RISK MANAGEMENT AND INSURANCE 12TH EDITION BY JAMES TRIESCHMANN, SANDRA GUSTAVSON, ROBERT HOYT, DAVI

SOLUTIONS MANUAL

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RISK MANAGEMENT AND INSURANCE 12TH EDITION BY JAMES TRIESCHMANN, SANDRA GUSTAVSON, ROBERT HOYT, DAVID SOMMER SOLUTIONS MANUAL CONTENTS INSTRUCTOR’S MANUAL PART 1: Chapter 1: Chapter 2: Chapter 3: Chapter 4: Chapter 5: Chapter 6: Chapter 7: Chapter 8: PART 2:

Chapter 9: Chapter 10: Chapter 11: Chapter 12: PART 3:

Chapter 13: Chapter 14: Chapter 15: PART 4:

Chapter 16: Chapter 17: Chapter 18: Chapter 19: Chapter 20: Chapter 21: PART 5: Chapter 22: Chapter 23:

RISK AND THE RISK MANAGEMENT PROCESS Introduction to Risk ................................................................................................1 Risk Identification and Evaluation ..........................................................................4 Property and Liability Loss Exposures ...................................................................8 Life, Health, and Loss of Income Exposures ........................................................12 Risk Management Techniques: Noninsurance Methods .......................................16 Insurance as a Risk Management Technique: Principles ......................................20 Insurance as a Risk Management Technique: Policy Provisions ..........................25 Selecting and Implementing Risk Management Techniques.................................28 COMMERCIAL RISK MANAGEMENT APPLICATIONS: PROPERTY-LIABILITY Risk Management and Commercial Property: Part I.............................................31 Risk Management and Commercial Property: Part II ...........................................34 Risk Management and Commercial Liability Risk ...............................................38 Workers' Compensation and Alternative Risk Financing......................................41 PERSONAL RISK MANAGEMENT APPLICATIONS: PROPERTY-LIABILITY Risk Management for Auto Owners: Part I...........................................................44 Risk Management for Auto Owners: Part II .........................................................47 Risk Management for Homeowners......................................................................50 RISK MANAGEMENT APPLICATIONS: LIFE, HEALTH, AND INCOME EXPOSURES Loss of Life ...........................................................................................................54 Loss of Health ....................................................................................................... 59 Retirement Planning and Annuities ......................................................................65 Employee Benefits: Life and Health Benefits .......................................................69 Employee Benefits: Retirement Plans ...................................................................73 Financial and Estate Planning ...............................................................................77 THE RISK MANAGEMENT ENVIRONMENT Risk Management and the Insurance Industry ......................................................81 Functions and Organization of Insurers ................................................................85

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Chapter 24:

Government Regulation of Risk Management and Insurance ...............................89

TEST BANK PART 1: Chapter 1: Chapter 2: Chapter 3: Chapter 4: Chapter 5: Chapter 6: Chapter 7: Chapter 8: PART 2:

Chapter 9: Chapter 10: Chapter 11: Chapter 12: PART 3:

Chapter 13: Chapter 14: Chapter 15: PART 4:

Chapter 16: Chapter 17: Chapter 18: Chapter 19: Chapter 20: Chapter 21: PART 5: Chapter 22: Chapter 23: Chapter 24:

RISK AND THE RISK MANAGEMENT PROCESS Introduction to Risk ..............................................................................................95 Risk Identification and Evaluation ...................................................................... 100 Property and Liability Loss Exposures ............................................................... 106 Life, Health, and Loss of Income Exposures ...................................................... 114 Risk Management Techniques: Noninsurance Methods ..................................... 119 Insurance as a Risk Management Technique: Principles .................................... 124 Insurance as a Risk Management Technique: Policy Provisions ........................ 130 Selecting and Implementing Risk Management Techniques............................... 135 COMMERCIAL RISK MANAGEMENT APPLICATIONS: PROPERTY-LIABILITY Risk Management and Commercial Property: Part I........................................... 140 Risk Management and Commercial Property: Part II ......................................... 145 Risk Management and Commercial Liability Risk ............................................. 150 Workers' Compensation and Alternative Risk Financing.................................... 155 PERSONAL RISK MANAGEMENT APPLICATIONS: PROPERTY-LIABILITY Risk Management for Auto Owners: Part I......................................................... 160 Risk Management for Auto Owners: Part II ....................................................... 165 Risk Management for Homeowners.................................................................... 168 RISK MANAGEMENT APPLICATIONS: LIFE, HEALTH, AND INCOME EXPOSURES Loss of Life ......................................................................................................... 173 Loss of Health ..................................................................................................... 178 Retirement Planning and Annuities .................................................................... 184 Employee Benefits: Life and Health Benefits ..................................................... 190 Employee Benefits: Retirement Plans ................................................................. 195 Financial and Estate Planning ............................................................................. 200 THE RISK MANAGEMENT ENVIRONMENT Risk Management and the Insurance Industry .................................................... 205 Functions and Organization of Insurers .............................................................. 211 Government Regulation of Risk Management and Insurance ............................. 218

CHAPTER 1

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Introduction to Risk THE BURDEN OF RISK DEFINITIONS OF RISK Pure versus Speculative Risk Static versus Dynamic Risk Subjective versus Objective Risk SOURCES OF PURE RISK Property Risks Liability Risks Life, Health, and Loss of Income Risks Financial Risk MEASUREMENT OF RISK Chance of Loss Physical Hazard Morale Hazard Moral Hazard Degree of Risk MANAGEMENT OF RISK KEY TERMS AND CONCEPTS Chance of loss Chief risk officer Cost of risk Degree of risk Dynamic risks Enterprise risk management Financial risks Frequency Hazards Integrated risk management Moral hazard Morale hazard Objective risk Peril Pure risk Risk Risk management Risk management process Risk manager Severity Speculative risk Static risks Subjective risk

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

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Risk can be defined as uncertainty as to loss. Risk can create an economic burden by requiring reserve funds to pay for contingent losses and price increases of some goods and services. Risk may deprive society of some goods and services that are determined to involve too much risk to justify their production. a. Pure risk involves uncertainty as to whether loss will occur. It does not involve a possibility of gain. Speculative risk involves uncertainty about an event that could produce either a profit or loss. b. Static risks are those that would exist in an unchanging society that is in stable equilibrium.

Dynamic risks are caused by societal changes. c. Subjective risks arise from psychological uncertainty that is based on an individual’s mental attitude or state of mind. Objective risk is more precisely observable and measurable.

Windstorm, flood, and other natural disasters are examples of risks that are both pure and static.

A peril is a specific contingency that may cause loss. A hazard is a condition that introduces or increases the chance of loss from the existence of a given peril. Examples of perils include fire, windstorm, collision, war, etc. Examples of hazards include oily rags, icy roads, a dishonest employee, a careless driver, etc. a Morale b. Moral c. Morale d. Moral e. Physical Risk management is the process used to systematically manage exposures to pure risk. The four steps are: (1) identify risks, (2) evaluate risks, (3) select risk management techniques, and (4) implement and review decisions. Traditionally, risk management has dealt primarily with pure risks. Enterprise risk management considers all of an entity’s risks together, both pure and speculative.

As a loss becomes more and more certain to happen, there is less and less uncertainty that it will not happen. If a point is finally reached when an event is certain to occur, then there is no risk at all.

Company ABC: (70 - 60) / 65 = 15 percent Company XYZ: (80 - 50) / 65 = 46 percent a. Collision or oil spill b. Flood c. Fire or explosion d. Death e. Theft or vandalism Answers will vary. It can be pointed out that the mathematical value of the game is (0.90 × $1,000) + (0.10 × $100,000) = $10,900, and a ―gambler‖ should choose the game. Most students will probably choose the cash. Since most persons are risk-averting and will take the certain amount, ventures like the game, similar to real-life investments bearing considerable risk and low probabilities for hitting it big (e.g., oil drilling), are not widely sought. Hence, the capital cost of such ventures must be high in order to overcome risk. This high cost is the economic burden imposed by risk because it will produce higher consumer prices for the final product.

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11.

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A has the greater risk. B has the greater probability of loss. Using the objective risk formula (Probable Variation of Loss / Probable Losses), we get 3 / 2 = 150% for A and 12 / 30 = 40% for B. The probable loss is 2 / 100 = 2% for A and 30 / 1,000 = 3% for B. This question opens an opportunity to discuss subjective risk and its effect on economic or buyer behavior. Information and explanation is a major industry today, and much of its effort is designed to smooth the course of commerce by reducing perceived risk in the minds of customers. Information reduces perceived risk by making it easier for the buyer to understand the product and the ways in which the product will solve problems for the buyer. The purpose, of course, is to make it easier for the buyer to come to an intelligent buying decision.

Risk is defined as uncertainty as to loss, and variation is a measure of uncertainty. Expected annual loss is not a measure of uncertainty. There is a higher degree of risk when there is a lower probability of occurrence because as a loss becomes more certain to occur there is less uncertainty that it will not occur. Risk would totally disappear only when the probability of occurrence is 0% and 100%.

Property losses would be easiest to estimate because the value of the property concerned can help in estimating the maximum possible loss. Liability risks would be difficult to estimate because they are subject to wide variation and are contingent on several factors both within and outside of the company’s direct control. Personal risks are also difficult to estimate because evaluation involves such problems as placing a value on human life or health, which can be a very difficult undertaking.

SUPPLEMENTARY QUESTIONS 1.

What is involved in an entity’s cost of risk?

An entity’s cost of risk is the sum of its (1) outlays to reduce risks, (2) opportunity cost of activities foregone due to risk considerations, (3) expenses of strategies to finance potential losses, and (4) the cost of unreimbursed losses.

2.

What words, if any, should be substituted for risk in the following statements to make them more accurate? a. When children play with fire in a dry forest, a serious risk is present. b. An icy highway is a risk factor in safe driving. c. To underwrite this risk is dangerous. d. Flood is a risk that we will not retain. e. You don’t have a large enough group of people to enable us to reduce the risk sufficiently to handle this on a group basis. a. hazard b. hazardous c. exposure unit d. peril e.

Risk is used properly since the statement refers to uncertainty. The statement might be improved, however, by using degree of risk.

3.

What type of risk is involved in betting on a sports game? How would your answer change if the game had already been played and you knew the results of the game before the bet?

Speculative risk is involved in betting. If the outcome was already known before the bet, then there would be no risk involved. (An exception would be the personal risk involved with the chance of the person finding out that you had prior knowledge.)

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CHAPTER 2 Risk Identification and Evaluation RISK IDENTIFICATION Loss Exposure Checklists Financial Statement Analysis Flowcharts Contract Analysis On-Site Inspections Statistical Analysis of Past Losses RISK EVALUATION Risk Mapping or Profiling Statistical Concepts Probability Measures of Central Tendency or Location Measures of Variation Loss Distributions Used in Risk Management The Binomial Distribution The Normal Distribution The Poisson Distribution Integrated Risk Measures ACCURACY OF PREDICTIONS Law of Large Numbers Number of Exposure Units Required

KEY TERMS AND CONCEPTS Binomial formula Coefficient of variation Continuous Contractual liability Discrete Empirical probability distribution Expected value Financial statement analysis Flowchart Independent Law of large numbers Loss exposure Loss exposure checklist Maximum possible loss Maximum probable loss Mean Measures of central tendency Median

Mode Normal distribution Poisson distribution Probability Probability distribution Random Risk-adjusted return on capital (RAROC) Risk management information system (RMIS) Risk mapping Risk profiling Standard deviation Theoretical probability distribution Value at risk (VAR) Variance

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

One method uses loss exposure checklists that enumerate various specific sources of loss.

Another is the financial statement method that involves analyzing each item on a firm’s income statement and balance sheet regarding risks that may be present. A third method uses flowcharts to map out the physical flow of goods. Flowcharts can be analyzed with respect to the types of risks that may affect goods at each point.

2.

The important elements are the frequency and severity of an occurrence, the maximum probable loss, and the maximum possible loss.

3.

A risk manager can use the information from a distribution to approximate the actual experience. This information is useful for monitoring past losses and predicting future losses.

4.

The first peril produces an expected annual loss of $20,000 (0.02 × $1,000,000). The other peril produces an expected annual loss of $20,000 (20 × $1,000).

5.

The mean is 2.40 [(3+4+3+3+1+0+2+2+3+3) / 10]. The median is 3 (rearrange from 0 to 4 like this: 0, 1, 2, 2, 3, 3, 3, 3, 3, 4 and take the value between the fifth and sixth values, which are both 3s). The mode is 3, since it shows up the most times. The variance calculation is: Losses Mean Loss 0 2.40 1 2.40 2 2.40 2 2.40 3 2.40 3 2.40 3 2.40 3 2.40 3 2.40 4 2.40 Total 24

Deviation from Mean -2.40 -1.40 -0.40 -0.40 0.60 0.60 0.60 0.60 0.60 1.60

Squared Deviation 5.76 1.96 0.16 0.16 0.36 0.36 0.36 0.36 0.36 2.56 Total 12.40

Variance = 12.40 / 10 = 1.24 Standard Deviation = 1.24 = 1.11 Coefficient of Variation = 1.11 / 2.40 = 46.25% 6.

MDC Corporation’s probable range of losses are from $4,000 to $16,000 ($2,000 × 3 = $6,000, $6,000 +/– $10,000) with 99% confidence. If only 95% confidence was needed, the range would be from $6,000 to $14,000 ($2,000 × 2 = $4,000, $4,000 +/– $10,000).

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Chapter 3: Property and Liability Loss Exposures

7.

Callaghan Company’s probable range of losses are from $67,000 to $83,000 ($4,000 × 2 = $8,000, $8,000 +/– $75,000) with 95% confidence.

8.

The first step to calculate QAZ Company’s probability of 2 or fewer losses (which is the same as 3 or more losses) is to calculate the mean, which is 5 (100 × 0.05). Then substitute in to the Poisson formula and solve for each p (probability) that meets the conditions. The first p is 0.006738 [(50e-5) / 0!]. The second p is 0.03369 [(51e-5) / 1!]. The third p is 0.08422 [(52e-5) / 2!]. These probabilities are then added up and the sum is subtracted from 1, which is 0.87535 (1 – 0.12465).

9.

The objective risk would decrease. As the number of exposure units increases, the predictability of the number of losses increases. That in turn causes a decrease in the amount of risk. This phenomenon illustrates the law of large numbers.

10.

WFS could use informal techniques of evaluation to categorize probabilities of losses. Knowing the values of assets, WFS could use the concepts of maximum possible loss as well as maximum probable loss. Because WFS Corporation does not have a large number of exposure units, most of the statistical techniques would not apply. However, using industrywide data on losses, past year’s experience, and any change in exposures that affect the likelihood of a loss may be helpful.

11.a.

The company that brings together in two airplane flights nearly all of its dealers and distributors faces a major business interruption exposure. If nearly all of the dealers and distributors are killed in a plane crash, then a good part of the company’s products may not be able to get to the customers. If the company owns the planes, it faces property and liability exposures. Also, some of the dealers may owe the company for past sales, and in the event of a crash the company may not be able to collect what it is owed.

b. The company that makes the contract with the foreign country risks the nationalization of their assets if the country becomes unstable. There are property exposures if something happens to the special machinery during shipment. Also, late delivery could cause extra customs charges.

12.

Data such as dates of past injury, causes of losses, and property values would be useful to any firm. An auto manufacturer could use industry-specific data, such as the number of back injuries of all manufacturers, safety regulations, liability claims resulting from drivers that deliver the cars, pollution emissions from the factories, etc.

A theme park may be more concerned with the liability exposures resulting from injury to its guests. The theme park may collect more detailed information about the safety features of the rides, past losses on rollercoasters, past injuries of guests and employees and where the injuries happened most often, data on line movement, how long people must stand in the sun, etc.

13.

A large multinational corporation will have numerous exposures to risk, both pure and speculative. An advantage of using RAROC is that managers contemplating various projects are forced to consider the cost of risk in evaluating the potential profitability of those projects. Another advantage is that risk must be anticipated in advance, thereby lessening the likelihood that potential risks will be nintentionally retained. A disadvantage of RAROC is the additional cost associated with RAROC calculations.

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SUPPLEMENTARY QUESTIONS 1.

Why would a risk manager use statistical techniques?

Information is the key tool for all managers, whether they manage risk or anything else.

Statistics makes information out of data, information that can help the risk manager make good decisions about managing losses.

2.

RBF’s production company is considering purchasing a risk management information system (RMIS) to do statistical analysis of property (to sets, filming equipment, etc.) and liability (from contractual transfer to slips and falls) losses. What functions should this software have?

The software should be able to do some of the statistical calculations mentioned in the chapter, such as the measures of central tendency, the various distributions, and the measures of variation. It should also have report writing capability and claims management capability. The ability to do risk mapping, as well as value at risk and risk-adjusted return on capital (RAROC), are increasingly becoming available from RMIS systems. Finally, there are other functions that certain industries or companies may need more than others, so a thorough needs analysis should be done before an RMIS is purchased.

3.

Why should a risk manager be careful when using the statistical tools in this chapter?

Mathematical tools make many assumptions and therefore must be used with great caution.

Only experienced and knowledgeable persons should interpret results that may lead to specific company applications.

CHAPTER 3 Property and Liability Loss Exposures PROPERTY LOSS EXPOSURES Sex and Property Loss Exposures LIABILITY EXPOSURES The High Cost of Airplane Crashes and Other Liability TYPES OF LIABILITY DAMAGES Bodily Injury Property Damage Personal Injury Legal Expenses CRIMINAL AND CIVIL LAW TORTS BASIC LAW OF NEGLIGENCE The Negligent Act A Negative Act A Voluntary Act An Imputed Act Proximate Cause of the Loss DEFENSES AGAINST NEGLIGENCE CLAIMS Contributory Negligence Assumed Risk

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Chapter 3: Property and Liability Loss Exposures

Guest-Host Statutes FACTORS LEADING TO HIGHER STANDARDS OF CARE Expanding Application of Liability Weakening of Defenses against Liability Res Ipsa Loquitur Expansion of Imputed Liability Changing Concepts of Damage Increased Damage Awards TYPES OF LIABILITY EXPOSURES Contractual Liability Employer-Employee Liability Property Owner-Tenant Liability Assumption of Liability by Tenant Attractive Nuisance Doctrine Consumption or Use of Products Breach of Warranty Strict Tort Negligence Completed Operations of a Contractor Professional Acts Principal-Agent Liability

Ownership and Operation of Automobiles Liability of the Operator Liability of the Owner-Nonoperator Liability of Employers MISCELLANEOUS LIABILITY INTEGRATED RISK EXPOSURES

KEY TERMS AND CONCEPTS Attractive nuisance doctrine Collateral source rule Civil law Common law Comparative negligence Completed operations liability Contributory negligence Criminal law Direct loss Family-purpose doctrine Guest-host statutes Hard markets Imputed acts

Indirect loss Invitees Joint and several liability Lack of privity Last clear chance rule Legal injury Libel Licensees Negative act Negligence Pain and suffering damages Personal property Positive act Professional liability

Punitive damages Real property Res ipsa loquitur Respondeat superior Slander Soft market Superfund legislation Tort Tort feasor Trespassers Underwriting cycle Vicarious liability Voluntary act

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

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Negative act, voluntary act, imputed act, and proximate cause of loss are the elements of a negative act.

Contributory negligence: other party was also at fault.

Assumed risk: plaintiff knew of danger of the risk and participated in the event. Should be willing to assume the loss.

Guest-Host: operator of a vehicle not liable to a guest unless grossly negligent.

Bodily injury: medical services, loss of income, rehabilitation expenses, loss of services, pain and suffering, punitive damages.

Personal injury: libel, slander, invasion of privacy.

Invitee: invited on the premises, such as the customer of a business.

Licensee: on premises for a legal purpose, such as a Mail Carrier Trespasser: any other person, such as a robber.

The attractive nuisance doctrine is a legal doctrine that transforms the status of a trespassing minor to that of an invitee. It says that an unusual condition of the premises invites the minor to the premises.

Res ipsa loquitur is a legal doctrine that allows the plaintiff to collect even though the plaintiff cannot or does not prove the defendant negligent. It is useful in medical malpractice because the doctor has total control of the situation, especially surgery, and if something goes wrong the plaintiff does not cause the error or contribute to it.

The owner, a user, and a lessee may be held responsible for the operation of an auto. Also, if someone uses an auto on your behalf, you can be held liable.

The insurance industry is supporting these types of tort reform: imposing restriction on rights to sue, limiting punitive damages and pain and suffering, reducing standard of care required for product liability, and repealing collateral source rule.

The effect of this decision is to make it a little easier for a member of the public to obtain a Judgment against an employer for negligence. The question of whether or not this represents more evidence of the ―trend toward absolute liability‖ appears borderline. If an employee smokes in an area where a safety order prohibits smoking and, as a result, a member of the public is injured in a subsequent fire caused by the employee’s smoking, then negligence appears to exist and the employer is liable for the acts of its agents. On the other hand, if goggles are required in a certain area, and in observing that an employee failed to wear goggles, a member of the public also failed to wear goggles and suffered an eye injury thereby, the employer’s liability would not appear as clear-cut.Yet, strict consistency of a court would require that the employer pay. a.

The defendant won the case because the plaintiff failed to establish proximate cause. b.

The case admirably illustrates that there must be a direct connection between some negligent act and the cause of death, accident, or injury. Even if there had been a lifeguard handy, his or her presence would not necessarily have saved the boy’s life.

The case also illustrates assumption of risk.

High standards of care are imposed on professionals. Although doctors are not held for failing to cure a patient, they are liable in case the patient’s recovery is prevented by an act of the doctor, which under reasonable prudence of similarly situated doctors would not have taken place. Failing to consider the consulting radiologist’s opinion that the possibility of tumor should be investigated might well be such an act—a failure to behave as a reasonably prudent person should have behaved in similar circumstances. The auto mechanic case is similar.

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12.

There are no data to prove that malpractice is more common now than formerly, but certainly one cannot deny that suits are becoming more common and judgments are rising.

Other reasons for rising suits, besides actual malpractice, include: (1) increasing complexity of medicine; (2) breakdown of legal rules in which a local doctor must be found to testify against a fellow doctor—lawyers can now in many cases bring in outside doctors for this purpose; (3) increased recognition by the public of the existence of malpractice insurance to pay resulting claims; (4) breakdown on the close ties formerly existing between a family doctor and the patient, ties that might discourage suits; and (5) increasing medical specialization and lack of communication between the various specialists over indicated medical procedures. This list is, of course, not exhaustive.

SUPPLEMENTARY QUESTIONS 1.

A’s automobile was struck by an approaching vehicle belonging to B, who had swerved to avoid striking another vehicle whose driver, C, was negligently backing out of a driveway without looking. A sued B for damages, but B defended on grounds of no negligence. A contended that it was B’s car that actually did the damage. Who should win this case?

Why? It seems clear that under proximate cause, C’s car was the real culprit. B’s car is merely the instrumentality by which C’s negligence was wrought. C should therefore pay, unless it can be shown that B contributed to the loss.

2.

In the case of Gothberg v. Nemerowski, Ill. App., 108 N.E. (2d) 12 (1965) a minor telephoned a broker of insurance and arranged to get coverage on his auto. The broker’s office wrote to the applicant that insurance had been ordered as of the date of the phone call.

Later the applicant called the broker to ask if the coverage was effective then, and obtaining an affirmative reply, asked the person who had answered the telephone (the broker was out of the office) to repeat this to the applicant’s mother, who would not let him drive the car until she knew he was insured. Prior to the date the applicant sent in the balance of his premium, he had an accident and a judgment of $20,000 was rendered against him. The applicant sued the broker for this sum but the broker denied liability on the grounds that he was under no legal duty to procure insurance until the balance of the premium had been sent in. Decide this case and explain your reasoning, based on your understanding of the liability of insurance agents and brokers.

