loss 6. Unilateral ____ F. One-sided contract; only the insurance company is legally bound to perform under the contract 7. Utmost ____ G. Includes conditions good faith that both the insured and the insurer must comply with Property and Casualty Insurance LEM 1eRev.indb 22 5/9/2014 12:41:03 PM  Unit 2 The Insurance Contract 23 A nswers and R ationales T O U N I T T E S T 1. A. Legal purpose. One of the requirements in drafting the contract. An insurance for a valid contract is that it be formed contract is unilateral because it is one for a legal purpose. A contract that is in sided—only the insurance company is violation of the law—such as this example, legally bound to perform its part of the which involves arson—is not enforceable. agreement. Another characteristic of an insurance contract is that it is a contract of B. Consideration. A valid contract must utmost good faith. The insurance company involve consideration—a thing of value must be able to rely on the honesty and exchanged for the performance promised cooperation of the insured, and the insured in the contract. With insurance, the must rely on the company to fulfill its consideration that the insured gives is the obligations. premium payment. Since Susan did not pay the premium, there is no consideration 3. A. The Declarations list who is insured, what involved. property or risk is covered, when and where coverage is effective, and how much C. Offer and acceptance. A contract coverage applies. involves two parties: one who makes an offer and one who accepts it. Since JAG B. Insuring agreements describe what is Insurance did not accept George’s offer covered and the perils the policy insures (an application for insurance), no contract against. exists. C. The conditions explain the rights and D. Competent parties. A contract is not valid duties of the insured and the insurer under unless it is made between two parties who the policy. are considered competent under the law. In most cases, a person who is a minor is D. The exclusions list property, perils, persons, considered incompetent. or situations that are not covered by the policy. 2. 5. A.; 7. B.; 4. C.; 3. D.; 2. E.; 6. F.; 1. G. Insurance contracts have a number of E. Definitions clarify the meaning of certain special characteristics. An insurance terms used in the policy. contract is a conditional contract because it contains a number of conditions F. Endorsements are documents attached to that both parties must comply with. the policy that change the policy in some An insurance contract is a contract of way. indemnity because when a loss occurs, the insured is restored to the approximate financial condition he occupied before the loss occurred, no better or no worse. An insurance contract is a personal contract because it insures a person, not property. An insurance contract is aleatory because it is contingent on an uncertain event (a loss). An insurance policy is an adhesion contract because one party (the insurer) has more power than the other party Property and Casualty Insurance LEM 1eRev.indb 23 5/9/2014 12:41:03 PM  24 Property and Casualty Insurance License Exam Manual U nit 2 E x ercise answers Exercise 2.A Exercise 2.B 1. A 1. Declarations 2. B 2. Definitions 3. Exclusions 4. Conditions 5. Insuring agreements Property and Casualty Insurance LEM 1eRev.indb 24 5/9/2014 12:41:03 PM  u n i t 3 Insurance Company Organization and Regulation 25 Property and Casualty Insurance LEM 1eRev.indb 25 5/9/2014 12:41:03 PM  26 Property and Casualty Insurance License Exam Manual ❚ 3.1. learning objectives After completing Unit 3—Insurance Company Organization and Regu- lation, you will be able to do the following: Describe the most common types of insurance companies Define the four broad categories of insurance Explain the difference between personal and commercial insurance Describe the duties an agent has to insureds and insurance companies Identify the four basic distribution systems used to market insurance Explain the roles of other insurance professionals, such as solicitors, bro- kers, and consultants Describe major functions of insurance companies, such as underwriting, claims, and loss control Describe how state insurance departments regulate the insurance indus- try and its agents ❚ 3.2. TYPES OF INSURANCE ORGANIZATIONS 3.2.1. Stock and Mutual Companies Now that we’ve talked about the insurance contract in general, we want to look more closely at the organizations that issue these contracts. There are several types of insurance companies that represent different ways in which companies raise the money necessary to begin business and enroll their pros- pects for insurance. The first type is called a stock company. When a stock company first forms, it sells stock to stockholders to raise the money necessary to operat