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Notes from topc 6,7, and a little bit of 8

by: Shakayla Stewart

Notes from topc 6,7, and a little bit of 8 FINA 3154

Marketplace > East Carolina University > Finance > FINA 3154 > Notes from topc 6 7 and a little bit of 8
Shakayla Stewart

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Notes between topics 6-8
Principles of Risk Management and Insurance
Dr. Brad Karl
Risk Management and Insurance
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This 13 page Bundle was uploaded by Shakayla Stewart on Wednesday March 23, 2016. The Bundle belongs to FINA 3154 at East Carolina University taught by Dr. Brad Karl in Winter 2016. Since its upload, it has received 11 views. For similar materials see Principles of Risk Management and Insurance in Finance at East Carolina University.


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Date Created: 03/23/16
Historical Development of Insurance Regulation • Paul v. Virginia (1868) • Affirmed states rights to regulate insurance • U.S. v. Southeastern Underwriters Association (1944) • Reversed Paul V. Virginia • McCarran­Ferguson Act (1945) • Congress gave insurance regulation back to the states • Financial Modernization Act of 1999 (Gramm­Leach­Bliley) • Allowed banks and insurers to operate together Insurance Regulation • What entity is responsible for regulating insurers? • The state regulates insurance through an insurance regulation  department • Insurance commissioner oversees the regulatory duties • Elected or appointed • Reasons for insurance regulation include: • Maintenance of insurer solvency • Compensate for inadequate consumer knowledge • Ensure reasonable rates • Make insurance available Methods of Regulation • Legislation • State laws • Ex: formation of companies, licensing of agents, solvency  requirements,ext • Courts • Paul v. Virginia • US v. SEUW • State Insurance Departments • National Association of Insurance Commissioners Regulated Areas • Formation and licensing of insurers • Ex: will an insurer be permitted to operate in a state • Solvency regulation • Capital and surplus requirements • Rate regulation • Ensure rates are adequate and not excessive • Policy forms • i.e. insurance policy language  • Sales practices and consumer protection • Consumer complaints or unfair trade practices Rate Regulation • Prior approval laws • Rates must be filed and approved by the state before use • File­and­use law • Rates must be filed and can be used immediately after filing • Use­and­file law • Insurers can put into effect immediately any rate change, but rates  must be filed within a certain period of time • Open competition • Insurers are not required to file their rates Methods of Ensuring Insurer Solvency • Financial requirements • Risk­based capital (RBC) standards • Annual financial statements • Field examinations • Early warning system  • Insurance Regulatory Information System (IRIS) • Financial Analysis Solvency Tracking (FAST) Principle of Indemnity What is the Principle of Indemnity? • States that the insurer agrees to pay no more than the actual amount of the loss Purposes: 1. Prevent the insured from making a profit 2. Reduce moral hazard Actual Cash Value (ACV) • ACV supports the principle of indemnity • Courts use a number of methods to determine ACV • Fair Market Value • The price a willing buyer would pay a willing seller in a free  market • Broad Evidence Rule • Determination of ACV should include all relevant value • Replacement Cost Less Depreciation • ACV = Replacement cost of property ­ depreciation • Note: Replacement cost is the current cost of restoring the  damaged property with new materials of like kind and quality.   ACV: RP minus Depreciation Example • Sam has a favorite couch that burns in a fire. Assume that she bought the  couch five years ago, the couch is 50 percent depreciated, and a similar  couch today would cost $1,000. Under ACV, how much will Sam collect for her couch?  $1,000­$500= $500 More on ACV • ACV supports principle of indemnity in Property insurance • Different methods are employed in other lines of insurance • Liability insurance: insurer pays up to the policy limit the amount an  insured is legally obligated to pay.  • Business income insurance: amount paid is based on the amount of  profits lost by the business.  • Life insurance: amount paid is based on the face value of the policy.  