The court decided in favor of the applicant. The court said that the applicant had been assured that he had coverage, and that the public has the right to assume that the person answering the telephone is clothed with authority to transact business. Courts in these cases have held that failure of an agent to notify the insured of his or her inability to obtain insurance is sufficient to hold the agent liable to the client for breach of professional duty.

The court said that the telephone conversation was sufficient evidence that the broker had contracted to procure insurance prior to the receipt of full payment thereof.

CHAPTER 4 Life, Health, and Loss of Income Exposures EXPOSURES DUE TO PREMATURE DEATH Executor Fund Income Needs of Survivors

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Surviving Children Surviving Spouse Other Surviving Dependents Business-Related Exposures Likelihood of Premature Death Needs versus Human Life Values Medical Care Expenses Hospitalization Physicians’ and Surgeons’ Services Dental Care Prescription Drugs and Other Expenses Mental Health Services Long-Term Care Loss of Income Causes of Disability Length of Disability Effects of Disability OTHER INCOME LOSS EXPOSURES Unemployment Retirement KEY TERMS AND CONCEPTS Continuance tables Experience rating Cost shifting Home health care Custodial nursing homes Human life value Defensive medicine Intermediate nursing home care Disability loss Key employee Executor Long-term care Executor fund Mortality table

Partial disability Permanent disability Personal care homes Premature death Skilled nursing home care Temporary disabilities Total disability

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

The executor fund is designed to pay for the expenses associated with the funeral and burial of the decedent, estate and inheritance taxes, estate distribution and administration costs, and the outstanding debts of the decedent.

One form of business-related premature death exposure involves the death of a key employee.

The death of an employee who performs services that would be particularly hard to replace may cause the delay or abandonment of some of the firm’s projects. The death of a key employee may also cause extra costs for replacement and training and might result in the loss of customers. Another business-related exposure involves the death of a person with an ownership interest in the business. This death could cause ownership to pass to undesirable beneficiaries who could harm the value of the ownership interests of the surviving owners and the estate of the deceased owner.

The answers will differ, but each answer should reflect a change in circumstances that would cause a change in income need for the survivor. a.

Surviving children: As children age, the time that they will be dependent on their parents shortens. Further, a child could become sick or disabled and need special health care, or a child could start college.

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b.

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Surviving spouse: The spouse could become sick or disabled or develop a marketable skill that decreases dependence on the other, or the children may attain an age that would allow the spouse to switch to full-time employment. c.

Surviving parents: A parent could become disabled or sick and require medical or convalescent care. a.

Age 4 or 5 years for males, age 5 or 6 for females b.

6.8 c.

0.99753, calculated as: 1 – [(0.47 + 0.48 + 0.50 + 0.50 + 0.52)/1,000] $689,787, calculated as: $824,849 – ($26,507 + $26,758 + $27,010 + $27,265 + $27,522) The five major categories of medical expenses are hospitalization, physicians’ and surgeons’ services, dental care, mental health services, and long-term care. Currently, hospital costs account for almost half of all personal health care expenditures.

Skilled nursing home care includes ongoing medical services, with residents seen regularly by doctors. Custodial nursing home care does not include medical services and concentrates on the provision of personal care services, such as assistance with bathing, dressing, eating, and other daily activities. Intermediate nursing home care includes a level of medical services that is less than those provided by a skilled nursing home.

A disability may result in either a total or a partial loss in income, may be either temporary or permanent, may involve a subjective element, and may increase the family’s expenses by the amount needed for the disabled person’s personal consumption and health care costs. Death always involves a total loss of income, is always permanent, is certainly not subjective, and reduces the family’s expenses by the amount of the decedent’s personal consumption.

Some reasons for the increased proportion of income spent for medical care in the United States may include the following: people are living longer and require more medical care in advancing years, treatments are being discovered for sicknesses that were untreatable in the past, increasing frequency and severity of liability awards causes higher malpractice premiums and may encourage the practice of ―defensive medicine‖, medical technology tends to be expensive, and hospitals and physicians may wastefully purchase equipment that their patients already have access to from competing sources.

Disabilities may be total or partial, depending on whether or not the person is completely incapable of gainful employment. Disabilities may also be either temporary or permanent, depending on whether the person is expected to eventually recover enough to return to work.

Disability losses have a subjective element because different people may have differing tolerances for pain, work ethics, or levels of income loss. Two people suffering from the same injury could have different periods of disability due to these differences.

To be eligible to collect unemployment insurance benefits, an unemployed worker usually must either have worked for some minimum period during the previous 12 months or have earned some minimum amount of wages. Many states require a one-week waiting period before benefit payments begin.

The degree of risk associated with the occurrence of death is zero because everyone is certain to die. Since risk can be defined as uncertainty, there is no risk associated with the question of whether a person’s death will occur. The risk related to death is related to the time that the death occurs. Premature death can present several financial exposures including the expenses arising from the death, such as funeral and estate administration expenses; income for surviving relatives, such as a spouse, children, or aging parents, who were dependent on the decedent’s income; and business risks, such as the loss of a key employee or the transfer of a deceased owner’s interest in the business. Financial risks associated with living too long may include the exhaustion of retirement resources, the cost of a nursing home for someone physically unable to care for him or herself, and the higher medical costs often associated with advancing age.

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Some possible reasons for the ―hump‖ at ages 15 to 30 may include war-related deaths, a higher accident rate, a higher suicide rate, or an increased frequency of drug or alcohol abuse at these ages. The higher death rate at these ages for males may be partially explained by the higher likelihood of men to suffer war-related deaths and motor vehicle deaths.

The term human life value refers to the present value of all of the income less taxes and personal maintenance expenses that a person is expected to earn throughout life. This may differ from the amount of financial need that will be experienced after a person’s death because this term does not include consideration of individual circumstances, resources, or income needs. Human life value is the best measure of loss severity used to compute damages for wrongful death claims because these claims are meant to compensate survivors for their actual loss and not to provide them with the necessary funds to meet their needs.

Answers may vary with the opinion of the student, but it seems that people have a tendency to more frequently recognize property loss exposures than business-related premature death exposures. A key employee may be more important than a building because a key employee may not be able to be replaced at any cost. A key employee may have possessed or acquired special skills, talents, relationships, or knowledge that are very valuable to a company and are perhaps irreplaceable.

A decrease in death rates might result from medical advances that extend the lives of people who are suffering from or are susceptible to disabilities. These people might include those who are elderly, physically or mentally handicapped, or suffering from a debilitating disease.

While at one time these people would have died, the medical advances may extend their lives without enabling them to return to work, thereby increasing the disability rate. Other factors that might explain an increase in the disability rate include societal changes in pain thresholds, disability benefits, and work ethics.

SUPPLEMENTARY QUESTIONS 1.

It has been suggested that the family income needs after a parent’s premature death are greatly reduced in many families today in which both spouses are working. Therefore, it has been said, the death of a spouse no longer produces the total financial catastrophe that once might have occurred with the death of the ―breadwinner‖ spouse. Do you agree? Why or why not?

In a sense the argument is true. Because both spouses work, the financial impact of the death of one may be reduced greatly, but typically is not eliminated. At least one study has demonstrated that total insurance purchased by two-working-spouse families is less than that purchased when only one spouse works. On the other hand, families with two incomes typically adjust their lifestyles to depend on the incomes of both spouses. Furthermore, needs still exist for child care costs, future education of children, etc.

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Suggest and discuss possible reasons for the increase in the proportion of disposable income that is being spent on health care in the United States.

Possible reasons that could be suggested and discussed include the following: higher standards of medical care, a larger proportion of elderly people, increased expenses for professional liability insurance due to the increasing incidence and severity of litigation, the practice of ―defensive medicine‖ in which physicians are overly cautious in an effort to avoid future litigation, increased and expense for more advanced medical technology.

Should a family be concerned about the financial impact of the death of a spouse who does not work outside of the home? Why or why not? What additional expenses might a family with children expect to incur with the death of a spouse who does not earn an income?

Despite the fact that an income would not be lost, there may be a significant financial impact at the death of a non-working spouse. Additional expenses may be required after this death. The surviving spouse may feel a need to reduce the amount of time that is spent at

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work in order to spend more time with the children and to assume more domestic responsibilities. The surviving spouse may also incur expenses such as child care and housekeeping that were not previously required. In addition, there will be expenses in relation to the funeral, burial, and estate administration.

Most of the expenses involved with death discussed in this chapter involved risks arising from premature death. However, the expenses in the executor fund would be present even if the death occurred when expected. Identify and discuss an example of an expense that might increase if the death occurred as expected instead of prematurely.

Estate taxes may become more burdensome as a person ages and accumulates wealth.

List and discuss several reasons that a person might be more concerned about the losses associated with disability than with those associated with premature death.

Disability directly affects the financial status of the person involved. A person may be less concerned with the financial impact of death because the person won’t be around to suffer the loss. Premature death reduces the amount of consumption of a family by the amount that would be consumed by the decedent. However, disability does not have this financial advantage.

CHAPTER 5 Risk Management Techniques: Noninsurance Methods RISK AVOIDANCE LOSS CONTROL Types of Loss Control Focus of Loss Control Timing of Loss Control Decisions Regarding Loss Control Potential Benefits of Loss Control Potential Costs of Loss Control RISK RETENTION Planned versus Unplanned Retention Funded versus Unfunded Retention Credit Reserve Funds Self-Insurance Captive Insurers Decisions Regarding Retention Financial Resources Ability to Predict Losses Feasibility of the Retention Program RISK TRANSFER Hold-Harmless Agreements Forms of Hold-Harmless Agreements Enforcement of Hold-Harmless Agreements Incorporation Diversification Hedging Insurance

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THE VALUE OF RISK MANAGEMENT

KEY TERMS AND CONCEPTS Broad form Hedging Captive insurer Hold-harmless agreements Concurrent loss control Indemnity agreements Diversification Intermediate form Domino theory Limited form Duplication Loss control Enterprise-wide risk Planned retention management Post-loss activities Frequency reduction Pre-loss activities Funded retention Risk avoidance Hedger Risk retention

Risk transfer Self-insurance Separation Severity reduction Speculator Transferee Transferor Unfunded retention Unplanned retention

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

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Risk avoidance is a conscious decision not to expose oneself or one’s firm to a particular risk of loss. This technique is appropriate when the costs of an activity are small in comparison with the benefits.

Frequency reduction involves an attempt to reduce the probability that a loss will occur. For instance, XYZ Corporation could institute a fire safety program designed to educate warehouse employees to be on the alert for fire hazards within the warehouses. Severity reduction involves methods of reducing the magnitude of a loss. XYZ Corporation could install fire extinguishers at various locations within the warehouses in an attempt to ensure that small fires are extinguished before they spread. Separation involves making certain that needed goods are not all stored in the same location so that all of the goods will not be destroyed in one occurrence. XYZ Corporation could make certain that needed supplies are not all stored in the same warehouse.

Separation involves the reduction of the maximum probable loss associated with a certain risk. A firm may disperse materials in such a way that an explosion or other catastrophe will not damage more than a limited amount of materials. Duplication might be used instead if there is an extreme need to have a certain piece of machinery around continuously, such as extra computers at another location.

Some categories are (1) repair or replacement of damaged property, (2) income losses due to destruction of property, (3) extra costs to maintain operations following a loss, (4) adverse liability judgments, (5) medical costs to treat injuries, and (6) income losses due to deaths or disabilities.

Risk retention can be planned or unplanned and involves the assumption of a risk. A loss will be paid for out of the funds of an individual or a firm at the time that the loss is experienced. Large firms can typically absorb some losses that a smaller firm could not because large firms may have greater financial resources. Large firms also have the advantage of a larger number of exposure units, making more accurate loss prediction possible.

Planned retention involves a conscious and deliberate assumption of recognized risk.

Unplanned retention occurs when the existence of a risk is unknown or underestimated.

Unfunded retention occurs when there is no intent to make funding arrangements in advance of a loss. Funded retention involves making various pre-loss arrangements to ensure that money is readily available to pay for losses that occur. All of these techniques can be

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appropriate depending on the type of losses considered, as long as there is an intent of the firm to apply the technique after careful analysis.

Credit provides some limited opportunities to fund losses that result from smaller retained risks. Use of credit for large losses is virtually impossible if there was no previous arrangement with a lending institution. Creditors may be unwilling to loan money to a firm facing bankruptcy because of a large loss.

Self-insurance must (1) involve a group of exposure units large enough to ensure accurate loss prediction and (2) the expected losses must be prefunded through a fund especially designed for that purpose. The establishment of a reserve fund does not necessarily involve a large enough number of exposure units to make accurate prediction possible.

Some financial factors are (1) total assets, (2) total revenues, (3) asset liquidity, (4) revenues/net worth, (5) retained earnings, and (6) total debt/net worth. In all of these except the last one, the greater the number the greater the ability to retain risk. In the case of the last ratio (total debt/net worth), the opposite is true.

Risk transfer involves a transferor, who pays or gives other valuable consideration to a transferee, who then bears the risk.

Hold-harmless agreements differ in the extent to which risk is transferred. The limited form states that all parties are responsible for liabilities arising from their own actions. The second type is the intermediate form in which the transferee agrees to pay for any losses in which both the transferee and transferor are jointly liable. Another is the broad form that requires the transferee be responsible for all losses arising out of particular situations, regardless of fault.

Courts may not enforce a hold-harmless agreement if a transferor has superior bargaining power or knowledge in comparison to the transferee. For example, contracts between a candy manufacturer and its distributors may state that the distributor must pay for all losses arising out of consumers’ use of the candy. However, if the distributors are students who are using the candy to raise funds, the courts probably would not enforce the clause.

Through incorporation, a firm can transfer risks from shareholders (transferor) to the firm’s creditors (transferee). This transfer is possible because personal assets of the owners cannot be attached to help pay for business losses as in sole proprietorships and partnerships.

Diversification serves as a form of risk transfer by creating a sharing of risk between business segments or geographic locations. Much like pooling of risk exposures by an insurer results in risk reduction, the diversification of a firm’s operations across different geographic locations or business segments, assuming less than perfect correlation among these exposures, can reduce total risk.

One loss control method could be to simply decide not to produce lights that are extremely hazardous The risks identified may vary greatly, but should include damage or loss by such perils as fire, flood, and other natural disasters, as well as theft or misplacing the books.

Risk management techniques identified will also vary with the students’ imaginations but may include: risk transfer (homeowners’ insurance may provide some coverage), risk avoidance (borrow a friend’s book instead of purchasing one or drop the class and get a refund from the bookstore), loss control (writing name in book or buying water resistant book bag), and risk retention. A wrong answer would be self-insurance, because the number of exposure units is probably not large enough.

In self-insurance there must be a group of similar exposure units large enough to ensure accurate loss prediction and not subject to simultaneous destruction. Self-insurance is a systematic approach to managing the potential losses that may arise from this group. Risk retention is merely the planned or unplanned assumption of a risk. Even if a reserve fund is established as part of a risk retention decision, this does not presuppose a large number of exposure units. It merely indicates that a firm sets some money aside to help meet a contingent loss. Neither technique should be used unless the financial condition of the firm

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is such that it can withstand large and unusual losses and unless management is willing to accept the possibility of these losses.

One loss control method could be to simply decide not to produce lights that are extremely hazardous. This would be considered avoidance and would emphasize frequency of losses since the goal is to reduce frequency to zero. Also, this is a pre-loss activity. Another method would be to train installers to be aware of safe and unsafe installation procedures.

This would concentrate on frequency reduction and is a pre-loss activity. Illuminating Concepts could separate some of the more dangerous lights from children and flammable materials. This would emphasize frequency reduction and be a pre-loss activity. The store could buy fire extinguishers and train employees on what to do in case of a fire. This would focus on the severity of the loss and be a concurrent loss activity. Shock, smoke inhalation, and other injury training for employees would also focus on severity and would be considered a post-loss activity.

The cost of avoidance is the revenue that is forgone by not selling the more hazardous lights.

The benefits may be reduced liability judgments and reduced medical costs for injured persons. Whether the costs will outweigh the benefits will depend on the forgone revenue and the likelihood of an accident. The costs of training may be outweighed by the benefits of reduced liability judgments, medical costs, and repair or replacement of damaged property of third parties, especially if the training is inexpensive. The benefits of separation definitely outweigh the costs of putting some lights elsewhere. The costs of fire extinguishers and training outweigh the benefits of reduced income losses due to the destruction of property, reduced adverse liability judgments, and reduced extra costs to maintain operations.

The Heinrich theory states that employee accidents can be viewed as a five-step process: (1) heredity and social environment, which causes persons to behave in a particular manner; (2) personal fault, which is the failure of individuals to respond appropriately in a given situation; (3) an unsafe act or the existence of a physical hazard; (4) the accident; and (5) the injury that results. Great Lakes can take action in the first step by keeping records or reviewing industry averages on which type of employees seem to cause the most accidents and instituting training for all employees. This training will hopefully have an effect on the second step as well. Most of the focus should be on step three by removing or reducing unsafe conditions or acts. If there are a number of slips and falls, Great Lakes can put down non-slip flooring in critical areas. If there are a number of boating accidents, drug testing and safe boating procedures could be implemented. Training on the care of injured persons would follow from the last step.

For home mortgages and auto loans the home and the car, respectively, generally serve as collateral for the loan. To protect this collateral the lender often requires the borrower to purchase property insurance coverage. The insurance coverage assures that financial resources will be available to repay the loan, even if the home or auto was destroyed. If insurance were not available the lender would either charge the borrower a higher interest rate or, perhaps, even refuse to loan the money at all.

SUPPLEMENTARY QUESTIONS 1.

It is commonly believed that the only moral risk management technique to protect the safety of an employee is loss control. Do you agree with this statement? Why or why not?

While it can be argued that a company probably has a moral obligation to use every reasonable opportunity to control losses by reducing the frequency and severity of employee injuries, there are several additional ways to manage this risk that would not offend most people’s sense of morality. For example, risks may be transferred through insurance or may be avoided. Risk management techniques are not mutually exclusive.

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3.

Consider this statement: It is always more efficient to retain a risk than to transfer it, because the transferee of the risk always charges more to assume a risk than the long-run expected value of the loss. How would you respond to this statement?

This statement generally may be true, but there are exceptions. In a non-insurance transfer a party may have sufficient bargaining strength to compel the other party to assume a loss without compensation. Even in insurance transfers it may rarely occur that a risk may be transferred for less than the expected loss. Another logical response would be that the longrun expected value of a loss is not the appropriate measure of a risk when deciding whether to retain the risk.

Suppose a friend told you that she had decided to cancel her automobile collision coverage and establish a self-insurance program by funding a special account with the money that she would have otherwise had to pay in insurance premiums. How might you correct her terminology?

Because your friend does not have a sufficient number of exposure units to ensure accurate loss prediction, she cannot have a true self-insurance program. What she really is doing is retaining the collision risk and attempting to fund anticipated future losses with a reserve fund.

CHAPTER 6 Insurance as a Risk Management Technique: Principles THE NATURE OF INSURANCE PRINCIPLE OF INDEMNITY PRINCIPLE OF INSURABLE INTEREST What Constitutes Insurable Interest When the Insurable Interest Must Exist PRINCIPLE OF SUBROGATION Reasons for Subrogation Exceptions to the Principle of Subrogation PRINCIPLE OF UTMOST GOOD FAITH Representations Warranties Concealments Mistakes REQUISITES OF INSURABLE RISKS Large Number of Similar Objects Accidental and Unintentional Loss Determinable and Measurable Loss Loss Not Subject to Catastrophic Hazard Large Loss Probability of Loss Must Not Be Too High REQUIREMENTS OF AN INSURANCE CONTRACT Requirements of All Valid Contracts DISTINGUISHING CHARACTERISTICS OF INSURANCE CONTRACTS Aleatory Contract Conditional Contract Contract of Adhesion

Chapter 7: Insurance as a Risk Management Technique: Policy Provisions

Unilateral Contract ROLE OF AGENTS AND BROKERS Authority of Agents and Brokers PRINCIPLES OF SOCIAL INSURANCE Compulsion Set Level of Benefits Floor of Protection Subsidy Unpredictability of Loss Conditional Benefits Contributions Required Attachment to Labor Force Minimal Advance Funding

SOCIAL AND ECONOMIC VALUES AND COSTS OF INSURANCE Social and Economic Values Reduced Reserve Requirements Capital Freed for Investment Reduced Cost of Capital Reduced Credit Risk Loss Control Activities Business and Social Stability Social Costs of Insurance Operating the Insurance Business Losses That Are Intentionally Caused Losses That Are Exaggerated

KEY TERMS AND CONCEPTS Adverse selection Floor-of-protection concept Affirmative warranty General agent Agency agreement Implied warranties Aleatory contract Indemnify Asymmetric information Insurable interest Beneficiary Insurance Binds Insured Broker Insurer Concealment Large-loss principle Conditional contract Material Conditional receipt Policies Consideration Pooling Contract Premium Contract of adhesion Principle of indemnity Estoppel Promissory warranty Express warranties

Ratification Reasonable expectations Reinsurance Representation Requisites of insurable risks Risk reduction Social insurance Special agent Subrogation Underwriting Unilateral contract Utmost good faith Valued policy laws Waiver Warranty

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION

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If an honest mistake is made in a written insurance contract, it may be reformed if there is proof of mutual mistake or a mistake on one side that is known to be a mistake by the other party.

The beneficiary must prove insurable interest if evidence suggests that the policy was issued in violation of anti-gambling laws. A beneficiary might have paid the insured to name him or her beneficiary of a policy obtained for speculative purposes. Evidence may suggest that the only thing giving rise to the speculation was the desire to make money at the expense of the insurer.

The doctrine of insurable interest determines whether or not any loss is suffered by a person insured, whereas the principle of indemnity governs the measurement of that loss.

No. D can collect only to the extent of his or her insurable interest, and each insurer will bear the loss equally. a. This case constitutes a material misrepresentation on the part of the applicant and provides grounds for avoidance of the contract by the insurer. b. The doctrine of warranties and representations rests on the general premise that insurance is a contract of utmost good faith. The test of materiality is whether or not the insurer would have issued the contract had the facts been known.

An express warranty is a specific circumstance that must exist as described in writing in the insurance contract. An implied warranty is not in the contract, but it is assumed to be.

Implied warranties are most commonly found in ocean marine insurance.

Yes, one can be contractually responsible for nonowned property because he or she is renting it or has the property under his or her control.

A warranty is a condition of the contract. A breach of a warranty can void the contract. A representation is a statement made by the insured before the contract is written and only affects the transaction if it is material.

Legal capacity: persons have legal right and capacity to execute the contract.

Legal purpose: must not be an illegal venture.

Offer and acceptance: offer communicated effectively and accepted. In insurance, the insured is usually the one deemed to have made the offer.

Consideration: act or promise bargained for.

Additional features of an insurance contract include: (l) Insurer must be properly approved by the insurance commissioner.

(2) Insurable interest must exist.

(3) There must exist some uncertainty as to loss.

(4) Insurer must assume risk.

In a contract of adhesion, ambiguities are construed against the insurance company. a. Large enough number, accidental loss, determinable and measurable, and noncatastrophic in nature. b. Sufficiently severe so as to cause financial hardship and probability of loss not too high so as to drive the premium up beyond the means of the buyer.

A waiver is a relinquishing of a known right and is based on consent and contract law.

Estoppel prevents one from asserting a right because of prior conduct that is inconsistent with such an assertion and is more closely associated with contract law.

Adverse selection is the tendency of insureds who have a greater than average chance of loss to purchase more than the average amount of insurance. Underwriting is necessary because the insurance company does not want to write insurance only for these high risk insureds.

Writing only this group would not spread the risk for the insurance company and would eventually cause higher and higher premiums. The company would eventually fail.

Insurance is socially valuable because it reduces the need to accumulate funds to meet loss; increases the pool of investable funds, thus reducing the cost of capital; improves credit;

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reduces losses through loss control; and reduces worry. The social costs are the need to operate the insurance business, intentionally caused losses, and losses that are exaggerated.

The text definition states nothing about the building of a fund, but it certainly includes situations in which there is only transfer of risk instead of reduction of risk.

