保險學 Insurance

Principles of Risk Management and
Insurance
Major Reference
GEORGE E. REJDA
7th Edition (2011)

E-mail: paulkm@cc.kuas.edu.tw
PART TWO
Law And the Insurance Contract
Chapter 5 Legal Principles in Insurance
Chapter 6 Analysis of Insurance Contracts
PART SIX
The Private Insurance Industry
Chapter24 Types of Private Insurers and Marketing
Systems
Chapter25 Functional Operations of Private Insurance
Chapter26 Financial Operations of Private Insurers
Chapter 5
Legal Principles
in Insurance
Copyright 2011 Pearson Education. All Rights Reserved
Agenda
Principle of Indemnity
Principle of Insurable Interest
Principle of Subrogation
Principle of Utmost Good Faith
Requirements of an Insurance Contract
Distinct Legal Characteristics of Insurance
Contracts
Law and the Insurance Agent
4
The insurer agrees to pay no more than
the actual amount of the loss
Purpose:
To prevent the insured from profiting from a
loss
To reduce moral hazard
In property insurance, indemnification is based on
the actual cash value of the property at the time of
loss
There are three main methods to determine actual
cash value:
Replacement cost less depreciation
Fair market value is the price a willing buyer would pay a
willing seller in a free market
Broad evidence rule means that the determination of ACV
should include all relevant factors an expert would use to
determine the value of the property
There are some exceptions to the principle of
indemnity:
A valued policy
pays the face amount of insurance if a total loss
occurs
Some states have a valued policy law that

requires payment of the face amount of insurance
to the insured if a total loss to real property
occurs from a peril specified in the law
7
indemnity:
Replacement cost insurance
means there is no deduction for depreciation in
determining the amount paid for a loss

()

60%
60%
indemnity:
A life insurance contract is a valued policy that
pays a stated sum to the beneficiary upon the
insureds death

10
indemnity:
A life insurance contract
It is difficult to determine accurately the value
of a human life, and the amount paid may
substantially exceed the economic value of the
insureds life. The human life value approach
gives a crude estimate of how much a person's
life is worth, but few people insure their lives
fully, and all losses are total.
11

The insured must stand to lose financially if a
loss occurs
An insurable interest is required in every insurance

contract in order to prevent gambling, to reduce moral
hazard, and to measure the amount of the insureds loss
in property insurance.
12
Purpose:
To prevent gambling
To reduce moral hazard
To measure the amount of loss

13

(2)Examples of an Insurable Interest
1.Property and liability Insurance
A.Ownership of property
owners of property will lose financially if their property is

damaged or destoryed
B.Potential legal liability
The firm may be legally liable for damage to customers goods
cause by the firms negligence
C.Secured creditors
A commercial bank that lends money to buy a house has an
insurable interest in the property of mortgage.
14

D.Contractual right
a business firm that contracts to purchase goods from abroad on
the condition that they arrive safely has an insurable interest in the
goods.
2.Life Insurance
A.Family or Marriage
a husband can purchase a life insurance policy on his wifes life

and be named as beneficiary.
B.Pecuniary interest
Even when there is no relationship by blood or marriage, one

person may be financially harmed by the death of another.
15
16
16
A.
B.
(Mortgagee)
C.
17

D.
(
)
18

E.
(Invoice Value)
(
)
19
A.
()
B.
20
1.

21

22

2.
23

3.
4.

(434
)
24
1.
(1122,1123)
(1114)
A.
100111161
1003
25

B.
26
()
27

2.
3.
4.
28

5.
6.
1114
29

1115
1117
30

When must insurable interest exist?
Property insurance: at the time of the loss

Reasons:
A. most property insurance contracts are contracts of indemnity.
B. you may not have an insurable interest in the property when the
contract is first written but may expect to have an insurable
interest in the future, at the time of possible loss.
31
When must insurable interest exist

?
Life insurance: only at inception of the
policy

Reasons:
A. life insurance is not a contract of indemnity but is a
valued policy that pays a stated sum upon the insureds
death.
32

When must insurable interest exist
?
Life insurance: only at inception of the
policy
Reasons:
B. the beneficiary has only a legal claim to receive the policy
proceeds, the beneficiary does not have a show that a loss
has been incurred by the insureds death.
33
(Proceed)
34
Insurer is entitled to recover from a
negligent third party any loss payments
made to the insured.
Substitution of the insurer in place of the
insured for the purpose of claiming indemnity
from a third person for a loss covered by
insurance.

35
Purposes:
To prevent the insured from collecting
twice for the same loss
To hold the negligent person responsible

for the loss
To hold down insurance rates
36
Importance of Subrogation
The insurer is entitled only to the amount it
has paid under the policy
The insured cannot impair the insurers
subrogation rights
Subrogation does not apply to life insurance
and to most individual health insurance
contracts
The insurer cannot subrogate against its
own insureds
37

A higher degree of honesty is imposed on
both parties to an insurance contract than
is imposed on parties to other contracts
148

38
Supported by three legal doctrines:

Representations
are statements made by the applicant
for insurance
39

A contract is voidable if the representation is
material, false, and relied on by the insurer
An innocent misrepresentation of a material fact,
if relied on by the insurer, makes the contract
voidable
Representation
(voidable)
1.materialif the insurer knew the true facts, the policy
not have been issued or it would have been issued on different
terms
2.falsestatement is not true or is misleading

40
3.relied on by the insurer

A concealment
is intentional failure of the applicant for
insurance to reveal a material fact to the
insurer
1.the concealed fact was known by the insured to be material

2.the insured intended to defraud the insurer

41

A warranty
is a statement that becomes part of the
insurance contract and is guaranteed by the
maker to be true in all respects
Statements made by applicants are considered
representations, not warranties
42
To be legally enforceable, an insurance

contract must meet four requirements:
Offer and acceptance
of the terms of the contract
In most cases, the applicant for insurance makes the offer, and the
company accepts or rejects the offer.
(Binder)
43
Consideration
the values that each party exchange
The value that each party gives to the other.
A. Insured's consideration generally is payment of the first
premium.

