IRMI ON PERSONAL LINES 101

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1 IRMI ON PERSONAL LINES 101

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3 2005, 2009, 2011, 2015 by International Risk Management Institute, Inc. ALL RIGHTS RESERVED. THIS COURSE OR ANY PART THEREOF MAY NOT BE REPRODUCED IN ANY FORM OR BY ANY MEANS WITHOUT THE WRITTEN PERMISSION OF THE PUBLISHER. All course materials relating to this course are copyrighted by IRMI. Purchase of a course includes a license for one person to use the course materials. Absent specific written permission from IRMI, it is not permissible to distribute files containing course materials or printed versions of course materials to individuals who have not purchased the courses. It is also not permissible to make the course materials available to others over a computer network, Intranet, Internet, or any other storage, transmittal, or retrieval system. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If professional advice is required, the services of a competent professional should be sought. IRMI International Risk Management Institute, Inc Merit Drive, Suite 1600 Dallas, TX (972) Fax (972) International Risk Management Institute, Inc., and IRMI are registered trademarks.

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5 IRMI on Personal Lines 101 Contents Introduction... 1 Course Objectives... 2 Chapter 1 Basic Insurance Concepts... 3 Chapter Objectives... 3 Financial and Legal Definitions of Insurance... 3 Financial Definition... 4 Legal Definition... 4 Fundamental Characteristics of Insurance... 4 Loss Pooling... 4 Payment of Accidental Losses... 4 Transfer of Risk... 4 Indemnification... 4 Basic Insurance Terminology... 5 Loss... 5 Peril... 5 Hazard... 5 Proximate Cause... 6 Risk... 6 Risk Classification... 7 Tort... 7 Reinsurance... 7 Elements of a Valid Contract... 7 Offer and Acceptance... 8 Consideration... 8 Legal Capacity... 8 Legal Purpose... 8 Other Legal Terminology... 8 Distinctive Characteristics of Insurance Contracts... 9 Principle of Indemnity... 9 Insurable Interest... 9 Subrogation Unilateral Contract Conditional Contract Personal Contract Aleatory Contract Contract of Adhesion Contract of the Utmost Good Faith Requirements of Ideally Insurable Loss Exposures Large Number of Similar Exposure Units Accidental and Unintentional Loss Definite and Measurable Loss Low Probability of a Catastrophic Loss Calculable Probability of Loss i

6 IRMI on Personal Lines 101 Costs and Benefits of Insurance Costs Benefits Distinctions between Types of Insurance Property and Casualty Insurance Life and Health Insurance Chapter 1 Review Questions Answers to Chapter 1 Review Questions Chapter 2 How the Insurance Industry Operates Chapter Objectives Insurance Distribution Systems Selecting an Insurer Selecting an Agent Agency Services and Compensation Arranging Coverage and Determining Premiums Underwriting Cycles Claims and the Adjusting Process Chapter 2 Review Questions Answers to Chapter 2 Review Questions Chapter 3 Insurance Regulation Chapter Objectives Reasons for Regulation Preserve Insurer Solvency Complex Product and Unequal Knowledge Ensure Fair Rates Promote Social Objectives Legal Background of Regulation State versus Federal Regulation Advantages of State Regulation Advantages of Federal Regulation Entities Involved in Regulation Courts Legislative Bodies State Insurance Departments Regulated Insurance Activities Solvency Regulation Investment Regulation Rate Regulation Policy Form Regulation Agency Practices Adjuster Practices Consumer Protection Chapter 3 Review Questions Answers to Chapter 3 Review Questions ii

7 Contents Chapter 4 Anatomy of an Insurance Policy Chapter Objectives Standard versus Nonstandard Policies Policy Format Declarations Insuring Agreement Covered Perils Exclusions Definitions Conditions Endorsements Insurance Policy Review Chapter 4 Review Questions Answers to Chapter 4 Review Questions Chapter 5 Homeowners Insurance Overview Chapter Objectives Different Homeowners Forms Eligibility Requirements Policy Format/Layout Property Coverages Coverage A Dwelling Coverage B Other Structures Coverage C Personal Property Coverage D Loss of Use Additional Coverages Deductible Covered Perils Dwelling and Other Structures Insuring Agreement Dwelling and Other Structures Exclusions Personal Property Perils General Property Exclusions Key Conditions Insurable Interest and Limit of Liability Duties after Loss Loss Settlement Liability Coverages Personal Liability Medical Payments to Others Liability Exclusions Homeowners Endorsements Chapter 5 Review Questions Answers to Chapter 5 Review Questions iii

