insuring individual risks - bookmark education

INSURING INDIVIDUAL RISKS

Continuing Education for California Insurance Professionals

www.BookmarkEducation.com

Chapter One / Motor Vehicle Insurance

INSURING INDIVIDUAL RISKS COPYRIGHT © 2006 by Bookmark Education All rights reserved. No part of this book may be reproduced, stored in any retrieval system or transcribed in any form or by any means (electronic, mechanical, photocopy, recording or otherwise) without the prior written permission of Bookmark Education.

A considerable amount of care has been taken to provide accurate and timely information. However, any ideas, suggestions, opinions, or general knowledge presented in this text are those of the authors and other contributors, and are subject to local, state and federal laws and regulations, court cases, and any revisions of the same. The reader is encouraged to consult legal counsel concerning any points of law. This book should not be used as an alternative to competent legal counsel.

Printed in the United States of America. P1

All inquires should be addressed to:

Bookmark Education 6203 W. Howard Street Niles, IL 60714 (800) 716-4113 www.BookmarkEducation.com

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TABLE OF CONTENTS

....................................................................................1 CHAPTER 1 – MOTOR VEHICLE INSURANCE......................................................................................................................................1 Introduction

...............................................................1 The Tort Liability System and Automobile Insurance.......................................................................................................1 Personal Auto Policy: Overview

.............................................................................................................2 The Declarations Page.........................................................................................2 Insuring Agreement and Definitions

.......................................................................................................................3 Eligible Vehicles.........................................................................................4 Personal Auto Policy: Liability Coverage

.......................................................................................................................5 Insured Persons........................................................................................................5 Supplementary Payments

................................................................................................................................6 Exclusions.........................................................................................................................9 Limit of Liability

...........................................................................................................10 Out of State Coverage......................................................................................................................10 Other Insurance

......................................................................10 Personal Auto Policy: Medical Payments Coverage..............................................................................................................................11 Exclusions

.......................................................................................................................13 Limit of Liability......................................................................................................................14 Other Insurance

...................................................................14 Personal Auto Policy: Uninsured Motorists Coverage..............................................................................................................................15 Exclusions

.......................................................................................................................16 Limit of Liability......................................................................................................................17 Other Insurance

...........................................................................................17 Underinsured Motorist Coverage.........................................................17 Personal Auto Policy: Coverage for Damage to Automobile

..............................................................................................................................19 Exclusions.......................................................................................................................22 Limit of Liability.....................................................................................................................22 Payment of Loss

................................................................................................................22 No Benefit to Bailee......................................................................................................................23 Other Insurance

................................................................................................................................23 Appraisal................................................................23 Personal Auto Policy: Duties After an Accident or Loss

.....................................................................................24 Personal Auto Policy: General Provisions.........................................................................................................24 Legal Action Against Us

.............................................................................................25 Our Right To Recover Payment....................................................................................................25 Policy Period And Territory

............................................................................................................................25 Termination....................................................................................................26 Two Or More Auto Policies

...................................................26 Personal Auto Policy: Insuring Motorcycles and Other Vehicles........................................................27 Approaches for Compensating Automobile Accident Victims

..................................................................................29 Automobile Insurance for High-Risk Drivers........................................................................................................30 Cost of Automobile Insurance

..................................................................................................................................30 Territory.................................................................................................................................30 Age, Sex

...........................................................................................................30 Use of The Automobile.....................................................................................................................31 Driver Education

..........................................................................................................31 Good Student Discount..........................................................................................31 Number and Type of Automobiles

.......................................................................................................31 Individual Driving Record.................................................................................................31 Purchase Higher Deductibles

.......................................................................................................31 Improved Driving Record.....................................................................................................................................31 Conclusion

...................................32 CHAPTER 2 – HOMEOWNERS AND PERSONAL PROPERTY INSURANCE....................................................................................................................................32 Introduction

.........................................................................................32 The History of Property Insurance.............................................................................................................................34 Negligence

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......................................................................................35 The Language of Liability Insurance................................................................................................................................35 Summary

..........................................................................................36 Homeowners Insurance – Introduction.............................................................................................36 Coverage and Limits of Liability

...................................................36 Types of Homeowners Policy Forms and Their Coverages............................................................................................................37 HO-1 and HO-2 Policy

............................................................................................................................38 HO-3 Policy

............................................................................................................................39 HO-5 Policy.........................................................................................................39 HO-4 and HO-6 Policies

............................................................................................................................40 HO-8 Policy.............................................................40 Homeowners Insurance – Property Coverage – Section I

...........................................................................................................................40 The Dwelling.......................................................................41 Detached Structures Located on the Property

...................................................................................................................41 Personal Property.............................................................................................43 Loss of the Use of the Structure

...............................................................................................................43 Additional Coverage.............................................................44 Homeowners Insurance – Liability Coverage – Section II

..................................................................................................45 Personal Liability Exclusions.......................................................................................46 Filing the Homeowners Insurance Claim

.................................................................................................46 Replacement Cost Coverage......................................................................................................................47 Dwelling Claims

.......................................................................................................48 Personal Property Claims.......................................................................................49 Other Homeowners Insurance Concepts

............................................................................................................................49 Subrogation.............................................................................................................................50 Statements

...................................................................................................................................50 Salvage..........................................................................................................50 Non-Waiver Agreement

............................................................................................................................50 Cancellation...........................................................................51 Homeowners Insurance – Concluding Thoughts

...................................................................................51 Personal Property Insurance – Introduction.................................................................................................................51 Inland Marine Insurance

......................................................................................51 Inland Marine Insurance – Definition.....................................................................................51 Inland Marine Floater Characteristics

............................................................................................52 Inland Marine Floater Provisions...........................................................................................53 Inland Marine Floater Exclusions

................................................................................................................54 Personal Articles Floater..............................................................................................................58 Personal Property Floater

....................................................................................58 Scheduled Personal Property Floater.............................................................................................59 Unscheduled Personal Property

........................................................................................................59 Newly Acquired Property.............................................................................................................60 Property Not Covered

.................................................................................................................61 Personal Effects Floater.....................................................................................................61 Personal Effects Coverage

..................................................................................................................61 Property Excluded.................................................................................................................61 All-Risks Coverage

....................................................................................................................62 Other Exclusions.................................................................................62 Limitations on Certain Personal Effects

............................................................................................62 Personal Umbrella Liability Insurance.................................................................................63 Nature of Personal Umbrella Insurance

......................................................................................................63 Excess Liability Insurance.....................................................................................................................63 Broad Coverage

............................................................................................................64 Self-Insured Retention...............................................................................................64 Personal Umbrella Coverages................................................................................................65 Personal Umbrella Exclusions

......................................................................................................................67 Watercraft Insurance............................................................................................67 Hull and Trailer Loss Exposures

..................................................................67 Homeowners Policy Physical Damage Coverage

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...............................................................68 Personal Auto Policy Personal Damage CoverageLiability Loss Exposure...........................................................................................................68

..................................................................................68 Homeowners Policy Liability Coverage......................................................................................69 Outboard Motor and Boat Insurance

...................................................................70 Outboard Motor and Boat Insurance Exclusions..................................................................................................70 Watercraft Package Policies

..............................................................................................................72 Personal Yacht Insurance.........................................................................................................73 Uninsured Boaters Coverage

...........................................................................73 Uninsured Boaters Coverage – Exclusions..................................................................................................................74 Specialized Coverages

.....................................................................................74 Ocean Marine Specialized Coverage

.....................................................................................75 Inland Marine Specialized Coverage................................................................................................................79 Ocean Marine Insurance

...................................................................................................................80 Hazards Covered...............................................................................80 Other Types of Ocean Marine Coverage

Conclusion – Personal Property Insurance....................................................................................83 ..................................84 CHAPTER 3 – UNDERWRITING PROPERTY AND CASUALTY INSURANCE

Major Underwriting Goals...............................................................................................................84 .................................................................................................................84 Underwriting Gains

...........................................................................................................85 Contribution to SocietyMaintaining a Strong Insurance Industry................................................................................85

..................................................................................................86 Individual and Class Underwriting.........................................................................................................86 Underwriting Individuals

............................................................................................................87 Underwriting By Class.................................................................................89 Specific Underwriting Factors and Practices

............................................................................................................................89 Loss History.....................................................................................................................89 Accident Record

.......................................................................................................................................90 Fault..............................................................................................................90 Number of Accidents

...................................................................................................91 Commercial/Personal Risks.....................................................................................................................91 Property Losses

.......................................................................................................................92 Liability Losses......................................................................................92 Recommendations for Improvement

.....................................................................................................................92 Traffic Violations............................................................................................................92 Non-Verifiable Record...........................................................................................................93 Sources of Information

........................................................................................................................93 Driving RecordCondition of Property..............................................................................................................93

.....................................................................................................................95 Age of Buildings...................................................................................................................96 Value of Buildings

..........................................................................................................97 Occupancy of Buildings.........................................................................................................................98 Neighborhood........................................................................................................................98 Age of Insured

.........................................................................................................................................99 Sex.........................................................................................................................99 Marital Status

.............................................................................................................................99 Occupation.................................................................................................................................100 Stability

...........................................................................................................101 Social Maladjustment.................................................................................................................................101 Attitude

....................................................................................................................102 Criminal Record...........................................................................................................102 Mental Incompetence...........................................................................................................103 Physical Impairments

................................................................................................................104 Alcohol and Drugs.........................................................................................................................104 Foreign Born

.................................................................................................................104 Related Business.....................................................................................................................105 Prior Insurance

.................................................................................................................105 Prior Cancellation

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....................................................................................................................................106 Conclusion.......................................................................................................107 CHAPTER 4 – LIFE INSURANCE

.............................................................................................................107 The Life Insurance Policy..................................................................................................................107 Uses of Life Insurance

........................................................................................................107 Life Insurance as a Property.....................................................................................................108 The Life Insurance Application

............................................................................................108 Three Parties to an Application..................................................................................................................108 Insurable Interest

...........................................................................................................109 The Application Form................................................................................................................110 Minor Applications

Correcting Applications.........................................................................................................110 ....................................................................................110 Incorrect or Incomplete Applications

..........................................................................................110 Representations and Warranties....................................................................................................................................110 Fraud

........................................................................................................................111 Concealment..............................................................................................................111 Conditional Receipt

........................................................................................111 Policy Effective Date / Backdating.........................................................................................111 How Much Life Insurance Do I Need?