No. She should rejoice in not having a loss. First, had an accident occurred, the policy would not have paid all her losses. Delay, inconvenience, etc., would not have been reimbursed.

Further, her rates might have been higher next year due to reclassification into a different rating group. Had the loss occurred, she would not have gained anything. The premium should be viewed as protection, not speculation.

The decision as to whether a given proposition is or is not insurance must rest on the interpretation of what one believes to be the proper definition of insurance. Using the definition given in the text, the auto parts guarantee would actually seem to fall under the definition since it amounts to an enforceable guarantee to reimburse the ―insured‖ for a loss suffered during the term of the agreement. This is the legalistic definition of insurance. It does not conform to the ―economic institution‖ definition. State courts have held differently on this question, some courts holding that guarantees are, in fact, insurance contracts and others holding that they are not. a. Some students will agree and others will disagree. Those who disagree can argue that, in many cases, punitive damages stem from an accidental occurrence that was unintended by the insured, and hence, should be covered by liability insurance. Those who agree will argue that if a corporation can insure losses from judgments that a court awards to punish and deter wrong conduct, the insurance, not the corporation suffers. The wrong conduct would thus go unpunished. Insurance policies usually exclude losses that are the result of deliberate and intentional behavior by the insured because such losses are not considered ―accidental.‖ Courts are not uniform in saying whether or not punitive damages are ―deliberate and intentional.‖ Some policies exclude coverage for punitive damages, but others are silent on the matter, leaving it to the courts to decide whether the insurer must pay such damages. b. Not insurable privately because it is subject to catastrophic loss, lack of agreement on how to measure, and unpredictability. But, alleviative measures by government, unemployment insurance payments, diversification of industry, and other measures have been used to combat losses caused by economic depression. c. Probably not insurable, at least directly. Theft coverage for definable property is available, of course, but the loss by trade secret theft would be hard to define, estimate, and predict. d. Similar comment to part c. e. Similar comment to part c. In parts c, d, and e, the loss would have to be handled through methods other than insurance. Loss control, risk transfer, and diversification are all possible to mitigate or prevent the possible loss.

The indemnity allowed by the insurer will depend on the adjuster’s judgment on the actual loss sustained. It is the purpose of the insurer to indemnify the insured in such a way that his or her economic position after the loss is as it was before. If a reasonable judgment is that the bumper does not require replacement, only the cost to repair will be allowed. The insurer is not obligated to give new for old. However, if only a new bumper can do the job, then a new bumper cost will be allowed. The question illustrates the moral hazard involved in loss settlements. Considerable subjective judgment is involved. More parties lose than the insurance company itself. Specifically, the policyholders must pay premiums to support loss; they are the real losers, particularly if these losses are exaggerated.

Students’ answers may vary, but the cost of running the insurance business itself, which costs perhaps 15 to 20 percent of the premium dollar, may be considered the most significant cost.

The problem of insurance fraud is also growing in importance.

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SUPPLEMENTARY QUESTIONS 1.

Some have argued that the social costs of some types of insurance are too high, and that the insurance itself should be eliminated rather than trying to use loss control activities. For example, some crime rings include dishonest attorneys, physicians, and others who conspire to defraud insurers by what is termed ―ambulance-chasing.‖ Accident victims are often unwitting accomplices to the crime, being duped into cooperating with the crime ring in exaggerating accident losses. False medical evidence may be used to obtain out-of-court settlements with liability insurers. Such activity would probably not exist if it were not for the existence of liability insurance. In your opinion, is this a sufficient reason to outlaw or restrict the issuance of liability insurance? Why? Is the social cost of liability insurance too high?

An argument in favor of outlawing liability insurance is that a person should not be permitted to purchase insurance against his or her own negligence, an event at least partially within the control of the insured, not random, and hence, not insurable. An argument against outlawing liability insurance is that under our legal system, a person can be held liable for events that are unintended and accidental from the viewpoint of the defendant. For example, in the crime case cited above, a defendant in an auto liability case may not have deliberately or voluntarily committed an act resulting in his or her liability, but may still be held to blame and be required to respond financially.

The social cost of insurance is not deemed ―too high‖ considering the benefits of insurance, at least in our society. However, laws have been enacted to limit the operation of liability insurance, especially in the case of product liability. For example, states have passed statutes of limitations that limit the number of years within which a manufacturer can be sued for having produced defective products that caused loss to a user. This is a step in the direction of taking the course of restricting insurance rather than using loss control as a solution to the problem of reducing the social costs of insurance.

2.

Distinguish between a concealment and a misrepresentation.

A concealment is ―silence when obligated to speak.‖ A misrepresentation is a misstatement of fact. A concealment is negative while a misrepresentation is positive. Both, if material, void the contract.

3.

What are some of the differences between social and private insurance?

Social insurance characteristics are (1) compulsory nature, (2) the set level of benefits, (3) the floor of protection, (4) an element of subsidy, (5) the unpredictability of loss, (6) conditional benefits, (7) contributions required, (8) attachment to labor force, and (9) minimal advance funding. Private insurance has few if any of these characteristics.

CHAPTER 7 Insurance as a Risk Management Technique: Policy Provisions DECLARATIONS THE INSURING AGREEMENT Named Perils versus All-Risk Agreements Defining the Insured EXCLUSIONS Excluded Perils Perils That Are Basically Uninsurable

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Perils to Be Covered Elsewhere Perils Covered Under Endorsement at Extra Premium Excluded Losses Excluded Property Excluded Locations COMMON POLICY CONDITIONS Fraud Protection for Mortgagees Separate Insurance for the Mortgagee’s Interest Assignment by the Insured Loss Payable Clause Mortgagee Clause Notice of Loss Proof of Loss Appraisal Preservation of the Property Cancellation Assignment DEFINITIONS BASIS OF RECOVERY Actual Cash Value Replacement Cost CLAUSES LIMITING AMOUNTS PAYABLE Dollar Limits Deductibles Straight Deductible Aggregate and Calendar-Year Deductibles Disappearing Deductible Franchise Deductible Coinsurance Operation of the Coinsurance Clause Dangers of Coinsurance Coinsurance Credits Coinsurance Rationale Time Limitations

Other Insurance Clauses Pro-Rata Clause Equal Shares Other Insurance Prohibited Excess and Primary Coverage KEY TERMS AND CONCEPTS Actual cash value (ACV) Additional insureds Aggregate deductible Aggregate dollar limits

Apportionment clauses Assignee Assignment Assignor

Average adjusters Binder Calendar-year deductible Coinsurance

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Chapter 7: Insurance as a Risk Management Technique: Policy Provisions

Conditions Coordination of benefits provisions Declarations Deductible Direct loss Disappearing deductible Endorsement Equal shares Excess Exclusions Fire Franchise deductible Friendly fire Hostile fire Indirect loss Insuring agreement Loss payable clause Mortgagee Mortgagee clause Named insured Named perils agreement Open-perils agreement Other insurance clauses Policyholder Primary Pro-rata clause Proximate cause Pure premium Replacement cost Specific dollar limits Straight deductible Sue-and-labor clause

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

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A straight deductible is one in which the insured pays the first $250, $500, etc., of a loss and the insurer pays the rest. A franchise deductible is one in which there is no liability on the part of the insurer unless the loss exceeds a certain amount. It is difficult to say which will save the insured more money because the amount the insured pays will depend on the size and frequency of losses. A company with a lot of losses that are not large enough to reach the franchise deductible amount, could be paying out more than they would if there was a straight deductible.

A policy may cover the peril wind, but exclude wind damage to property, such as smokestacks. The peril is covered, but the loss is partially excluded. a. (1) $500, (2) $2,500, (3) $25,000, (4) $40,000, (5) $45,000. The recovery in each case is 50 percent of the loss, which is found by the following formula: $45,000 / (.90 × $100,000). b. In all cases the insured recovers not over 45/90 or 1/2 of the loss, and in no case can this amount exceed the face of the policy, $45,000.

In each case, 2/3 of the loss (60/90) is recovered.

The purpose of coinsurance is to reduce underinsurance. A basic reason for this lies in the fact that unless the insured, who is underinsured, either pays a higher rate or collects less on suffering a loss than the person who is carrying full insurance to value, the insurer either will not collect enough money to meet all its claims or will be charging an unfair rate to some of its insureds. The insurer could accomplish its result either by a sliding scale of rates, depending on the amount of insurance to value taken, or by using the coinsurance clause. Of course, it does both in that it gives a discount in rate for use of the coinsurance clause.

(1) The mortgagee receives ten days notice of cancellation rather than five, as in a fire policy; (2) the mortgagee can sue in its own name; and (3) if there is an increase in hazard unknown to the mortgagee, the mortgagee’s interest is still protected. a. Using the equal shares method, the insurers will pay $50,000 each. b. Insurer A will pay $300,000, insurer B will pay $300,000, insurer C will pay $700,000, and insurer D will pay $700,000.

Using the pro-rata method, insurer A will pay $10,000, insurer B will pay $30,000, and insurer C will pay $60,000.

In order to recover on a replacement cost basis, Ms. Quaker must first replace the property and then file the replacement cost claims. Actually, she may file a claim on an ACV basis first and then collect the difference between ACV and replacement cost after she replaces the property.

Perils are excluded because (1) they are not insurable (e.g., rust, wear and tear), (2) they are covered by other insurance (e.g., auto, watercraft), and/or (3) an additional premium is needed (e.g., theft of jewelry, war coverage on cargo).

Property insurance policies are usually written for a period of one year. They are subject to some problems with intentional losses since destroyed property can be converted to cash and spent by the insured. Life insurance policies represent policies with a long life and heavy early-year expenses that must be paid by the insured. As a matter of public policy, society feels that people need to be able to depend on their life insurance being available when they get sick and die. Also, there is less moral hazard since one must die to collect. a. From memory Y can start setting down everything owned, supporting their values by records from retail stores where the items were purchased, check records, testimony of neighbors and friends, etc.

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b. In such a case Y will undoubtedly forget a lot of things and so will not be able to collect in full. The average person will greatly underestimate the value of personal possessions in the home.

SUPPLEMENTARY QUESTIONS 1.

A certain residential fire insurance form allows up to 10 percent of the face amount of insurance to apply to losses described as ―rental value,‖ but in no case may the recovery exceed 1/12 of this amount in any one month. (a) If the policy is for $12,000 and the rental value of the property is $150 per month, how much can be collected if the insured is displaced for two months? (b) What type of dollar limits are illustrated in this case? (c) What purpose is served by such limits? a. $100 per month, or $200. b. Both aggregate and specific limits are illustrated here. c. The purpose is to prevent the insured from unreasonably taking the entire amount provided, say $1,200 for a month or two, and thus getting perhaps a vacation at the expense of the insurer. The general purpose is to keep the cost of benefits within the reach of all insured.

2.

Why is it unnecessary for a policy to state that fraud will void the contract?

Under common law, fraudulent contracts are void anywhere.

3.

A piece of property valued at $100,000 is insured with an insurance policy containing an 80 percent coinsurance clause. The coverage amount on the policy is $60,000 (assume that there is no deductible). A $40,000 loss occurs that is caused by a covered peril. (a) How much will the insurance company compensate the owner of the property for the loss? (b) Why? a. The insurance company will pay only $30,000 for the loss [($60,000 / $80,000) × $40,000 = $30,000]. b. If the insurance coverage does not meet the coinsurance requirement, the policyholder shares in covered losses.

CHAPTER 8 Selecting and Implementing Risk Management Techniques AVOID RISKS IF POSSIBLE IMPLEMENT APPROPRIATE LOSS CONTROL MEASURES Analyzing Loss Control Decisions Present Value Analysis An Example SELECT THE OPTIMAL MIX OF RISK RETENTION AND RISK TRANSFER General Guidelines Selecting Retention Amounts The Deductible Decision The Self-Insurance Decision IMPLEMENTING DECISIONS Risk Manager versus Insurance Agent Organization for Risk Management Commercial Risk Management Managing a Risk Management Program SUBJECTIVE RISK MANAGEMENT Obtaining More Information

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Group Discussion ENTERPRISE RISK MANAGEMENT AND ALTERNATIVE RISK TRANSFER Alternative Risk Transfer Tools

KEY TERMS AND CONCEPTS Net present value Present value Opportunity cost Risk management policy

Third-party administrator

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1. Risk management decisions must be reviewed regularly because so many relevant factors change. The nature of an exposure may change over time, or the frequency and severity of losses may vary, causing estimates to become out of date. The selection of appropriate techniques is a dynamic, not static process.

2. One step is to avoid risks, if possible. The second is to implement appropriate loss control measures. The third is to select the optimal mix of risk retention and risk transfer.

3. Effective loss control can reduce the frequency and severity of expected losses. This reduction may provide the opportunity for a company to retain more than it would without the loss control techniques. The company may decide to take a higher deductible or self-insure.

4. $793,832.24, calculated as: $1,000,000 / 1.083.

5.

Some of the inflows to be considered are reduced costs resulting from loss reduction, premium savings, tax savings resulting from depreciation of loss control equipment, and possibly some salvage value of the equipment. The outflows are the costs of training and maintenance of the equipment.

6. As a rule, when expected frequency is high or low along with low expected severity, retention makes the most sense, because the entity can afford to pay for or can predict those losses.

Only when the expected severity is high and the expected frequency is low should transfer be considered. When both expected severity and frequency are high, risk avoidance is recommended.

7. The risk manager usually determines a targeted amount of losses to retain, but not exceed, such as $10,000. The risk manager is given a variety of choices of deductible levels and premium amounts from the insurance company. The objective is to obtain the optimal level of deductible and premium amount to avoid paying over that targeted amount for the policy year.

The tradeoffs between higher deductible amounts and lower premiums are analyzed, and a decision is made.

8. The opportunity cost of funds is the cost that companies incur when they set aside capital for losses instead of using it for working capital in the business. That capital has a value. If the capital is used in the business, then the value is often more than if it is used for paying losses.

The difference between these values (the opportunity cost) could affect decisions to self-insure or not. As opportunity costs rise, so does the likelihood that there will be no self-insurance.

9. The four considerations are: (1) the firm should have a sufficient number of units situated so that the units are not subject to simultaneous destruction, (2) the firm must have accurate records or statistics to enable it to make adequate estimates of expected losses, (3) the firm must make arrangements for administering the plan and managing the self-insurance fund, and (4) the general financial condition of the firm should be adequate enough to be able to deal with large and unusual losses.

10. Two ways of reducing subjective risk are: (1) obtaining more information through research, education, or training and (2) group discussion.

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The commercial insurance should be purchased. To establish a reserve fund $100,000 in liquid assets would have to be set aside. The opportunity cost of these investments is ($100,000 × 0.25) – ($100,000 × 0.10) = $15,000. Since the insurance policy is less expensive, it should be purchased.

The initial principal P is multiplied by a factor that takes into account the interest earned and the effect of compounding over time. The factor is calculated by multiplying 1 plus the interest rate by itself for N number of times, to yield Q. The second formula starts with the final value Q and multiplies it by the inverse of the factor that takes into account interest and compounding. There is a basic algebraic relationship between the two formulas, which are merely rearrangements of the same mathematical relationship between P and Q. WPR should avoid risks associated with business activities not consistent with its goals. For example, there are risks associated with running homeless shelters that WPR does not have in its business plan. Another example might be the risks involved in storage of expensive items such as computers left on premises. Other risks like acquiring properties with environmental hazards definitely should be avoided. Risks associated with sporting activities or discos may also be candidates for avoidance.

Some of the pros of using statistical analysis are: (1) specific statistical techniques may be the best way to discover specific information and (2) statistical techniques bring a measure of academic rigor to bear on a practical problem. Some of the cons are: (1) potential distributions rely on certain assumptions that could be overlooked, (2) data used must be accurate or the result of the analysis will be inaccurate, and (3) there must be enough units and data on those units to make many of these analyses useful.

An airline could purchase a double-trigger insurance policy. Under this type of contract payment would be made to the airline by the insurer if one or both of these risks occurred and losses exceeded the combined deductible.

SUPPLEMENTARY QUESTIONS 1. Identify and briefly explain several reasons that may explain why money available today is more valuable than money that will become available some time in the future.

Money currently available is more valuable due to several reasons, including the preference for present consumption over future consumption, the risk that inflation will reduce the purchasing power of money held for future use, and the risks involved with storing or investing money.

2. Suppose a corporate executive indicated to you that he or she was resistant to the idea of undertaking the task of a thorough risk identification process, stating that there were enough things to worry about without looking around for more. What type of risk might actually be increased by identifying previously undiscovered risks? How are unidentified risks automatically handled? If you found out that this executive had been very successful in business in the past, how might you explain this success?

Subjective risk may actually be increased through identifying risks that previously went unnoticed. If a risk is unidentified then it is automatically retained. This executive either has been very lucky or has had subordinates who have performed the risk management function.

A less likely explanation might be that the executive is very skilled at identifying risks without undergoing a formal risk identification process.

3. Risk avoidance is one technique used to handle risk. To avoid risk would eliminate the need to handle it in other ways such as risk transfer and risk reduction. If insurance and loss control techniques are known to be costly to the firm, why are not all risks simply avoided?

Chapter 9: Risk Management and Commercial Property - Part I

In most instances, risk avoidance is costly to the firm as well. In situations where risk is not avoided, it has been determined that avoiding the risk is more costly than handling it by other methods. Typically, the costs involved with avoiding such a risk are in the form of opportunity costs involved with not participating in an activity or owning a particular asset.

CHAPTER 9 Risk Management and Commercial Property—Part I THE COMMERCIAL PACKAGE POLICY (CPP) Building and Personal Property Coverage Form (BPP) Buildings Your Business Personal Property Personal Property of Others Extensions of Coverage Scheduled versus Blanket Coverage Common Clauses in the BPP Insured Perils Debris Removal Endorsements Used with the BPP BOILER AND MACHINERY INSURANCE Special Characteristics Insuring Agreements Loss to Property Expediting Expenses Optional Endorsements Business Income Insurance Extra Expense Consequential Damage BUSINESS OWNERS’ PROGRAM Property Forms Used Recovery Basis OTHER COMMERCIAL PROPERTY FORMS Difference in Conditions Insurance (DIC) Builder’s Risk REPORTING FORMS CONSEQUENTIAL LOSS COVERAGE TIME-ELEMENT CONTRACTS Business Income Insurance Basic Characteristics Business Income Loss Coinsurance How Much Insurance to Carry?

Insurance-to-Value Requirements Maximum Period of Indemnity Monthly Limit of Indemnity Agreed Amount Clause Contingent Business Income Extra Expense Insurance

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CONTRACTS WITHOUT TIME ELEMENT Manufacturers Selling Price Accounts Receivable Insurance Rain or Event Insurance Hospital Disaster Risk Management KEY TERMS AND CONCEPTS Accounts receivable insurance Agreed amount clause Automatic coverage Basic form Blanket coverage Boiler and machinery insurance Broad form Building and personal property coverage form (BPP) Business income insurance Commercial Package Policy (CPP) Consequential damage endorsement Consequential losses Contingent business income insurance Contracts without time element Expediting expenses Extended-period-ofindemnity endorsement Extra expense insurance Insurable value Manufacturers selling price Rain insurance Reporting forms Scheduled coverage Special form Time-element contracts Use and occupancy

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1. a. Bond has a maximum coverage of $100,000, but is subject to a coinsurance penalty and receives no refund of premium. Its premium is initially lower than Perez’s because it took out only $100,000 rather than $150,000. In case of loss, Bond collects only 100/200 of any provable loss. Perez, on the other hand, has a maximum coverage of $150,000 and no coinsurance penalty. b. No. The agreed amount is $150,000 and Perez maintains it. c. Perez can collect $150,000 if it suffers a $150,000 loss.

2. The extensions of coverage are: (1) newly acquired building or additions, (2) business personal property located at newly acquired premises, (3) personal effects and property of others, (4) valuable papers, and (5) off-premise property. They are used to cover incidental loss exposures. If there is significant exposure, there is a need to purchase separate insurance.

3. Coverage is on a named-peril or an ―open perils‖ basis. There are three options: basic perils, broad form perils, and special (open perils).

4. Insureds need reporting forms to cover property that varies in amount during the year.

5. The insured peril must occur and income must be reduced. The insured must maintain partial operations if possible. Coinsurance requirements cause problems.

6. The indemnities are loss due to the fact that you do not know who owes you the money, interest on loans made necessary by the loss, and excess cost of reproducing records after the loss occurs.

7. A leasehold may become very valuable to the lessee because changing business conditions, improvements in the property, and good management may increase the rental value of real estate considerably above the rental due under the lease. It is very common in leases to provide that the agreement is void or voidable if the premises are destroyed by fire, if a certain percentage of the sound value of the premises is destroyed by fire, or if the premises are so damaged that they cannot be restored within a given number of days. It is this source of loss that is insurable under a form of coverage known as leasehold interest insurance.

8. The coverages are: (1) loss to property of the insured; and (2) expediting expenses.

9. The actual loss, after all, is the loss of earning power to a family dependent on a breadwinner, leaving aside the emotional costs involved. Hence, life insurance is really consequential in nature.

10. In time-element contracts, the loss is measured by means of lapsed time. Time is the essential element in causing a loss. In contracts without a time element, the loss is not measured by elapsed time, but according to some other criterion, e.g., monetary outlays in the past representing profits that would have been realized except for the occurrence of some peril.

11. Possibly because of coinsurance penalties. Profits are so much higher that a coinsurance penalty is involved, because the insured has failed to take out sufficient coverage.

12. First, a careful analysis of potential loss should be made, including possible fluctuations in profits and expenses. Second, sufficient coverage to avoid coinsurance penalties should be purchased.

13. Probably what the agent has in mind is extra expense insurance, under the theory that if fire or other peril were to damage the dairy’s building, the firm would continue its business in other quarters at higher cost. In this event the business is not really interrupted and no indemnity would be payable under the business income form.

SUPPLEMENTARY QUESTIONS 1. Under the BPP, an insured may purchase scheduled coverage or blanket coverage. Define and discuss the differences between the two.

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2.

Under scheduled coverage, property at two or more locations is listed and specifically insured.

Blanket coverage insures property at several different locations as a single item. For example, all computer equipment in a tire manufacturing company’s five plants would be insured separately from the machinery, and the machinery would be insured separately from the stock of tires produced. Under blanket coverage, all computers, machinery, stock, and other components from all five plants would be insured as one large item.

Discuss the special characteristics of boiler and machinery insurance.

(1) Prevention of loss is strongly emphasized. Insurers send inspectors to the plants to identify any problems or potential problems. Failure of the company to immediately repair or replace defective equipment can result in suspension of coverage. (2) An exact definition of ―accident‖ is included in the endorsement of the object. Due to the technical and diverse nature of boilers, furnaces, and related equipment, what constitutes an ―accident‖ for one may not for another. (3) A single boiler and machinery contract provides coverage against different types of losses, such as liability for damage to persons or property of others, direct loss of property to the insured, and indirect loss due to shutdown. (4) An aggregate limit of loss is stated for the first four coverages, and all payments must be satisfied out of that limit in numerical order.