B. Insurer's consideration is the promise to perform the contract.

44
Legally competent parties, with legal capacity

to enter into a binding contract

This means the parties must have legal capacity to enter into a
binding contract.
Minors normally are not legally competent to enter
into binding insurance contracts.
The insurer generally must be licensed to sell insurance, and
the insurance sold must be within the scope.
45
The contract must exist for a legal purpose

An insurance contract that encourages or promotes something
illegal or immoral is contrary to the public interest and cannot be
enforced

46
Distinct Legal Characteristics of

Insurance Contracts
Aleatory: values exchanged are not equal
Unilateral: only the insurer makes a legally
enforceable promise
Conditional: policyowner must comply with
all policy provisions to collect for a covered
loss
Personal: property insurance policy cannot
be validly assigned to another party without
the insurer's consent
Contract of adhesion: since the insured

must accept the entire contract as it is written,
any ambiguities are construed against the
47
insurer

Insurance Contracts
Aleatory
: values exchanged are not equal
(Commutative
Contract)
48

Insurance Contracts
Unilateral
: only the insurer makes a legally
enforceable promise
(Bilateral Contract)
most commercial contract are bilateral contract in nature. Each
party makes a legally enforceable promise to the other party.
49

Insurance Contracts
Conditional
: policyowner must comply with all policy
provisions to collect for a covered loss
That is, the insurers obligation to pay a claim depends on

whether the insured or the beneficiary has comply with all
policy conditions.
Conditions are provisions inserted in the policy that qualify or
place limitations on the insurers promise to perform.
50

Insurance Contracts
Personal
which means the contract is between the insured and the insurer.
property insurance policy cannot be validly assigned to another party
without the insurer's consent.
Thus, the insurers consent is normally required before a property
insurance policy can be validly assigned to another party.
(character)(moral)(credit)
(assignment)
because the assignment does

not usually alter the risk or increase the probability of death
51

Insurance Contracts
Contract of adhesion
: since the insured must accept the entire
contract as it is written, any ambiguities are
construed against the insurer
the insured must accept the entire contract, with all its terms and
conditions.
(endorsement)
52

An agent is someone who has the authority to act
on behalf of a principal (the insurer)
Several laws govern the actions of agents and their
relationship to insureds
There is no presumption of an agency relationship
An agent must be authorized to represent the principal
Authority is either express, implied, or apparent
Knowledge of the agent is presumed to be knowledge of

the principal with respect to matters within the scope of
the agency relationship
Insurers can place limitations on the power of agents by
adding a nonwaiver clause to the application or policy
53

Waiver
is defined as the voluntary

relinquishment of a known legal right
54

Estoppel
occurs when a representation of fact made by

one person to another person is reasonably relied
on by that person to such an extent that it would
be inequitable to allow the first person to deny
the truth of the representation
(
)
55
Key Concepts and Terms

Actual Cash Value
Aleatory Contract
Binder
Broad Evidence Rule
Commutative Contract
Concealment
Conditional Contract
Conditional Premium
Receipt
Consideration
Contract of Adhesion
Estoppel
56

Express Powers
Fair Market Value
Implied Powers
Innocent Misrepresentation
Legal Purpose
Legally Competent Parties
Material Fact
Offer and Acceptance
Pecuniary Interest
Personal Contract
Principle of indemnity
57
Chapter 6
Analysis of
Insurance
Contracts
Agenda
Basic parts of an insurance contract

Definition of the Insured
Endorsements and Riders
Deductibles
Coinsurance
Other-insurance provisions
59
Basic Parts of an Insurance Contract

Declarations
are statements that provide information about

the particular property or activity to be insured
Usually the first page of the policy
In property insurance, it contains name of the insured,
location of property, period of protection, amount of
insurance, premium and deductible information
Insurance contracts typically contain a page or

section of definitions
For example, the insured is referred to as you
60

The insuring agreement
summarizes the major promises of the insurer
The two basic forms of an insuring agreement in
property insurance are:
Named perils policy
where only those perils specifically named in the policy
are covered
61

The insuring agreement
summarizes the major promises of the
insurer
All-risks policy
where all losses are covered except those losses
specifically excluded
May also be called an open-perils policy or special
coverage policy
Insurers have generally deleted the word all from
policies
All-risks coverage has fewer gaps, and the

burden of proof is placed on the insurer to deny a
claim
62

Insurance contracts contain three major
types of exclusions
1.Excluded perils
e.g., flood, intentional act
In a homeowners policy, the perils of flood, earth movement, and

nuclear radiation or radioactive contamination.
In property and liability insurance, most insurance contract
exclude coverage for acts of war.
The war exclusion clause is important today because of the
terrorist attack on the United States on September 11, 2001.
63

types of exclusions
2.Excluded losses
certain types of losses may be excluded.
e.g., a professional liability loss is excluded

in the homeowners policy
64

types of exclusions
3.Excluded property
in a homeowners policy, certain types of personal

property are excluded, such as cars, planes, animals,
birds, and fish.
in a liability insurance policy, property of others in the
care, control, and custody of the insured is usually
excluded.
65
Why are Exclusions Necessary?