Exceptions to the Principle of Indemnity 1) Valued Policy • Policies that pays the face amount of insurance if a total loss occurs • Used to insurer antiques, fine arts, family heirlooms, etc. • Used in cases where determining ACV is difficult/impossible 2) Replacement Cost Insurance • NO deduction for physical depreciation in determining the amount  paid for a loss 3) Life Insurance  Principle of Subrogation • Subrogation • The insurer is entitled to recover from a negligent third party any loss  payments made to the insured • Strongly supports the Principle of Indemnity Purposes of Subrogation: 1. Prevents the insured from collecting twice for the same loss 2. Used to hold the guilty person responsible for the loss 3. Helps to hold down insurance rates Additional Comments Regarding Subrogation 1. The insurer is entitled only to the amount it has paid under the policy 2. The insured cannot impair the insurer’s subrogation rights 3. Subrogation does not apply to life insurance and to most individual health  insurance contracts 4. The insurer cannot subrogate against its own insureds Principle of Insurable Interest • Principle of Insurable Interest: • states the insured must be in a position to lose financially if a covered loss occurs • Insurance contracts must be supported by an insurable interest to be  legally enforceable Purposes of Insurable Interest: 1. Prevent Gambling 2. Reduce Moral Hazard 3. Measure the amount of the insured’s loss in property insurance Insurable Interest in PC Insurance • All of the following support insurable interest in PC insurance • Ownership of property • Potential legal liability  • Secured creditors • e.x. bank has an insurable interest in a house for which is  has an existing mortgage outstanding • Contractual right Insurable Interest in Life Insurance • Beneficiary does not need insurable interest • Close family ties/marriage • Reduce moral hazard • Less likely to murder someone for insurance money • Pecuniary Interest • Ex: a corporation can purchase life insurance on their leading sales  person When Must Insurable Interest Exist? • In Property Insurance: • At the time of of the loss • In Life Insurance • At the time of the purchase Principle of Utmost Good Faith What is the Principle of Utmost Good Faith? A higher degree of honesty is imposed on both parties to an insurance contract than is imposed on parties to other contracts. Q: Why do we care? A: If the Principle of Utmost Good Faith is violated, coverage is voidable. • Three important legal doctrines support the Principle of Utmost Good Faith 1) Representations 2) Concealment (Nondisclosure) 3) Warranty • Note, if one of these doctrines is violated, insurer has the right to void  coverage Three Important Legal Doctrines 1. Representations • Statements made by the applicant for insurance • If applicant provides false information, the insurer must prove the  applicant spoke fraudulently and intended to deceive Three aspects of representation: • Material: if the insurer knew the true facts, the policy would not have been issued or the policy would have been issued on different terms. • False: The statement is not true or misleading. • Reliance: the insurance relies on the misrepresentation in issuing the  policy at a specific premium. Three Important Legal Doctrines 2. Concealment (Nondisclosure) • Intentional failure of the applicant for insurance to reveal  a material fact to the insurer Must prove 2 things: 1. Concealed fact was known by the insured to be material 2. Insured intended to defraud the insurer Three Important Legal Doctrines 3. Warranty ­ Statement that becomes part of the insurance contract and is guaranteed by  the maker to be true in all respects. • Ex: an insurer agrees to insure a business on the condition that the insured  will install burglar and fire alarms.  • Here, the condition of alarm installation is the warranty Legal Requirements of an Insurance Contract • For an insurance contract to be legally enforceable, the following four  requirements must be met: 1) Offer and Acceptance 2) Consideration 3) Competent Parties 4) Legal Purpose Offer and Acceptance • Who makes the offer?  Who accepts (rejects) the offer? • Applicant for insurance makes the offer • Insurance company either rejects or accepts the offer  • Property – Offer and acceptance can be oral or written  • Life Insurance – Application always in writing • What is a binder?   • A temporary contract for insurance • In property insurance, who can issue a binder? Consideration • What is consideration? • The value that each party gives to the other Mariah purchases auto insurance from a  local insurance agent.  What is the  consideration? • Insurer • Promise to do certain things specified in the contract • i.e. payment after a loss • Insured • Payment of premium Competent Parties • What is meant by “Competent”? • Parties must have legal capacity to enter into a legally binding  contract • Exceptions • Children, intoxicated, mentally disabled • Minors • If a minor enters into an insurance contract, it is voidable (for  any reason) at the discretion of the minor Legal Purpose • Contract must be for a legal purpose • Don’t want to promote illegal activities contrary to public interest • Ex: a person cannot purchase automobile insurance on a stolen vehicle • Ex: A heroin dealer cannot purchase property insurance that would  cover the seizure of heroin.  