................................................................................................................112 Types of Life Insurance....................................................................................................................112 Term Insurance

............................................................................................................113 Whole Life Insurance.......................................................................................................114 Universal Life Insurance

.........................................................................................................114 Variable Life Insurance.....................................................................................................115 Adjustable Life Insurance

........................................................................................................115 Modified Life Insurance...........................................................................................................116 Family Life Insurance

...................................................................................................116 Types of Insurance Companies............................................................................................116 Stock Life Insurance Company

.................................................................................................116 Mutual Insurance Company......................................................................................................117 Fraternal Benefit Society

........................................................................................117 Government Insurance Programs...........................................................................................................................117 Reciprocals

.................................................................................................................118 Lloyd’s of London.............................................................................................................118 Insurer’s Financial Status

...............................................................................................118 Life Insurance – Policy Provisions................................................................................................................119 Ownership Clause

.........................................................................................................119 Entire Contract Clause............................................................................................................119 Incontestable Clause

......................................................................................................................120 Suicide Clause........................................................................................................................120 Grace Period

..........................................................................................................120 Reinstatement Clause.............................................................................................................120 Misstatement of Age

........................................................................................................120 Beneficiary Designation.....................................................................................................121 Change of Plan Provision

.................................................................................................121 Exclusions and Restrictions.....................................................................................................................................121 Premiums

............................................................................................................122 Parts of the Premium.......................................................................................................123 Net and Gross Premium

................................................................................................................................123 Mortality............................................................................................123 Level Premiums and Reserves

......................................................................................................................124 Insurance Age..........................................................................................................124 Payment of Premiums

.......................................................................................................................124 Settlement Options..........................................................................................................125 Lump Sum Settlement..........................................................................................................125 Proceeds and Interest

......................................................................................................125 Fixed Years Installments...........................................................................................................................125 Life Income

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..................................................................................................................126 Joint Life Income...................................................................................................126 Fixed Amount Installments

............................................................................................126 Other Mutually Agreed Method.................................................................................................................126 Non-Forfeiture Options

..........................................................................................................127 Cash Surrender Value................................................................................................127 Reduced Paid-Up Insurance

....................................................................................................127 Extended Term Insurance..............................................................................................127 Automatic Premium Provision

..............................................................................128 Dividend Accumulations to Avoid Lapse..........................................................................................................................128 Dividend Options

......................................................................................................................128 Cash Payment..........................................................................................................128 Reduction of Premium

.......................................................................................................128 Accumulation of Interest.................................................................................................................128 Paid-Up Additions

....................................................................................................................128 One-Year Term........................................................................................................129 Life Insurance Policy Riders

...............................................................................................................129 Waiver of Premium................................................................................129 Accidental Death and Dismemberment

..............................................................................................130 Guaranteed Purchase Option.........................................................................................................130 Life Insurance Underwriting

......................................................................130 Underwriting Factors for Individual Coverage............................................................................................................131 Underwriting Actions

.....................................................................................................................132 Delivering the Policy............................................................................................................132 Policy Effective Date

................................................................................................................................132 Delivery........................................................................133 Agents Responsibilities Regarding Delivery

.........................................................................................133 Income Tax Benefits of Life Insurance......................................................................................................................................134 Annuities

................................................................................................................134 Types of Annuities..................................................................................................................136 Premium Options

...............................................................................................................136 Settlement Options...........................................................................................................137 Number of Annuitants

..................................................................................................................137 Surrender Terms.................................................................138 Determining the Mathematics of Fixed Annuities

...........................................................................138 Investor Considerations – Fixed Annuities................................................................................................................140 Variable Annuities

...................................................................................................142 Choosing an Annuity Type...............................................................................................................143 Accumulation Units

........................................................................................................................143 Annuity Units..........................................................................144 Risk Considerations for Variable Annuities

..........................................................................................144 Life Insurance Terms and Definitions...................................................................................................................................148 Conclusion

.................................................................................149 CHAPTER 5 – REGULATION OF INSURANCE........................................................................................................149 State vs. Federal Regulation

......................................................................150 National Association of Insurance Commissioners..............................................................................................................152 Gramm-Leach-Bliley Act

............................................153 Creating Uniformity in the Regulation of Insurance Producers............................................................................156 Reciprocity and Uniformity Requirements

......................................................................................156 The Producer Licensing Model Act................................................................................................................157 Protecting Privacy

..........................................................................................................158 Financial Privacy Rule...................................................................................................................160 Safeguards Rule

....................................................................................................162 Implementing Safeguards.....................................................165 Permitted Disclosure of Nonpublic Personal Information

........................................................................................................165 Other GLBA Provisions................................................................................................................166 GLBA – Summary

......................................................................................................166 Legal Cases and Implications

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......................................................................................................................166 Paul v. Virginia

......................................................................................................................167 Munn v. Illinois..................................................................................................................167 The 20th Century

......................................................................168 The South-Eastern Underwriters Association.......................................................................................................................169 Public Law 15

...........................................................................169 The U.S. v. Insurance Board of Cleveland................................................................................................................170 Purposes of Regulation

....................................................................................................172 Major Categories of Regulation...................................................................................172 The Financial Strength of the Insurer

.........................................................................................................172 Regulation of Products..............................................................................173 Regulation of Sales and Sales Activities

.................................................................................................173 Government and Self-Regulation..........................................................................................................174 Legislative Regulation

...............................................................................................................174 Judicial Regulation............................................................................................................174 Executive Regulation

.....................................................................................................................174 Self-Regulation........................................................................................................175 Specific Types of Regulation

...........................................................................................175 Regulation of Insurer Expenses.............................................................................................175 Regulation of Admitted Assets

..................................................................................................................176 Regulating Rates..............................................................................176 Regulating Automobile Insurance Rates

..............................................................176 Regulating Property and Liability Insurance Rates........................................................................177 Regulating Life and Health Insurance Rates

............................................................................................................177 Regulating Reserves........................................................................................................178 Regulation of Dividends

.....................................................................178 Regulation of Capital Stock/Surplus Accounts..........................................................................................178 Regulation of Business Capacity

....................................................................................................178 Regulation of Investments..........................................................179 Requirements for Organizing and Licensing Insurers

..........................................................................................................179 Liquidation of Insurers.........................................................................................................179 Regulation of Products

............................................................................................................................................180 Taxes.................................................................................................180 Applicable Rates and Rules

...........................................................................................................181 Pricing of Insurance Rates..................................................................................................181 Rate Regulation Objectives

..........................................................................182 The State Insurance Commissioner’s Role....................................................................................................................................183 Conclusion

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CHAPTER 1 – MOTOR VEHICLE INSURANCE Introduction Automobile accidents can cause financial and economic havoc to individuals and families. Legal liability arising out of the negligent operation of an automobile can reach traumatic levels. Medical expenses, pain and suffering, the death of a family member, and the damage or loss of property, or loss of the automobile itself can be devastating. The insurance buying public relies on insurance producers for guidance toward the proper insurance policy. The Tort Liability System and Automobile Insurance Each individual has certain legal rights. A legal wrong is a violation of the individual’s legal rights or a failure to perform a legal duty owed to an individual or to society as a whole.

A tort is a legal wrong. Specifically, a tort can be defined as a legal wrong, other than a breach of contract, for which the law allows a remedy in the form of money damages. The person who is injured or harmed (called the plaintiff or claimant) by the actions of another person (called the defendant) can sue for damages.

Torts can generally be classified into three categories:

• Intentional torts.

An intentional act or omission that results in harm or injury to another person or damage to the person’s property. (For example, assault, battery, trespass, false imprisonment, fraud.)

• Absolute liability.

Absolute liability exists when a party is liable for damages even though that party’s fault or negligence cannot be proven. Examples of circumstances giving rise to absolute liability include occupational injury, blasting operations that injure another person, manufacturing of explosives, and crop spraying by airplanes.

• Negligence.