1.Some perils are not commercially
insurable
e.g., catastrophic losses due to war

2.Extraordinary hazards are present
e.g., using the automobile for a taxi
3.Coverage is provided by other contracts
e.g., use of auto excluded on
homeowners policy
66
Why are Exclusions Necessary?

4.Moral hazard problems
e.g., coverage of money limited to $200
in homeowners policy
5.Attitudinal hazard problems
e.g., individuals are forced to bear losses
that result from their own carelessness
6.Coverage not needed by typical insureds
e.g., homeowners policy does not cover
aircraft
67
Conditions
are provisions in the policy that qualify or
place limitations on the insurers promise to
perform
If policy conditions are not met, insurer
can refuse to pay the claim
Insurance policies contain a variety of
miscellaneous provisions
e.g., cancellation, subrogation, grace
period, misstatement of age

68

1.Give notice of loss
()
2.Preserve and protect property from
further loss or damage

()
69

3.Repair before Evaluation
()

()
70
(4)Miscellaneous provision
In Property and Liability Insurance
1.Cancellation clause
()
71

(4)Miscellaneous provision
In Property and Liability Insurance
2.Appraisal
Arbitration
72
3.Assignment
()
73

4.Other Insurance
Other Insurance
74

Double Insurance
75

Double Insurance
76

Double Insurance
1.
2.
3.
4.
5.
77

78

5.Subrogation
()
79

Subrogation
1.
2.
3.
4.

80

(5).In Life and Health Insurance
1.Grace Period

81

2.Reinstatement Clause
()
82

96.7.18
83

3.Misstatement of age

84
Definition of an Insured
An insurance contract must identify the
persons or parties who are insured under the
policy
The named insuredis the person or persons
named in the declarations section of the policy
The first named insured has certain additional rights
and responsibilities that do not apply to other named
insureds
A policy may cover other parties even though they
are not specifically named
e.g., the homeowners policy covers resident relatives
under age 24 who are full-time students away from
home
Additional insuredsmay be added

using an endorsement
85
Definition of an Insured

1.
2.
86

In property and liability insurance, an
endorsement
is a written provision that adds to, deletes
from, or modifies the provisions in the
original contract
e.g., an earthquake endorsement to a homeowners
policy

Earthquake Endorsement
87

In life and health insurance, a rider
is a provision that amends or changes

the original policy
e.g., a waiver-of-premium rider on a life

insurance policy

waiver-of-premium rider

88

(3)Purpose
1. to add, delete, or modify provisions in the original contract
2.Riders may increase or decrease benefits or amounts of
insurance.
3.Riders may add coverage for new perils or losses
(4)()
An endorsement attached to a contract generally takes precedence
over any conflicting terms in the contract.
89
Deductibles
A deductible
is a provision by which a specified amount
is subtracted from the total loss payment
that otherwise would be payable

A deductible is not used in life insurance because the insureds
death is always a total loss.
90
Deductibles
The purpose of a deductible is to:
Eliminate small claims that are expensive to handle
and process
Reduce premiums paid by the insured
Under the large loss principle, insurance should pay for
high severity losses; small losses can be budgeted out of
the persons income
Reduce moral hazard and attitudinal hazard
Some dishonest insureds may deliberately() cause a loss to profit from

insurance.
Deductibles encourage people to be more careful with respect to
the protection of their property and prevention of a loss.
91
Deductibles
With a straight deductible
, the insured must pay a certain amount
before the insurer makes a loss payment
e.g., an auto insurance deductible
The insured must pay a certain number of dollars of loss.
1
5
2

92
Deductibles
An aggregate deductible
means that all losses that occur during a
specified time period are accumulated to
satisfy the deductible amount
()
93
Deductibles in Health Insurance

A calendar-year deductible
is a type of aggregate deductible that is
found in basic medical expense and major
medical insurance contracts

94

A corridor deductible
is a deductible that can be used to
integrate a basic medical expense plan
with a supplemental major medical
expense plan
95

An elimination (waiting) period
is a stated period of time at the

beginning of a loss during which no
insurance benefits are paid
96

An elimination (waiting) period
Elimination periods are commonly used in disability income

insurance contracts.
For example, disability-income contracts that replace part of

a disabled workers earnings typically have elimination
periods of 30, 60, 90 days or even longer.
97

(Insurable value)
(Actual cash value)
=(Replacement cost)
(Accumulated depreciation)
(1)Full Insurance
1,500,000
1,500,000300,000
98

(2)Under Insurance
1,500,000
1,000,000300,000
( ) =
99

(3)Over Insurance
1,500,000
2,500,000300,000
1.()
2.()
100
Coinsurance
A coinsurance clause
in a property insurance contract encourages the
insured to insure the property to a stated
percentage of its insurable value

If the coinsurance requirement is not met at the
time of the loss, the insured must share in the
loss as a coinsurer