CHAPTER 10 Risk Management and Commercial Property—Part II TRANSPORTATION INSURANCE The Perils of Transportation The Liability of the Carrier The Carrier’s Liability in Ocean Transportation The Carrier’s Liability in Land Transportation Need for Transportation Insurance OCEAN TRANSPORTATION INSURANCE Major Types of Coverage Hull Policies Cargo Policies Freight Coverage Legal Liability for Proved Negligence Perils Clause Deductibles General Average Clause Sue-and-Labor Clause Abandonment Warehouse-to-Warehouse Clause Coinsurance Warranties in Ocean Marine Insurance Express Warranties FC&S Warranty SR&CC Warranty Delay Warranty Trading Warranty Implied Warranties

Chapter 10: Risk Management and Commercial Property - Part II

Seaworthiness Deviation Legality LAND TRANSPORTATION INSURANCE The Marine Definition Inland Transit Policy Trip Transit Insurance FLOATER CONTRACTS Bailed Property Business Floater Policies Block Policies Jewelers’ Block Policy Scheduled Property Floater Risks Contractors’ Equipment Floater Electronic Data Processing (EDP) Floater

CREDIT INSURANCE Types of Credit Insurance Insurance of Bonds Credit Life and Credit Accident/Sickness Domestic Merchandise Credit Insurance Government Credit Insurance TITLE INSURANCE The Title Insurance Contract Defense Premium GLASS COVERAGE FORM CRIME CRIME INSURANCE AND BONDS Insurance versus Bonding Fidelity and Surety Bonds Types of Fidelity Bonds Bonds in Which an Individual Is Specifically Bonded Blanket Bonds Types of Surety Bonds Construction Bonds Contract Construction Bond Bid Bond BURGLARY, ROBBERY, AND THEFT INSURANCE Business Coverages Federal Crime Insurance RISK MANAGEMENT OF THE CRIME PERIL Assumption Insurance Case Study: Disaster Risk Management Disaster Risk Management Questions for Discussion 1. a.

Worker was on outside of roof. Fire was on inside. b.

Smoke in area where the fire was.

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c.

Nearby construction. d.

Difficult for fire department to drive trucks next to building. e. Asbestos in building.

2.

Provided extra expense coverage as well as debris removal of asbestos. Replacement cost coverage provided with upgrades for building law changes.

3.

The CEO is extremely important. Only he or she can tell everyone what to do. The CEO must make recovery the number one priority of the firm.

KEY TERMS AND CONCEPTS Abstract Acts of God Acts or negligence of the shipper Actual total loss Bailment Bid bond Blanket bond Blanket position bond Block policy Bond Bottomry contracts Burglary Cash loan credit insurance Commercial blanket bond Constructive total loss Contract construction bond Contractors’ equipment floater Credit insurance Credit life insurance Deposit insurance program Domestic merchandise credit insurance Express warranties Fidelity bonds Floater policy Forgery Free-of-capture-and-seizure (FC&S) clause Free-of-particular-average (FPA) clause Freight General average clause Glass coverage form Hull insurance Implied warranties Individual bond Inherent nature of the goods Inland marine insurance Inland transit policy

Jewelers’ block policy Memorandum clause Obligee Obligor Open contract Penalty Principal Protection and indemnity (P&I) clause Released bill of lading Respondentia contracts Robbery Running down clause (RDC) Schedule bond Scheduled property floater Sue-and-labor clause Surety Surety bond Theft Theft insurance Title insurance Warehouse-to-warehouse clause

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

Plate glass insurance is needed to have damaged glass quickly repaired.

2.

The perils of transportation are covered.

3.

Hull: damage to the ship.

Cargo: damage to the property carried by the ship.

Protection and Indemnity: liability insurance.

4.

The ocean carrier’s liability is less than the land carrier’s.

5.

The jeweler’s property, property of customers, property on consignment, and property of other dealers are covered under a jewelers’ block policy.

6.

This is true because credit losses are an expected normal cost of doing business. Since this is a certainty, credit losses are uninsurable. Only the abnormal or excessive credit loss is subject to insurance.

7.

Under ICC endorsement the insurer must pay the claim, but since the insured violated an express warranty, the insurer has a right to collect its payment from the insured.

8.

Court decisions have been centered around the wording of the Lloyd’s ocean peril clause and the exact meaning is known. To change it would subject the contract to legal uncertainties that are well avoided.

9.

This is a particularly average loss. It is not total, nor is it considered a constructive total loss unless the shipment is not worth the cost of repair. In this case, the cost of repair is $2,000 and would be the total payment. a. A definition given by W. D. Winter in Marine Insurance (New York: McGraw-Hill Book Co., 1952, p. 405) is: ―That which has been destroyed for all shall be replaced by the contributions of all.‖ b. The loss is the result of a sacrifice voluntarily made, under fortuitous circumstances, of a portion of either ship or cargo or the voluntary incurrence of expense for the sole purpose of preserving the common interest from an impending danger.

10.

In a floater policy, the property may be moved at any time, the property is not expected to remain permanently at one location, and the floater covers the property while at any given location and while in transit.

11.

The main benefit of the contract is, of course, the investigation of a title that turns up liens and other defects that can cloud a title. These defects are naturally excluded because to cover them would amount to insuring a known loss. Also, the benefit lies in paying for losses that are unknown and are not excluded by the contract.

12. a. The text sides with those who say this practice is inequitable. b. The title insurer probably would argue that frequent transfers are somewhat unusual and it is not feasible to alter the rating system to accommodate an occasional case.

SUPPLEMENTARY QUESTIONS 1.

Why is abandonment permitted in ocean marine insurance and not in most other lines of insurance?

Abandonment is permitted in ocean marine insurance because of the difficulty that the average insured would experience in attempting his or her own salvage.

2.

A shipowner insures a ship with Company T on July 1 for $100,000. Later, on July 5, fearing insufficient coverage, the shipowner takes out another $50,000 policy with Company U. (a) In the event of a $30,000 loss to the hull, how would the two companies divide the claim?

Explain. (b) What would the settlement be if the loss were $60,000? Explain. a. Company T would pay the entire claim in the case of the $30,000 loss.

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3.

4.

b. For the $60,000 loss, Company T would pay $60,000. Each company pays to the fullest extent of its coverage in the order in which the coverage was placed, chronologically. If the loss had been $110,000, Company T would pay $100,000 and Company U, $10,000.

List at least six causes of loss for which an ocean-going common carrier is not liable at common law. Errors in navigation or management of the vessel, strikes or lockouts, acts of God, acts of war or public enemies, seizure of the goods under legal process, quarantine, inherent vice of the goods, failure of the shipper to exercise due care in the handling or packing of the goods, fire, perils of the seas, latent defects in the hull or machinery, and other losses where the carrier is not at fault.

Ms. Adams objects to certain wording that she sees in her title insurance contract. It states that she may recover for no losses that are discovered after issuance of the policy. Ms. Adams claims that there has been a mistake and what the insurer really intended was to eliminate all losses occurring before the contract is issued. Is Ms. Adams correct? Why or why not?

Ms. Adams is incorrect. The title insurance contract is unique in that it covers only losses occurring before the contract is issued but which are also undiscovered. Even some undiscovered losses are commonly excluded from coverage.

CHAPTER 11 Risk Management and Commercial Liability Risk COMMON LIABILITY CONTRACT PROVISIONS The Insuring Clause Supplementary Payments Definition of the Insured Exclusions Limits of Liability Claims-Made versus Occurrence Coverage Basic Extended Reporting Period Supplemental Tail Notice COMMERCIAL LIABILITY INSURANCE COMMERCIAL GENERAL LIABILITY Exclusions in the CGL Automobile Product Recall Liquor Liability Pollution Endorsements Exclusion of Specific Accident(s), Products, Work, or Location(s) Vendor’s Endorsement EMPLOYMENT PRACTICES LIABILITY BUSINESS AUTO COVERAGE Risk Management Tips—Commercial Auto PROFESSIONAL LIABILITY INSURANCE Professional versus Other Liability Contracts Medical Malpractice Insurance

Chapter 11: Risk Management and Commercial Liability Risk

Insurance Agents’ and Brokers’ Errors-and-Omissions Liability Other Professional Liability Insurance Commercial Umbrella A Profile of a Catastrophic Liability Program

38 KEY TERMS AND CONCEPTS Aggregate limits Broad form property damage liability program Business Automobile Policy (BAP) Claims-made policy Commercial general liability (CGL) Commercial umbrella Dramshop exclusion Errors-and-omissions policies Exposure doctrine Extended period of indemnity Extended reporting period Malpractice policies Manifestation doctrine Occurrence policy Professional liability Sistership exclusion Supplemental tail Triple-trigger approach Vendor’s endorsement

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

Legal liability insurance means the insurer pays only if the policyholder is legally liable.

2.

Aircraft; watercraft; property in the insured’s care, custody, or control; workers’ compensation; failure of product to perform; war; and pollution.

3.

Claims-made covers losses occurring after the retroactive date and reported during the policy period. Occurrence covers loss that occurs during the policy period; it may be reported many years later.

4.

Property damage, bodily injury, and personal injury.

5.

With professional liability insurance, the insurer often needs the insured’s permission to settle the contract; there is one insuring clause, and it covers intentional acts that give rise to unintentional results.

6.

Commercial umbrellas are purchased to cover large losses. Umbrellas normally provide broad coverage and high limits of liability. They also have underlying coverage.

7.

Yes, but it will be more expensive.

8.

They should purchase higher limits because each loss will count toward the yearly aggregate.

9.

Mr. Wood is protected by his CGL even though the manufacturer will most likely be held responsible for the damage caused by the furnace.

10. a. This claim would be paid under the general liability section of the policy. b. If the washer was in the home of the insured, the claim would be a products liability claim.

11.

The court held the insurer liable, stating that the care, custody, and control exclusion applies to essential work done by the insured and not property involved only incidentally. In a similar case, Boswell v Travelers Indemnity, 120A. (2d) 250, the insured had a contract to renovate and replace some heating units in a building. One unit was damaged by the negligence of the insured in testing the work after completion. A New Jersey court held that the insured was covered because the heating unit was part of the building, and therefore not in the insured’s control.

12. a. Under strict liability the plaintiff does not have to prove negligence, just that an accident occured and the defendant’s product caused a loss. The defendant can use the doctrine of negligent use by the plaintiff, but in the case of breast implants it is very difficult for the plaintiff to have access to the implants after they are implanted. b. In the CGL, products coverage is provided if the insured pays the appropriate premium.

SUPPLEMENTARY QUESTIONS 1.

In Great American Indemnity Company of New York v Saltzman, 8 CCH Fire and Casualty Cases 388, an insured had a general liability policy. Without permission, he entered an airplane belonging to another person to inspect it and started the engine. Because of his unfamiliarity with the controls, the insured could not stop the plane, which crashed into a hangar and caused substantial damage. The insurer refused to defend the insured in the resulting suit for damages. (a) On what grounds is it likely that the insurer relied? Explain, with reference to appropriate policy provisions of the typical business liability policy. (b) Do you think that the defense in part a should be found to be good? Discuss. a. The obvious question is whether or not this was a business act. Business policies cover only liability arising out of the operation of a business, and if this was a personal act not connected with business it would have had to be considered under a comprehensive personal liability policy. Another question is the ―care, custody, and control‖ exclusion.

Was the airplane in the physical control of the insured and hence excluded under the liability policy? If so, damage to the plane would have been excluded, but perhaps damage to the hangar would have been covered.

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b. Assuming that the insurer defended on the basis that the insured’s act was essentially nonbusiness in character, the facts would have had to be investigated further to determine whether or not the defense was good. Questions requiring answers include the following: Were planes a part of the insured’s business operations? Was the insured on a business trip and was the inspection of the plane a part of this venture? If the care, custody, and control exclusion was the defense used by the insurer, it appears that loss to the plane might be excluded, but not loss to the hangar. There appears to be little similarity to this case and the case cited in the text in which the court held a concrete wall to be in the care of the insured who was handling a bulldozer.

On the way to a meeting with a client, an attorney injures a third party in an automobile accident. (a) Does such an occurrence arise out of the attorney’s professional practice? If so, would the professional liability respond in damages? Why? (b) Would your answer be different if the accident occurred because the attorney and client were discussing a legal question while driving and, as a result of not paying attention to driving, the attorney caused the accident? Discuss. a. The question of professional versus nonprofessional negligence is raised here. The malpractice policy covers only professional errors, and the attorney still needs general liability insurance. b. It is doubtful if the fact that the accident resulted from lack of attention by the attorney who is discussing a professional matter with a client would make any difference. The attorney needs automobile insurance, too.

The city of Y hires a contractor, C, to perform some work, and specifies that C name Y as an additional insured under his CGL. Y also requires C to sign a hold-harmless agreement to the effect that C will assume any liability that Y might have arising out of the work that C is performing. C points out that such an agreement is unnecessary and, in fact, dangerous because the city would in effect be holding itself harmless for any liability arising out of the work. (a) Do you agree? Why? (b) In your opinion should the city not only require a holdharmless agreement but also be named as an additional insured? Discuss. a. The city is in the position of (1) being an insured and (2) as an insured, being ―held harmless for acts of itself against itself.‖ This seems to be an incongruous position, since if the city on one hand agrees to hold itself harmless for loss, it might be construed that the insurer, or the contractor, has no liability to the city for damage arising out of third-party suits. b. For reasons cited in part a, the city should either require that it be named as an additional insured or require a hold-harmless agreement in its contract with C, but not both.

CHAPTER 12 Workers’ Compensation and Alternative Risk Financing WORKERS’ COMPENSATION INSURANCE Major Reform Insurance Methods Private Insurance State Funds and Federal Agencies Self-Insurance Evaluation of Insurance Methods Major Features of State Laws

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Employment Covered Income Provisions Survivor Benefits Medical Benefits Rehabilitation Benefits Benefits Experience Rating Retrospective Rating RISK MANAGEMENT AND WORKERS’ COMPENSATION Factors Favoring Self-Insurance Lower Administrative Expenses Cash Flow Benefits Claims-Conscious Management Factors against Self-Insurance Size of Firm Stability of Work Force Tax Consequences Availability of Services Excess Insurance Risk Management Application: Retrospective Insurance Plan Details of a Retro Plan Problems with Retros A Creative Alternative Risk Management Application: Self-Insuring Workers’ Compensation Payment Pattern Cash Flow Model Potential Problems Alternative Workers’ Compensation Risk Financing Strategies CAPTIVE INSURANCE COMPANIES Special Tax Status of Insurance Companies Operation of a Captive Onshore versus Offshore Captives Other Attributes of Captives Potential Problems of Captives

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KEY TERMS AND CONCEPTS Assigned risk plan Basic premium Captive insurer Excess insurance

Experience rating Experience modification factor Liquidating damages Loss conversion factor

Retrospective rating Standard premium Tax multiplier Workers’ compensation insurance

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

When large unexpected losses occur. The maximum premium limitation in the retro plan will limit the insured’s cost to the maximum premium.

When losses are very low. Even if there are no losses, under a retro plan the insured still must pay the minimum premium or if no minimum, the basic premium.

2.

Marketing costs: commissions and advertising. Premium taxes, residual market assessments, some underwriting costs.

3.

Age of work force, number of workers and whether they are in one state or spread throughout the country, opening or closing a number of plants, rate of increase of benefits (insurance rates lag as benefit increases), interest rates.

4.

Basic distinction: Experience rating rewards or penalizes an insured in the future for a good or bad past record of losses, while retrospective rating rewards or penalizes for the period just past; i.e., the rating enables the insured to make his or her own premium in whole or in part after all the facts are collected. Basic similarity: Both are merit rating plans designed to differentiate an individual risk from members of his or her class.

5.

The student may agree with this on the grounds that retrospective rating permits the insured to transfer as much or as little risk as he or she wishes, and makes it necessary for the insured to set up an elaborate plan. The student may disagree with the argument in that retrospective rating is a form of self-insurance, and the statement is inconsistent.

6.

Factors that favor self-insurance include the possibility of lower program costs. The selfinsurer does not pay for acquisition costs of the insurer and the insurer’s profit. Cash flow benefits are received because the self-insurer holds the reserve rather than the insurance company. Also, managers tend to be more claims-conscious under self-insurance, and usually loss experience is lower under self-insurance. Also, there are certain tax advantages of selfinsurance such as the deductibility of insurance premiums.

7.

Many firms do not self-insure because they are not large enough and do not have the financial capacity to do so. Another reason not to self-insure is the administrative burden placed on the risk manager as well as the fact that self-insured losses tend to rise faster than insurance premiums when benefit levels are being increased.

8.

Large deductible plans serve a good purpose for many insureds and insurers. However, from a public fairness viewpoint, residual market assessments should be added on the full premium.

9.

It would eliminate the health care part of workers’ compensation.

10.

The state systems seem to be working better than in the early 1990s when they were so heavily criticized. A national system would probably lead to high income replacement limits and higher cost. If you are on a union pension, nationalization would be attractive. It would not be attractive to many companies.

11.

Yes: Government plan would eliminate marketing cost.

No: With private plans available, competition between companies keeps cost down, increases the variety of plans, and pays premium taxes to the states.

12.

In some cases, the premium paid by the parent to the captive may be tax deductible.

Usually there must be a captive where a significant amount of the business is not the parent. Sears’ relationship to Allstate is a good example.

SUPPLEMENTARY QUESTION

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Chapter 13: Risk Management for Auto Owners—Part I

An employer in a state with an exclusive workers’ compensation fund elects not to come under the state law. The law prohibits purchase of private workers’ compensation insurance and the employer does not wish to assume the risk. What alternatives to insuring in the state fund are available if any?

The employer may take a workers’ compensation and employers’ liability policy with a voluntary compensation endorsement. Such a policy provides benefits to the worker just as though the worker were covered under the state’s law, but these benefits are voluntarily extended and the employee must release the employer from all liability. The policy also protects against employee lawsuits, if they arise. The employer may also set up a self-insurance fund, assuming that the firm is large enough to make this feasible.

CHAPTER 13 Risk Management for Auto Owners—Part I THE HIGH COST OF AUTOMOBILE LOSSES INSURANCE CLAIMS THE NEED FOR INSURANCE PERSONAL AUTOMOBILE POLICY Eligibility Definitions PERSONAL AUTOMOBILE POLICY COMPONENTS Liability Supplementary Benefits Limit of Liability Exclusions Other Liability Conditions Medical Payments Exclusions Other Conditions Uninsured Motorist Uninsured Motor Vehicles Exclusions Other Conditions Physical Damage to Autos Exclusions Transportation and Towing Other Provisions Duties after an Accident or Loss General Provisions Policy Cancellation Provisions Endorsements to the PAP Motorcycles and Other Vehicles Snowmobiles Auto Loan/Lease Coverage AUTOMOBILE INSURANCE AND THE LAW Financial Responsibility Laws Compulsory Insurance Laws Unsatisfied Judgment Fund

Chapter 13: Risk Management for Auto Owners—Part I

Uninsured-Underinsured Motorist Coverage RISK MANAGEMENT AND PERSONAL AUTOMOBILE RATING Rating Factors Deductibles for Damage to Your Auto The Youthful Driver Dilemma Selection of Liability Limits

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Chapter 13: Risk Management for Auto Owners—Part I

KEY TERMS AND CONCEPTS Collision Covered auto Family member Financial responsibility laws Losses other than collision Medical payments No-fault Nonowned auto Nonstandard risk Occupying Personal automobile policy (PAP) Security provisions Trailer Underinsured motorists endorsement Uninsured motorist coverage Uninsured motor vehicle Unsatisfied judgment fund (UJF) Youthful driver

Chapter 14: Risk Management for Auto Owners—Part II

iii

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

Coverage exists on the basis that the son’s car is a temporary, substitute automobile.

Most likely coverage will exist because one can assume that permission was given. a. The liability of $2,000 is covered, but the physical damage of $1,000 is not covered. The definition of a trailer for liability differs from the definition given in the physical damage section. b. If the trailer were just a utility trailer, the physical damage would have been covered assuming the trailer had been declared and a premium paid on it.

Josephine’s PAP will pay (if she is negligent) under its property damage liability section.

There is no coverage for Josephine under her PAP’s physical damage coverage.

A nonowned auto is not covered for liability while used in the automobile business by the insured. Since this is a nonowned car, he is not covered. If the car had been in any other business use, however, and involved in an accident with a private car, coverage would apply under the PAP. Motorcycles may be insured under the PAP using the miscellaneous-type vehicle endorsement.

Age, number of accidents, multiple cars insured, and location reduce or increase a person’s rates. Rates increase the younger you are, the more accidents you have, if you only insure one car, and if you live in an urban area.

It will cover only you, not other people on the bus.

Young drivers have considerably more accidents. They make up 10 percent of all drivers, but account for about 21 percent of all accidents. Older drivers have relatively fewer accidents.

Among the possible reasons are: (1) the higher cost of making cars safer may offset savings in insurance premiums, (2) car buyers may not like the looks of safer cars, e.g., those with extended bumpers, and (3) insurers have not given sufficient reduction in premium rates for safety features.

The PAP excludes damage for injuries to employees where the employee had, or was required to have, workers’ compensation coverage. This exclusion prevents duplicating coverage.

It is conceivable that the insured might claim that the proximate cause of loss was theft, particularly since the car was locked and was taken without permission. Another argument might be that the proximate cause was vandalism.

SUPPLEMENTARY QUESTIONS 1.

A thief steals the insured’s car and wrecks it. Is this a collision loss or a theft loss? Discuss.

This is clearly a theft loss and is covered under comprehensive (loss-other-than-collision) insurance.

2.

In Harris v Allstate Insurance Company, 309 N.Y. 72, the insured had driven rapidly over a portion of highway inundated by water. He lost control and the car went over an embankment. There was no collision insurance, but the insured had comprehensive (lossother-than-collision) insurance. Should the insurer pay the claim?

The court held that this was a collision loss, not comprehensive, thus reversing other decisions involving water losses.

CHAPTER 14 Risk Management for Auto Owners—Part II

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Chapter 14: Risk Management for Auto Owners—Part II

WHERE DOES THE AUTO INSURANCE PREMIUM GO? AUTO DEATH RATES CAR THEFT COST CONTAINMENT Loss Control and Prevention Restriction of Payments Redistribution of Losses and Expenses NO-FAULT Modified No-Fault Add-On States Choice No-Fault Evaluation of No-Fault ALCOHOL AND DRIVING NEW LAWS ADVANCES IN DRIVER AND AUTO SAFETY AIR BAGS, AUTO PROPERTY DAMAGE, AND TEENAGE DRIVERS KEY TERMS AND CONCEPTS Dollar amount Driving while intoxicated (DWI) No-fault Original equipment manufacturer (OEM) parts Verbal threshold

Chapter 15: Risk Management for Homeowners

iii

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

4.

5.

6.

7.

8.

9.

Insureds do not choose the $1,000 deductible because the rate credits do not make it attractive and they believe it would be a poor buy.

Under no-fault insurance, the insurance company would pay for damage to the insured’s car and for injuries to the insured and his or her family riding in the car, regardless of who caused the accident. Since fault would not have to be determined, costs for adjusters would be reduced. Legal fees and awards for pain and suffering would be eliminated because most auto accident cases would not go to court. There would be a redistribution of the benefits, with a higher percentage going to the insured rather than to adjusters and lawyers.

A verbal threshold uses a verbal definition to determine the point after which an insured may bring legal action when a no-fault insurance system exists. States that use verbal thresholds have a much lower ratio of bodily injury claims per 100 property damage claims than those using a dollar threshold. Where bodily injury claims are lower, insurance rates are usually lower.

Various states have increased efforts to reduce drunk driving. The legal drinking age is 21 in all 50 states now. There has also been a decline in the number of youthful drivers. Because drivers under the age of 24 are involved in a disproportionate number of DWI accidents, a decline in the number of drivers should reduce the number of deaths.

Padded auto interiors, especially dashboards, have reduced head and neck injuries. Modified windshields act as a net and give on impact. Redesigned instrument panels do not protrude and injure occupants in a crash. Center-mounted brake lights reduce rear-end collisions. Seatbelt and car-seat laws for children have been enacted in most states.

The more insurance companies that exist in the marketplace, the greater is the competition for each individual company. Competition tends to keep rates lower.

Higher oil prices generally lead people to buy smaller, lighter, more fuel-efficient cars. These cars are not as safe as larger ones and usually sustain worse damage in an accident. From this point of view, high oil prices may lead to higher insurance rates. However, higher gas prices also lead to less driving, which may lead to fewer accidents. A reduction in the number of accidents could reduce rates. Generally, high oil prices increase the severity of accidents, but reduce their frequency.