8 IRMI on Personal Lines 101 Chapter 6 Personal Auto Policy Overview Chapter Objectives Policy Format/Layout Eligibility Requirements Liability Coverage Insuring Agreement Supplementary Payments Liability Exclusions Limit of Liability Medical Payments Coverage Insuring Agreement Exclusions Limit of Liability Uninsured/Underinsured Motorists Coverage Insuring Agreement Exclusions Limit of Liability Physical Damage Coverage Insuring Agreement Transportation Expenses Key Exclusions Limit of Liability Duties after an Accident or Loss Condition General Provisions PAP Endorsements Chapter 6 Review Questions Answers to Chapter 6 Review Questions Chapter 7 Miscellaneous Personal Lines Coverages Chapter Objectives Dwelling Insurance Reasons for Purchasing Dwelling Coverage ISO Dwelling Program Dwelling Coverage Other Structures Personal Property Fair Rental Value and Additional Living Expenses Separate Supplemental Coverages Farmowners Insurance Property Coverages Liability Coverages Additional Coverages Mobile Home Insurance Ways To Insure Mobile Homes Property Coverages Liability Coverages Personal Inland Marine Insurance iv

9 Contents Motor Home Insurance Full-Timers Personal Liability and Medical Payments Vacation Liability Watercraft Insurance Property Coverage Liability Coverage Uninsured Watercraft Coverage Marine Warranties/Representations Personal Umbrella Insurance Chapter 7 Review Questions Answers to Chapter 7 Review Questions v

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11 Introduction This course provides an introduction to personal lines insurance, which concerns financial protection for individuals and families, as compared to commercial lines insurance, which focuses on protection for businesses and corporations. Examples of personal lines policies include homeowners, personal auto, and motor home insurance. This course is geared to individuals with little or no experience in the field of insurance. It begins with a general discussion about how insurance operates and how it is defined and provides some basic insurance terminology. The course also discusses contract principles and the distinctive characteristics of insurance contracts. The course then looks at some big picture issues, such as the operations and practices of the insurance industry. This includes an overview of the role of the agent, the claims adjusting process, claims administration, and underwriting practices. This is followed by a discussion of insurance regulation, focusing on the role of the courts, statutory law, and the responsibilities of the state s department of insurance. The anatomy of an insurance policy is also reviewed, with discussions about declarations, covered perils, exclusions, definitions, conditions, and endorsements. The course then shifts its focus to different types of personal lines insurance. The main attention will be on homeowners insurance and the personal auto policy (PAP). The course concludes with shorter discussions about miscellaneous personal lines forms, such as the personal umbrella, personal inland marine, watercraft, mobile home, motor home, dwelling, and farmowners policies. The course does not cover life and health insurance. 1

12 IRMI on Personal Lines 101 Course Objectives On completion of this course, you should be able to 1. recognize how insurance is defined and how it operates; 2. identify contract principles and distinctive characteristics of insurance contracts; 3. recognize how the insurance industry operates in general terms; 4. recognize how the insurance industry is regulated by various entities; 5. identify the basic components of a typical insurance policy and recognize the role of each component; 6. recognize the coverages offered by standard homeowners policies; 7. recognize the coverages offered by standard PAPs; and 8. recognize the coverages that can be provided by ancillary personal lines forms, such as personal umbrella, personal inland marine, watercraft, mobile home, motor home, dwelling, and farmowners policies. 2

13 Chapter 1 Basic Insurance Concepts This chapter focuses on fundamental insurance principles designed to give individuals new to the insurance industry basic information on what insurance is, insurance terminology, legal principles as they relate to contracts in general and insurance contracts, and other pertinent matters. Chapter Objectives On completion of this chapter, you should be able to 1. recognize financial and legal definitions of insurance, 2. recognize the correct use of common insurance terms, 3. identify four fundamental characteristics of insurance, 4. identify the requisite elements of a valid insurance contract, 5. identify nine distinctive characteristics of insurance contracts, 6. identify five requirements of an ideally insurable loss exposure, 7. recognize the insurance system s costs and benefits to society, and 8. distinguish between the two major types of insurance. Financial and Legal Definitions of Insurance Insurance professionals and attorneys do not always agree on the definition of insurance. This particular disagreement has led to hundreds if not thousands of court cases. Whether a transaction or product is considered insurance can make a huge difference because insurance is subject to specific tax laws, accounting rules, and regulation. State laws and statutes regulate insurance transactions. There are at least two distinct ways to define insurance a financial definition and a legal definition. Before jumping into the insurance definitions, however, two other terms need to be defined. First, the insurance company is referred to as the insurer. Second, the policyholder (e.g., owner of the house or car) is referred to as the named insured or insured. The named insured is the person specifically named in the policy declarations, and an insured can be either the named insured or a related party (for example, a resident son or daughter) covered by the insurance, based on the policy s definition of an insured. 3