Amount of insurance carried

x Loss Amount of recovery
Amount of insurance required
101
Coinsurance

1,500,000
600,00080%coinsurance clause
1,200,000300,000
( x )
=
600,000 (1500,000 x 80%) X 300,000
= 150,000
102
Coinsurance
The purpose of coinsurance
is to achieve equity in rating
A property owner wishing to insure for a total

loss would pay an inequitable premium if other
property owners only insure for partial losses
If the coinsurance requirement is met, the
insured receives a rate discount, and the
policyowner who is underinsured is penalized
through application of the coinsurance formula
103
Exhibit 6.1 Insurance to Full Value
104
Exhibit 6.2 Insurance to Half Value
105
Coinsurance
Coinsurance problem
1.Inflation can result in a serious coinsurance penalty if the amount
of insurance is not periodically increased for inflation.

2.Insured may incur a coinsurance penalty if property values
fluctuate widely during the policy period

3.If a small loss occurs, the insured may incur financial hardship if
he or she is required to take a physical inventory of the undamaged
and damaged goods
106
Coinsurance in Health Insurance
Health insurance policies frequently contain a

percentage participation clause
The clause requires the insured to pay a

certain percentage of covered medical
expenses in excess of the deductible
80-20 Coinsurance clause
80%20%
107
Coinsurance in Health Insurance
The purpose is
to reduce premiums
and prevent overutilization of policy

benefits
108
Other-insurance Provisions
The purpose of other-insurance provisions is to
prevent profiting from insurance and violation of
the principle of indemnity
109
Under a pro rata liability provision, each
insurers share of the loss is based on the
proportion that its insurance bears to the total
amount of insurance on the property
(1)Pro rata liability
1:500,000A
300,000 B100,000 C100,000
100,000
Company A:300,000500,000 x 100,000 = 60,000

Company B:100,000500,000 x 100,000 = 20,000
Company C:100,000500,000 x 100,000 = 20,000
110
Total loss payment

= 100,000
Under contribution by equal shares, each insurer shares
equally in the loss until the share paid by each insurer
equals the lowest limit of liability under any policy, or
until the full amount of the loss is paid
(2)Contribution by Equal Shares

1.Amount of loss = 150,000
amount of insurance contribution by equal shares

Company A 100,000
50,000
Company B 200,000
50,000
Company C 300,000
50,000
total paid
50,000
50,000
50,000
2.Amount of loss = 500,000
amount of insurance contribution by equal shares

Company A 100,000
100,000
Company B 200,000
100,000 +100,000
Company C 300,000
100,000 +100,000
total paid
100,000
200,000
200,000
111
Exhibit 6.3 Pro Rata Liability Example
112
Exhibit 6.4 Contribution by Equal Shares

(Example 1)
113
Exhibit 6.5 Contribution by Equal Shares

(Example 2)
114
Under a primary and excess insurance provision, the
primary insurer pays first, and the excess insurer
pays only after the policy limits under the primary
policy are exhausted
(3)Primary and Excess Insurance

The primary insurer pays first, and the excess insurer pays only after
the policy limits under the primary policy are exhausted.
Primary insurer Excess insurer
Primary insurer

APrimary insurer500,000 B
Excess insurer300,000600,000
A500,000
115
B100,000
The coordination of benefits provision

in group health insurance is designed to

prevent overinsurance and the duplication
of benefits if one person is covered under
more than one group health insurance plan
e.g., two employed spouses are insured as
dependents under each others group health
insurance plan
116

Aggregate Deductible
All-Risks Policy
Calendar Year Deductible
Coinsurance Clause
Contribution By Equal Shares
Equity in Rating
Exclusions
Insuring Agreement
Large Loss Principle
Named Insured
Named perils Policy
117
Coordination of benefits Provision
Corridor Deductible
Declarations
Elimination(Waiting)Period
Other Insurance Provision
Percentage Participation Clause
Primary and excess insurance
Pro rata Liability
Straight deductible
118
Chapter 24
Types of Private
Insurers and
Marketing
Systems
Agenda
Overview of Private Insurance in the
Financial Services Industry
Types of Private Insurers
Agents and Brokers
Types of Marketing Systems
Group Insurance Marketing
120
Overview of Private Insurance in the

Financial Services Industry
The financial services industry consists of:
Commercial banks
Savings and loan institutions
Credit unions
Life and health insurers
Property and casualty insurers
Mutual Funds
Securities brokers and dealers
Private and state pension funds
Government-related financial institions
121
Exhibit 24.1 Assets of Financial Services

Sectors, 2007 ($billions)
122
Overview of Private Insurance in

the Financial Services Industry
Changes in the financial services industry
include:
Consolidations
The number of firms has declined due to mergers and
acquisitions
Convergence
Existing financial institutions now sell a wide variety
of financial products that earlier were outside their
core business area
123

Size of the insurance market, 2007
Life and health insurers: 1009
These insurers sell life and health insurance
products, annuities, mutual funds, pension plans,
and related financial products
Property and casualty insurers: 2723

These insurers sell property and casualty insurance
and related lines, including marine coverages and
surety and fidelity bonds
124
Exhibit 24.2 Top Twenty U.S. Life/Health

Insurance Groups by Revenues, 2007 ($ millions)
125
Exhibit 24.3 Top Twenty U.S. Property/ Casualty