An argument for agreeing with the statement is the following: A 20 percent reduction in rates requires that insurance companies cut back on the benefits they offer. While people may not like reduced benefits, they will understand that if they pay less, they will receive less. If consumers find that they do not like the reduced benefits, they can lobby for a no-fault system that would redistribute the losses, with more going to them and less to lawyers. Either way, a 20 percent reduction would be relatively easy to execute. An argument for disagreeing with the statement is the following: A 20 percent reduction strikes at the operating budget for the insurance company; once losses are paid, there will be no money left to run the company and it will go bankrupt. Reducing benefits to the insured is not an option. The whole point of the rate cutback is to offer the same services for less money. The only way a 20 percent rate reduction could work without causing major hardship to both the insurer and the insured would be to redistribute the present benefits through a no-fault system.

Answers will vary, but might include some of the following points: (1) regulation (prior approval) of rate changes, (2) issue of antitrust status of insurance companies, (3) protection against consumer fraud, (4) redistribution of expenses and losses through a no-fault system, and (5) dollar or verbal threshold in a no-fault system.

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Chapter 15: Risk Management for Homeowners

SUPPLEMENTARY QUESTIONS 1.

How should society address the drinking and driving problem?

Answers will vary, but may include discussion of legal drinking age, legal driving age, stricter enforcement of existing laws, and harsher penalties.

2.

Some people believe auto insurance would be cheaper if the government provided it. Give reasons for and against this position.

An argument agreeing with the statement is as follows: If the government provided auto insurance, the competition and the motive for profit that exists in the open market would be gone. Rates could be set at a reasonable level and the shift from ―hard‖ to ―soft‖ markets would be softened considerably, even totally eliminated. With the U.S. Treasury subsidizing the insurance system, there would always be money available for loss payments; insureds would not have to worry about individual companies failing.

An argument disagreeing with the statement is as follows: If the government provided auto insurance, the rates that it set might be somewhat lower than those often seen in the open market, but taxpayers would make up the difference in new taxes. If the U.S. Treasury subsidized insurance, the money would have to come from somewhere, almost certainly from additional taxes. The consumer would realize no true savings. In addition, the government would have a monopoly of sorts on the insurance business. Rates would not be subject to decline due to competition; insureds would just have to hope that, when economic conditions warranted it, the rates would be lower.

CHAPTER 15 Risk Management for Homeowners HOMEOWNERS’ PROGRAM: DEVELOPMENT Concise Language Multiple-Line Minimum Amount of Coverage Lower Cost OUTLINE OF HOMEOWNERS’ COVERAGES ANALYSIS OF HOMEOWNERS’ POLICY HO-3 Coverage A—Dwelling HO-3 Coverage B—Other Structures HO-3 Coverage C—Unscheduled Personal Property HO-3—Property Excluded HO-3—Special Dollar Limits HO-3 Coverage D—Additional Living Expenses HO-3 Additional Coverages Debris Removal Reasonable Repairs Trees, Shrubs, and Other Plants Fire Department Service Charge Removed Property Credit Card, Electronic Fund Transfer Card, Forgery and Counterfeit Money Collapse Glass or Safety Glazing Material Replacement Landlord’s Furnishings Loss Assessment Ordinance or Law

Chapter 15: Risk Management for Homeowners

Grave Markers Special Conditions in Homeowners’ Property Coverages Loss Settlement Clause Pair-and-Set Clause PERILS COVERED IN HOMEOWNERS’ INSURANCE Open-Perils Dwelling Exclusions Freezing Fences, Pavement, Patios, and Similar Structures Buildings under Construction Vacancy beyond 30 Days Mold, Fungus or Wet Rot General Open-Perils Exclusion All-Property Exclusions Concurrent Causation Named-Perils Protection Fire and Lightning Windstorm and Hail Explosion Riot and Civil Commotion, Aircraft, and Vehicles Smoke Vandalism or Malicious Mischief Theft Limitations on the Premises Off-Premises Limitations Falling Objects Weight of Ice, Snow, or Sleet Accidental Discharge or Overflow of Water or Steam Sudden and Accidental Tearing Apart, Cracking, Burning, or Bulging of a Steam, Hot Water, or Air-Conditioning System or an Appliance for Heating Water Freezing Sudden and Accidental Damage from Artificially Generated Electrical Current Volcanic Eruption OPTIONAL PROPERTY ENDORSEMENTS TO HOMEOWNERS’ POLICIES Earthquake Inflation Guard Guaranteed Replacement Cost Personal Property Replacement Cost Unit Owners, Building Additions, and Alterations Special Personal Property Inboard Watercraft Outboard Watercraft FLOOD INSURANCE PERSONAL ARTICLES FLOATER (PAF) MOBILE HOME ENDORSEMENT TO HOMEOWNERS’ POLICY Mobile Home Eligibility Mobile Home Coverage SHOPPING TIPS FOR HOMEOWNERS HO-3 COVERAGE E – PERSONAL LIABILTY Damage to the Property of Others

v

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Chapter 15: Risk Management for Homeowners

Persons Insured Exclusions HO-3 COVERAGE F – MEDICAL PAYMENTS TO OTHERS OPTIONAL LIABILITY ENDORSEMENTS TO THE HOMEOWNERS’ POLICY Watercraft Liability Personal Injury Business Pursuits Business Insurance Coverage Personal Umbrella Limits of Liability and Self-Retained Limits Underlying Limits Umbrella Contract Provisions Personal Injury Property in the Insured’s Care, Custody, or Control Incidental Business Pursuits Automobiles DWELLING PROGRAM (NOT HOMEOWNERS’) Underwriting Eligibility Property Insured Insured Perils of Dwelling Forms FARMOWNERS’-RANCHOWNERS’ POLICY RISK MANAGEMENT—PERSONAL LINES Loss Control Loss Retention Claims-Settling Procedure Open-Perils versus Broad Named-Perils Coverage PERSONAL RISK MANAGEMENT KEY TERMS AND CONCEPTS Additional living expenses Bare wall doctrine Broad named perils Business pursuit Comprehensive personal liability (CPL) Concurrent causation Cost-to-repair basis Dwelling Dwelling policy Extended coverage (EC) Fair rental value Farmowners’-ranchowners’ policy Flood Guaranteed replacement cost Inboard watercraft Limited named perils Loss settlement clause

Medical payments to others Mobile home endorsement Other structures Outboard watercraft Pair-and-set clause Personal articles floater (PAF) Personal umbrella Residence premises Self-retained limit Underlying limit Unscheduled personal property

Chapter 16: Loss of Life

iii

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

Since she failed to meet the coinsurance requirement, she will receive (100,000/160,000) x 30,000 = $18,750.

The HO-2 insures real and personal property on a named-peril basis. The HO-3 insures real property on an all-risk basis and personal property on a named-peril basis. The HO-6 insures real and personal property on a named-peril basis but has no replacement cost coverage on the dwelling. a.

Covered, HO-3 is ―all-risk.‖ b.

Table covered. c.

All covered. d.

Covered, fire is the proximate cause of loss. e.

Vandalism covered.

Expenses Reductions Net Rent, $450 +$450 Utilities (included) –$100 –$100 Food, $300 –$200 +$100 Cleaning and Transportation, $150 –$50 +$100 $550 per month ×5 months Recovery $2,750 He is covered because his child is less than 13 years old. A 15-year-old child would not be covered for intentional loss.

Yes, the CPL will pay the claim because it insures business activities that are incidental to non-business pursuits. a. The child is an insured under the CPL by virtue of being in the named insured’s family.

The claim would be defended, whether the parents or the child were sued, as long as the suit involves a peril covered by the policy. b. The CPL would cover the parents unless by some construction it were determined that the parents directed the child to perform the assault. In such a case, the event would not be fortuitous. c. If both hunters had a CPL, each policy would respond. d. The insured is covered if a separate policy is written for the beach house; otherwise, this claim would be excluded. e. The insured is covered. Animals are not excluded. f. This would appear to be property damage for which the insured is liable; there might be a question of ―intentional‖ here, but the insurer would probably pay.

Take an inventory of all assets and identify liability exposures. Retain low value loss exposures and insure those you cannot avoid.

Personal articles floater, replacement cost coverage for personal property, high theft limits for silverware.

Determine the value of the car and make a decision whether to insure or self-insure for property loss to the vehicle. May buy loss other than collision insurance but not collision.

Purchase basic liability limits and attach a personal umbrella for large loss coverage.

Persons with the potential for large losses and assets that need the protection from those losses. Umbrellas provide protection for catastrophic losses and those not covered by the basic liability policy.

Chapter 16: Loss of Life

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12.

13.

14.

15.

16.

17.

18.

Advantages: (1) secure broad protection at lower cost than if separate coverages were purchased, (2) better service, and (3) easier to get ―hard-to-obtain‖ coverage. Possible disadvantages: (1) much higher cost and (2) necessity of buying some coverages that would not normally be purchased if available separately.

Yes, he should worry. The insurance company will subrogate against him. Ms. Valdez cannot collect from the insurer unless she gives her rights of subrogation to the insurer.

Cases similar to this have occurred with the decision being that if a loss is a progressive type, continuous in nature, the first payment did not discharge the insurer’s obligations since the total loss had not been incurred.

He can collect if he is considered a resident relative in his mother’s household. The Florida District Court of Appeals, First District Case NO-0-437 (Becklin v The Travelers Indemnity Company) ruled that he was a resident of his mother’s household.

One should not raise the deductible unless an attractive rate reduction is given. Often a deductible above $100 gives little reduction. However, in areas unprotected by a fire department and with no adequate water supply, high deductibles are a good selection.

To protect your future income. A fourth-year medical student might have a negative net worth but a high future income.

Higher limits on insurance to cover cash in the home could be purchased, lower auto deductibles, higher life insurance limits, insurance to cover nonowned PCs, towing and labor coverage for an automobile.

SUPPLEMENTARY QUESTIONS 1.

Why is earthquake insurance difficult to sell?

While the severity is large, the frequency is low. Given the low frequency, few people choose to purchase it.

2.

What are the advantages of ―open-perils‖ coverage versus ―broad form named peril‖?

The burden of proof of loss is on the insurance company. The insured must prove only that the loss was accidental.

CHAPTER 16 Loss of Life TYPES OF LIFE INSURANCE Term Insurance Duration of Term Coverage Coverage Options and Guarantees Face Amount Variability Whole Life Insurance Universal Life Insurance Other Types of Life Insurance Variable Life Variable Universal Life Modified Life Endowment Industrial Life Credit Life INCOME TAX TREATMENT OF LIFE INSURANCE Premiums Death Benefits Cash Values

Chapter 16: Loss of Life

v

LIFE INSURANCE CONTRACT PROVISIONS Incontestability Clause Suicide Clause Misstatement of Age or Sex Entire Contract Clause Assignments Dividend Options Cash or Payment of Premium Accumulation at Interest Paid-Up Additions One-Year Term Option Nonforfeiture Options Cash Value Option Paid-Up Insurance Option Extended-Term Option Policy Loans Beneficiary Designation Excluded Causes of Death Settlement Options Lump-Sum Option Fixed-Period Option Fixed-Amount Option Interest Option Life Income Options Coverage Extension Options Waiver of Premium Benefit Accidental Death Benefit Accelerated Death Benefit Spendthrift Trust Clause Grace Period and Reinstatement Clauses KEY TERMS AND CONCEPTS Accelerated death benefit Accidental death benefit Assign Automatic premium loan provision Aviation hazard exclusion Beneficiary Cash value Cash value option Common disaster clause Contingent beneficiaries Convertible Cost-of-living rider Credit life insurance Debit insurance Decreasing term Endowment insurance Entire contract clause

Extended-term option Face amount Fixed-amount option Fixed-period option Grace period clause Guaranteed insurability rider Home service life Incontestability clause Increasing term Industrial life Inside buildup Interest option Irrevocable beneficiary Level term Life insurance Limited-pay life Living benefit option Long-term care rider

Lump-sum option Misstatement-of-age clause Misstatement-of-sex clause Modified endowment contracts Modified life Nonforfeiture options One-year term option Paid-up additions option Paid-up insurance option Participating Reinstatement clause Renewable term Revocable beneficiary Settlement options Seven-pay test Single-premium life Spendthrift trust clause

6 Straight life Straight term Suicide clause Ten-year certain period Term insurance Twenty-pay life Type A universal life Type B universal life Universal life Variable life insurance Variable universal life Waiver of premium benefit War hazard exclusion Whole life insurance

Chapter 16: Loss of Life

Chapter 17: Loss of Health

iii

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

4.

5.

6.

7.

8.

9.

The three major types of life insurance sold are term, whole life, and universal. Term insurance is designed to provide protection if an insured dies within a stated period of time.

Whole life insurance is designed to be kept in force throughout the life of the insured and includes a cash value element. Universal life insurance is similar to whole life in that it is designed to be kept in force throughout the life of the insured and includes a cash value element, but universal life also includes flexibility in the amount of the premiums paid and sometimes in the amount of the death benefits.

Renewable term is a type of term insurance that guarantees renewability without regard to the health of the insured. This form of insurance can be desirable for an individual who needs a large amount of coverage over a period of several years because a large face amount is relatively inexpensive when compared to other forms of insurance. Another important feature is its renewability. The insured can renew the policy at the end of each policy period until the need no longer exists for the coverage.

Convertible term insurance can be converted at the policyholder’s option into a permanent form of coverage. This form of insurance may be desirable for a person who has a need for a large amount of insurance now and is concerned that his or her health may decline in the future. In this case, the individual could purchase a large amount of coverage at a relatively low price but retain the option to convert the policy to a more permanent form at a later time.

Level term is a form of term insurance in which the face amount does not change over time.

The cash value is a savings element contained in some forms of life insurance contracts. It is composed of a portion of each premium payment and the investment earnings on these funds.

Cash values are refunded to the insured if the policy is terminated prior to death. The insured can generally borrow an amount equal to the cash value from the insurer. a. People who experience health problems that might prevent them from obtaining other insurance at a comparable price are more likely to renew their policies. b. People who experience health problems that might prevent them from obtaining other insurance at a comparable price are more likely to exercise their right to increase the amount of coverage. c. People who experience health problems that might prevent them from obtaining other insurance at a comparable price are more likely to exercise their right to increase the amount of coverage using a term policy with a cost-of-living rider.

Type A universal life has a level death benefit throughout the time that the policy is in force.

A Type B policy has a fluctuating death benefit, made up of a specified amount of death protection plus the policy’s cash value. a. A revocable beneficiary can be changed by the policy owner. b. An irrevocable beneficiary can only be changed with the consent of the beneficiary. c. A contingent beneficiary will only receive the death benefits if the primary beneficiary is not alive at the death of the insured. d. A common disaster clause specifies that the proceeds will be held by the insurer for a stated period of time and then paid to the primary beneficiary if that person is still alive.

If the primary beneficiary is not alive, the benefits are paid to the contingent beneficiary. a. The lump-sum option results in the insurer paying the entire amount of the death benefits all at once. b. The fixed-period option results in the insurer paying the proceeds in equal installments over a specified time period.

Chapter 17: Loss of Health

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10.

11.

12.

13.

14.

15.

16.

17.

c. The fixed-amount option results in the payment of a specified amount over a period of time that is determined by the size and frequency of the payments as well as the interest rate paid by the insurer. d. The interest option results in the payment of only the interest earned on the policy proceeds. The beneficiary usually has the right to withdraw all or part of the principal amount. e. Life income options are variations of settlement options that guarantee a beneficiary an income for his or her remaining lifetime.

A reinstatement clause gives the insured the right to be reinstated within a specified period after a policy has lapsed, after providing proof of insurability. A grace period clause gives the insured an extra 30 days of coverage before a lapse occurs, in which to pay a premium that is due. An insured may prefer to use a reinstatement clause because the provisions of the old policy may be more favorable than those available in a new policy. A decline in health or the expiration of the reinstatement period would preclude an insured from reinstating a policy.

The insured is not under obligation to repay the loan, but interest is charged on the loan. If the insured dies before the loan is repaid, then the loan balance (including interest) is deducted from the death benefits paid to the beneficiary.

An individual is generally not allowed to deduct premium payments when made. As a general rule, death benefits are not subject to income taxation. However, a portion of each distribution may be subject to income taxation if paid under a settlement option other than the lump-sum option.

A policy’s inside buildup may be subject to taxation if the policy does not meet the Internal Revenue Code’s definition of insurance. Contracts that are judged to be primarily investment vehicles and contain only a nominal death benefit are subject to income taxation on the increases in cash value as they occur. This treatment is given to prevent abuse by investors who might be tempted to add a nominal amount of insurance to an investment contract in order to get the favorable tax treatment given to insurance contracts.

Whole life insurance can be used to fund either one of these goals, but is not appropriate to fund both of them simultaneously. To access the cash value at retirement, the insured would need to terminate the insurance coverage or borrow the funds. Borrowing the funds would obligate the insured to pay interest and would reduce the amount of the death benefit if not repaid.

The suicide clause would exclude coverage for a death resulting from suicide if the suicide occurred within a stated period of time. This peril is not excluded altogether because suicide can result from a mental illness that is unforeseeable to the insured at the time the insurance is purchased. It is unlikely that a suicidal person would still desire to end his or her life after a two-year waiting period. The answers to whether this coverage should apply to voluntary refusal of life support may vary, but the consensus is that it should not apply.

The insurer would probably contest the claim with an argument that a valid contract was not formed because of the fraudulent allegations of the insured. If the incontestability clause and misstatement-of-age or -sex clauses were upheld, this may be seen as fair because the insurer knew that it had a limited time in which to investigate the truthfulness of the information on the application.

If Mr. Brown is a shrewd investor the best option for him would probably be the lump-sum distribution. With his investment skills he could probably obtain a better rate of return than the typically conservative returns offered by insurance companies. If he had been diagnosed with Alzheimer’s disease, it may be better for him to elect the life income option or another settlement option that would provide a reliable cash flow.

SUPPLEMENTARY QUESTIONS

Chapter 17: Loss of Health

1.

2.

3.

4.

v

If the primary beneficiary of an insured policy dies prior to the death of the insured and no contingent beneficiary has been named, should the insurer be allowed to keep the death benefits? If not, to whom do you feel the proceeds should be paid?

In this situation, the insurer would not be allowed to keep the death proceeds. The death benefit would be paid to the estate of the insured and would be used to pay administration expenses and debts of the insured, with the remainder distributed to the beneficiaries named in the insured’s will. If there is not a valid will then the remainder would be given to the heirs.

Decreasing term insurance is often used to provide funds to pay off the remaining balance of an installment debt. Why is this form of insurance particularly suited for this purpose?

Decreasing term insurance can be structured to allow the death benefit to decrease with the decreasing balance of the installment debt. This feature will allow the insured to purchase only the amount needed for this purpose, which should help reduce the premiums required for the coverage.

Pure insurance involves pooling similar loss exposures so that the law of large numbers operates to reduce the overall risk because the aggregate loss is more predictable than individual losses. Based on this fact, which of the main types of life insurance can be termed as ―pure insurance‖? Why? Term insurance is pure insurance because this type of insurance involves only the pooling of similar loss exposures to reduce risk. The other types of life insurance mix the pure insurance protection with savings and investment features.

In your opinion, why are accidental death benefits relatively inexpensive? Why would someone purchase this option?

Accidental death benefits are relatively inexpensive because of the low probability that a person’s death will result from an accident. There seems to be very little reason for a person to purchase this type of insurance from a need-based financial planning view because the financial needs of the surviving dependents will be relatively unaffected by the cause of death of the insured. There may be some psychological advantage involved with the chance that a larger death benefit will be passed to the beneficiaries.

CHAPTER 17 Loss of Health HEALTH INSURANCE PROVIDERS Insurers and the Blues Health Maintenance Organizations Point-of-Service Plans Preferred Provider Organizations Medicaid and Medicare MECHANICS OF COST SHARING Deductibles Copays Coinsurance Caps Maximum Limits HEALTH EXPENSE INSURANCE Hospital Insurance Surgical Insurance Regular Medical Expense Insurance Major Medical Insurance Dental Insurance

Chapter 17: Loss of Health

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Long-Term Care Insurance Medicare Other Health Expense Insurance DISABILITY INCOME INSURANCE Benefit Duration Definition of Disability Elimination Period Benefit Level HEALTH INSURANCE POLICY PROVISIONS Continuation Provisions Mandatory Provisions Grace Period and Reinstatement Claims Miscellaneous Optional Provisions Occupation Misstatement of Age Other Insurance Miscellaneous HEALTH CARE REFORM Guaranteed Access to Health Care Health Savings Accounts Minimum Required Benefits

Patient’s Bill of Rights Direct Access to Specialists Definition of an Emergency Liability Provisions Other Proposed Restrictions Any Willing Provider Laws Anti-Gag Provisions

KEY TERMS AND CONCEPTS Activities of daily living (ADLs) Ancillary charges Any occupation for which reasonably suited Any willing provider (AWP) laws Basic health insurance policies Blue Cross and Blue Shield associations Cancellable

Capitation basis Coinsurance cap Comprehensive Conditionally renewable Continuation provisions Copay Dental insurance Disability income insurance Elimination period Excess major medical Fee-per-service basis Gatekeepers

Group practice HMO Guaranteed renewable Health maintenance organizations (HMOs) Hospice Hospital insurance Individual practice HMO Internal maximums Lifetime maximum Long-term care (LTC) insurance

Chapter 17: Loss of Health Long-term disability (LTD) insurance Major medical insurance Medicaid Health Savings Accounts (HSAs) Medicare Medigap insurance Noncancellable Nonscheduled basis Open-ended HMO Optionally renewable Out-of-pocket cap Own occupation Per-cause deductible Point-of-service (POS) plan Preferred provider organizations (PPOs) Primary care physician Reasonable and customary Regular medical expense insurance Residual disability Scheduled basis Short-term disability (STD) insurance Staff model HMO State mandated coverages Supplementary medical insurance Surgical insurance Term contract

7

Chapter 18: Retirement Planning and Annuities

iii

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

4.

5.

6.

7.

8.

The types of health insurance providers are commercial insurers, Blue Cross and Blue Shield associations (the Blues), health maintenance organizations (HMOs), point-of-service (POS) plans, and preferred provider organizations (PPOs). The Blues are independent groups established by health care service providers set up to prepay some types of health care expenses. HMOs are programs in which the members, who live within a well-defined geographical area, are provided with comprehensive health services by physicians associated with the HMO. A POS plan is similar to an HMO, but allows more freedom in the selection of doctors and other medical care providers. A PPO is an organization in which the health care providers agree to give a discount from their usual fees in exchange for promises from the participating employers. a. In a group practice HMO, a large group of physicians share facilities and support personnel and work out of one or a few locations. The physicians are not employees of the HMO, but have a contractual relationship with it. b. A staff model HMO also operates out of one or a few locations, but the doctors are employees and are paid a salary by the HMO. c. An individual practice HMO does not operate out of a centralized location; instead, the physicians operate out of their own offices.

A POS (point-of-service) plan is similar to an HMO except individuals are given the choice to use a medical care provider outside of the system if they pay for a larger share of their medical bills.

The sponsoring organization might promise to provide a minimum number of patients each month, pay promptly, and encourage participants to take advantage of health education programs. a. $0 (Smith has not yet met the deductible). b. $100 (After meeting the $1,000 deductible, the insurer will pay 80 percent of the remainder). c. $2,200 (80 percent of $2,750). d. $2,480 (80 percent of $3,100). e. $38,695 ($42,500 less the remaining coinsurance amount). a. $400 (80 percent of the quantity $750 – $250). b. $100 (80 percent of the quantity $375 – $250). c. $2,200 (80 percent of $2,750). d. $2,480 (80 percent of $3,100). e. $39,295 ($42,500 – $5,000 cap + $1,795 already paid by John this year).

Insurers determine ―reasonable and customary‖ fees by analyzing the range of fees prevailing in the relevant geographical area at the time that the surgery is performed. Fees in excess of those charged by others in the region will be found to be more than the reasonable and customary amount.

Surgical policies written on a scheduled basis contain a listing of several surgical procedures together with a maximum payable for each procedure. Those written on a nonscheduled basis cover insured procedures up to the full amount of what is considered to be reasonable and customary. Generally, it is better for the insured to have a policy written on a nonscheduled basis.