14 IRMI on Personal Lines 101 Financial Definition This definition specifies that insurance is a financial agreement involving the redistribution of financial losses. This process involves shifting potential losses that persons or businesses may face into an insurance pool. The pool, typically operated by the insurer, combines all of these possible losses and then shares the cost of the predicted losses among those parties exposed to the loss. Legal Definition This definition stipulates that insurance is a contractual agreement in which one party (the insurer) agrees to compensate or indemnify another party (the insured) for fortuitous losses. Fundamental Characteristics of Insurance Insurance contains several unique characteristics, including (a) loss pooling, (b) payment of accidental losses, (c) transfer of risk, and (d) indemnification. Loss Pooling Pooling involves the sharing of total losses sustained by a few members of the insured group. This decreases the amount of uncertainty present in a given situation. Pooling also involves the combining of a large number of similar but independent exposure units. This process takes advantage of the law of large numbers, which states that as the number of homogeneous but separate exposure units (e.g., homes insured) increases, the predictability of future losses also increases. Payment of Accidental Losses Payment of accidental or fortuitous losses is another key characteristic of insurance. An accidental loss is unexpected and is the result of sheer chance. This allows the insurer to more accurately predict future losses. Note that intentional losses committed by the insured are excluded under virtually all personal lines policies. Transfer of Risk This characteristic involves the transfer of risk from the insured to the insurer, which is a larger entity more financially able to absorb the loss. Indemnification This process involves the act of an insurer compensating the insured for a covered loss. The goal is to put the insured back in the same financial position he or she was in prior to the loss. This topic will be addressed in detail later in this chapter. 4

15 Chapter 1 Basic Insurance Concepts Basic Insurance Terminology It is important in an introductory insurance course to discuss some basic insurance terms, including the following. Loss Peril Hazard Proximate cause Risk, including pure and speculative risk Risk classification Tort Reinsurance Loss A loss, in insurance terms, refers to the basis of a claim for damages under the terms of the policy. It also refers to the loss of assets resulting from a pure risk, such as a fire loss. (Pure risk is discussed later in this chapter.) Planned losses include expenses such as depreciation on an automobile or boat. Insurance is not designed to cover planned losses, only accidental ones. Insurable losses include direct and indirect losses. A direct loss is the immediate result of a covered cause of loss. An indirect loss is a consequential result of a direct loss. There cannot be an indirect loss if there is no direct loss. For example, a direct loss would be a house fire and the indirect loss would be hotel expenses while the home is being repaired. Peril A peril is defined as the cause of the loss. Thus, if thieves enter a home and steal property, theft is the peril. Property policies such as homeowners insurance cover losses on either a named perils basis or an all risks basis. A named perils policy is one in which the policy specifically lists the covered perils. An all risks policy provides broader protection and covers any accidental loss, subject to a host of policy exclusions. An exclusion is a policy provision that identifies losses that are not covered. Hazard A hazard is defined as a condition or conditions that increase the probability of a loss. A hazard can result in increases in the frequency of losses and/or the severity of losses. The three types of hazards are physical hazards, moral hazards, and morale hazards. Physical Hazard A physical hazard can be defined as a physical condition or situation that increases the possibility of a loss. For example, outdated or frayed wiring in a home is a physical hazard. Concerning auto loss exposures, heavy fog is another physical hazard because driving in fog increases the likelihood of a collision. Note that if an accident occurs, the fog is the hazard and the collision is the peril. 5

16 IRMI on Personal Lines 101 Moral Hazard A moral hazard concerns intentional acts committed by the insured that either create or exaggerate a loss. Moral hazard is measured by the character of the insured and the circumstances surrounding the subject of the insurance. Two examples of moral hazards will illustrate. First, if the insured is unable to make his car payments, he may torch the car to receive the insurance proceeds. This is the creation of a loss. Second, assume the insured s home is burglarized with the thieves stealing the insured s television, stereo, and computer. The thieves, however, cannot find the hidden jewelry. The insured exaggerates the loss by telling the adjuster that the thieves also stole the jewelry. Morale Hazard Morale hazard, as contrasted to moral hazard, does not imply a propensity to cause a loss but implies an indifference to loss simply because of the existence of insurance. Morale hazard is sometimes referred to as attitudinal hazard ; an insured s attitude may be indifferent to a potential loss because he or she has insurance coverage. To illustrate, a person who carelessly leaves the doors to his or her home unlocked on a regular basis is unconcerned with theft because of the existence of a homeowners policy. One way to mitigate this hazard is for the insurer to insist on high deductibles so that the insured has to pay a large amount of money for each loss. Proximate Cause This term refers to a substantial factor in setting events in motion that cause a loss. For example, assume a fire partially damages one major section of a home, weakening a wall in the process. If a windstorm a few hours later were to cause the wall to collapse, fire would be considered the proximate cause of the loss. Risk This term is used in at least two ways. First, it is considered the uncertainty arising from the possible occurrence of given events, such as a fire to a residence. Insurers bear the burden of assuming risk in return for an established premium paid by the insured. Second, many insurance professionals refer to a risk as the insured or the property to which an insurance policy applies. For example, if an auto insurance applicant had been convicted of two driving while intoxicated (DWI) incidents, the insurer would likely decline that risk. Risks are typically organized into two types pure risk and speculative risk. Pure risk is the risk involved in situations that present the opportunity for loss but no opportunity for gain. Thus, there are two possibilities (a) loss or (b) no loss. Pure risks are generally insurable. Examples of pure risks include the uncertainty of loss to property by flood or lightning. In contrast, a speculative risk is the uncertainty about an event under consideration that could produce either a profit, no change in a financial position, or a loss, such as investing in the stock market or a new business venture. Speculative risks often create risks that did not previously exist; thus, they are generally uninsurable. 6