Companies by Revenues, 2007 ($millions)
126

Insurers can be classified by their
organizational form:
Stock insurers
Mutual insurers
Reciprocal exchanges
Lloyds of London
Blue Cross and Blue Shield Plans
Health maintenance organizations (HMOs)
Other types of private insurers
127

A stock insurer is a corporation owned by
stockholders
Objective: earn profit for stockholders
Increase value of stock
Pay dividends
Stockholders elect board of directors

Stockholders bear all losses
Insurer cannot issue an assessable policy
128

129


A mutual insurer is a corporation owned by the policyowners
Policyowners elect board of directors, who have effective
management control
May pay dividends to policyowners, or give a rate reduction in
advance
There are three main types of mutual insurers:
An advance premium mutual is owned by the policyowners; there are
no stockholders, and the insurer does not issue assessable policies
An assessment mutual has the right to assess policyowners an
additional amount if the insurers financial operations are unfavorable
A fraternal insurer is a mutual insurer that provides life and health
insurance to members of a social or religious organization
130

The corporate structure of mutual insurers
is changing due to:
An increase in company mergers
Demutualization, in which a mutual company is
converted into a stock insurer by:
Pure conversion
Merger
Bulk reinsurance
The creation of mutual holding companies

A holding company is a company that directly or
indirectly controls an authorized insurer
131
Exhibit 24.4 Mutual Holding Company Illustration
132
Lloyds of London is not an insurer, but a society

of members who underwrite insurance in
syndicates
Membership includes corporations, individual members
(Names), and Scottish limited partnerships
New individual members, or Names, who belong to the
various syndicates now have limited legal liability
Corporations with limited legal liability and limited liability
partnerships can also join Lloyds of London
Lloyds is licensed only in a small number of jurisdictions
in the U.S.
133

A reciprocal exchange is an unincorporated
mutual
The reciprocal is managed by an attorney-infact
In a pure reciprocal exchange, insurance is
exchanged among the members; each member
of the reciprocal insures the other members
A separate account is kept for each member
A modified reciprocal exchange is similar to an

advance premium mutual
No individual accounts
134

Blue Cross and Blue Shield Plans are generally
organized as nonprofit, community oriented plans
Blue Cross plans provide coverage for hospital services
Blue Shield plans provide coverage for physicians and
surgeons fees
Most plans have merged into one entity
Many sponsor HMOs and PPOs
Some plans have converted to a for-profit status to raise
capital and become more competitive
135

A Health Maintenance Organization (HMO)
provides comprehensive health care
services to its members
Broad health care services are provided for a
fixed prepaid fee
Cost control is emphasized
Choice of health care providers may be
restricted
Less costly forms of treatment are often
provided
136

A captive insurer is an insurer owned by a parent
firm for the purposes of insuring the parent firms
loss exposures
More than 5100 captives exist today
Savings Bank Life Insurance refers to life

insurance that is sold by mutual savings banks,
over the phone or through Web sites
137
Agents and Brokers

An agent is someone who legally represents
the principal and has the authority to act on
the principal's behalf
(Insurance Agent)

Authority may be:
Expressed
Implied
Apparent
The principal is responsible for all acts of an

agent when the agent is acting within the
scope of authority
138
Agents and Brokers
A property and casualty agent has the

power to bind the insurer
A binder provides temporary insurance
until the policy is actually written
A life insurance agent normally does not

have the authority to bind the insurer
The applicant for life insurance must be
approved by the insurer before the
insurance becomes effective
139
Agents and Brokers

A broker is someone who legally represents the insured,
and:
solicits applications and attempts to place coverage with an
appropriate insurer
is paid a commission from the insurers where the business
is placed
does not have the authority to bind the insurer
(Insurance Broker)

A surplus lines broker is licensed to place business with
a nonadmitted insurer
Surplus lines refer to any type of insurance for which there
is no available market within the state, and coverage must
be placed with a nonadmitted insurer
140
Marketing Systems in Life Insurance
An agency building system is a system by which an insurer

builds its own agency force by recruiting, financing, training,
and supervising new agents
General agency system
The general agent is an independent contractor who represents only one
insurer, and receives a commission based on the amount of business
produced
Insurer provides some financial assistance, but the general agent is
responsible for recruiting, training, and motivating new agents
Managerial system
Branch offices are established in various areas
The branch manager is responsible for hiring and training new agents,
and receives a commission from the insurer
Insurer pays expenses of the branch office
141
Marketing Systems in Life Insurance

A nonbuilding agency system is a marketing system
by which an insurer sells its products through
established agents
A personal-producing general agent is a successful
agent who is hired primarily to sell insurance under a
contract
Under a direct response system, insurance is sold

directly to customers without the services of an agent
142
Marketing Systems
in Property and Liability Insurance
The independent agency is a business firm
that usually represents several unrelated insurers
Agents are paid a commission based on the amount of
business produced, which vary by the line of insurance
Agency owns the expirations or renewal rights to the
business
Under the exclusive agency system, the agent

represents only one insurer or group of insurers
under common ownership
Agents do not usually own the expirations or renewal
rights to the policies
Agents are generally paid a lower commission rate on
renewal business than on new business
143
Marketing Systems
in Property and Liability Insurance
A direct writer is an insurer in which the salesperson
is an employee of the insurer, not an independent
contractor.
Employees are usually compensated on a salary plus
arrangement
A direct response insurer sells directly to the

consumer by television or some other media
Used primarily to sell personal lines of insurance
Many property and casualty insurers use multiple

distribution systems
144
Group Insurance Marketing
Many insurers use group marketing

methods to sell individual insurance
policies to:
Employer groups
Labor unions
Trade associations
Some property and liability insurers use

mass merchandising plans to market their
insurance
Employees pay for insurance by payroll
deduction
145
Chapter 25
Functional
Operations of
Private Insurers
Agenda
Rating and Ratemaking