Negligence is a tort that results in harm or injury to another person. Negligence typically is defined as the failure to exercise the standard of care required by law to protect others from harm. The meaning of the term “standard of care” is based on the care required of a reasonably prudent person. Actions are compared with the actions of a reasonably prudent person under the same circumstances. The standard of care required by law is not the same for each wrongful act.

Liability coverage is the most important part of the Personal Auto Policy. It protects a covered person against a suit or claim arising out of the negligent ownership or operation of an automobile.

Personal Auto Policy: Overview The Personal Automobile Policy (also referred to as the “Personal Auto Policy”) is designed to be the most commonly purchased insurance policy for the average family automobile. The Insurance Services Office (ISO) first introduced the Personal Auto Policy in 1977. The ISO form of the Personal Automobile Policy is written in simplified English, making it easier to read and understand than earlier contracts of automobile insurance. It contains simple definitions and short sentences. Highly technical terms have been eliminated from the policy, and the policy language is informal and personal.

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The Personal Auto Policy emphasizes liability protection, making it the first coverage in the policy. (As a comparison, a Homeowners Policy provides liability protection as the last coverage in the policy.) The nature of the property covered, mobile rather than stationary, makes the Personal Auto Policy quite different from a Homeowners Policy. The potential number of non-family members using an automobile is greater than those potentially living in the family house. The possibility that the insured may drive several different non-owned automobiles also makes the Personal Auto Policy a more complicated policy with respect to defining the “insured.”

The Personal Auto Policy begins with a Declarations page, an Insuring Agreement, and Definitions. (Examples of policy language appear in shaded boxes throughout this chapter.) The Declarations identify the named insured, the vehicles covered, and the premium charged for the coverage. The Insuring Agreement makes the contract effective.

The Declarations Page The Declarations Page is the first part of most insurance contracts. Declarations are statements that provide information about the property being insured. Information contained in the Declarations Page is used for underwriting and rating purposes and for identification of the property to be insured. The Declarations section can be found on the first page of the policy or on a policy insert. In some contracts the declarations are part of the written application that is attached to the policy. In property insurance, the declarations section contains information concerning the identification of the insurer, name of the insured, location of the property, period of protection, amount of insurance, amount of the premium, size of the deductible (if any), and other relevant information.

The Declaration Page lists a single limit of liability for the insurer, such as $100,000. This is the limit for all types of damage an insured may cause, including bodily injury and property damage. If judgments are greater than this limit, the insured, not the insurer, pays the excess.

The Personal Auto Policy may also be written on a split limit basis (e.g. $50,000 / $100,000 / $25,000). When coverage is written with split limits of $50,000 / $100,000 / $25,000, the insurer will pay only $50,000 to any one individual and only $100,000 for one accident for bodily injury liability. The $25,000 indicates the maximum amount which the insurer will pay for property damage liability.

Insuring Agreement and Definitions After the Declarations Page, the Personal Auto Policy sets forth the Insuring Agreement and Definitions. The Insuring Agreement states that, “In return for payment of the premium and subject to all the terms of the policy, the insurer agrees with the insured as follows:” The definitions and body of the insurance policy then follow that Insuring Agreement.

Definitions in a standard Personal Auto Policy may include the following:

• Throughout this policy, “you” and “your” refer to:

• The “named insured” shown in the Declarations; and

• The spouse if a resident of the same household.

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• “We,” “us” and “our” refer to the Company providing this insurance. For purposes of this policy, a private passenger type auto shall be deemed to be owned by a person if leased:

• Under a written agreement to that person; and

• For a continuous period of at least 6 months.

• Bodily injury means bodily harm, sickness or disease, including death that results.

• Business includes trade, profession or occupation.

• Family member means a person related to you by blood, marriage or adoption that is a resident of your household. This includes a ward or foster child.

• Occupying means in, upon, getting in, on, out or off.

• Property damage means physical injury to, destruction of or loss of use of tangible property.

• Trailer means a vehicle designed to be pulled by a:

• Private passenger auto; or

• Pickup or van.

• It also means a farm wagon or farm implement while towed by one of the above.

Eligible Vehicles Only certain types of vehicles are eligible for coverage under the Personal Auto Policy. An eligible vehicle is a four-wheel motor vehicle (other than truck-type) that is owned by the insured or is leased by the insured for at least six continuous months.

Pickups and vans are also eligible for coverage if the vehicle is not customarily used in the insured’s business or occupation other than farming or ranching. A vehicle that is owned by a family farm or ranch partnership or corporation is eligible for coverage if the vehicle is garaged principally on the farm or ranch, and other eligibility requirements are met.

A private passenger automobile owned by two or more resident relatives or two or more non-related individuals living together can be insured by adding a miscellaneous type vehicle endorsement to the policy. Motorcycles, motor homes, motor scooters, golf carts, and similar vehicles can be insured under the Personal Auto Policy by adding the same endorsement to the policy.

The actual definition for eligible vehicles may include the following:

“Your covered auto” means:

• Any vehicle shown in the Declarations.

• Any of the following types of vehicles on the date you become the owner:

• A private passenger auto; or

• A pickup or van.

• This provision applies only if:



• You acquire the vehicle during the policy period.

• You ask us to insure it within 30 days after you become the owner.

• With respect to a pickup or van, no other insurance policy provides coverage for that vehicle.

If the vehicle you acquire replaces one shown in the Declarations, it will have the same coverage as the vehicle it replaced. You must ask us to insure a replacement vehicle within 30 days only if:

• You wish to add or continue Coverage for Damage to Your Auto.

• It is a pickup or van used in any “business” other than farming or ranching.

If the vehicle you acquire is in addition to any shown in the Declarations, it will have the broadest coverage we now provide for any vehicle shown in the Declarations.

• Any “trailer” you own.

• Any auto or “trailer” you do not own while used as a temporary substitute for any other vehicle described in this definition which is out of normal use because of its:

• Breakdown;

• Repair;

• Servicing;

• Loss; or

• Destruction.

Personal Auto Policy: Liability Coverage After the Declarations Page, Insuring Agreement and Definitions, Part A of the Personal Auto Policy then sets forth Liability Coverage. Part A sets forth its own Insuring Agreement which describes the major promises of the insurer regarding liability coverage. In the Insuring Agreement, the insurer agrees to pay damages for bodily injury or property damage for which the insured is legally responsible because of an automobile accident.

The insuring agreement in Part A may read as follows:

We will pay damages for bodily injury or property damage for which any covered person becomes legally responsible because of an auto accident. We will settle or defend, as we consider appropriate, any claim or suit asking for these damages. In addition to our limit of liability, we will pay all defense costs we incur. Our duty to settle or defend ends when our limit of liability for this coverage has been exhausted. We have no duty to defend any suit or settle any claim for “bodily injury” or “property damage” not covered under this policy.

Liability coverage is generally written as a single limit that applies to both bodily injury and property damage liability. That is, the total amount of insurance applies to the entire accident without a separate limit for each person. The Personal Auto Policy can also be written with split limits. Split limits mean the amounts of insurance for bodily injury liability and property damage are stated separately.


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In addition to the payment for damages for which the insured is legally liable, the company also agrees to defend and pays all legal defense costs. The defense costs are paid in addition to the policy limits. However, the company’s duty to settle or defend the claim ends when the limit of liability has been exhausted. Once the policy limits are paid out, the company has no further obligation to defend the insured. The company also has no obligation to defend any claim not covered under the policy.

Insured Persons Part A of the Personal Auto Policy provides liability coverage for four different categories of parties:

• Category 1 – You or any “family member” for the ownership, maintenance or use of any auto or “trailer.”

In Category 1 the named insured and resident family members are covered for the ownership, maintenance, or use of any auto, whether it is owned or borrowed, unless exclusions apply.

• Category 2 – Any person using “your covered auto.”

Category 2 relates to any person using a covered auto. The car owner’s insurance, not the driver’s insurance, would pay a claim if the owner allows another party to borrow his or her car. Coverage on the auto involved in an accident is considered primary coverage. If the owner’s insurance is exhausted by the claim, then the driver could turn to his own insurer to pay the remainder of the claim until his own insurance was exhausted.

• Category 3 – For “your covered auto,” any person or organization but only with respect to legal responsibility for acts or omissions of a person for whom coverage is afforded under this part.

• Category 4 – For any auto or “trailer,” other than “your covered auto,” any other person or organization but only with respect to legal responsibility for acts or omissions of you or any “family member” for whom coverage is afforded under this Part. This provision applies only if the person or organization does not own or hire the auto or “trailer.”

Categories 3 and 4 recognize that in some situations, people or organizations other than a driver can be sued due to a driver’s negligence. In some of these instances the Personal Auto Policy will cover the liability of these people. Assume that a trade union sends a member, John, to buy some supplies for a union picnic. Also assume that John uses his own car. If an accident occurs during this trip, the Personal Auto Policy would cover the trade union’s liability in a suit resulting from the accident. The union’s liability arises because John was technically an agent of the union while on his way to purchase supplies for the picnic. The difference between Categories 3 and 4 is the difference between the insured driving an owned or non-owned vehicle.

Supplementary Payments Under the Personal Auto Policy, the insurance company may provide liability coverage beyond its stated limit of liability by making certain supplementary payments. Part A of the Policy describes five categories of supplementary payments:



• Up to $250 for the cost of bail bonds required because of an accident, including related traffic law violations. The accident must result in “bodily injury” or “property damage” covered under this policy.