17 Chapter 1 Basic Insurance Concepts Risk Classification Most insurers place their applicants for insurance in well-defined homogeneous classes based on the probability of loss. For example, homes are classified (and rated) based on the type of construction (e.g., wood, brick), occupancy (e.g., one-family, two-family, etc.), protection (e.g., voluntary fire department versus paid fire department), and exposure (types of property adjacent to the dwelling). For personal auto loss exposures, there are separate classes for young male drivers, young female drivers, adult drivers, elderly drivers, and other distinct groups. Each class of homogeneous insureds should theoretically pay its mathematically fair share of the insurance pool s losses. Tort A tort is a civil wrong, other than a breach of contract or a criminal act, giving rise to legal liability. (Liability is the obligation to pay a monetary award for injury or damage caused by one s negligence.) A tort can result from (a) negligence, (b) intentional acts, or (c) strict liability. Negligence Negligence involves the failure to use a reasonable degree of care under a given set of circumstances. The four elements of negligence are (1) a duty owed to a plaintiff (the party bringing suit or seeking damages), (2) an unintentional breach of that duty by the defendant (the party against whom the suit has been brought), (3) an injury or damage suffered by the plaintiff, and (4) a sufficient causal connection between the defendant s unintentional negligence and the plaintiff s injury or damage. Personal lines liability insurance virtually always covers negligence. Intentional Acts If an act is committed with the purpose of injuring someone or damaging another s property, the result is an intentional injury. Nearly all personal lines insurance policies exclude these types of actions. Examples of these acts are assault and defamation of character. Strict Liability Strict liability is a doctrine that concerns liability for damages regardless of fault. An example is a homeowner who keeps a tiger he owns in his backyard. If a teenager cuts a hole in the fence and taunts the tiger, resulting in a mauling, no negligence has to be established for the insured to be held legally liable. Strict liability often deals with inherently dangerous property or situations. Reinsurance Reinsurance is a transaction in which one party (the reinsurer) in consideration of a premium paid to it, agrees to indemnify another party (the insurer) for part or all of the liability assumed by the insurer under a policy it has issued. In simpler terms, reinsurance is insurance protection for insurers. For extremely large risks, such as a $10 million home, the insurer often procures reinsurance. Elements of a Valid Contract A contract is a binding agreement between two or more persons that is enforceable by law. This agreement must be made under certain conditions before a court can enforce it. There are four requirements common to all contracts, including (a) offer and acceptance, (b) consideration, (c) legal capacity, and (d) legal purpose. 7

18 IRMI on Personal Lines 101 Offer and Acceptance An offer is an expression of the willingness to enter into an agreement with another party. The offer must be made in a clear and well-communicated manner. An acceptance is the assent of the offer; it must be unconditional and communicated clearly as well. Legal experts refer to this process as a meeting of the minds because both parties must agree to the identical terms of the agreement. In an insurance transaction, the applicant for insurance makes the offer to buy insurance by completing an application. The insurance agent normally is the party that conveys this offer to the insurer. The insurer has three options in this situation. It may (a) accept the offer and issue a policy, (b) reject the offer because the applicant does not meet its underwriting guidelines for some reason, or (c) accept the offer with modifications. This last option is often referred to as a counteroffer. For example, the insurer s underwriter may agree to insure the home if a large dead tree hanging dangerously over the house is cut down and removed from the premises. Consideration Consideration is a legal term referring to the value that each party gives to the other when making the contract. Each party must give something of value in order for the transaction to be enforceable. In an insurance contract, the insurer promises to pay for a covered loss, to defend the insured in litigation, or to perform other services such as an inspection. The insured agrees to pay the premium and abide by the requirements of the insurance policy. Legal Capacity Legal capacity is the right to make binding agreements for oneself. Parties who have no legal capacity include minors, intoxicated individuals, and insane persons because these people normally cannot understand the agreement itself. A court would not recognize them as competent parties. In addition, corporations acting outside the scope of their articles of incorporation or outside the scope of authority granted by a governmental body lack legal capacity. For example, an insurer would lack legal capacity in a certain state if it did not have a license to operate in that jurisdiction. Legal Purpose A final requirement is that the agreement must be for a legal purpose. For example, a court of law does not consider a written agreement regarding child pornography or drug dealing a contract. It would be considered void from its very beginning. Other Legal Terminology A few extra terms merit a brief discussion: (1) valid contract, (2) voidable contract, and (3) void contract. A valid contract is a contract that complies with all the essentials of a contract and is binding and enforceable on all parties to it. A voidable contract is a contract that appears to be valid on the surface, but one or both of the parties may void it. For example, in an insurance contract, if the insured commits fraud, the insurer may be able to successfully break the agreement due to the insured s illegal actions. In contrast, a void contract is one that has no legal force because it does not meet the essential elements of a contract. For example, a court would declare an insurance contract with a minor void from its very beginning. 8