Underwriting
Production
Claim settlement
Reinsurance
Investments
147
Rating and Ratemaking

Ratemaking refers to the pricing of
insurance and the calculation of insurance
premiums
A rate is the price per unit of insurance
An exposure unit is the unit of measurement used in
insurance pricing
premium rate * exposure units
Total premiums charged must be adequate for

paying all claims and expenses during the policy
period
Rates and premiums are determined by an actuary,
using the companys past loss experience and
industry statistics
148
Underwriting
Underwriting refers to the process of
selecting, classifying, and pricing applicants
for insurance
A statement of underwriting policy
establishes policies that are consistent with
the companys objectives, such as
Acceptable classes of business
Amounts of insurance that can be written
A line underwriter makes daily decisions

concerning the acceptance or rejection of
business
149
Underwriting
Important principles of underwriting:
The primary objective of underwriting is to attain an
underwriting profit
The second principle is to select prospective
insureds according to the companys underwriting
standards
The purpose of underwriting standards is to reduce
adverse selection against the insurer
Adverse selection is the tendency of people with a
higher-than-average chance of loss to seek insurance
at standard rates. If not controlled by underwriting,
this will result in higher-than-expected loss levels.
Underwriting should also maintain equity among the

policyholders
One group of policyholders should not unduly subsidize
another group
150
Underwriting
Underwriting starts with the agent in the field
Information for underwriting comes from:
The application
The agents report
An inspection report
Physical inspection
A physical examination and attending physicians report
MIB report
After reviewing the information, the underwriter can:

Accept the application
Accept the application subject to restrictions or
modifications
Reject the application
151
Production
Production refers to the sales and
marketing activities of insurers
Agents are often referred to as producers
Life insurers have an agency or sales department
Property and liability insurers have marketing
departments
An agent should be a competent professional

with a high degree of technical knowledge in
a particular area of insurance and who also
places the needs of his or her clients first
152
Claim Settlement
The objectives of claims settlement
include:
Verification of a covered loss
Fair and prompt payment of claims
Personal assistance to the insured
Some laws prohibit unfair claims practices,

such as:
Refusing to pay claims without conducting a
reasonable investigation
Not attempting to provide prompt, fair, and
equitable settlements
Offering lower settlements to compel
insureds to institute lawsuits to recover
153
amounts due
Claim Settlement
The claim process
begins with a notice of loss
Next, the claim is investigated
A claims adjustor determines if a covered loss has
occurred and the amount of the loss
The adjustor may require a proof of loss

before the claim is paid
The adjustor decides if the claim should be
paid or denied
Policy provisions address how disputes may be
resolved
154
Reinsurance
Reinsurance
is an arrangement by which the primary
insurer that initially writes the insurance
transfers to another insurer part or all of the
potential losses associated with such
insurance
The primary insurer is the ceding company
The insurer that accepts the insurance from the
ceding company is the reinsurer
The retention limit is the amount of insurance
retained by the ceding company
The amount of insurance ceded to the reinsurer is
known as a cession
155
Reinsurance
Reinsurance is used to:
Increase underwriting capacity
Stabilize profits
Reduce the unearned premium reserve
The unearned premium reserve represents the
unearned portion of gross premiums on all
outstanding policies at the time of valuation
Provide protection against a catastrophic

loss
Retire from business or from a line of
insurance or territory
Obtain underwriting advice on a line for
which the insurer has little experience
156
Types of Reinsurance Agreements

There are two principal forms of reinsurance:
Facultative reinsurance is an optional, caseby-case method that is used when the ceding
company receives an application for insurance that
exceeds its retention limit
Facultative reinsurance is often used when the primary
insurer has an application for a large amount of
insurance
Treaty reinsurance means the primary insurer

has agreed to cede insurance to the reinsurer, and
the reinsurer has agreed to accept the business
All business that falls within the scope of the agreement
is automatically reinsured according to the terms of the
treaty
157
Methods for Sharing Losses

There are two basic methods for sharing losses:
Under the Pro rata method, where the ceding company
and reinsurer agree to share losses and premiums based
on some proportion
Under the Excess method, where the reinsurer pays only
when covered losses exceed a certain level
Under a quota-share treaty, the ceding insurer and the
reinsurer agree to share premiums and losses based on
some proportion
Under a surplus-share treaty, the reinsurer agrees to
accept insurance in excess of the ceding insurers
retention limit, up to some maximum amount
An excess-of-loss treaty is designed for catastrophic
protection
A reinsurance pool is an organization of insurers that
underwrites insurance on a joint basis
158
Types of Reinsurance
1.Facultative reinsurance
2.Treaty reinsurance
under treaty reinsurance, if the business falls within the
scope of the agreement, the primary company must cede
insurance to the reinsurer and the reinsurer must accept.
159
B.Types of automatic treaties
(1)Quota share
(2) Surplus share