A comprehensive form of a major medical policy is designed to replace basic health coverage and to insure all medical expenses within the same policy.

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The important points that should be considered are: whether the spouse of the named insured is also covered, the conditions necessary to trigger benefit payments, whether the daily maximum and the overall policy limit will increase over time, whether the overall limits can be restored and under what conditions, selection of an elimination period, whether the plan covers custodial care as well as skilled and intermediate nursing home care, whether losses related to Alzheimer’s disease are excluded, and whether hospitalization immediately prior to entering a long-term care facility is required.

Part A of Medicare is the hospital insurance that covers inpatient hospital care, skilled nursing home care, home health services, and hospice care. Part B is referred to as the supplementary medical insurance that covers doctors’ bills and related expenses. Medigap insurance provides coverage for medical care that is not covered by Medicare because of deductibles, coinsurance, and coverage limitations. Under Medicare reform legislation passed in 2003, optional prescription drug coverage for Medicare beneficiaries will be available beginning in 2006. The monthly premium for the prescription drug coverage will initially be about $35.

The plan will have a $250 deductible. After that, the beneficiary will pay 25 percent of the cost for drug costs up to $2,250. The beneficiary is then responsible for all drug costs between $2,250 and $3,600. For drug costs exceeding $3,600, the beneficiary will pay 5 percent of costs or a modest copayment.

Disability income insurance can be distinguished from other forms of health insurance because, rather than covering specified medical or other health expenses, disability income insurance provides periodic income payments to the insured while the insured is unable to work as a result of sickness or injury.

The ―own occupation‖ definition is the most liberal definition of disability. It provides that the insured will be considered disabled if unable to perform the major duties of his or her own occupation. The ―any occupation for which reasonably suited‖ definition of disability will result in a finding that the insured is disabled only if unable to perform the major duties of any occupation for which he or she is reasonably suited through education, training, or experience. a. A term contract expires at the end of a certain period of time and cannot be renewed.

These policies are generally used to cover exposures for special events or trips. b. A cancellable contract involves the insurer retaining the right to cancel a health policy at any time and for any reason. c. An optionally renewable policy is a contract in which the insurer retains the right to choose not to renew the policy or to increase the premiums on the policy anniversary dates, but the coverage and premiums cannot be changed between anniversary dates. The insurer has no restrictions placed on it regarding the level of increase in premiums or the conditions under which renewal can be refused. d. A guaranteed renewable contract provides that termination of coverage is prohibited prior to a specified age as long as the premiums are paid when due. Premiums can be increased only if the premiums are increased for an entire class of insureds. e. A noncancellable contract also provides that termination of coverage is prohibited prior to a specified age as long as the premiums are paid when due. The premiums are fixed in advance and cannot be increased during the life of the contract.

A grace period clause provides that coverage stays in force for a specified length of time after an unpaid premium is due. If the payment is not made before the end of the grace period, the policy lapses. A reinstatement clause provides that a lapsed policy may be renewed under certain conditions, but the insurer is not required to reinstate a lapsed policy. b. When an illness or accidental injury occurs, the insured generally must notify the insurer within a specified time. The insurer then has a period of time in which it must provide claims forms to the insured. After the insurer receives all of the information to support a claim, it is allowed a reasonable period of time in which to check the validity of the claim.

After an investigation period, the covered expenses must be paid immediately.

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c. Losses incurred while committing a felony or engaged in an illegal occupation are typically excluded from coverage. If an insured switches to a more hazardous occupation after the inception of the policy, the insurer is generally allowed to lower the benefits to the level that the premiums would have purchased for a person engaged in the new occupation. d. A misstatement-of-age clause provides that if age is misstated then the benefits can be adjusted to the level that the premiums would have purchased had the true age been reported. e. An other insurance clause provides that benefits will be reduced to a specified level if the insured had other insurance that covered the same loss. Generally, this clause would not apply to group insurance provided by an employer, medical payments from automobile insurance, or workers’ compensation benefits.

The basic idea behind HSAs is that people will be more careful consumers of health care if they are paying for much of their care with their own money, rather than relying on insurance to pay for most health care costs. To be eligible for an HSA, a person must be covered under a high deductible health plan, defined as a plan with a deductible of at least $1,000 for individual coverage or at least $2,000 for family coverage. The individual or his or her employer then has the ability to make an annual contribution to an HSA up to the amount of the deductible. All contributions to the HSA are tax-deductible (or not included in income if paid by the employer), and distributions from the HSA are tax-free as long as they are used to pay for qualified medical expenses. Unused HSA balances can roll over from year to year and invested, potentially accumulating a substantial ―health care nest egg‖ over time.

Proponents of Health Savings Accounts argue that HSAs will introduce a new element of consumerism into the health care market and thus reduce moral hazard. HSA supporters feel that HSAs will introduce stronger market forces into the health care arena that will result in reduced health care cost increases. Opponents of HSAs argue that these plans are only beneficial to the healthy and wealthy, and will result in adverse selection. HSA opponents also argue that people with HSAs may consume too little health care, leading to poor health and ultimately higher health care costs.

The insurer is concerned with the moral hazard created by allowing an injured worker the ability to collect 100 percent of prior income. The insurer would rather have a lower percentage in order to encourage the worker to recover from the disability and return to work.

The insured also might not want to insure 100 percent of income because some expenses might be reduced by the fact that the worker is disabled. Therefore, the additional premiums involved in insuring 100 percent of income may be an unnecessary expense. A worker may not have to spend as much on such expenses as transportation, entertainment, or work-related clothing.

Elizabeth could probably afford to retain such health exposures as dental, prescription drug, and vision care expenses. She could also probably afford a relatively high deductible and coinsurance cap. These exposures could be retained because they have a low level of severity and a relatively high level of frequency associated with them. Some insurance coverages that Elizabeth should strongly consider include health care coverage (a comprehensive major medical policy would probably be suitable) and disability insurance. These exposures are particularly suited to transfer to an insurer because they have a high potential severity.

Edward should consider selecting the own occupation definition of disability. An injury that would prevent his continuation of his present occupation would not necessarily preclude his working at another occupation for which he is particularly suited through education, training, or experience. In fact, if he selected the any occupation for which he is reasonably suited definition, he would probably not be entitled to any benefits at all for certain injuries because he can probably make more money at a less physically demanding job.

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Carl could reduce the coverage purchased in any of the following ways in order to reduce the premiums: a shorter benefit period could be selected, such as until he will be eligible for Social Security; the ―any occupation for which reasonably suited‖ definition of disability could be chosen; a longer elimination period could be used; a lower percentage of prior earnings benefit level could be chosen; or the cost-of-living adjustments could be dropped.

Answers will vary. In general, recent reforms tend to decrease the rights of health networks to restrict access and patient choice. Most students will probably welcome such changes, though it is possible that the changes will also lead to greater costs and reduced availability as employers drop coverage. Because of the highly changing and personal nature of health care delivery today, there are as many opinions about why a certain change should be made as there are opinions of what needs to be changed.

SUPPLEMENTARY QUESTIONS 1.

Identify the advantages to a physician who participates in a PPO. What are some disadvantages that physicians must endure to participate in a PPO? Physicians are generally promised one or more of the following benefits: a guarantee of a minimum number of patients each month, a promise of prompt payment, and employers’ promises to take steps to encourage employees to take advantage of health education programs designed to reduce health care expenses. These promises can help physicians build a profitable practice. The primary disadvantage of participating is the required fee reduction.

This disadvantage may make participation unappealing to physicians with busy and profitable practices.

2.

Would you agree with the assertion that persons with medical expense insurance are generally more healthy than comparable persons without health insurance? Suggest some reasons why this statement might be true.

At least one study has concluded that persons with medical insurance tend to be more healthy than those without coverage. Possible reasons for this phenomenon are (1) uninsured people may be less likely to seek health care until the need becomes critical and (2) diagnostic tests may be less likely to be performed on uninsured persons.

3.

If you were an insurer, would you agree to provide a short-term disability policy that provides disability benefits of 150 percent of previous earnings? What problems could arise from doing so? Some people might want extra coverage to help offset the medical bills that often accompany a disability. What advice might you give to them?

The answer to this question should probably be no, although an affirmative answer could be justified by charging a very high premium. The primary problem with this practice would relate to the moral hazard that might result from financially rewarding workers for being disabled. Workers would have a financial incentive to delay their recovery. If a person is worried about the extra expenses from medical fees, a health insurance policy should be purchased to supplement the disability coverage.

4.

If you could only purchase either short-term disability or long-term disability insurance, which would you purchase? Why? The most easily justifiable answer would be a long-term policy. A long-term disability can drastically affect the long-term living standards of a person, whereas it may be possible to recover from a short-term income loss. The long-term policy’s elimination period could be reduced to the point where it also covers longer short-term disabilities.

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Chapter 18: Retirement Planning and Annuities

STRUCTURE OF ANNUITIES ANNUITY CHARACTERISTICS How Are Annuity Premiums Paid?

When Do Benefits Begin?

How Long Are Benefits Payable?

Annuity Certain Straight Life Annuity Joint and Survivor Annuity Period-Certain Guarantees Refund Guarantees Temporary Life Annuity Is the Contract Fixed or Variable?

ANNUITY TAXATION Taxation of Annuity Benefits Tax Issues before Benefits Begin

KEY TERMS AND CONCEPTS Accumulation units Annual-premium annuity Annuitant Annuity Annuity certain Annuity units Cash refund guarantee Deferred annuity Exclusion ratio Fixed annuity Flexible-premium annuity Immediate annuity Installment refund guarantee Joint and survivor annuity Joint and X percent survivor annuity Market value–adjusted (MVA) annuity Modified guaranteed annuity Single-premium annuity Straight life annuity Survivorship benefit Temporary life annuity Ten-year period-certain life annuity Variable annuity

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

An annuity is a contract that provides for the liquidation of a sum of money through a series of payments over a specified period of time. Three situations in which an annuity might represent an appropriate personal risk management tool are: (1) a retiring couple may want to ensure a certain level of income throughout the retirement years, (2) a single parent might die leaving a substantial life insurance settlement to support very young children until they are able to take care of themselves, or (3) a newly widowed individual may need to periodically withdraw an amount of savings to maintain the standard of living previously enjoyed.

2.

The three elements that may make up a payment to an annuitant are interest earnings, partial liquidation of principal, and, sometimes, a survivorship benefit.

3.

The risk of living beyond one’s financial resources involves the risk that individuals may live to advanced ages and use up their financial assets while the need for them still exists.

4.

The survivorship benefit is the portion of an annuity payment that is attributable to the release of funds from the other annuitants who have already died.

5. a. A single-premium annuity is paid for all at once. b. A flexible-premium annuity allows considerable latitude regarding the timing and amount of premiums. c. An annuity certain is payable for a specified period of time, without regard to the life or death of the annuitant. d. A straight life annuity pays benefits only during the life of the annuitant. e. A joint and survivor annuity is an annuity issued on more than one life that pays as long as either annuitant is alive. f. A market value–adjusted annuity is a fixed deferred annuity with an option to provide a higher minimum interest rate guarantee during the first few years after the contract is issued but before benefits begin. g. A variable annuity’s benefits are expressed in terms of annuity units. The value of an annuity unit fluctuates with the performance of a specified portfolio of investments that causes the annuity income to fluctuate as well.

6. a. A period-certain guarantee ensures the annuitant of a lifelong income and also guarantees that a minimum number of payments will be made regardless of the timing of the annuitant’s death. b. An installment refund guarantee ensures the annuitant that at least the purchase price will be paid out in benefits, regardless of the time of the annuitant’s death. If the annuitant dies before the purchase price has been paid out in benefits, then the regular installments continue to be paid until the difference has been paid. c. A cash refund guarantee ensures the annuitant that at least the purchase price will be paid out in benefits regardless of the time of the annuitant’s death. If the annuitant dies before the purchase price has been paid out in benefits, then the difference is paid in a single lump-sum distribution.

7.

A variable annuity is generally purchased with the intent of providing the annuitant with an income that fluctuates in dollar value but remains reasonably constant in terms of purchasing power.

8.

Each premium is used to purchase accumulation units that vary in price according to the performance of the investment portfolio. At the time that benefits are to be paid, the total accumulation units are converted by formula into annuity units. The benefit distributions will then fluctuate with the performance of the investment portfolio.

9.

Ben’s exclusion ratio is 0.33, calculated as: [$100,000 / ($15,000 × 20)]. Therefore, $10,000 of the distribution will be taxable [$15,000 – (0.33 × $15,000)].

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If an annuity dividend is received by an annuitant before any annuity benefits have been received, the dividend is treated as a return of principal and is not subject to income taxation.

However, if annuity benefit payments have already been received, then the amount of the dividend is added to the amount of the periodic benefit and taxed accordingly. a. The types of annuities that are particularly suited for Donna’s situation and purposes are a flexible-premium annuity, a deferred annuity, and a straight life annuity. A flexiblepremium annuity is appropriate because of Donna’s varying income. A deferred annuity is appropriate because she will not need the benefits until her retirement. A straight life annuity can ensure her of an income level throughout her retirement years. b. A single-premium annuity would be appropriate because George intends to purchase the annuity with his inheritance. A deferred annuity would allow George to begin collecting the benefits on his retirement. A joint and survivor annuity will allow his wife to be paid a percentage of the annuity benefits if he predeceases her. c. A single-premium annuity would allow the annuity to be purchased immediately with the distribution from Mary’s stock purchase plan. An immediate annuity would begin to pay the benefits immediately so that she can take her first annual vacation this year. A temporary life annuity would be ideal because she will need the $10,000 dollars per year over the next ten years unless she dies prior to the end of the ten-year period. A fixed annuity would allow Mary to be ensured of the fact that she will have the budgeted $10,000 each year. a. While annuities can be very valuable tools in avoiding many forms of investment risks, there are some risks that an annuity cannot be used to avoid. b. Some of the risks that may be avoided through the purchase of an annuity include the risk of living longer than an individual’s resources, interest rate risk, and certain investmentrelated risks. Several other risks can be reduced, but most are not avoided entirely. c. Risks that cannot be avoided through the purchase of an annuity include the risk that the issuer of the annuity will be financially unable to pay the benefits when due and inflation risk for fixed annuities. d. An annuity could be structured to have a rate of return that fluctuates with an inflation index such as the consumer price index, thereby eliminating inflation risk. However, it would be impossible to develop an annuity to entirely avoid the risk that the issuer would be financially unable to meet its obligations.

The main tax advantage of an annuity is the deferral of income taxation on the interest earned by the annuity until the distributions are made. This advantage might outweigh the disadvantage of a 10 percent penalty tax on distribution in some situations. The factors that should be considered when an annuity is purchased in this situation are whether the tax savings associated with deferral and the increased income accumulation resulting from the lack of recognition of income as it is earned are greater than the cost of the 10 percent of any distributions made prior to age 59.5.

Annuities can be seen as a form of tax shelter because the income that accumulates within the annuity is sheltered from taxation until distributed. A stock that does not pay dividends and increases in value would be treated similarly to an annuity for tax purposes. Since no dividends are paid it would not be necessary to recognize any income until the stock was sold.

However, no penalty tax would be due if the stock were sold prior to the shareholder’s attaining the age of 59.5 as would be the case if a distribution were made from an annuity.

Because annuities have qualities of both insurance and investments, opinions as to which they most closely resemble may vary. Arguments that could be made in support of the proposition that they more closely resemble insurance include the fact that a basic motivation for purchasing an annuity is an attempt to pool a risk with others facing similar uncertainty, that the rates of return may be guaranteed and therefore not as subject to traditional investmentrelated risks, and that the issuer uses mortality tables to predict the total of the benefits that

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will be paid out. Arguments for similarity to investments may include the fact that they are primarily purchased and marketed as a tax-sheltered means of saving for retirement and that they may have a variable yield that fluctuates with the return of traditional security portfolios.

The penalty tax on distributions made before the annuitant turns 59.5 discourages the use of annuities for many purposes other than retirement. The deferral of income taxation makes annuities an ideal long-term savings vehicle and many people anticipate being in a lower income tax bracket at retirement. The ability to get certain guarantees can reduce or eliminate risks that retirees are not comfortable retaining. By linking the payment period to a person’s lifetime, the risk of living longer than the retiree’s resources is reduced.

Answers may vary. One student may suggest that there should be a difference in annuity income on the basis of health, because health differences are similar to age differences.

Healthy annuitants would probably live longer than those in poor health, so there would be more monthly income to unhealthy rather than healthy annuitants.

SUPPLEMENTARY QUESTIONS 1.

If you were 62 years old, single, planning to retire in three years, and had $500,000 to invest, would you prefer an investment in 30-year certificates of deposit promising a 10 percent annual return or a straight life annuity with a monthly benefit of $5,000?

With these facts, most people would prefer the certificates of deposit (CDs). By the time of retirement, the investment in the CDs would be worth $615,963 (assuming a 28 percent tax rate) which would yield an annual income of $61,596 (or $5,133 monthly) without invading the principal. However, a few extremely risk averse retirees might prefer to purchase the annuity because it would guarantee the payments would last until the death of the annuitant.

There would be no guarantee that CD rates of return would remain at 10 percent at the expiration of the 30-year term.

2.

Why is the cost of a joint and survivor annuity higher than the cost of a single-life annuity with an equal benefit amount? Would you expect this to be true even if one annuitant’s age varied significantly from the other? For example, if an 89-year-old man and his 20-year-old granddaughter purchased a joint and 100 percent survivor annuity, would the premium still be higher than a single-life annuity on the 20-year-old granddaughter? How would you expect the cost differential between a joint and survivor annuity and a single-life annuity purchased by the younger annuitant to relate to the age disparity?

The benefit period is expected to be longer when paid until two people die than when only one life is used. Although in this drastic example the differential may be small, it will always be more costly to add the survivor benefit. The cost differential decreases as the age disparity increases.

3.

What do you see as the greatest advantage of annuities over other forms of investments?

The answers to this question may vary, but the most common answers should be either the annuity’s ability to guard against the risk of outliving a person’s income or the tax deferral of investment earnings.

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Chapter 19: Employee Benefits: Life and Health Benefits

REASONS FOR EMPLOYEE BENEFITS Employee Relations Tax Advantages PREMATURE DEATH BENEFITS Social Security Benefits Distinguishing Features of Group Insurance Underwriting Unit Is a Group Lower Expenses Experience Rating Group Life Insurance Eligibility for Benefits Contributory versus Noncontributory Plans Structure and Level of Death Benefit Type of Insurance Contractual Provisions HEALTH EXPENSE BENEFITS Eligibility Contributory versus Noncontributory Plans Providers of Coverage Choice of Physician Coverage and Exclusions Cost to the Employee Other Provisions Cost Containment Coordination of Benefits Pre-Existing Conditions Termination Rights DISABILITY INCOME BENEFITS Social Security Disability Income Benefits Sick Leave Plans Disability Income Plans Definition of Disability Elimination Periods Benefit Levels Contributory versus Noncontributory Plans

KEY TERMS AND CONCEPTS Consumer-driven health care Contributory Conversion clause

Coordination of benefits (COB) provisions Currently insured Dependent life

Earnings multiple approach Employee benefits Fully insured

Chapter 19: Employee Benefits: Life and Health Benefits Group accidental death and dismemberment (AD&D) Group ordinary Group term insurance Group universal life Job classification approach Long-term disability (LTD) income plans Managed care Medicare carve-out Noncontributory OASDI wage base Precertification Pre-existing condition Qualification rules Salary bracket approach Short-term disability (STD) income plans Sick leave plans Social Security Survivor income benefit insurance (SIBI) Underwriting Utilization review Wellness programs

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

4.

5.

6.

7.

8.

Two main reasons that employers provide employee benefits are to improve employee relations and to take advantage of the special income tax status granted to many benefit programs.

The four tax advantages are: (1) the employer can deduct the cost of the benefit from current taxable income, (2) the employees may not have to report the cost of the benefit as taxable income, (3) the employees may be able to avoid or defer taxation on the benefit payments, and (4) the employer may be able to prefund expenses in a manner in which interest earnings on these funds will be deferred or not taxable.

In group insurance the underwriting unit is a group instead of an individual. Group insurance typically has lower expenses associated with it because the sales commissions tend to be lower, individual selection is not required, and employers may handle some administrative tasks. Experience rating is generally used in group insurance but not in individual insurance.

The friend should be advised to consider the amount of the contribution versus the amount of benefit received, whether individual insurance is available at a lower rate, and the relevant tax considerations.

If a commercial insurer is chosen, the employee is more likely to have more freedom when choosing a physician, may have routine medical care excluded, will probably not have generous prescription drug coverage, will have some state-mandated benefits, and will probably be subject to deductibles and coinsurance amounts. If an HMO is chosen, the employee will be required to use HMO physicians unless there is an emergency while out of town, will generally have more routine care covered, will have more generous prescription drug coverage, will perhaps not have some state-mandated benefits, will have employer’s contributions subject to federal minimums in some circumstances, and will have minimal cost sharing in the form of deductibles and coinsurance. If a POS is chosen instead of a commercial insurer, the employee will have a choice whether to use a POS physician; will generally have more routine care covered; will have more generous prescription drug coverage; will perhaps not have some state-mandated benefits; and will have lower fees, deductibles, and coinsurance requirements when using a POS physician. If a PPO is chosen, the employee will have discretion when choosing whether to use a PPO physician; will perhaps not have some state-mandated benefits; and will have lower fees, deductibles, and coinsurance requirements when using a PPO physician.

Consumer-driven health care plans attempt to control costs by providing employees with incentives to keep costs down (via high deductibles) as well as information to help them make good, cost-effective health care decisions. Many people are interested in these plans because they like the idea of controlling their own health care and potentially building up substantial health care savings over time in a tax-advantaged manner. Others do not like the idea of being exposed to the risk paying a large deductible every year and prefer traditional health plans.

A pre-existing condition is a health problem that exists prior to the point when health expense coverage becomes effective. The Health Insurance Portability and Accountability Act of 1996 prohibits employers from using pre-existing conditions limitations of more than one year in length. In addition, employees must receive credit for time covered in previous health plans if it has not been more than 63 days since the previous coverage was in effect. a. Sick leave plans generally are designed to pay the full amount of an employee’s salary during periods of temporary disability. These plans are generally not funded with insurance but are typically commitments made by the employer. b. Salary continuation plans are identical to sick leave plans.

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c. Short-term disability income plans have maximum benefit periods of about two years. d. Long-term disability income plans have maximum benefit periods of longer than two years.

In 2000, workers and their employers each paid 6.2 percent on the first $76,200 (the OASDI wage base) of earned income for social security retirement, disability income, and survivors income benefits.

Answers to this question may vary. Arguments for giving the money spent on benefits in the form of a salary increase include greater flexibility and decreasing benefits given to employees without a particular need (such as group life insurance to an employee with no dependents).

Arguments in support of benefit plans include the reduced cost of group insurance plans, the benefits that accrue to employers from assuring more financially stable employees, and the tax benefits that accrue to most employee benefit plans.

Factors that should be considered include the following: whether nurses at other hospitals report to work sick and possibly endanger their patients who may be susceptible to infection, what impact a change in policy would have on the hospital’s ability to recruit highly qualified nurses, what impact a change in policy would have on employee morale, and whether a program could be instituted that would require the nurse to prove sickness before being compensated for the missed time.

The insurer incurs lower expenses when dealing with a group because lower commissions are paid, the employer may share some of the administrative tasks, and the insurer does not need to evaluate every member of the group on an individual basis. The employer typically pays a portion of the cost. The employer may have lower rates based on better than average experience ratings that are not available to individuals. It is typically easier to estimate the amount of the loss with a group of individuals than with one individual. Some situations in which individual insurance may be less expensive than the contribution required by an employer’s plan include an individual who is younger and in better health than the overall group; an employer that has bad past experience with health claims; an employer that pays very little of the cost of the plan; or an employee who is a member of another group, such as a professional or trade association, that provides lower rates to its members.