19 Chapter 1 Basic Insurance Concepts Distinctive Characteristics of Insurance Contracts Insurance contracts are based on a set of distinctive characteristics, including the following. Principle of indemnity Insurable interest Subrogation Unilateral contract Conditional contract Personal contract Aleatory contract Doctrine of adhesion Doctrine of utmost good faith Principle of Indemnity This principle stipulates that an insured will be reimbursed for his or her loss, subject to the policy s limits and terms. The goal of indemnity is to put the insured back in the same financial condition he or she was in before the loss occurred. In other words, the insured should not profit from an insured loss because this overindemnification increases the moral hazard. For personal lines policies, there are two key exceptions to this rule. First, the policy, such as homeowners insurance, may provide replacement cost coverage, which means the cost to replace the damaged or stolen property with new property without any deduction for depreciation. This is in contrast to paying the claim on an actual cash value basis, which is defined as replacement cost less physical depreciation. With replacement cost coverage, the insured can be overindemnified or overcompensated. For example, if the insured has replacement cost coverage on his dwelling and a hailstorm destroys his 15-year-old roof, the old roof is replaced with brand new shingles. Second, the policy may provide coverage on a valued basis. Valued coverage is property coverage that pays a stipulated dollar amount (rather than the actual cash value or replacement cost of the property) in the event of a total loss. Fine arts coverage is often written on a valued basis because it is typically difficult to ascertain the exact value of the artwork. Insurable Interest Insurable interest is the insured s financial interest in the value of the subject of insurance, such as an owned home or car. In other words, an insured must clearly prove a personal stake in the item being insured or else be unable to collect compensation due when an insured peril causes a loss. Insurable interest usually results from property rights, contract rights, and potential legal liability. For example, assume that a person could procure an insurance policy on a business associate s house. If this same person (the insured) would collect payment when this house burns down, a moral hazard would be created because monies are provided for an event in which the insured did not suffer a financial loss. However, a person can buy insurance on his own home because if the home suffers a major loss, the insured s financial condition also suffers. 9

20 IRMI on Personal Lines 101 Subrogation Subrogation is defined as the assignment to an insurer, after the insurer s payment of a loss to the named insured, of the rights of the insured to recover the amount of the loss from one legally liable for it. This right is based on the principle that if a party must pay for the debt for which another party is liable, such payment should give the party providing payment the right to collect the debt from the guilty party. The right of subrogation is automatically recognized by the courts and in statutes and is often additionally specified in insurance policies themselves. For example, assume the insured purchases an older home. After he moves in, he has to replace his gas water heater that malfunctions. The contractor improperly installs a new water heater, which later explodes and starts a major fire in the home. If the insured chooses to collect payment from his homeowners policy, his insurer will be subrogated to his right to sue the responsible contractor. Thus, subrogation prevents the insured from collecting twice (double indemnification) for the loss. If this were allowed to occur, the moral hazard of insuring property would be greatly heightened. Unilateral Contract An insurance contract is a unilateral one. This type of contract is one in which only one party (the insurer) makes an enforceable promise (to pay a covered loss). By contrast, the insured makes few, if any, enforceable promises to the insurer. Instead, the insured must only fulfill certain conditions such as paying premiums and reporting accidents. Conversely, a bilateral contract is one in which the parties involved give mutual promises. Conditional Contract A conditional contract is one in which the performance of some or all terms of the agreement is dependent upon a condition. A condition is an event, not certain to happen, that must occur before performance under a contract becomes due. For example, the insured is required to cooperate with the insurer in the investigation of a claim as a condition for the loss to be paid. Personal Contract This term means that the contract is solely between the named insured and the insurer. The insured applicant must meet certain underwriting standards such as loss history, moral character, and credit history. A personal contract is one that the named insured cannot assign or transfer to another party. For example, if the named insured sells his only car to a friend, he cannot simply assign his PAP to his friend. His insurer will want to cancel the policy and request that the neighbor complete a new application for insurance. Aleatory Contract This distinctive characteristic refers to an agreement concerned with an uncertain event that provides for unequal transfer of value between the parties. Insurance policies are aleatory contracts because an insured can pay premiums for many years without sustaining a covered loss. Conversely, insureds sometimes pay relatively small premiums for a short period of time and then receive payment for a substantial loss. 10