Distinct Legal Characteristics of Insurance Contracts 1. Aleatory Contract  • Unequal values exchanged  2. Unilateral Contract  • Only one party makes a legally enforceable contract 3. Conditional Contract • Obligation to pay depends on whether the insured has complied with  all policy conditions 4. Personal Contract (Assignments) • Insurance contracts do not transfer with the property 5. Contract of Adhesion • Insured must accept the insurance contract with all its terms and  conditions Insurance Agents – Legal Background What is an Agent? • Has the authority to act on behalf of someone else What is a Principle? • The party for whom action is to be taken Insurance contracts are often sold by an AGENT who represents the  INSURANCE COMPANY Basic Parts of an Insurance Contract 1. Declarations 2. Definitions 3. Insuring Agreement 4. Exclusions 5. Conditions 6. Miscellaneous Provisions Declarations • What are Declarations? • Statements that provide information about the particular property  or activity to be insured. • What information is provided? • Identification of the insured (name, DOB, address, ext.) • Location of property  • Amount of insurance • Size of deductible  Definitions • What is the purpose of the definitions section? • The purpose is to define clearly the meaning of key words or  phrases so that coverage under the policy can be determined more  easily  • Example: “we” refers to the insurance company and “you” refers to  the insured. Insuring Agreement What is the insuring agreement? ­Summarizes the major promises of the insurer 2 types of insuring agreements: 1. Named Perils Coverage • only those perils specifically named in the policy will be covered 2. “All­Risks” Coverage (Open Perils) • all losses are covered except those which are specifically excluded • How does burden of proof differ? • For an insurer to deny payment under an all risk policy, the insurer  must prove that the loss is excluded • Under a named peril contract, the burden of proof is on the insured to  show that the loss was caused by a named peril. Exclusions What is an Exclusion? • a provision in an insurance contract in which the insurer states  situations when coverage will not apply 3 Major Types of Exclusions: 1. Excluded Perils  • e.g. flood or nuclear radiation 2. Excluded Losses • e.g. professional liability in HO 3. Excluded Property • e.g. airplanes in HO Reasons for Exclusions 1. Some perils considered uninsurable • e.g. fundamental risks such as flood or was 2. Presence of extraordinary hazards • e.g. using personal autos as a taxi 3. Coverage provided by other contracts • Moral hazard problems • e.g. limits on cash in HO  4. Coverage not needed by typical insureds Conditions What are Conditions? • Provisions in the policy that qualify or place limitations on the  insurer’s promise to perform.   Some common conditions include: 1. Notifying the insurer if a loss occurs 2. Protecting the property after a loss 3. Preparing an inventory of damaged personal property 4. Cooperating with the insurer in the event of a liability suit Miscellaneous Provisions • Cancellation of policy • states when an insurer can cancel a policy (i.e. 30, 60, or 90 days after missed premium payment) • Subrogation  • the insurer states it has the right to subrogate • Other­insurance provisions • Reinstatement of lapsed policy • states the conditions of how an insured can reinstate coverage that has  lapsed due to missed premiums  Definition of the “Insured” Who is the insured? 1. Some policies insure only one person 2. The policy may contain a formal definition of the named insured • John and his wife, Jane • The name of a business entity 3. The policy may also cover other parties even though they are not specifically named in the policy • Resident relatives Endorsements and Riders • What are Endorsements/Riders? • A written provision that adds to, deletes from, or modifies the  provisions in the original contracts.   • When are Endorsements used? • Endorsements are used in property insurance to modify, extend, or  delete provisions • e.g. California residents purchase earthquake endorsements • When are Riders used? • Riders are used in life/health insurance to add or increased benefits,  waive conditions, or amend the basic policy Deductibles What is a Deductible? • A provision by which a specified amount is subtracted from the  total loss payment that would otherwise be payable.   Purposes of Deductibles: 1. Eliminate small claims 2. Reduce premiums 3. Reduce moral and morale hazard Deductibles in Property Insurance • Straight Deductible • The insured must pay a certain number of dollars of loss before the  insurer is required to make a payment • Aggregate Deductible • All losses that occur during a specified time period are  accumulated to satisfy the deductible amount Deductibles in Health Insurance • Calendar­Year Deductible • Aggregate Deductible  • Elimination (Waiting) Period • Time Deductible Coinsurance (Property) • What is the coinsurance clause? • Encourages the insured to insure the property to a stated percentage of its insurable value.   • Typically uses an 80% coinsurance clause • What is the purpose of coinsurance? • Equity in Rating • the notion that if everyone insured for partial losses instead of  full losses, insurance rates would be higher Coinsurance Problems 1. Inflation  • the insured may be in compliance when the policy went into effect at  first but price inflation could increase the replacement cost of the  property.  2. Insured may incur a coinsurance penalty if property values fluctuate 


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