If Peg accepts the job offer, she should elect to be covered by the health plan offered by her employer. Since this coverage is offered at no cost to her, it would certainly be prudent to accept the coverage. The extent of the coverage offered by each employer and the amount of the contribution necessary to add Peg to Jim’s plan should be carefully examined before deciding whether or not Peg should also be covered under Jim’s plan. For the rest of the family members the factors to be considered include the types of providers of coverage involved in each plan; the extent of coverage offered by each plan, including the deductible and coinsurance amounts; the contribution costs of each plan; and the particular policy provisions.

SUPPLEMENTARY QUESTIONS 1.

The National Association of Insurance Commissioners (NAIC) has suggested rules pertaining to the coordination of benefits. These rules allow reimbursement of 100 percent of expenses that are covered by more than one policy. What problems can arise from this lack of cost sharing? What do you feel may have motivated the NAIC to recommend this rule which clearly conflicts with traditional insurance theory?

One of the goals of requiring cost sharing is to provide an incentive to the insured to reduce fees whenever possible. If an employee will be reimbursed for all incurred expenses, he or she may feel very little need to attempt to reduce costs or to assure that the medical fees charged are correct. The previous NAIC rules suggested that employees always have some

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2.

3.

4.

level of cost sharing even when covered by two policies. However, these rules were very unpopular with consumers who provided the pressure necessary to motivate the NAIC to abandon their previous position.

The suggested rules in question 1 also state that benefits from personal health insurance can be collected in addition to the benefits from employer provided insurance. This situation would enable employees to collect more than 100 percent of the incurred expenses. What problems can you see with this arrangement? If you were a personal insurance underwriter, what action might you take to avoid this problem?

The employee’s ability to collect more than 100 percent of expenses actually may provide them with a financial incentive to increase the cost of care. This would increase not only the morale hazard involved in the previous question but also the moral hazard. Personal insurance underwriters have been understandably hesitant to allow this to take place. Two methods of handling the problem that have developed are to refuse personal coverage for a person covered by an employer provided plan and to insert a clause within the personal insurance policy stating that the benefit from the personal policy will be reduced by the benefit collected from employer provided insurance.

If you were an insurer, how would you feel about providing health insurance to a person who already suffers from a pre-existing chronic illness? How does this situation compare with a fire insurer insuring a building known to be burning? How might the composition of the group being insured affect your willingness to cover pre-existing conditions?

Of course, insurers are very reluctant to offer health insurance to a person with a chronic illness for expenses related to that illness. Such coverage would be similar to a fire insurer insuring a building known to be burning. Underwriting considerations might include whether the coverage is noncontributory or requires only a nominal contribution, and whether the group consists of individuals who would have little ability to join the group for the purpose of obtaining the coverage. These considerations reduce the level of adverse selection involved.

When determining how much cost sharing the employer provided health expense insurance should provide, what factors should the employer consider?

Some of the relevant considerations are that (1) the cost of the benefits increases as cost sharing declines, (2) the claims experience should be more favorable if there is more cost sharing because it adds incentives to the employee to reduce costs, (3) employee relations may be harmed by a high amount of cost sharing, and (4) the benefits provided to employees will have higher value to them with less cost sharing.

CHAPTER 20 Employee Benefits: Retirement Plans SOCIAL SECURITY RETIREMENT BENEFITS Relationship of Work History to Benefit Amount Benefits Payable to Retired Workers Benefits Payable to Spouses and Children Taxation of Benefits PENSION PLANS Traditional Defined Benefit Pension Defined Contribution Pension Cash Balance Pension PLAN QUALIFICATION Eligibility Retirement Ages Form of Payment

Chapter 20: Employee Benefits: Retirement Plans

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Other Plan Design Factors Benefit and Contribution Limits Inflation Protection Permitted Disparity Vesting Disability Provisions Pension Funding Plan Termination Insurance DEFERRED PROFIT-SHARING PLANS EMPLOYEE SAVINGS PLANS Thrift Plans Section 401(k) Plans INDIVIDUAL RETIREMENT ACCOUNTS Traditional IRA Roth IRA Rollover IRA SIMPLE PLANS KEOGH PLANS SECTION 403(b) PLANS

KEY TERMS AND CONCEPTS Actuarial cost assumptions Actuarial cost methods Allocated plans Average indexed monthly earnings (AIME) Cash balance pension plans Deferred profit-sharing plans

Defined benefit plan Defined contribution pension Early retirement Elective deferrals Employee Retirement Income Security Act (ERISA)

Employee savings plans Employee stock ownership plans (ESOPs) Five-year cliff vesting 401(k) plan Full actuarial equivalent Graded seven-year vesting

Individual retirement account (IRA) Insured pension plans Keogh plans Late retirement Lump-sum distribution option Mandatory retirement age Normal retirement age Pension Benefit Guarantee Corporation (PBGC) Pension plan Permitted disparity Plan termination insurance Premature distribution penalty Primary insurance amount (PIA) Qualified plans Retirement test Rollover Roth IRA Savings incentive match plan for employees (SIMPLE) Section 403(b) plans

Social Security normal retirement age Stock bonus plans Thrift plan Trust fund plans Unallocated plans Vesting

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

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The factors are the age of the individual who elects to receive benefits, the number of years the individual worked in employment subject to Social Security taxes, the wages earned in such employment, and the amount of earned income in the year Social Security benefits are paid.

Benefits change based on either months late or months early, relative to the normal retirement age. There is an actuarial reduction of 5/9 of 1 percent for each of the first 36 months that a worker retires early, plus an additional 5/12 of 1 percent for each additional month early. For workers who delay the start of benefits until after the social security normal retirement age, benefits are increased by 6.5 percentage points per year for those who reached age 62 in 2000.

This figure is scheduled to increase by 0.5 percentage point every two years until it reaches 8 percent.

Retirees who are not yet age 65 can earn up to the annual limit ($10,080 per year as of 2000) without penalty. For earnings over the limit, the penalty is a reduction in benefits of $1 for every $2 in wages. At age 65, retirees may earn an unlimited amount of income and still collect full Social Security retirement benefits.

A traditional defined benefit plan uses a formula to compute the monthly benefit payment at retirement. A defined contribution plan specifies the amount that the employer will contribute to the plan, and the exact amount of retirement benefit that will be paid is left undetermined until each employee retires. A cash balance plan is technically a defined benefit plan because the employer retains the investment risk. But a cash balance plan is designed to look like a defined contribution plan by reporting individual account balances for employees rather than a benefit formula.

Qualification depends on whether or not the plan meets minimum requirements set out in the Internal Revenue Code. Qualified retirement plans are subject to preferential tax treatment, in that employers can deduct contributions from current taxable income in the year in which they are made, taxation of investment earnings is deferred until retirement, and employees do not report income from the plan until distribution.

Permitted disparity allows an employer to make high contributions for employees who have an income level above the Social Security wage base. The reasoning behind this is to offset the higher percentage of a lower paid worker’s salary that an employer contributes to Social Security for the benefit of that worker. Vesting is the degree to which a plan participant’s pension rights are nonforfeitable, regardless of whether the employee continues working for the employer. Both of these are important for employees because they help to determine the benefits to which the employee is legally entitled.

For an allocated plan, each dollar that an employer contributes is associated with a particular worker. With unallocated plans, the funds are kept in trust for the employees as a group.

The maximum annual contribution is $2,000. Contributions to traditional IRA plans are fully or partially tax deductible when made unless the owner earns more than a specified income and is a participant in a qualified retirement plan sponsored by his or her employer. (See Table 20-3 for the specific amounts that are deductible at various income levels for active participants in an employer sponsored plan.) Contributions to Roth IRAs are never tax deductible.

In general, public schools, universities, and nonprofit organizations operated exclusively for religious, scientific, charitable, literary, educational, cruelty prevention, or public safety testing purposes are eligible to establish Section 403(b) plans.

Chapter 22: Risk Management and the Insurance Industry

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A 401(k) plan is very similar to a thrift plan in that both types of plans may involve an employer matching a percentage of each employee’s contributions, as well as deferral of income taxes on the investment earnings prior to distribution. However, 401(k) plans involved the additional tax advantage of allowing employees to deduct the amount of their contributions in the year that they are made. A 401(k) plan also involves extra qualification rules, a limit on the maximum deductible employee contribution, and more restrictions on the distribution of past elective deferrals.

By exercising a lump-sum distribution option, an employee gives up the lifetime income guarantee that is associated with an annuity distribution. This results in the possibility that the employee may outlive his or her income. In addition, the employee incurs the risks that are involved with investments. However, the employee who receives a lump-sum distribution has the advantage of flexibility. The tax consequences should also be considered.

A SIMPLE can be set up as either a 401(k) plan or through the use of individual IRAs. The most likely uses will be for small employers eager to avoid some of the administrative rules that would otherwise apply. For example, a SIMPLE 401(k) plan is exempt from nondiscrimination testing, in exchange for a requirement that the first 3 percent of all employee contributions will be matched by the employer. The SIMPLE 401(k) is not as attractive to highly-paid employees, however, because of the lower limit on elective deferrals, compared to the the limit for regular 401(k) plans.

A Keogh plan is a retirement savings plan designed for use by those who have selfemployment income. The contributions made to the plan and the investment returns are not subject to current income taxation but are taxed on distribution.

This argument refers to the text discussion that if no conditions were attached to the right of receiving benefits, the cost of social insurance would rise greatly and some would be paid when benefits were not really needed and others would receive less than they otherwise would. If OASDHI were operated on this basis, for example, the cost would approach that of privately sold annuities, a prohibitive cost for many lower-paid workers. This argument was successfully applied, however, when the retirement test was eliminated in 2000 for those 65 and older. Prior to 2000, the retirement test applied to all persons under age 70.

Young workers should seriously consider the Roth IRA, due to the many years expected to elapse before distribution. With an extensive number of years, the value of the Roth’s tax advantage increases dramatically. Even workers who do not consider themselves particularly young should consider the Roth IRA if they are eligible. High income earners who most need the tax advantage of the traditional IRA likely will not qualify to establish a Roth IRA. Reasons to support the findings would include the fact that employees own a part of the business and will benefit if the company has increased profit levels and increased employee morale resulting from the value of the added benefit. These plans might have a higher motivational value than a pay raise because they give employees a stake in the profitability of the company.

Answers to this question may vary. Disadvantages would include the fact that more employees might decide to retire early which would result in several highly productive citizens ceasing to contribute to the nation’s productivity. Encouraging the trend could also lead to some people outliving their retirement resources and becoming dependent on the government for support.

Supportive arguments for defined benefit plans might include the fact that the employee can more readily predict the amount of income that will be received from the plan and the fact that it is not subject to investment-related risk. Arguments in support of defined contribution plans might include the fact that more flexible investment options are often made available, that it is easier to see the amount of the benefit as it accrues, and that the amount of the benefit will increase with the investment return which may decrease the erosion of purchasing power from

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inflation. Workers who expect to change employers many times during their careers will generally fare better with defined contribution plans.

SUPPLEMENTARY QUESTIONS 1.

If you were a young participant in a pension plan, would you prefer the plan to be contributory or noncontributory? Would you prefer a defined benefit plan or a defined contribution plan?

Why? Noncontributory plans are almost universally preferred by employees because their total cost is paid by the employer, whereas a contributory plan requires an employee contribution.

Answers may vary, however, on the relative size of the benefits possible under each arrangement. All else the same, however, nearly everyone should prefer a noncontributory plan. Whether or not the student would prefer a defined benefit or defined contribution plan will vary with the risk aversion of the student. Defined contribution plans tend to benefit younger employees more than defined benefit plans because there is a longer period in which the contributions can accumulate investment returns. Defined benefit plans tend to be more popular with risk averse people because the benefit level can be readily determined, whereas the level of benefit received from a defined contribution plan fluctuates with the investment income of the fund.

2.

If you were self-employed, would you rather use an IRA or a Keogh? Why? Keogh plans are generally preferable to traditional IRAs because the allowable contribution amount and the associated tax deduction are higher when a Keogh is used. However, if a person has very low self-employment income, then a traditional IRA will provide a higher allowable contribution amount and perhaps a higher tax deduction. Note, however, that people with Keogh plans may establish IRAs in addition to the Keogh plan. For those who qualify, the Roth IRA presents tax advantages that are not present with Keogh plans.

3.

Why don’t employers who sponsor Section 403(b) plans generally take income tax deductions for their contributions to the plan?

Employers who are qualified to sponsor Section 403(b) plans are generally exempt from income taxation.

4.

If an employee could participate in an IRA or in an employer sponsored 401(k) plan in which the employer matched contributions up to 3 percent of the employee’s salary, which plan would you recommend the employee choose? What considerations went into your recommendation? Can both be chosen?

The 401(k) plan generally should be chosen because the employer’s matching of contributions provides a very attractive benefit. The 401(k) plan also provides for contribution limits and tax deductions that generally are higher than those allowed for traditional IRAs. However, the IRA provides more flexibility in investment options. Both can be chosen, however, the traditional IRA contributions may not be tax deductible because the employee is an active participant in a qualified retirement plan. For those who qualify, the Roth IRA presents tax advantages that are not present with 401(k) arrangements.

CHAPTER 21 Financial and Estate Planning FINANCIAL PLANNING ESTATE PLANNING Estate Transfer Costs Debts Administrative Costs

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Death Taxes Estate Planning Tools Wills Life Insurance Gifts Trusts A CASE STUDY: THE JOHNSON FAMILY The Facts of the Case Risk of Premature Death Problems Resulting from Gwen’s Premature Death Problems Resulting from Tim’s Premature Death Possible Solutions Loss of Health CONSIDERATIONS IN BUYING LIFE AND HEALTH INSURANCE Selecting an Insurer Coverage Needed Evaluating Financial Strength Evaluating Service Selecting a Contract Contractual Provisions Cost Factors

KEY TERMS AND CONCEPTS Administrator Buy-sell agreements Charitable deduction Credit shelter trust Decedent Donor Estate planning Estate shrinkage Estate tax

Financial planning Inheritance tax Inter vivos Intestacy laws Intestate Life insurance trust Living trust Marital deduction Net payment index Probate

Probate court Right of survivorship Second-to-die life insurance Surrender cost index Survivorship life insurance Testamentary trust Trust Trustee Unified transfer tax credit Will

ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

Financial planning is the process of establishing financial goals, developing and implementing a plan for achieving those goals, and periodically reviewing and revising the overall plan.

The personal risk management process is properly classified as a subset of the personal financial planning process.

The executor fund is primarily composed of the expenses related to settling the deceased person’s estate and transferring the assets to his or her heirs. Some specific expenses that would be paid from the executor fund include funeral and burial expenses, debts of the

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decedent, legal fees, appraisal fees, court costs, executor fees, bond premium, and estate and inheritance taxes.

Four specific objectives of estate planning are: (1) minimizing the cost of transferring property, (2) providing liquid funds to pay transfer costs in the most economical manner, (3) assuring that estate assets will be transferred to the desired beneficiaries, and (4) planning for the most efficient use of estate assets.

Debts are the unpaid balances of loans and other legally enforceable obligations that the decedent was obligated to pay at the time of death. Administrative costs are costs incurred during the estate administration process and may include legal fees, court costs, accounting charges, appraisal fees, etc. Death taxes include estate taxes levied by the federal government and sometimes by state governments against the estate. Inheritance taxes may be charged by the state against the heirs who receive the estate property. a. An executor is appointed by a probate court to oversee the administration of an estate of a decedent who died with a valid will in force. An administrator is appointed by a court to oversee the administration of an estate of a decedent who did not leave a valid will. b. An estate tax is levied by the federal or state government against an estate. An inheritance tax is sometimes levied by a state government against the beneficiaries or heirs who receive property from a decedent. c. A testamentary trust is created by a will, while an inter vivos trust is created during the life of the grantor.

All property transfers, whether made before or after death, are linked together in a cumulative manner for transfer tax purposes. a. A marital deduction is allowed for the value of all qualified transfers to the decedent’s spouse. b. A charitable deduction is allowed against federal estate taxes for all transfers to a qualified charity. c. The unified transfer tax credit is a credit against federal estate or gift taxes payable. The available credit is scheduled to gradually increase from its 2000 level of $220,550 until it reaches $345,800 in 2006. d. A decedent is the deceased person whose property comprises the estate.

A probate court decides on the authenticity and validity of a will, appoints an executor, and oversees the work of the executor. If a person dies without a valid will and a necessity exists for the administration of the estate, then the probate court may appoint an estate administrator and oversee the work of the administrator.

The beneficiary is the individual, organization, or group that the trust is set up to benefit. The trustee is the person or organization that holds legal ownership to the trust property and is responsible for the administration of the trust assets in the manner set out in the trust instrument. The donor is the person who establishes the trust and transfers the initial trust assets to it.

A credit shelter trust is established to ―shelter‖ assets from inclusion in the estate of the second spouse to die. The trust generally is created in the will of the first spouse to die and is funded with assets with a value equal to the largest taxable estate that can still result in a taxable estate of zero after the unified transfer tax credit is used. The remainder of the estate presumably is given to the surviving spouse and qualifies for the martial deduction. The surviving spouse can be given all of the income produced by the trust assets, with the remainder being transferred at the death of the surviving spouse to beneficiaries selected by the terms of the trust. a. $0. b. $225,000, computed as: $2,010,000 – $10,000 expenses = $2,000,000 taxable estate, which results in an estate tax payable of $780,800 – $555,800 unified transfer tax credit = $225,000.

Chapter 22: Risk Management and the Insurance Industry

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c. $0, computed as: $2,010,000 – $10,000 expenses – $1,400,000 marital deduction = $600,000 taxable estate. d. $0, computed as: $1,500,001– $10,000 expenses = $1,490,001 taxable estate. The $555,800 unified credit effectively eliminates estate taxes on taxable estates of up to $1,500,000 in 2004.

First the coverage needed should be considered. Insurers’ policies sometimes vary as far as the protection offered and some insurers have developed specialized niches in which they can provide particularly good protection. Second, the financial strength of the insurer should be considered. An insurance policy is of very little value if the insurer is not financially able to pay valid claims as they are made. In particular, the quality of the insurer’s investments and the size of its surplus should be examined. Third, the insurer’s service should be considered.

Evaluating service will be subjective to some extent but should include consideration of service provided by the person selling the coverage, as well as the service of the home office.

The surrender cost index is a cost comparison tool. It is similar to the net payments index, but it also incorporates cash value as of a particular time. It is computed for the Nth year through the use of the following formula: (P – D – CV) / A, where P is the accumulated premiums for N years, D is the accumulated dividends for N years, CV is the cash value at the end of N years, and A is the accumulated value of an annuity of $1 for N years.

Even though the specific services were available prior to the emergence of the financial planning industry, coordination between the different financial planning professionals was sometimes difficult. This lack of coordination often led to a myriad of financial products and services that collectively were inefficient and did not focus on the overall goals of the consumer. The financial planner therefore emerged as a professional whose main purpose was to coordinate the services of the various professionals in a manner intended to efficiently accomplish the goals of the client. A financial planner can help a consumer formalize financial goals and implement those goals in an efficient manner. The financial planner’s focus should be on the coordination of the services of the various other financial professionals in a manner that is most likely to accomplish the goals of the client.

Two legitimate purposes of this trust could be the avoidance of the probate process and provision for the management of the trust assets if Allen becomes disabled. These assets should not avoid estate tax because Allen retains complete control and use of the assets and can revoke or amend the trust at any time. The assets should not be safe from the claims of creditors for the same reasons they should remain subject to estate tax. If the assets were safe from creditors’ claims, collection of legitimate claims would be impossible because everyone threatened by these claims would simply create such a trust.

These answers will vary but should reflect well-reasoned application of some of the principles and methods discussed in the chapter.

A contingent arrangement could be provided in their wills, so that a trust would be created only if property were transferred to the minor children. A relative, friend, or trust company could be appointed as the trustee of the assets until the children reach the age of majority, at which time the assets could be distributed to them. The trustee could be given broad management rights that might even allow the trustee to sell or lease the real property or to manage or sell the business. The trustee also might be given the right to make distributions from the trust to benefit the children while they are still minors.

As an insurance agent, the student should consider which type of life insurance would best meet Joe’s needs, which insurer should be used, and which particular insurance contract should be selected. The choice of which type of insurance would best meet Joe’s needs would be determined according to the principles discussed in Chapter 16. The choice of an insurer would depend on evaluations of the coverage provided by each insurer, the financial strength of the insurer, and the level and types of services provided by the insurer. The choice among

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particular contracts would be affected by the particular contract provisions and the cost of the policies.

SUPPLEMENTARY QUESTIONS 1.

The probate process is a public process that can result in significant expenses and annoying delays in the distribution of the assets of a person’s estate. Therefore, probate avoidance is sometimes seen as a goal. What advantages can arise out of probate avoidance? What are some ways in which this can be accomplished with respect to particular property?

Probate avoidance can potentially avoid some of the expenses relating to the probate process and can speed the distribution of assets to the beneficiaries. The loss of privacy relating to a public probate process can also be avoided. Particular property can be passed to beneficiaries in several ways that do not involve probate, such as holding property jointly with right of survivorship (this commonly is used for real estate or bank accounts), placing property in trust, making certain that life insurance benefits are payable to a living named beneficiary, and beneficiary designations on retirement accounts.

2.

Referring to question 1, are there any reasons that a person would specifically not want to avoid probate? Do you feel that a prudent person could design an effective estate plan that does not involve the use of a will?

A person may be concerned that relatives or friends might disagree with the manner in which the property is handled and may attempt to steal or misuse the property. These people might prefer the judicial scrutiny involved in the probate process. It is far easier for some people to write a will than to ensure that all of the property is held in a manner that would avoid probate.

A prudent person’s estate plan will always include a valid written will. A person may have the belief that all of the person’s property interests will pass outside of the probate process, but overlooking a single piece of property could result in some property passing by the laws of intestacy. The administration costs associated with intestacy are often much higher than those associated with the probate of a will.

3.

Why do you think that the trustee holds title to trust property instead of the beneficiaries?

What interest do the beneficiaries hold in the property?

There are several reasons that the title is held by the trustee. If the beneficiaries held title to the trust property, they could obtain or transfer the trust property in a manner that is contrary to the terms of the trust. In cases that involve several beneficiaries it would be impractical to obtain all of their signatures on a deed, stock certificate, or other legal document. Third parties might be very hesitant to buy or otherwise deal with trust property due to concern about whether all of the beneficiaries have properly agreed to a transaction, particularly when contingent beneficiaries may be involved. The interest held by the beneficiaries can be called a beneficial interest. While they are not free to deal directly with the property, as a group they are exclusively entitled to the benefits that accrue from the property.

4.

If insurance can be found at a far lower price from an insurer that is financially unstable, should it be purchased?

Insurance has very little value if the insurer cannot be relied on to meet its obligations under the contract. However, if a person cannot afford to obtain coverage from a more stable insurer, the coverage may be better than having no coverage at all. State insurance guarantee funds might at least partially pay the claim. However, dealing with unstable insurers generally should be avoided.

CHAPTER 22 Risk Management and the Insurance Industry THE FIELD OF INSURANCE Personal Coverages

Chapter 22: Risk Management and the Insurance Industry

Property Coverages Private and Public Insurance Voluntary and Involuntary Coverages TYPES OF INSURERS Stock Companies Mutual Companies Class Mutuals Farm Mutuals Factory Mutuals General Writing Mutuals Fraternal Carriers Reciprocals Lloyd’s Associations London Lloyd’s Relative Importance of Private Insurers Insolvency of Insurers Employment in Insurance Ownership of Insurance CHANNELS OF DISTRIBUTION IN INSURANCE Direct Distribution in Life Insurance Group Insurance Individual Agents Reasons for Direct Distribution in Life Insurance Need for Close Control over Product Need for Control over Sales Promotion and Competition Infrequent Purchase of Life Insurance Better Living through Specialization The Changing Environment in the Life Insurance Company Direct Writing in Property-Liability Insurance Indirect Distribution (American Agency System) Brokers versus Agents Is the American Agency System Doomed?