21 Chapter 1 Basic Insurance Concepts Contract of Adhesion This characteristic stipulates that the insured must accept or adhere to the entire contract, with all of its terms and conditions. The insurer develops and prints the contract or policy, and the insured typically has to accept it in its entirety or reject it. The insured cannot insist that it be rewritten or that certain phrases be added or removed. Some amendments may be allowed, such as endorsements that restrict or expand coverage. However, the insurer also writes these endorsements. As a result, the courts normally rule that any ambiguities within the policy should be ruled in favor of the party with lesser knowledge (i.e., the named insured). This encourages insurers to draft policies that are clearly written, and it promotes the effective usage of definitions to help clarify important terms. Contract of the Utmost Good Faith This is a type of contract in which one party is in particular possession of facts unknown to the other party at the time the contract is negotiated. As a result, a higher standard of honesty is imposed on parties to an insurance transaction than is imposed on regular commercial contracts. The level of good faith an insured owes to an insurer is best explained through the concept of representation. An integral part of an insurance transaction is the named insured s truthful completion of an insurance application. Courts refer to the applicant s answers as representations. If the insurer relies on a dishonest answer, it may be able to void the contract, depending on the materiality of the facts. The test as to the materiality of a particular fact is whether the answer on the application, if honestly rather than dishonestly disclosed, would have influenced an insurer to decline the applicant or to have caused the insurer to write the applicant s policy for a higher premium. The duty of good faith also applies to the insurer in its promise to pay for a covered loss. Requirements of Ideally Insurable Loss Exposures From the insurer s perspective, there are five key requirements of ideally insurable loss exposures: Large number of similar exposure units Accidental and unintentional loss Definite and measurable loss Low probability of a catastrophic loss Calculable probability of loss Large Number of Similar Exposure Units An insurer needs a large number of homogeneous but independent loss exposure units to achieve predictive accuracy, taking advantage of the law of large numbers. Accidental and Unintentional Loss The loss should be fortuitous and generally outside the insured s control. If intentional losses were covered, the moral hazard would greatly increase, leading to even more losses. 11

22 IRMI on Personal Lines 101 Definite and Measurable Loss The loss must be specific as to time and place. For this reason, many homeowners policies do not cover mysterious disappearance of property but cover instead definite theft losses. The loss also must be measurable to aid in the claims adjusting process. Thus, termite damage is not covered under virtually all homeowners policies because ascertaining the exact date of the initial occurrence and the extent of the damage is very difficult. Low Probability of a Catastrophic Loss Insurers want to avoid situations in which most of the risks in the insured pool might suffer losses at the same time from the same peril, such as earthquake or flood. This can lead to major financial problems for the insurer. For this reason, the federal government is closely involved in flood insurance. Calculable Probability of Loss The chances of a loss must be reasonably calculable. The insurer must be able to calculate with some degree of accuracy the average frequency (the likelihood that a loss will occur) and average severity (amount of damage) of upcoming losses. This is essential in order for the insurer to charge the correct premium that will cover losses and expenses as well as provide a profit margin. Costs and Benefits of Insurance There are various costs and benefits of the insurance system to society. It is generally agreed that the benefits of insurance far exceed the costs of insurance. Costs There are two main costs to society of operating an insurance system: Cost of the resources utilized by the system, including land, capital investment, and labor Costs arising from increased losses due to the morale and moral hazards. For example, there would be less arson if there were no insurance proceeds to be possibly collected from this act. Benefits The insurance system provides several benefits to society: Stability to families and businesses through the indemnification process, a family or business can be restored to its pre-loss financial condition. Peace of mind insurance provides comfort to families that may worry about losing their home or being sued due to automobile accidents. In other words, they experience less fear and worry about financial matters. Facilitates credit transactions creditors are more willing to lend funds if they know the house or car they are financing will be replaced or repaired if damaged. Thus, the creditor s collateral remains intact. Risk control insurers are very involved in loss prevention and reduction programs. Many insurers employ inspectors and loss control engineers to make recommendations to insureds on ways to reduce the frequency and severity of losses. 12

23 Chapter 1 Basic Insurance Concepts Source of investment capital insurers collect premium in advance and do not necessarily pay for incurred losses immediately. This net cash flow between premium collections and loss payments can be invested in the stock market and other financial products, thus bolstering the economy. Distinctions between Types of Insurance The insurance industry is typically organized into two separate arenas (a) property and casualty and (b) life and health. Most insurance professionals work in only one area, with some exceptions. For example, some agents deal with property and casualty insurance as well as life, health, and disability insurance. Other agents, however, deal exclusively with one or the other. Most other insurance occupations focus solely in one of these two areas. Property and Casualty Insurance Property insurance deals with first-party insurance that indemnifies the owner or user of property (e.g., homeowner) for his or her loss if caused by a covered peril such as fire or windstorm. First party refers to a situation in which the insured (the first party to the insurance contract) has an issue directly with his or her own insurer (the second party to the insurance contract). In contrast, casualty insurance generally deals with third-party insurance that is primarily concerned with the losses caused by injuries to persons and legal liability imposed on the insured for such injury or for damage to property of others. Third party refers to the addition of the claimant (e.g., party that has been injured due to the insured s negligence) into the mix along with the insured and insurer. Thus, the claimant is the third party to the insurance contract. Although practitioners often treat casualty insurance and liability insurance as though they were synonyms, the term casualty technically includes some lines of insurance other than liability insurance. Many personal lines policies, such as the homeowners policy and PAP, contain property and liability coverages packaged together. In contrast, a dwelling policy often deals solely with property coverage, and a personal umbrella policy deals exclusively with liability coverage. These two policies will be discussed in the last chapter of this course. Life and Health Insurance This area of insurance focuses on life, disability, and health insurance, topics not addressed in this course. 13