Premiums up to $250 may be paid for bail bonds arising out of an automobile accident that results in property damage or bodily injury. Payment would not be made for a traffic violation such as a speeding ticket except if an accident occurs.

• Premiums on appeal bonds and bonds to release attachments in any suit we defend.

• Interest accruing after a judgment is entered in any suit we defend. Our duty to pay interest ends when we offer to pay that part of the judgment, which does not exceed our limit of liability for this coverage.

Premiums on appeal bonds and any bond to release an attachment of property in any suit defended by the insurer are also paid as supplementary payments. If interest accrues after a judgment is handed down, the interest is also paid as a supplementary payment. However, any prejudgment interest is subject to the policy’s liability limits.

• Up to $50 a day for loss of earnings, but not other income, because of attendance at hearings or trials at our request.

• Other reasonable expenses incurred at our request.

The insured may be a defendant in a trial and be requested to testify, and the policy will cover up to $50 per day for loss of earnings. If the insured incurs meal or transportation expenses as a result of requests by the insurer, those expenses would be paid as a supplemental payment.

Exclusions Part A of the Personal Auto Policy next details the specific exclusions to liability coverage.

Specifically, the insurance company will not provide liability coverage for any person:

• Who intentionally causes “bodily injury” or “property damage.”

For example, if the insured intentionally runs over a bicycle with his car, the property damage is not covered.

• For damage to property owned or being transported by that person.

For example, if a suitcase or camera were damaged in an automobile accident while a person is on vacation, the damage would not be covered.

• For damage to property:

• Rented to;


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• Used by; or

• In the care of… that person.

This exclusion does not apply to damage to a residence or private garage.

For example, if the insured rents skis that are damaged in an automobile accident, the property damage is not covered by the policy. However, if the insured rents a house and carelessly backs into a partly opened garage door, the property damage would be covered by the policy.

• For “bodily injury” to an employee of that person during the course of employment. This exclusion does not apply to “bodily injury” to a domestic employee unless workers compensation benefits are required or available for that domestic employee.

The intent here is to cover the employee’s injury under a workers compensation law. However, a domestic employee injured during the course of employment would be covered if workers compensation benefits are not required or available.

There is no liability coverage on a vehicle while it is being used to carry persons or property for a fee. If bus drivers or taxicab drivers are on strike and the insured transports passengers for a fee, the policy’s liability coverage does not apply to that circumstance.

• For that person’s liability arising out of the ownership or operation of a vehicle while it is being used to carry persons or property for a fee. This exclusion does not apply to a share-the-expense car pool.

• While employed or otherwise engaged in the “business” of:

• Selling;

• Repairing;

• Servicing;

• Storing; or

• Parking vehicles designed for use mainly on public highways. This includes road testing and delivery. This exclusion does not apply to the ownership, maintenance or use of “your covered auto” by:

• You;

• Any family member; or

• Any partner, agent or employee of you or any “family member.”

If a person is employed or engaged in the automobile business, liability arising out of the operation of vehicles in the automobile business is excluded from coverage under the policy. The automobile business refers to the selling, repairing, servicing, storing, or parking of vehicles designed for use mainly on public highways. This also includes road testing and delivery. If an automobile mechanic has an accident and injures someone while road testing an insured’s car, the Personal Auto Policy liability coverage does not apply to that circumstance. However, if the insured is sued because he is the owner of the car, coverage



applies. The intent of this exclusion is to exclude loss exposures that should be covered under the employee’s liability policy, such as a garage policy.

• Maintaining or using any vehicle while that person is employed or otherwise engaged in any “business” (other than farming or ranching) not described in the prior exclusion. This exclusion does not apply to the maintenance or use of a:

• Private passenger auto;

• Pickup or van that you own; or

• Trailer used with a vehicle described in above.

The purpose here is to exclude liability for commercial vehicles and trucks that are used in a business. However, if a party drives your car on company business, the Personal Auto Policy liability coverage remains in force.

• Using a vehicle without a reasonable belief that the person is entitled to do so.

For example, if the insured’s car is stolen, and someone is injured in an ensuing accident, the injured party is not covered under the insured’s liability policy.

• For “bodily injury” or “property damage” for which that person:

• Is an insured under a nuclear energy liability policy; or

• Would be an insured under a nuclear energy liability policy but for its termination upon exhaustion of its limit of liability.

A “nuclear energy liability policy” is a policy issued by any of the following or their successors:

• American Nuclear Insurers;

• Mutual Atomic Energy Liability Underwriters; or

• Nuclear Insurance Association of Canada.

Each of the above exclusions relate to the actions of a person, whether the insured or another party using the insured’s vehicle. The Personal Auto Policy also presents exclusions which are tied to a particular type of property.

Specifically, the Personal Auto Policy does not provide liability coverage for the ownership, maintenance or use of:

• Any motorized vehicle having fewer than four wheels.

Motorcycles, motor scooters, mini-bikes, mopeds, and trail bikes are excluded under the policy; however, the insured may add a miscellaneous vehicle endorsement to the policy in order to cover these types of vehicles.

• Any vehicle, other than “your covered auto,” which is:


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• Owned by you;

• Furnished or available for your regular use.

The insured may occasionally drive another person’s car and still have coverage under the policy; however, if a non-owned vehicle is driven regularly or is furnished or made available for regular use, the Personal Auto Policy liability coverage will not apply to use of that vehicle. If the insured’s employer furnishes the insured with a car, or if a car is available for regular use in a company carpool, the liability coverage will not apply to use of that vehicle.

• Any vehicle, other than “your covered auto,” which is owned by, furnished or available for the regular use of any “family member.”

If a son or daughter drives a non-owned vehicle on a regular basis, or the vehicle is furnished or made available for their regular use, the liability coverage does not apply.

However, this exclusion does not apply to your maintenance or use of any vehicle, which is:

• Owned by a “family member;” or

• Furnished or available for the regular use of a “family member.”

The exclusion does apply to the named insured and spouse, or if a mother occasionally drives a car owned by another household member, (for example, a son or daughter), the mother’s Personal Auto Policy provides coverage while driving her son’s or daughter’s car.

Limit of Liability The next portion of Part A of the Personal Auto Policy explains the limits of liability under the policy:

The limit of liability shown in the Declarations for this coverage is our maximum limit of liability for all damages resulting from any one-auto accident. This is the most we will pay regardless of the number of –

• “Insureds;”

• Claims made;

• Vehicles or premiums shown in the Declarations;

• Vehicles involved in the auto accident.

We will apply the limit of liability to provide any separate limits required by law for bodily injury and property damage liability. However, this provision will not change our total limit of liability.

The company’s maximum limit of liability from any single automobile accident is the amount stated in the Declarations. This is true regardless of the number of insureds, claims made, vehicles or premiums shown in the declarations, or vehicles involved in the auto accident.



Out of State Coverage The Personal Auto Policy next provides details regarding out of state liability coverage:

If an auto accident to which this policy applies occurs in any state or province other than the one in which “your covered auto” is principally garaged, we will interpret your policy for that accident as follows:

• If the state or province has:

• A financial responsibility or similar law specifying limits of liability for “bodily injury” or “property damage” higher than the limit shown in the Declarations, your policy will provide the higher specified limit.

If an accident occurs in a state that has a financial responsibility law with higher liability limits than the limits shown in the declarations, the Personal Auto Policy automatically provides the higher specified limits.

• A compulsory insurance or similar law requiring a nonresident to maintain insurance whenever the nonresident uses a vehicle in that state or province, your policy will provide at least the required minimum amounts and types of coverage.

If the state has a compulsory insurance or similar law that requires a nonresident to have insurance whenever he or she uses a vehicle in that state, the Personal Auto Policy also provides the required minimum amounts and types of coverages.

• No party will be entitled to duplicate payments for the same elements of loss.

Other Insurance The final section of Part A of the Personal Auto Policy explains the policy’s liability coverage benefits in the event the insured carries other, additional insurance:

If there is other applicable liability insurance we will pay only our share of the loss. Our share is the proportion that our limit of liability bears to the total of all applicable limits. However, any insurance we provide for a vehicle you do not own shall be in excess over any collectible insurance.

In some cases, more than one automobile liability policy covers a loss. If other applicable liability insurance applies to an owned vehicle, the company pays only its pro rata share of the loss. The company’s share is the proportion that its limit of liability bears to the total applicable limits of liability under all policies. However, if the insurance applies to a non-owned vehicle, the company’s insurance is in excess over any other collectible insurance.

Personal Auto Policy: Medical Payments Coverage Part B (or sometimes included as Part B1) of the Personal Auto Policy sets forth Medical Payments Coverage for the insured. Part B’s insuring agreement sets forth the company’s promises regarding its coverage of medical payments required as a result of bodily injury arising out of an automobile accident. Specifically, the policy may provide:


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We will pay reasonable expenses incurred for necessary medical and funeral services because of “bodily injury:”

• Caused by accident; or

• Sustained by an “insured.”

We will pay only those expenses incurred within 3 years from the date of the accident.

The company will pay all reasonable medical and funeral expenses incurred by an insured within three years from the date of the accident. The benefits limits apply to each insured that is injured in the accident.