(One Line)(Lines)
20
160
(3)Excess of loss
(4)Excess of loss ratio
=
=
161
Reinsurance Alternatives
Some insurers use the capital markets as
an alternative to traditional reinsurance
Securitization of risk
means that an insurable risk is
transferred to the capital markets
through the creation of a financial
instrument, such as a futures contract
162
Reinsurance Alternatives
Catastrophe bonds are corporate bonds that
permit the issuer of the bond to skip or
reduce the interest payments if a
catastrophic loss occurs
Catastrophe bonds are growing in importance and
are now considered by many to be a standard
supplement to traditional reinsurance.
163
Investments
Because premiums are paid in advance, they
can be invested until needed to pay claims and
expenses
Investment income is extremely important in
reducing the cost of insurance to policyowners
and offsetting unfavorable underwriting
experience
Life insurance contracts are long-term; thus,
safety of principal is a primary consideration
In contrast to life insurance, property
insurance contracts are short-term in nature,
and claim payments can vary widely
depending on catastrophic losses, inflation,
164
medical costs, etc
Exhibit 25.1 Growth of Life Insurers Assets
165
Exhibit 25.2 Asset Distribution of Life

Insurers 2007
166
Exhibit 25.3 Investments, Property/Casualty

Insurers, 2007 Investments by Type
167
Other Insurance Company Functions

The electronic data processing area
maintains information on premiums, claims,
loss ratios, investments, and underwriting
results
The accounting department prepares
financial statements and develops budgets
In the legal department, attorneys are used
in advanced underwriting and estate
planning
Property and liability insurers provide
numerous loss control services
168
Chapter 26
Financial
Operations of
Private Insurers
Agenda
Property and Casualty Insurers
Life Insurance Companies
Ratemaking in Property and Casualty
Insurance
Ratemaking in Life Insurance
The Financial Crisis and Insurers
170
Financial Statements of Property and

Casualty Insurers
Balance Sheet: a summary of what a
company owns (assets) and what it owes
(liabilities)
Total Assets = Total Liabilities + Owners Equity
171
Exhibit 26.1 ABC Insurance Company
172

Casualty Insurers
The primary assets for an insurance
company are financial assets
Insurers liabilities include required
reserves
A loss reserve is an estimated amount for:
Claims reported and adjusted, but not yet paid
Claims reported and filed, but not yet adjusted
Claims incurred but not yet reported to the
company
173

Casualty Insurers
Case reserves are loss reserves that are
established for each individual claim
Methods for determining case reserves
include:
The judgment method: a claim reserve is
established for each individual claim
The average value method: an average value is
assigned to each claim
The tabular method: loss reserves are
determined for certain claims for which the
amounts paid depend on data derived from
mortality, morbidity, and remarriage tables
174

Casualty Insurers
The loss ratio method establishes
aggregate loss reserves for a specific
coverage line
A formula based on the expected loss ratio
is used to estimate the loss reserve
The incurred-but-not-reported (IBNR)

reserve is a reserve that must be
established for claims that have already
occurred but that have not yet been
reported
175

Casualty Insurers
The unearned premium reserve is a liability
item that represents the unearned portion of
gross premiums on all outstanding policies at
the time of valuation
Its purpose is to pay for losses that occur during the
policy period
It is also needed so that refunds can be paid to
policyholders that cancel their coverage
It also serves as the basis for determining the
amount that must be paid to a reinsurer for carrying
reinsured polices
The annual pro rata method is one method of
calculating the reserve
176

Casualty Insurers
Policyholders surplus is the difference
between an insurance companys assets and
liabilities
The stronger a companys surplus position, the
greater is the security for its policyholders
177

Casualty Insurers
The income and expense statement
summarizes revenues and expenses paid over
a specified period of time
The two principal sources of revenue are
premiums and investment income
Earned premiums are those premiums for which the
service for which the premiums were paid (insurance
protection) has been rendered
Expenses include the cost of adjusting claims,

paying the insured losses that occurred,
commissions to agents, premium taxes, and
general insurance expenses
178
Exhibit 26.2 ABC Insurance Company
179
Measuring the Performance of Property

and Casualty Insurers
The loss ratio is the ratio of incurred losses and loss
adjustment expenses to premiums earned
Loss Ratio
Incurred Losses Loss Adjustment Expenses

Premiums Earned
The expense ratio is equal to the companys

underwriting expenses divided by written premiums
Expense Ratio
Underwriti ng Expenses
Premiums Written
The combined ratio is the sum of the loss ratio and

the expense ratio. A positive ratio indicates an
underwriting loss
180
Measuring the Performance of Property

and Casualty Insurers
The investment income ratio compares net
investment income to earned premiums
Investment Income Ratio
Net Investment Income