24 IRMI on Personal Lines 101 Chapter 1 Review Questions 1. Ted owns a home insured with a homeowners policy issued by MegaInsurance. Ted, the policyholder named in the declarations, is referred to as a. the buyer. b. the named insured. c. the resident insured. d. the related party. 2. MegaInsurers pays Henry Homeowner for a loss sustained to his roof during a hailstorm. In doing this, what is MegaInsurers goal? a. To inspire customer loyalty b. To justify a premium increase c. To provide more business for Rolf s Roofing d. To put Henry back into the same financial position he was in before the loss 3. Harry Homeowner pays premiums on his homeowners policy for 30 years but never files a claim because he suffers no losses. Cassandra Cottage insures her newly purchased home and, just 2 months after buying and insuring it, files a claim for a major fire loss. These two examples illustrate that an insurance contract is a(n) contract. a. personal b. immoral c. unconditional d. aleatory 4. Because he has insurance against theft losses, Omar never locks his car when he parks it. Omar s behavior in this example is an example of what type of hazard? a. Moral b. Morale c. Physical d. Proximate 5. Although his gun was not in any sense defective, Chester managed to shoot himself in the foot. Chester then sued the gun manufacturer for negligence. However, the suit was not successful because one element of negligence was missing. Which one was it? a. A duty owed to the plaintiff b. An unintentional breach of that duty by the defendant c. Causal connection between the defendant s unintentional negligence and the plaintiff s injury or damage d. Injury or damage suffered by the plaintiff 14

25 Chapter 1 Basic Insurance Concepts Answers to Chapter 1 Review Questions 1. b. The policyholder whose name appears in the declarations is the named insured, often referred to in policies as you. 2. d. MegaInsurers fulfills the promises in Henry s policy by indemnifying him putting him in the same financial position he was in prior to the loss, when he had an undamaged roof. 3. d. Harry paid his insurer more than the insurer ultimately paid him; Cassandra paid less. An aleatory contract involves an unequal transfer of values. 4. b. Omar s failure to lock his car because he has insurance against theft losses increases the probability that somebody will steal property from his car or even steal the car itself. 5. b. The gun manufacturer owed Chester (the plaintiff) the duty to provide a safe weapon, and Chester clearly suffered injury or damage. But the gun manufacturer (defendant) provided a safe gun and did not breach its duty. If the gun had been defective, the defect might have caused Chester s injury, but there was no defect. 15

26 IRMI on Personal Lines

27 Chapter 2 How the Insurance Industry Operates On the surface, the process for obtaining insurance is simple. A salesperson, typically called an agent, producer, or account executive, works with the prospective insured or policyholder to complete an application for insurance. The agent provides this information to underwriters at one or more insurers, and they (1) accept the offer, (2) reject the offer, or (3) accept the offer with modifications. For the third option, an underwriter may agree to insure a personal auto risk if the named insured is willing to choose and maintain a high collision deductible on his sports car. If the insurer agrees to write the business, there is a meeting of the minds, and coverage is then bound and in force. When the insured experiences a loss, it is reported to the insurer, and a claims adjuster is assigned to handle the claim. The adjuster investigates the claim and determines whether the loss falls within the coverage parameters of the insurance policy. Assuming coverage applies, the adjuster will determine how much to pay the insured to resolve the loss for property insurance claims or coordinate the defense of liability insurance claims. This chapter explores the insurance procurement process and claims adjusting process in more detail. Chapter Objectives On completion of this chapter, you should be able to 1. recognize how the insurance system operates and 2. recognize the roles of insurance producers, underwriters, and claims representatives. Insurance Distribution Systems In the United States, property and liability insurance is distributed by four types of systems: the direct writer system, the exclusive agency system, the independent agency system, and direct response marketing. The direct writer and exclusive agency insurance companies market insurance through salaried salespeople or commissioned agents who sell only the insurance products of a particular company. Examples of direct writer and exclusive agency companies include Farmers Group, Nationwide, and State Farm. The independent agency system insurance companies, on the other hand, depend on independent insurance agents to sell their products. These agents often represent many insurance companies. A few examples of the many independent agency system insurance companies are CNA, Chubb, The Hartford, and Travelers. Both exclusive and independent producers represent some insurance companies, such as Liberty Mutual. 17