Medical payments coverage is not based on fault. If an individual is injured in an automobile accident and that individual is at fault, medical payments can still be paid to the individual and to other injured passengers in the car.

The Personal Auto Policy defines “Insured” as used in this part B as:

• You or any “family member:”

• While “occupying” or

• As a pedestrian when struck by:

a motor vehicle designed for use mainly on public roads or a trailer of any type.

The named insured and family members are covered if they are injured while occupying a motor vehicle or are injured as pedestrians when struck by a motor vehicle designed for use mainly on public roads. If a farm tractor, snowmobile, or bulldozer injures an individual, that individual’s injury is not covered.

• Any other person while “occupying” “your covered auto.”

If an individual owns his car and is the named insured, all passengers in his car are covered for their medical expenses under his policy. However, if the insured is operating a non-owned vehicle, other passengers in the car (other than family members) are not covered for their medical expenses under his policy. The reason for this is to cause the other passengers in the non-owned vehicle to seek protection under the medical expense coverage that applies to the non-owned vehicle.

Exclusions Part B of the Personal Auto Policy provides specific exclusions to medical payments coverage. The insurer will not provide medical payments coverage for any person for “bodily injury”:

• Sustained while “occupying” any motorized vehicle having fewer than four wheels.

If the insured is injured while operating a motorcycle or moped, medical expense coverage does not apply.

• Sustained while occupying your covered auto when it is being used to carry



persons or property for a fee. This exclusion does not apply to a share-the-expense car pool.

• Sustained while occupying any vehicle located for use as a residence or premises.

If the insured owns and occupies a house trailer as a residence, medical expense coverage does not apply to injuries arising out of use of that vehicle.

• Occurring during the course of employment if workers compensation benefits are required or available for the “bodily injury.”

Coverage does not apply if the injury occurs during the course of employment and workers compensation benefits are required or available.

• Sustained while occupying or when struck by, any vehicle (other than your covered auto) which is:

• Owned by you;

• Furnished or available for your regular use.

The purpose here is to exclude medical payments coverage on an owned or regularly used car that is not described in the policy and for which an appropriate premium has not been paid.

• Sustained while “occupying,” or when struck by, any vehicle (other than “your covered auto”) which is:

• Owned by any “family member;”

• Furnished or available for the regular use of any family member.

However, this exclusion does not apply to you.

If a son living at home owns a car that is separately insured, and the parents are injured while occupying the son’s car, the parent’s medical expenses would be covered under their policy.

• Sustained while “occupying” a vehicle without a reasonable belief that that person is entitled to do so.

If a covered auto is stolen, the thief has no coverage for medical payments.

• Sustained while occupying a vehicle when it is being used in the business of an insured. This exclusion does not apply to “bodily injury” sustained while “occupying” a:

• Private passenger auto;

• Pickup or van that you own;


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• “Trailer” used with a private passenger auto or pickup or van that you own.

The purpose here is to exclude medical payments coverage for non-owned trucks and commercial vehicles used in the business of an insured person. The exclusion does not apply to a private passenger auto (owned or non-owned), an owned pickup or van, or trailer used with any of the preceding vehicles.

• Caused by or as a consequence of:

• Discharge of a nuclear weapon (even if accidental);

• War (declared or undeclared);

• Civil war;

• Insurrection;

• Rebellion or revolution.

• From or as a consequence of the following, whether controlled or uncontrolled or however caused

• Nuclear reaction;

• Radiation;

• Radioactive contamination.

If the insured drives his car in the vicinity of a nuclear power plant and a nuclear meltdown occurs, the radiation exposure is not covered.

Limit of Liability The next portion of Part B of the Personal Auto Policy explains the limits of liability for medical payments coverage:

The limit of liability shown in the Declarations for this coverage is that our maximum limit of liability for each person injured in any one accident. This is the most we will pay regardless of the number of:

• “Insureds;”

• Claims made;


• Vehicles involved in the accident.

Any amounts otherwise payable for expenses under this coverage shall be reduced by any amounts paid or payable for the same expenses under Part A or Part C.

No payment will be made unless the injured person or that person’s legal representative agrees in writing that any payment shall be applied toward any settlement or judgment that person receives under Part A or Part C.



Other Insurance The final section of Part B of the Personal Auto Policy explains the policy’s liability coverage benefits in the event the insured carries other, additional insurance:

If there is other applicable auto medical payments insurance we will pay only our share of the loss. Our share is the proportion that our limit of liability bears to the total of all applicable limits. However, any insurance we provide with respect to a vehicle you do not own shall be excess over any other collectible auto insurance providing payments for medical or funeral expenses.

Personal Auto Policy: Uninsured Motorists Coverage Some people drive without liability insurance, causing exposure to risk for other parties in the event of an automobile accident. Part C of the Personal Auto Policy sets forth Uninsured Motorists Coverage for the insured. The uninsured motorists coverage is designed to pay for the bodily injury (and property damage in some states) caused by an uninsured motorist, hit-and-run driver, or by a driver whose company is insolvent.

Part C’s insuring agreement sets forth the company’s promises regarding uninsured motorists coverage. Specifically, the policy may provide:

We will pay damages which an “insured” is legally entitled to recover from the owner or operator of an “uninsured motor vehicle” because of “bodily injury:”

• Sustained by an “insured;”

• Caused by an accident.

The owner’s or operator’s liability for these damages must arise out of the ownership, maintenance or use of the “uninsured motor vehicle.”

Any judgment that is for damages arising out of a suit brought without our written consent is not binding on us. The company pays the damages that an insured person is legally entitled to receive from the owner or operator of an uninsured motor vehicle because of bodily injury caused by an accident. However, the coverage applies only if the uninsured motorists are legally liable. If the uninsured motorists are not liable, the company will not pay for the bodily injury.

For purposes of Uninsured Motorists Coverage, “Insured” means:

• You or any “family member”;

• Any other person “occupying” your covered auto;

• Any person for damages that person is entitled to recover because of “bodily injury” to which this coverage applies sustained by one of the above parties.

“Uninsured motor vehicle” means a land motor vehicle or trailer of any type:

• To which no bodily injury liability bond or policy applies at the time of the accident;

• To which a bodily injury liabilities bond or policy applies at the time of the accident. In this case its limit for bodily injury liability must be less than the minimum limit for bodily injury liability specified by the financial responsibility law of the state in which “your covered auto” is principally garaged.


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This means the maximum amount paid for a bodily injury usually is limited to the state’s financial responsibility or compulsory insurance law requirements.

• Which is a hit and run vehicle whose operator or owner cannot be identified and which hits:

• You or any family member;

• A vehicle which you or any family member are occupying or;

• Your covered auto.

If a hit-and-run driver strikes the named insured or any family member while occupying a covered auto, non-owned auto or while walking, the uninsured motorists coverage will pay for the injury.

• To which a bodily injury liabilities bond or policy applies at the time of the accident and the bonding or insuring company:

• Denies coverage;

• Is or becomes insolvent.

However, “uninsured motor vehicle” does not include any vehicle or equipment:

• Owned by or furnished or available for the regular use of you or any “family member”;

• Owned or operated by a self-insurer under any applicable motor vehicle law;

• Owned by any government unit or agency;

• Operated on rails or crawler treads;

• Designed mainly for use off public roads while not on public roads;

• While located for use as a residence or premises.

Exclusions Part C of the Personal Auto Policy also provides exclusions to its Uninsured Motorists Coverage. Specifically, the Personal Auto Policy states that the insurer will not provide Uninsured Motorists Coverage for “bodily injury” sustained by any person:

• While “occupying,” or when struck by, any motor vehicle owned by you or any “family member” which is not insured for this coverage under this policy. This includes a trailer of any type used with that vehicle.

This exclusion was designed to prevent “free” uninsured motorists coverage on automobiles owned by the named insured or family member.

• If that person or the legal representative settles the “bodily injury” claim without our consent.



If a person settles a bodily injury claim without the company’s consent, coverage does not apply. The purpose of this exclusion is to protect the company’s interest in the claim.

• While “occupying” “your covered auto” when it is being used to carry persons or property for a fee. This exclusion does not apply to a share-the-expense car pool.

• Using a vehicle without a reasonable belief that that person is entitled to do so.

If a thief steals the insured’s car and is later injured by an uninsured motorist, the thief is not covered under the insured’s policy.

The exclusions also state that uninsured motorists coverage shall not apply directly or indirectly to benefit any insurer or self-insurer under any of the following or similar law:

• Workers compensation law;

• Disability benefits law.

The uninsured motorist coverage cannot directly or indirectly benefit a workers compensation insurer or self-insurer. A workers compensation insurer may have a legal right of action against a third party who has injured an employee. If an uninsured driver injures an employee who receives workers compensation benefits, the workers compensation insurer could sue the uninsured driver or attempt to make a claim under the injured employee’s uninsured motorist coverage. This exclusion prevents the uninsured motorist coverage from providing benefits to the workers compensation insurer.

Limit of Liability The next portion of Part C of the Personal Auto Policy explains the limits of liability for uninsured motorists coverage under the policy:

The limit of liability shown in the Declarations for this coverage is our maximum limit of liability for all damages resulting from any one accident. This is the most we will pay regardless of the number of:

• “Insureds”;

• Claims made;


• Vehicles involved in the accident.