Earned Premiums
The overall operating ratio is equal to the combined

ratio minus the investment income ratio
This ratio measures the companys total performance
(underwriting and investments)
181
Financial Statements of
Life Insurers
The balance sheet
The assets of a life insurer have a longer
duration, on average, than those of property
and casualty insurers
Because many life insurance policies have a
savings element, life insurers keep an interestbearing asset called contract loans or policy
loans
A life insurance company may have separate
accounts for assets backing interest-sensitive
products, such as variable annuities
182
Life Insurers
Policy reserves are a liability item on the balance
sheet that must be offset by assets equal to that
amount
State laws specify the minimum basis for calculating policy
reserves
The reserve for amounts held on deposit is a

liability representing funds that are owed to
policyholders and to beneficiaries
The asset valuation reserve is a statutory
accounting account designed to absorb asset value
fluctuations not caused by changing interest rates
183
Life Insurers
Policyholders surplus is less volatile in the life
insurance industry than in the property and
casualty insurance industry
Benefit payments, including death benefits
paid to beneficiaries and annuity benefits paid
to annuitants, are the life insurers major
expense
A life insurers net gain from operations equals
total revenues less total expenses,
policyowner dividends, and federal income
taxes
184
Measuring the Performance of Life

Insurers
A number of measures can be used to
gauge the performance of life insurers
Pre-tax or after-tax net income vs. total
assets
Rate of return on policyowners surplus
185

Insurance
State Laws Require:
Rates should be adequate for paying all losses
and expenses
Rates should not be excessive, such that
policyholders are paying more than the actual
value of their protection
Rates must not be unfairly discriminatory;
exposures that are similar with respect to losses
and expenses should not be charged significantly
different rates
186

Insurance
Business Rate-Making Objectives include:
Rates should be easy to understand.
Rates should be stable over short periods of
time
Rates should be responsive to changing loss

exposures and changing economic conditions
Rates should encourage loss prevention
187

Insurance
A rate is the price per unit of insurance.
An exposure unit is the unit of measurement
used in insurance pricing, e.g., a car-year
The pure premium is the portion of the rate
needed to pay losses and loss adjustment
expenses
Loading is the amount that must be added to
the pure premium for other expenses, profit,
and a margin for contingencies
The gross rate consists of the pure premium
and a loading element
The gross premium paid by the insured consists
of the gross rate multiplied by the number of188
exposure units

Insurance
There are three basic rate making

methods in property and casualty
insurance:
1. Judgment rating means that each
exposure is individually evaluated, and
the rate is determined largely by the
judgment of the underwriter
2. Class rating means that exposures with
similar characteristics are placed in the
same underwriting class, and each is
charged the same rate
189

Insurance
Class rates are determined using two
basic methods:
Under the pure premium method, the pure
premium can be determined by dividing the
dollar amount of incurred losses and lossadjustment expenses by the number of
exposure units
Under the loss ratio method, the actual loss
ratio is compared with the expected loss ratio,
and the rate is adjusted accordingly
190

Insurance
3. Merit rating is a rating plan by
which class rates are adjusted upward or
downward based on individual loss
experience
Under a schedule rating plan, each exposure is

individually rated
A basis rate is determined for each exposure, which

is then modified by debits or credits depending on
the physical characteristics of the exposure
Commonly used in commercial property insurance
191

Insurance
Under experience rating, the class or
manual rate is adjusted upward or downward
based on past loss experience
The insurers past loss experience is used to
determine the premium for the next policy period
Under a retrospective rating plan, the

insureds loss experience during the current policy
period determines the actual premium paid for that
period
A provisional premium is paid at the beginning of the
policy period; the final premium is calculated at the
end of the policy period
Commonly used in workers compensation insurance
192
Ratemaking in Life Insurance

Life insurance actuaries
use a mortality table or individual
company experience to determine the
probability of death at each attained age
The annual expected value of death claims
equals the probability of death times the
amount the insurer must pay if death occurs
193
The Financial Crisis and Insurers

The recent financial crisis has affected
financial institutions in different ways
Banks were more negatively impacted as they
issued the sub prime mortgage loans
Insurers were not heavily involved in sub prime
lending
Insurers did not securitize the bad mortgage loans
and mortgage debt was not a significant share of
insurers investment portfolios
Insurers were most affected by the sharp decline
in the value of their investment portfolios
194

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Principles of Risk Management and

Copyright 2011 Pearson Education. All Rights Reserved

Some states have a valued policy law that

Principle of Insurable Interest

An insurable interest is required in every insurance

Principle of Insurable Interest

Principle of Insurable Interest

owners of property will lose financially if their property is

Principle of Insurable Interest

a husband can purchase a life insurance policy on his wifes life

Even when there is no relationship by blood or marriage, one

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

Principle of Insurable Interest

When must insurable interest exist

Principle of Insurable Interest

Principle of Insurable Interest

To hold the negligent person responsible

To hold down insurance rates

Principle of Utmost Good Faith

Principle of Utmost Good Faith

Supported by three legal doctrines:

Principle of Utmost Good Faith

Principle of Utmost Good Faith

Principle of Utmost Good Faith

Requirements of an Insurance Contract

To be legally enforceable, an insurance

Requirements of an Insurance Contract

Requirements of an Insurance Contract

Legally competent parties, with legal capacity

Requirements of an Insurance Contract

The contract must exist for a legal purpose

Distinct Legal Characteristics of

Contract of adhesion: since the insured

Distinct Legal Characteristics of

Distinct Legal Characteristics of

Distinct Legal Characteristics of

That is, the insurers obligation to pay a claim depends on

Distinct Legal Characteristics of

because the assignment does

Distinct Legal Characteristics of

Law and the Insurance Agent

Knowledge of the agent is presumed to be knowledge of

Law and the Insurance Agent

is defined as the voluntary

Law and the Insurance Agent

occurs when a representation of fact made by

Key Concepts and Terms

Broad Evidence Rule

Key Concepts and Terms