28 IRMI on Personal Lines 101 Direct response marketing is becoming increasingly popular with personal lines insurance. Many transactions are now conducted through the Internet. Although it is easy to shop online (not only for insurance) within the comfort of one s home, those who buy insurance online forgo the advice and other value that can be added by dealing with an educated and experienced insurance agent. Although Internet transactions eliminate some sales expenses, insurers that sell through the Internet often have high advertising budgets. From the standpoint of the insurance buyer, each alternative for marketing insurance offers both advantages and disadvantages. A key advantage of the direct writer/exclusive agency system over the independent agency system is lower expense ratios, a fact that should ultimately be reflected in lower premiums. A key disadvantage of direct writers and exclusive agency companies is that their representatives can offer only the services and products that their employer provides. However, both segments have made changes so that the advantages of one system over another in a particular area are diminishing. Probably the most important advantage of using independent agents as compared to direct writers and exclusive agents is that independent agents can place insurance with any one company or a combination of many insurance companies with which they do business. An independent agency generally has contracts with the insurers it represents. Not being employees of the insurance company, some independent agents are more oriented toward representing the buyer of insurance than they are toward representing the insurance company. The insurance buyer should keep in mind, however, that an insurance agent is legally an agent of the insurance company and not of the insurance buyer. In contrast, a true insurance broker is legally an agent of the insured and not of the insurance company. In practice, the legal distinctions between insurance agents and brokers probably make little difference in the level of service provided to insurance buyers and should not be an important consideration in choosing an insurance representative. Selecting an Insurer An insurance buyer can have success using either the independent agency system or the direct writer/exclusive agency system. The named insured s selection of a financially strong insurance company is a very important factor. Insurance is simply a promise the insurer makes to pay for a covered loss, which can occur far into the future. However, the promise to pay a covered loss is worth no more than the financial strength of the insurer that makes it. The insured should also look for an insurer that is fair and prompt in settling claims and is able and willing to provide excellent service before and after a loss. Selecting an insurer based solely on low cost may result in unfortunate consequences. Gaining recommendations from friends and business colleagues is a good first step in selecting an insurer. Selecting an Agent The most visible function of an insurance representative that is, an agent or direct sales representative is to procure coverage for clients. Individuals should look for an agent who is knowledgeable, experienced, service oriented, technically proficient, and responsive. The evaluation process should encompass all personnel who will work with the insured, including assistants and anyone involved in providing ancillary services. More often than not, assistants (often called Customer Service Representatives or CSRs ) will handle much of the day-to-day activity on the account and will have some authority and responsibility to act alone. 18

29 Chapter 2 How the Insurance Industry Operates Unfortunately, some insureds choose a representative without careful consideration of the perils of engaging an inexperienced or incompetent representative. For example, many insureds engage agents because of social or family relationships. Others retain an agent based purely on the price quoted. While cost and comfortable relationships are important, they are not the only criteria on which insureds should base their selections. Naturally, insureds want to minimize their insurance costs. However, until all other factors are equal, price should not be the determining factor in selecting a representative. More important is the agent s knowledge, access to reputable and specialized insurance markets, education, experience in dealing with personal lines, and service capabilities. While knowledge cannot be measured directly, insureds can look at a number of other factors for evidence of the representative s knowledge. Most agents would agree that the majority of what they know is learned in the trenches. Therefore, length of time in the insurance business is one measure of a representative s overall familiarity with the markets (e.g., what a particular insurer s policy form does and does not provide). The amount and types of education, particularly continuing education (CE), also shed light on the representative s commitment to getting the proper background and staying current on developments in loss exposures, coverages, and markets. Designations such as CPCU (Chartered Property Casualty Underwriter), CIC (Certified Insurance Counselor), AAI (Accredited Advisor in Insurance), AFIS (Agribusiness and Farm Insurance Specialist), and PLCS (Personal Lines Coverage Specialist) demonstrate that the agent has completed a rigorous course of study in insurance and risk management. The key point to remember is that the agent is the primary interface/supplier of insurance protection, and it is therefore important to choose a knowledgeable and professional representative experienced in personal lines coverage. Agency Services and Compensation Most agents perform a host of services beyond simply delivering an insurance policy. These may include personal risk management program reviews, policy reviews, and assisting in getting claims settled and paid. These types of services are often referred to as value-added services because they are performed as part of a general agreement between the representative and the insured, and they do not carry extra charges. The term value-added services describes any services the agent performs as part of his or her role as adviser, over and above delivering a policy. The compensation paid to independent agents by the persons for whom they procure insurance is usually in the form of commissions paid by the insurance company (and passed through as part of the premium). Commissions vary from insurance company to insurance company, agent to agent, and region to region. They are also different for different lines of insurance. Arranging Coverage and Determining Premiums The insured asks an agent to obtain a quotation. The insured and the agent assemble the underwriting data necessary to determine whether the risk is insurable. An underwriter at the insurance company reviews the underwriting data and determines whether the company wants to issue the policy. The goal of an underwriter is to develop a book of business in which the actual losses approximate the expected losses. The underwriter has to look at a multiplicity of factors to determine whether he or she wants to write the risk. Increasingly, personal lines insurers are using expert systems in which a software program scores a personal lines applicant based on a list of predetermined parameters. 19