Any amounts otherwise payable for damages under this coverage shall be reduced by all sums:

• Paid because of the “bodily injury” by or on behalf of persons or organizations that may be legally responsible. This includes all sums paid under Part A; and

• Paid or payable because of the “bodily injury” under any of the following or similar law:

• Workers compensation law;

• Disability benefits law.


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Any payment under this coverage will reduce any amount that person is entitled to recover for the same damages under Part A.

The amount paid under the uninsured motorist’s coverage can be reduced under certain conditions. The amount paid is reduced by any sums paid by the negligent driver or organization legally responsible for the accident or by any benefits payable under workers compensation, disability benefits, or similar law.

Other Insurance The next section of Part C of the Personal Auto Policy explains the policy’s liability coverage benefits in the event the insured carries other, additional insurance:

If there is other applicable similar insurance we will pay only our share of the loss. Our share is the proportion that our limit of liability bears to the total of all applicable limits. However, any insurance we provide with respect to a vehicle you do not own shall be excess over any other collectable insurance.

Underinsured Motorist Coverage In addition to uninsured motorist coverage, underinsured motorist coverage can be added to the Personal Auto Policy to provide more complete protection. This coverage pays damages for a bodily injury caused by the ownership or operation of an underinsured vehicle. The maximum amount paid under this coverage is the underinsured motorists limit less the amount paid by the negligent driver’s insurer.

Underinsured Motorist Coverage and Uninsured Motorist Coverage are exclusive and do not duplicate each other. An insured can collect on one coverage or the other, but not both.

The conditions that must be satisfied before an underinsured motorist’s coverage can be written are:

• Higher uninsured motorist coverage limits must be carried than the limits required by the state’s financial responsibility or compulsory insurance law.

• Both the uninsured and the underinsured motorist coverage must be written for the same amount of insurance.

• The underinsured motorist coverage must apply to all automobiles covered under the policy.

Personal Auto Policy: Coverage for Damage to Automobile Part D of the Personal Auto Policy sets forth coverage in the event of damage to the insured’s automobile. Part D’s insuring agreement explains the company’s promises regarding its coverage of damage to the auto. Specifically, the policy may provide:

We will pay for direct and accidental loss to “your covered auto” or any “non-owned auto,” including their equipment, minus any applicable deductible shown in the Declarations. We will pay for loss to “your covered auto” caused by:

• Other than “collision” only if the Declarations indicate that Other Than Collision Coverage is provided for that auto;

• Collision only if the Declarations indicate that Collision Coverage is provided for



that auto.

If there is a loss to a “non-owned auto,” we will provide the broadest coverage applicable to any “your covered auto” shown in the Declarations.

The company agrees to pay for any direct and accidental loss to a covered auto or any non-owned auto, including its equipment, less any applicable deductible. A covered auto can be insured for both (1) a collision loss and (2) an other-than-collision loss (formerly called comprehensive coverage). A collision loss is covered only if the declaration page indicates that collision coverage is provided for that auto. Coverage for an other than collision loss is in force only if the declarations page indicates that other than collision coverage is provided for that auto. If both coverages are selected, the premium for each coverage is shown separately on the declaration page.

Part D of the Personal Auto Policy contains certain definitions:

• “Collision” means the upset of your covered auto or its impact with another vehicle or object.

Collision losses are paid regardless of fault. If the insured causes the accident, the insurer will pay for the damage to his car, less any deductible. If another driver damages his car, he can collect from the negligent driver (or the negligent driver’s insurer), or from his insurer. If an insured collects from his own company, he must give up subrogation rights to his company, thus allowing the company to seek reimbursement from the other driver’s insurance company.

• Loss caused by the following is considered other than “collision”:

• Missiles or falling objects;

• Fire;

• Theft or larceny;

• Explosion or earthquake;

• Windstorm;

• Hail, water or flood;

• Malicious mischief;

• Riot or civil commotion;

• Contact with bird or animal;

• Breakage of glass.

If breakage of glass is caused by a “collision,” the insured may elect to have it considered a loss caused by “collision.”

This is important because both coverages (collision loss and other-than-collision loss) may be written with deductibles. Without this qualification, an insured would have to pay two deductibles if the car had both body damage and glass breakage in the same accident


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(assuming both coverage’s are elected). By treating glass breakage as part of the collision loss, only one deductible has to be satisfied.

• “Non-owned auto” means any private passenger auto, pickup, van or trailer, not owned by or furnished or available for the regular use of you or any family member while in the custody of or being operated by you or any family member. However, “non-owned auto” does not include any vehicle used as temporary substitute for a vehicle you own which is out of normal use because of its:

• Breakdown;

• Repair;

• Servicing;

• Loss;

• Destruction.

A non-owned auto is defined as any private passenger auto, pickup, van or trailer not owned by or furnished or made available for the regular use of the named insured or family member, while it is in the custody of or is being operated by the named insured or family member.

The key point is not how frequently an insured individual drives a non-owned auto, but whether the vehicle is furnished or made available for that individual’s regular use.

Note that Part D coverages that apply to a covered auto also apply to a temporary substitute vehicle for that auto.

Part D also provides that the insurer will pay the insured certain amounts for transportation expenses. The policy may specifically provide the following:

In addition, we will pay up to $10 per day, to a maximum of $300, for transportation expenses incurred by you. This applies only in the event of the total theft or “your covered auto.” We will pay only transportation expenses incurred during the period:

• Beginning 48 hours after the theft;

• Ending when “your covered auto” is returned to use or we pay for its loss.

Payments can be for a train, bus, taxi, rental car, or any other transportation expense.

Exclusions As with other coverages in the Personal Auto Policy, Part D’s auto damage coverage is subject to specific exclusions:

We will not pay for:

• Loss to “your covered auto,” which occurs while it is used to carry persons or property for a fee. This exclusion does not apply to a share-the-expense car pool.

• Damage due and confined to:

• Wear and tear;



• Freezing;

• Mechanical or electrical breakdown or failure;

• Road damage to tires.

This exclusion does not apply if the damage results from the total theft of “your covered auto.”

The intent of this exclusion is to cover tire defects under the tire manufacturer warranty and to exclude normal maintenance costs of operating an automobile.

• Loss due to or as a consequence of:

• Radio active contamination;

• Discharge of any nuclear weapon (even if accidental);

• War (declared or undeclared);

• Civil war;

• Insurrection;

• Rebellion or revolution.

• Loss to equipment designed for the reproduction of sound. This exclusion does not apply if the equipment is permanently installed in “your covered auto” or any “non-owned auto.”

• Loss to tapes, records or other devices for use with equipment designed for the reproduction of sound.

An endorsement can be added that covers tapes, records, or other devices owned by the named insured or family members.

• Loss to a camper body or “trailer” you own which is not shown in the Declarations. This exclusion does not apply to a camper body or “trailer” you:

• Acquire during the policy period;

• Ask us to insure within 30 days after you become the owner.

• Loss to any non-owned auto or any vehicle used as a temporary substitute for a vehicle you own, when used by you or any family member without a reasonable belief that you or that family member is entitled to do so.

• Loss to:

• TV antennas;

• Awnings or cabanas;

• Equipment designed to create additional living facilities; or

• Loss to any of the following or their accessories;


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• Citizens band radio;

• Two-way mobile radio;

• Telephone;

• Scanning monitor receiver.

This exclusion does not apply if the equipment is permanently installed in the opening of the dash or console of “your covered auto” or any “non-owned auto.” The auto manufacturer for the installation of a radio must normally use this opening.

• Losses to any custom furnishings or equipment in or upon any pick-up or van. Custom furnishings or equipment include but are not limited to:

• Special carpeting and insulation, furniture, bars or television receivers;

• Facilities for cooking and sleeping;

• Height-extending roofs;

• Custom murals, paintings or other decals or graphics.

A special customizing equipment endorsement can be added that covers the excluded furnishings or equipment by payment of an additional premium.

• Loss to equipment designed or used for the detection or location of radar.

This exclusion has been incorporated into the policy because radar detection equipment is designed, and has been used, to circumvent state and federal speed laws.

• Loss to any “non-owned auto” being maintained or used by any person while employed or otherwise engaged in the “business” of:

• Selling;

• Repairing;

• Servicing;

• Storing;

• Parking

…vehicles designed for use on public highways. This includes road testing and delivery.

The above are business loss exposures that should be covered under a commercial garage policy.

• Loss to any “non-owned auto” being maintained or used by any person while employed or otherwise engaged in any “business” not described in the prior exclusion. This exclusion does not apply to the maintenance or use by you or any “family member” of a “non-owned auto” which is a private passenger auto or



“trailer.”

The above is a business loss exposure that should be insured by a commercial policy covering the “business.”

Limit of Liability The next portion of Part D of the Personal Auto Policy explains the limits of liability for auto damage coverage under the policy:

• Our limit of liability for loss will be the lesser of the:

• Actual cash value of the stolen or damaged property; or

• Amount necessary to repair or replace the property.

However, the most we will pay for loss to any “non-owned auto” which is a “trailer” is $500.

The actual cash value of the vehicle at the time of loss is determined by adjusting for depreciation and the physical condition of the damaged property. If the vehicle is declared a total loss, the amount paid is the actual cash value of the vehicle (less any deductible).