Outlook for the Agency System and Direct Writing Direct Response Mass Merchandising GLOBALIZATION OF RISK MANAGEMENT AND THE INSURANCE INDUSTRY Global Risk Management Global Risk Exposure Global Insurance Programs Globalization of the Insurance Business

KEY TERMS AND CONCEPTS American Agency System Assessable policy Attorney-in-fact Broker Class mutuals

Direct response Direct writers Exclusive agent Factory mutual Farm mutual

Fraternal carrier General agent General insurance General writing mutual Guaranty funds

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Independent agent Interinsurance exchange Involuntary coverage Lloyd’s association Mass merchandising Mutual company Name Participating and deviating Personal coverages Private insurance Property coverages Public insurance Reciprocal Stock company Surplus line market Syndicates Voluntary coverage

Chapter 23: Functions and Organization of Insurers

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

2.

3.

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a. The student might answer private and government or personal and property as the two major types of insurance. b. Depending on the classification used, the answer is that private insurance is larger than government insurance gauging from premium income, and personal insurance is more than three-fourths of the total of all insurance. Personal insurance is more prevalent than property insurance because perils that cause loss of life and health cause a loss that is much greater than loss of property. By almost any measure, loss of income has more consequence than loss of property, and the perils that endanger loss of income are more serious than those that endanger property. a. Some mutuals have assessments, but more often they do not. b. The advantage of being assessed, if one can say it is an advantage, is that the cost of insurance is minimized. But of course the main difficulty is that one is putting up one’s own capital rather than using the capital of someone else in meeting the particular risk. If the insured is unlucky, the assessment might be far more than the premium paid under a nonassessable policy.

Mutuals, mainly direct writers, have competed strongly in auto insurance where mass marketing techniques have been used effectively to reduce costs and premium rates.

Commercial lines, in which stock insurers specialize, have not lent themselves to this type of competition.

In reciprocals, each underwriter insures each other underwriter, whereas in Lloyd’s, each underwriter generally insures some member of the public as a person to whom risk is transferred. Thus, the underwriters in a reciprocal are cooperatively organized, whereas underwriters in a Lloyd’s organization are proprietary by nature.

In life insurance, mutuals write close to one half of the insurance. Stock companies have been gaining on mutuals in this field, but the situation is reversed in the property-liability field where mutuals are in a minority position but are gaining on stock companies.

The American Agency System is a relatively long channel, but this does not mean that it is doomed as the text points out. Long channels are often more efficient and more easily managed than short channels. They exist only because they are efficient and are needed by both the consumer and the producer.

Additional capacity is needed in the so-called hard-to-place lines, such as product liability and professional liability, especially in some fields. Surveys show that those who rent frequently do not buy insurance on the contents of their dwellings. Neither do they purchase liability insurance, although they are exposed to loss. Many other unfilled needs for insurance exist for those creative enough to supply it, e.g., dental insurance, legal expense insurance, and vision insurance are not universally sold or available, by any measure.

With direct distribution, the insurer’s agent or the company itself deals directly with the customer. For example, individual life insurance and auto coverages that are sold by mail or through exclusive agents such as State Farm and Allstate. In indirect distribution, contact with the final customer is made through intermediaries such as local agents who are not exclusive representatives of the insurer. For example, auto and homeowners’ insurance, which are sold through local agents, and most commercial lines, which are also sold through local agents or brokers.

Mass merchandising means group coverage of lines such as homeowners’ and automobile for individuals in a manner similar to group life and health insurance made available through employer groups.

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Chapter 23: Functions and Organization of Insurers

Direct response is the term given to that method of distributing insurance without the use of agents or other intermediaries. Communication is made directly with the insurance buyer by advertising and the buyer responds directly to the insurer. Perhaps the main limitation is the difficulty in explaining the complexities of insurance by mail or telephone and without the help of an agent. This limitation will probably prevent the sale of most types of insurance through direct response. Sales tend to be confined to standardized or relatively simple contracts that are well known to the buyer.

The mutual, of course, is certainly not ―communistic,‖ although extreme critics have so claimed. Mutuals argue that far from being ―communistic,‖ their form of organization actually represents free enterprise in its purest form because individuals are actually entering into a cooperative enterprise to reap ―profits‖ for themselves rather than employing the capital of outsiders, as in a stock company.

Among the possible reasons are inadequate capitalization, dishonest management, inexperienced management, insupportable underwriting losses, inadequate rates, investment losses, etc. Some students will recognize that the most likely reason in cases b and c are insupportable underwriting losses from auto and medical malpractice claims, respectively.

Case a appears to stem from dishonest management.

It is a business risk and hence speculative in nature. The requirements of predictability and noncatastrophic nature do not appear to be met. If a new generation of computers makes old computers obsolete, obviously losses will be registered. The insured event is not random in nature. If the event occurs, it has the same effect on all members of the insurable group and the losses occur simultaneously, causing catastrophic loss. The seven-year computer lease gives the holder the right to back out after three years, and obviously most will exercise this right (and cause a potential loss) if new equipment is available that does the job cheaper and better.

SUPPLEMENTARY QUESTIONS 1.

Studies by the Swiss Reinsurance Company show that sales of insurance vary directly with changes in industrial output. In your opinion, why should this be true? For example, why are insurance sales relatively small in underdeveloped countries primarily dependent on agriculture?

Industrialized countries have more exposures to loss than agricultural economies. Factories, human lives and health on which factory operations depend, and transportation of output from these factories all contribute to the larger size of the loss exposure in the industrialized country compared to agricultural economies.

2.

The trend toward ―financial service conglomerates‖ suggests that sales of insurance, stocks and bonds, real estate, mutual funds, banking services, and other financial services may change the distribution system for insurance in a significant way. In your opinion, does this trend threaten the future of the independent agent in property-liability insurance?

The trend toward financial service complexes (e.g., Citigroup, Bank of America) will affect insurance distribution systems for personal lines, but probably will not soon seriously reduce the importance of independent agents, who serve mainly commercial markets. Yet, it seems likely that many small, independent agencies will continue to face pressure from this trend, and the weaker agencies are likely to disappear.

CHAPTER 23 Functions and Organization of Insurers

Chapter 23: Functions and Organization of Insurers

FUNCTIONS OF INSURERS Production (Sales) Underwriting The Objective of Underwriting Services That Aid the Underwriter Policy Writing Conflict between Production and Underwriting Underwriting Associations Rate Making Makeup of the Premium Interest Earnings Rate-Making Guidelines Adequacy of the Rate Fair Allocation of Cost Burden Rate-Making Methods Manual or Class Rating (Pure) Method Loss Ratio Method Individual, or Merit Rating, Method Combination Method Credibility The Credibility Formula Rate-Making Associations Managing Claims and Losses Investing and Financing Financing Accounting Miscellaneous Functions Legal Advice Marketing Research Engineering Services Personnel Management REINSURANCE Uses and Advantages of Reinsurance Enlarging Financial Capacity Stabilizing Profits Reducing the Unearned Premium Reserve Retiring from Underwriting Types of Reinsurance Agreements Facultative Reinsurance Automatic Treaty Pro-Rata Treaties Excess-of-Loss Treaties

KEY TERMS AND CONCEPTS Accounting Actual loss ratio Actuaries

Automatic treaty Ceding company Cession

Claims management Class rating method Credibility

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Excess line treaty or first surplus treaty Excess-of-loss treaties Expected loss ratio Fair Claim Settlement laws Financing Formal facultative agreement Frequency/severity Gross premium Independent adjuster Individual method Informal facultative agreement Investment department Line Loading Loss ratio Manual method Merit rating method Nonstandard risks Policy writing Pools or syndicates Preferred risks Production Pro-rata treaties Public adjuster Pure premium Quota share treaties Rate making Rate-making associations Rating bureaus Reinsurance exchange Reinsurance pool Reinsurer Retention Retrocession Schedule rating Special rating classes Spread-of-loss treaty Surplus treaties Treaties

Chapter 24: Government Regulation of Risk Management and Insurance

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

The justification is that no product of insurance exists until it is sold to the customer. Thus, the act of selling creates the product, and it is reasonable to call selling an act of production.

2.

A rate is the price per unit, and the premium is the rate times the number of units purchased.

3.

The general formula is given in the text as gross premium = pure premium divided by the quantity (1 – loading percentage). The answer would thus be $375 / (1 – 0.25) = $500.

4. a. The criteria are that the rate should be adequate, it should not be excessive, it should be fair (not unfairly discriminatory), it should be flexible, and it should give some incentive for loss control by the insured. b. Students may complain that age is not a good criterion because age is not necessarily associated with losses in auto insurance, in that there are many very safe drivers who also happen to be young. Thus, age may unfairly discriminate among groups with different driving records. However, insurance data show much higher loss experience in the youthful age classes than among older drivers. Young age may not be the cause of bad driving, but it is associated with whatever attribute is associated with bad driving, and serves as a proxy variable for that attribute.

5.

The basic distinction is that experience rating rewards or penalizes the insured in the future for good or bad past records of losses, while retrospective rating rewards or penalizes the insured for the period just past; i.e., enables the insurer to develop a premium in whole or in part after all the facts are collected. The basic similarity between the two types of ratings is that both are designed to differentiate an individual risk from members of the general class to which this risk belongs. Large firms are much more likely to use retrospective rating than small firms, inasmuch as these firms are often large enough to develop ―credible‖ rates because of their size.

6.

Students may be referred to Chapter 24 for additional reading on this subject. Rate-making organizations do carry on price fixing in a sense, but the rates that are promulgated are advisory only. A given insurer is usually responsible for its own rate, and in many cases changes it from that which is recommended by the rate-making group. Even so, price fixing probably could be said to exist. It is not in violation of the antitrust acts, however, because the McCarran-Ferguson Act specifically exempts insurers from these acts, except with respect to boycotts and coercive activities. Price ―fixing‖ is necessary in insurance to some extent because of the necessity of gathering together credible bodies of data for rate-making purposes.

7. a. Competition in the property-liability field periodically causes insurers to lower insurance rates, often to levels where underwriting profits cannot be realized. These losses are made up by profits from investments. Hence, underwriting losses average out less than investment profits. In life insurance, on the other hand, underwriting losses are uncommon. Furthermore, premiums are enlarged in life insurance because many contracts are issued with a savings element. Hence, when interest earnings are compared to total premiums, the percentage is smaller than in the case of property-liability insurance where premiums do not reflect a savings element. b. In life insurance. Here state laws specify that some minimum interest rate, frequently 4 1/2 percent, be used in developing the life insurance level premium. In property-liability insurance only a few states require insurers formally to recognize investment earnings in developing insurance rates.

8.

An insurer might misrepresent, or misinterpret, a policy provision that actually grants coverage. For example, suppose a tree falls on the insured’s house during a windstorm. The insurer (through an adjuster or an agent) might claim no coverage exists because the policy

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excludes ―falling objects.‖ In this case the proximate cause of loss is windstorm, which is covered.

Inadequate underwriting means that insufficient attention is given to the acceptance problem– making sure that risks accepted conform to assumptions made in rate making. Resulting losses, particularly if they are continued over a period of time, will certainly cause financial difficulty. a. The conflict refers to the tendency for salespeople to secure applications for insurance that the underwriter turns down for want of sufficient merit as an insurance risk. The text discusses this question. b. The conflict is, in theory anyway, apparent, not real since the real objective of both the salesperson and the underwriter is to maximize company profit. Acceptance of poor risks does not aid in achieving this objective. a. The loss is distributed according to the proportion that each party has liability for loss. In this case R has liability for $100,000, the first surplus reinsurer has $900,000 (9 lines at $100,000 each), the second surplus reinsurer has $500,000, and the facultative reinsurer has $500,000—or 5 percent, 45 percent, 25 percent, and 25 percent, respectively. Thus R would pay $50,000 and the reinsurers would pay $450,000, $250,000, and $250,000, respectively. b. If R had the excess-of-loss treaty in effect, it would be able to recover the excess over $525,000 from that reinsurer, or a total of $25,000 ($50,000 – $25,000). a. The credibility formula is PP = PPi(Z) + PPp(1 – Z), where PPi is the pure premium for the insured’s territory, PPp is the pure premium for the larger group to which the insured belongs, and 5 is the degree of credibility. Substituting in the formula, we have PP(Territory A) = $400(0.25) + $200(0.75) = $100 + $150 = $250. b. Territory A might receive a low 25 percent credibility because it is too small to have developed sufficient numbers of claims for statistical reliability.

SUPPLEMENTARY QUESTIONS 1.

Reinsurance premiums have been rising as a percentage of total insurance premiums in recent years, growing roughly twice as fast as direct premiums. Suggest possible reasons for this phenomenon.

Among possible reasons are: (1) Self-insurance by corporations has been growing and these corporations have increasingly used reinsurance as a way to transfer excess risk. (2) Primary insurers have increasingly sought to reduce their own risks by seeking a greater spread of loss exposures. This is due to increasing technology that has caused great concentrations of exposure in such areas as large jumbo jet planes, oil-drilling rigs, large skyscrapers, etc. (3) There is increased participation in the reinsurance business by such groups as life insurers that have formed special divisions to offer reinsurance in the open market (e.g., Prudential Re). (4) Organized insurance exchanges to facilitate the exchange of both direct insurance and reinsurance have been established. (5) There is increasing recognition of the basic advantages of reinsurance, as outlined in the text.

2.

Insurers have been criticized for having too many rating classes, with consequent inability to obtain credible loss experience on which to base rates and rate revisions. For example, there have been as many as 10,000,000 possible rating groups in automobile insurance, compared to a total universe of perhaps 100,000,000 automobiles, roughly 10 cars per group. On the other hand, if rating groups were combined, many insureds might complain. Why might complaints be registered if this were done? Explain.

Complaints might stem from the fact that if groups were combined, some members would have to pay larger rates than formerly. No matter what size group, however, some members

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must pay a larger rate than ―average‖ within the group. Insurance is based on the combinatorial principle in which members of the group subsidize others who will suffer loss.

CHAPTER 24 Government Regulation of Risk Management and Insurance WHY INSURANCE IS REGULATED Future Performance Complexity Unknown Future Costs Violations of Public Trust THE LEGAL BACKGROUND OF REGULATION THE McCARRAN-FERGUSON ACT FEDERAL VERSUS STATE REGULATION RESPONSIBILITIES OF THE STATE INSURANCE DEPARTMENT Licensing and Financial Solvency Minimum Capital Investments Liquidation Security Deposits Guaranty Funds Regulation of Rates and Expenses Property-Liability Rates Prior Approval versus Open Competition Laws State-Mandated Rates Life Insurance Rates Agents’ Activities Regulation of Contract Provisions MISCELLANEOUS INSURANCE LAWS Service-of-Process Statutes Retaliatory Laws Anticancellation Laws Reciprocal Laws Anticoercion Laws TORT REFORM TAXATION OF INSURANCE Future of Insurance Regulation KEY TERMS AND CONCEPTS Anticoercion statutes Deficit Reduction Act of 1984 (DEFRA) File and use Insolvency funds Misrepresentation Open competition laws

Prior approval Rebating Reciprocal laws Retaliatory laws Risk-based capital Service-of-process statute

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ANSWERS TO QUESTIONS FOR REVIEW AND DISCUSSION 1.

Losses were substantial and so were assessments against insolvency funds during the time of their brief history (1969 to date). Losses occurred in all states. It would appear that even though the losses were small compared to the total premiums written by all insurers, the funds are needed and provide an orderly way to handle losses by spreading them out among participating insurers rather than having these losses fall on policyholders or taxpayers.

2.

Under prior approval law, an insurer must obtain permission to use a rate before it is actually used, whereas under the open competition law, the insurer may file a rate and then proceed to use it immediately unless stopped by the insurance commissioner. Under some open competition laws, filing is not required. In theory, free market forces will operate to protect the consumer’s interest as well or better under open competition laws as under prior approval laws, but the point is as yet undecided. There has been no strong recent trend for more states to adopt open competition laws. A majority of states (about 30) still use the prior approval laws as the way to best protect the consumer’s interests. See text for arguments pro and con.

3.

Three examples of competition in insurance are given in the text: price competition still exists, companies compete with better contracts or more flexible underwriting conditions, and finally, some companies give better service. For example, State Farm and Allstate advertise superior claims service facilities, providing an adjusting office in most cities of any substantial size any place in the United States. On the other hand, large multiple-line insurers advertise that they can take risks of larger size and offer a complete package in one company. Large workers’ compensation insurers advertise superior facilities in this area, with companies like Liberty Mutual noted for their efforts in rehabilitation of the worker and in loss control services in the employer’s plant.

4.

This, of course, is rebating and carries a penalty to the insured and to the agent, whose license may be revoked. It is illegal under state laws, but the laws are difficult to enforce. Florida repealed its anti-rebating law.

5.

Formerly it would have been necessary and it may be so today in H’s state, unless an unauthorized insurers service-of-process act has been passed. Most states now have these acts, and H can sue the mail-order insurer by serving the insurance commissioner in H’s state with a legal summons.

6.

Because of retaliatory laws in most states, if this tax were passed, the state’s own insurers would immediately have to pay a greater tax in all states affected by the increased tax. This might damage their competitive position and if your state has a substantial number of insurers so affected, the legislator might wish to reconsider.

7.

A retaliatory law provides automatic penalties to admitted insurers when similar penalties are levied against domestic insurers operating in other states. Reciprocal laws extend equal benefits to an admitted insurer when similar benefits are extended to domestic insurers operating in other states. One might say that retaliatory laws are negative in their concept, while reciprocal laws are positive. Both laws attempt to bring about uniformity in operating conditions affecting insurers operating across state lines.

8.

The main purpose is to reduce the cost of liability insurance, to make it more affordable and more readily available. The increasing cost of liability damage awards in the United States has driven up the rates to the level that many buyers, particularly those needing professional liability insurance, have had to pay huge premiums or to cease doing business in the areas where affordable insurance is not available. Examples in medicine are those working in iii

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gynecology and neurology. It is believed that damage suits have been more frequent mainly because of the knowledge of injured persons of the availability of insurance by the professional person, thus enlarging his or her ability to pay court judgments. It is hoped that the new laws will make it more difficult to sue and reduce the chance of large awards if suit is brought.

State laws usually have three provisions: the rate must be fair (not unfairly discriminatory), adequate, and not excessive. State insurance commissioners have some leeway in interpreting and enforcing these requirements.

Theoretically, insolvency funds would not be needed if regulators had perfect knowledge and perfect foresight and were able to control insurers fully. Of course this is not the case. A regulator cannot control natural catastrophes, human error, or mismanagement. These factors may cause an insurer to go insolvent before a regulator knows what is going on.

The need for insurance regulation rests on several fundamentals. This need is similar to that for public utilities in that the public interest is at stake to a greater extent than in tangiblegoods industries, where a person reasonably can be expected to examine what he or she is buying and decide whether or not the product is sound and if it is not, bring civil action if damages are sustained. The difficulty in insurance is that the ordinary person cannot be expected to know whether or not the insurance contract provides the protection expected because of the complexity of insurance. If it fails in its protection, it is often too late to do anything about it. The long-term nature of insurance requires special protection for the insured. The insured’s funds are being used by the insurer and special regulations are needed to guarantee that the funds are being managed soundly. The insured is paying for something that will not be collected for an indefinite period in the future.

Women have generally enjoyed lower auto and life insurance rates than men because of better driving records and greater longevity. Unisex rates, which pool loss experience of both sexes, would increase women’s rates and reduce men’s rates in the averaging process. On the other hand, women have had accident and health insurance rates greater than those of men because of greater frequency of illness among women and the resulting greater claim costs.

The NOW group contends that to base rates on sex is discriminatory and that rates should be based on causal factors such as driving records, smoking and drinking habits, etc. The insurance industry generally opposes unisex rates because their statistical records are based on sex and these records strongly support differential rates applicable to the sexes. For example, women live on the average perhaps seven years longer than men and their death rates are lower, justifying a lower life insurance rate.

An insurance commissioner has little control over insurance markets (existence of insurable capacity), except by prohibiting certain insurers from operating, in which case it is doubtful that such insurers would constitute a legitimate market anyway. Also, the commissioner would appear to have little control over the degree of uniformity in laws of the various states.

On the other hand, the commissioner does deal with rates and the insolvency of insurers. The statement is a good illustration of the delicate position of almost any administrator mediating the conflicting desires of the different groups with which he or she works.

Advantages are that federal district offices (1) would help solve the problem of dealing from afar, (2) would permit faster decisions, (3) would enable national uniformity in regulation, and (4) would bring about more impartial and probably better regulation. Disadvantages are that federal district offices (1) still would not solve the problem created by having two systems of regulation, although this problem exists in banking and other fields and apparently has caused no insurmountable difficulties; (2) would still have the same problems caused by the limited authority of the district managers and the consequent necessity of going to Washington for some types of decisions; and (3) do not answer the objection that there is no real proof that the federal government could do it better than state governments. Perhaps all that is needed is a

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re-education of state legislators to the problem of insufficient pay and improper status for insurance commissioners.

Usually a part-time agent is connected with some business concern to write all of its business or to get a line on a certain source of business not open to others. A part-time agent may actually be an employee of the business, which is using his or her license as a way of getting a discount on its insurance premiums. The captive agent is not really a legitimate insurance counselor from the professional agent’s viewpoint. Often even a legitimate part-time agent is not qualified and may damage the reputation of the insurance industry and cast doubt on the value of the professional agent. The part-time agent, in the view of the professional agent, has no more right to practice than a part-time doctor or dentist who is only partly trained. This all flows from an increasing effort of insurance agents to develop their status as professionals.

SUPPLEMENTARY QUESTIONS 1.

Although insurance premiums are subject to a tax averaging of about 2 percent in most states, similar taxes do not apply to savings bank deposits or to mutual fund shares, which compete with insurers for savings dollars. Similarly, states do not levy taxes on funds used by corporate self-insurers offering health and life insurance protection to their employees. Do you think this discrimination is justified? Explain.

Many have complained about this discrimination in taxation, but so far little has been done to change it. In fact, insurers are subject to much greater levels of premium taxation, 20 to 30 percent or more in some foreign countries (especially South America). About all that has been accomplished is to exempt annuity premiums from taxation in most states, to equalize the tax burden among life insurance products in which more of the premium represents savings dollars. For those using self-insurance, part of the move toward establishing captive insurers in off-shore locations such as Bermuda has been to escape state taxation on premiums and other state regulations affecting domestic insurers.

2.

Is it proper to state that one of the goals of regulating insurance pricing is to obtain fair discrimination among those purchasing insurance? For example, why not charge all auto drivers in a state the same basic rate? Explain.

Technically, most laws say their goal is to end unfair discrimination, but the end result is the same. Insurance rates are meant to reflect basic differences that exist among insurance applicants as far as loss susceptibility is concerned, and to see that insurers charge appropriately. It would violate the spirit of this requirement if all insureds were charged the same, regardless of their particular status. For example, if auto insurers charged everyone equally, it would mean that country drivers would subsidize city drivers, old drivers would subsidize the young, etc.

3.

In April 1989, the Insurance Services Organization (ISO) announced that beginning in 1990 it would no longer provide ―advisory rates‖ to its 1,400 members, but instead would issue only ―advisory average prospective loss costs.‖ Loss costs include data on claims, claims handling, and legal defense. Advisory rates include data on loss costs, marketing costs, overhead, underwriting profit, and contingencies. The National Association of Insurance Commissioners (NAIC) also approved a recommendation to bar the distribution of final rates by rate-making organizations in all lines of insurance except workers’ compensation, which is the subject of a separate study. Suggest reasons for these actions.

These actions stem from political and social pressures to do away with ―monopoly‖ powers of rate-making organizations to set insurance rates. Many believe that insurers have been using the collective database of the ISO to eliminate rate competition. The ISO will now apparently still gather data on losses and will distribute this information to its members, but will leave it to each separate insurer to promulgate a final rate that will include the insurer’s allowances for marketing, overhead, profit, and contingencies. v

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