• An adjustment for depreciation and physical condition will be made in determining actual cash value at the time of loss.

Payment of Loss The next section of Part D describes the manner in which the insurer will pay for loss resulting from damage to the auto:

We may pay for loss in money or repair or replace the damaged or stolen property. We may, at our expense, return any stolen property to:

• You;

• The address shown in this policy.

If we return stolen property we will pay for any damage resulting from the theft. We may keep all or part of the property at an agreed or appraised value.

In the case of an expensive antique or customized car, a stated amount endorsement can be inserted in the policy. If the stated amount of insurance is less than the actual cash value of the car, only the amount of insurance is paid (less any deductible). If the stated amount of insurance exceeds the actual cash value of the car, or the amount necessary to repair or replace the car, the lower of these latter two figures is the amount paid (less any deductible).

No Benefit to Bailee Next, Part D of the Personal Auto Policy states that auto coverage shall not directly or indirectly benefit any carrier or other bailee for hire.

In other words, any hired driver will not be entitled to collect from the insurance company for any damage to the automobile. Only the owner of the car is entitled to collect from the insurer for damage to the automobile. © 2006 Bookmark Education www.BookmarkEducation.com

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Other Insurance As with other sections of the Personal Auto Policy, Part D discusses the consequences of the insured carrying additional automobile coverage:

If other insurance also covers the loss we will pay only our share of the loss. Our share is the proportion that our limit of liability bears to the total of all applicable limits. However, any insurance we provide with respect to a “non-owned auto” or any vehicle used as a temporary substitute for a vehicle you own shall be excess over any other collectible insurance.

Appraisal The final section of Part D of the Personal Auto Policy covers the use of an appraisal to determine the amount of loss:

If you and we do not agree on the amount of loss, either may demand an appraisal of the loss. In this case, each party will select a competent appraiser. The two appraisers will select an umpire. The appraisers will state separately the actual cash value and the amount of loss. If they fail to agree, they will submit their differences to the umpire. A decision agreed to by any two will be binding. Each party will:

• Pay its chosen appraiser;

• Bear the expenses of the appraisal and umpire equally.

We do not waive any of our rights under this policy by agreeing to an appraisal.

The appraisal provision is intended to set forth an equitable solution to determine the amount of the loss in the event that the parties can not agree on their own.

Personal Auto Policy: Duties After an Accident or Loss Part E of the Personal Auto Policy describes the duties and obligations of the insured in the event of an accident or loss. The individual insured must follow these procedures in order to obtain the benefits of the policy. A typical Personal Auto Policy may set forth the duties and obligations as follows:

• We must be notified promptly of how, when and where the accident or loss happened. Notice should also include the names and addresses of any injured persons and of any witnesses.

• A person seeking any coverage must:

• Cooperate with us in the investigation, settlement or defense of any claim or suit.

• Promptly send us copies of any notices or legal papers received in connection with the accident or loss.

• Submit, as often as we reasonably require to physical exams by physicians we select and to examination under oath. We will pay for these exams.

• Authorize us to obtain:

• Medical reports;



• Other pertinent records.

• Submit a proof of loss when required by us.

• A person seeking Uninsured Motorist Coverage must also:

• Promptly notify the police if a hit and run driver is involved;

• Promptly send us copies of the legal papers if a suit is brought.

• A person seeking Coverage for Damages to Your Auto must also:

• Take reasonable steps after the loss to protect “your covered auto” and its equipment from further loss. We will pay reasonable expenses incurred to do this;

• Promptly notify the police if “your covered auto” is stolen;

• Permit us to inspect and appraise the damaged property before its repair and disposal.

• Under no circumstances should the insured admit that he caused the accident. The question of negligence and legal liability will be resolved by the insurers involved (or court of law if necessary) and not by the insured. The insured does not have the right to admit that he is responsible for the accident.

Personal Auto Policy: General Provisions Part F of the Personal Auto Policy contains a list of general provisions which apply to the policy. The following are examples of provisions which appear in Part F:

Bankruptcy Bankruptcy or insolvency of the “insured” shall not relieve us of any obligations under this policy.

Changes This policy contains all the agreements between you and us. Its terms may not be changed or waived except by endorsement issued by us. If a change requires a premium adjustment, we will adjust the premium as of the effective date of change. We may revise this policy form to provide more coverage without additional premium charge. If we do this, your policy will automatically provide the additional coverage, as of the date the revision is effective in your state.

Fraud We do not provide coverage for any “insured” that has made fraudulent statements or engaged in fraudulent conduct in connection with any accident or loss for which coverage is sought under this policy. Legal Action Against Us

• No legal action may be brought against us until there has been full compliance with all the terms of this policy. In addition, under Part A, no legal action may be brought against us until:

• We agree in writing that the “Insured” has an obligation to pay; or


24


• The amount of that obligation has been finally determined by judgment after trial.

• No person or organization has any right under this policy to bring us into any action to determine the liability of an “Insured.”

Our Right To Recover Payment

• If we make a payment under this policy and the person to or for whom payment was made has a right to recover damages from another we shall be subrogated to that right. That person shall do:

• Whatever is necessary to enable us to exercise our rights; and

• Nothing after loss to prejudice them.

However, our right in this paragraph does not apply under Part D, against any person using “your covered auto” with a reasonable belief that that person is entitled to do so.

• If we make a payment under this policy and the person to or for whom payment is made recovers damages from another that person shall:

• Hold in trust for us the proceeds of the recovery; and

• Reimburse us to the extent of our payment. Policy Period And Territory

• This policy applies only to accidents and losses, which occur:

• During the policy period as shown in the Declarations; or

• Within the “policy territory.”

• The “policy territory” is:

• The United States of America, its territories or possessions.

• Puerto Rico.

• Canada.

• This policy also applies to loss to, or accidents involving, “your covered auto” while being transported between their ports.

Termination This policy may be cancelled during the policy period as follows:

• The named insured shown in the Declarations may cancel by:

• Returning this policy to us;

• Giving us advance written notice of the date cancellation is to take effect.

• We may cancel by mailing to the named insured shown in the Declarations at the address shown in this policy:

• At least 10 days notice;

• If cancellation is for nonpayment of premium;

• If notice is mailed during the first 60 days this policy is in effect and this is not a



renewal or continuation policy; or at least 20 days notice in all other cases.

• After this policy is in effect for 60 days, or if this is a renewal or continuation policy, we will cancel only:

• For nonpayment of premium.

• If your drivers license or that of

• Any driver who lives with you

• Any driver who customarily uses your covered auto has been suspended or revoked.

• This must have occurred:

• During the policy period; or

• Since the last anniversary of the original date if the policy period is other than 1 year.

• If the policy was obtained through material misrepresentation. Two Or More Auto Policies If this policy and any other auto insurance policy issued to you by us apply to the same accident, the maximum limit of our liability under all the policies shall not exceed the highest applicable limit of liability under any one policy.

Personal Auto Policy: Insuring Motorcycles and Other Vehicles The basic Personal Auto Policy does not provide coverage for motorcycles, motor homes or off-road vehicles; however, a miscellaneous-type vehicle endorsement can be added to the Personal Auto Policy to provide coverage for motorcycles, motor homes, mopeds, golf carts, dune buggies, and other vehicles. Snowmobiles and large trucks, however, cannot be added to the policy with the miscellaneous type vehicle endorsement. The endorsement provides the same coverages that are found in the Personal Auto Policy, and it has a schedule that describes the vehicle to be covered, the limits of liability for each coverage, and the premium owed.

If the miscellaneous type vehicle endorsement is added to the Personal Auto Policy, there are certain conditions that should be brought to the policyholder’s attention:

• First, liability coverage generally does not apply if the insured is operating a non-owned motorcycle.

• Second, property damage to a non-owned vehicle is excluded; a borrowed or rented vehicle would not be covered.

• Third, passenger hazard exclusion is available; this excludes liability for bodily injury to any passenger on the vehicle. The election of this exclusion reduces the premium.

• Finally, the amount paid for any physical damage loss to the vehicle is limited to the lowest of:

• The stated amount shown in the endorsement.

• The actual cash value.


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• The amount necessary to repair or replace the property (less any deductible).

Approaches for Compensating Automobile Accident Victims The Personal Auto Policy provisions described above have evolved as a balance between the insurance companies’ requirements to operate a profitable insurance business and public policy considerations with respect to society and the individual consumer. The following concepts have affected the development of the standard Personal Auto Policy and may also supplement or modify the standard form insurance policy in some states.

• Financial Responsibility Laws. These types of laws require persons to furnish proof of financial responsibility up to certain minimum dollar limits.

Financial responsibility laws can be divided into two broad categories:

• Security-type.

• Security and proof method.

Under a security-type law, a person involved in an automobile accident is required to furnish proof of financial responsibility up to certain minimum dollar limits. Purchasing an automobile liability policy for the specified limits, posting a bond, or depositing securities or money in the amount required by law can establish proof of financial responsibility. The person may also establish responsibility by showing that the person is a qualified self-insurer.

Under the security-and-proof method, the driver’s license and vehicle registration can be suspended unless the involved person submits security to pay for a judgment arising out of a current accident and also shows proof of financial responsibility for future accidents. Both conditions must be met before the driver’s license and registration is restored.

Some flaws in the financial responsibility laws are:

• There is no guarantee that all accident victims will be paid. Financial responsibility laws normally have no penalties other than the loss of driving privileges.

• Accident victims may not be fully indemnified for their injuries. Most financial responsibility laws require only minimum liability insurance limits. If the bodily injury exceeds the minimum limit, the accident victim may not be fully compensated.

• There may be considerable delay in compensating the accident victim if the case goes to trial.

• Compulsory Insurance Laws. These laws require the owners and operators of automobiles to carry automobile liability insurance at least equal to a certain amount before the automobile can be registered and licensed. More than half of the states have enacted some type of compulsory automobile liability insurance law as a condition for driving within the state.

Compulsory insurance laws are considered superior to financial responsibility laws because they provide a stronger guarantee of protection to the public against loss.

However, compulsory insurance laws also have certain flaws:

• A compulsory insurance law may not reduce the number of uninsured motorists. Drivers may let their insurance lapse after the vehicle becomes licensed.

• Compulsory laws do not provide complete protection. The laws require only a minimum amount of liability insurance, which may not meet the full needs of the victims.



• Payment to all injured persons is not guaranteed. Some injured victims may not be compensated because they are injured by an out-of-state, uninsured driver.

• Compulsory laws do not prevent or reduce the number of automobile accidents, which ultimately is the heart of the automobile accident problem.

• Unsatisfied Judgment Funds. Some states have established unsatisfied judgment funds for compensating innocent accident victims. An unsatisfied judgment fund is a fund established by the state to compensate victims who have exhausted all other means of recovery.

To receive compensation from the unsatisfied judgment fund, the accident victim first must obtain a judgment against the negligent motorist who caused the accident and must show that the judgment cannot be collected.

The negligent motorist is not relieved of legal liability when payments are made out of the fund. The negligent motorist must repay the fund or lose his or her driver’s license until the fund is reimbursed.

• Uninsured Motorist Coverage. The insurer agrees to pay the accident victim who has a bodily injury (or property damage) caused by an uninsured motorist, by a hit-and-run driver, or by a driver whose company is insolvent.

• No-Fault Automobile Insurance. No-fault insurance means that after an automobile accident each party collects from his or her own insurer, regardless of fault. It is not necessary to determine who is at fault and prove negligence before a loss payment is made. A true no-fault law places some restrictions on the right to sue the negligent driver who actually caused the accident. If a claim is below a certain dollar threshold, ($2,500 for example) the motorist would not be permitted to sue but would instead collect from his or her own insurer. If the injury exceeds the threshold amount, the injured person has the right to sue the negligent driver for damages. A “verbal threshold” means that a suit for damages is allowed only in serious cases, such as those involving death, dismemberment, disfigurement, or permanent loss of a bodily member or function.

Under a pure no-fault law, the injured cannot sue at all, regardless of the seriousness of the claim, and no payments are made for pain and suffering. In effect, the tort liability system is abolished. The insured person receives unlimited benefits from his or her own insurer for medical expenses and the loss of wages.

Under a modified no-fault law an insured person has the right to sue a negligent driver only if the claim exceeds the monetary or verbal threshold.

An add-on plan pays benefits to an accident victim without regard to fault, but the injured person still has the right to sue the negligent driver who caused the accident.

• Arguments for no-fault laws.

• Difficulty of determining fault. Most accidents occur suddenly and unexpectedly, and details surrounding them can seldom be accurately determined.

• Limited scope of reparations system. Smaller claims may be overpaid, while serious claims may be underpaid. Small claims may be over-compensated because inflated settlements cost insurers less than taking claims into court.

• Large proportion of premium dollars used to pay legal costs.

• Delay in payments. Large numbers of claims may not be promptly paid because of investigations, negotiations, and wafting for court dates. Seriously injured persons or


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their survivors had to wait an average of sixteen months for final payment from automobile liability insurance.

• Arguments against no-fault laws.

• The defects of the negligence system are exaggerated.

• Claims of efficiency and premium savings are exaggerated.

• Safe drivers may be penalized.

• The present system needs only to be reformed, rather than completely overhauled.

• Basic characteristics of no-fault laws.

• About half the states have some type of no-fault insurance plan in existence. The majority of states have modified no-fault plans where restrictions are placed on the right to sue.

• No-fault benefits are provided by adding an endorsement to the automobile insurance policy. The endorsement is typically called personal injury protection coverage. The following no-fault benefits are typically provided:

• Medical expenses usually paid up to some maximum limit.

• No-fault benefits are made for a stated percentage of the disabled person’s weekly or monthly earnings, with a maximum limit in term of time and duration.

• Benefits are also paid for essential service expenses for certain services ordinarily performed by the injured person.

• Funeral expenses are also paid up to some limit.

• Survivors’ loss benefits can also be paid to eligible survivors, such as a surviving spouse and dependent children.

Automobile Insurance for High-Risk Drivers Drivers who have difficulty obtaining automobile insurance through normal market channels have an opportunity to obtain automobile insurance in the residual market (the shared market). In this market automobile insurers participate to make insurance available to drivers unable to obtain coverage in the standard market.

• Assigned Risk Plans. Under this arrangement, all automobile insurers in a state are assigned their proportionate share of high-risk drivers based on the amount of automobile liability insurance premiums written in the state.

• Persons applying for insurance in an automobile insurance plan must show that they have tried but were unsuccessful in obtaining automobile insurance within sixty days of the date of application.

• Premiums paid for the insurance are substantially higher than the insurance obtained in the voluntary markets.

• A company is not required to insure a high-risk driver for more than three years.

The major advantage of the Assigned Risk Plan is that a high-risk driver generally has at least one source for obtaining liability insurance.

The major disadvantages of Assigned Risk Plans include the following:



• Despite higher premiums paid by high-risk drivers, the automobile insurance plans have incurred substantial underwriting losses.

• High premiums may cause many high-risk drivers to remain uninsured.

• The driver does not have a choice of insurer, since the state assigns the driver to a particular insurer.

• Joint underwriting associations.

A joint underwriting association is an organization of automobile insurers in which high-risk business is placed in a common pool, and each company pays its pro-rata share of pool losses and expenses. Some states have established joint underwriting associations to make automobile insurance available to high-risk drivers.

• Reinsurance facilities.

Under this arrangement, the company must accept all applicants for insurance, whether both good and bad drivers. If the applicant is considered a high-risk driver the company has the option of placing the driver in the reinsurance pool. In the past, the reinsurance facilities have experienced substantial underwriting losses.

• Specialty automobile insurers.

Specialty automobile insurers are companies that specialize in insuring motorists with poor driving records. These companies typically insure drivers who have been cancelled or refused insurance, teenage drivers and drunk drivers. The premiums are substantially higher than premiums paid in the normal or standard markets.

Cost of Automobile Insurance There are a number of major factors for determining the rates of private passenger automobile premiums.

Territory Each state is divided into rating territories: a large city, a suburban, or a rural area. Largely, the territory where the automobile is principally used and garaged determines the base rate.

Age, Sex Most states permit age and sex to be used as factors in determining premiums. Age is an important rating since young drivers account for a disproportionate number of accidents. Young male drivers who own or are the principal operators of automobiles normally pay the highest rates, since this group has the highest accident rate and the most costly accidents.

Use of The Automobile Insurers classify automobiles on the basis of the purpose for which the car is driven.

• Pleasure use; not used in business or driven to work less than a specified distance, for example, less than three miles one way.

• Driven to work; not used in business but driven less than a specified number of miles to work each day.

• Business use; customarily used in business or professional pursuits.

• Farm use; garaged on a farm or ranch, and not used in any other business or driven to school or other work.


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A car classified for farm use has the lowest rating factor, using a car for business purposes requires a higher rating factor.

Driver Education This discount is based on the premise that driver education courses for teenage drivers can reduce accidents and hold down insurance costs.

Good Student Discount This discount is available from a limited number of companies and is based on the premise that good students are better drivers. To qualify the driver must be a full time high school or college student and be at least sixteen years of age. A school official must sign a form certifying that the student has met the scholastic requirements.

Number and Type of Automobiles The multi-car discount is based on the assumption that two cars owned by the same person will not be driven as frequently as only one car owned by the same person. The year, make and model of the cars also affect the cost of insurance on the car.

Individual Driving Record Some companies offer safe driver plans where the premiums paid are based on the individual driving record of the insured and operators who live with the insured. In states that have an accident point system, the actual premium paid may be based on the total number of accumulated points assessed against the insured’s driving record.

Purchase Higher Deductibles If the insured purchases a higher deductible on collision and comprehensive insurance, the premium can be reduced by as much as twenty percent.

Improved Driving Record A clean driving record covering the previous three years can substantially reduce the premiums of a high-risk driver. A conviction for drunk driving can be extremely costly when purchasing automobile insurance.

Conclusion Approximately $100 Billion a year in damage is estimated to be caused by automobile accidents. This damage includes destroyed property, medical and funeral expenses, and the lost income of people involved in accidents.

Since auto insurance is the first experience for most people with respect to the insurance industry, it is especially important for the agent to provide these purchasers the extra attention and care they need and desire in order to create a lifetime relationship with the purchaser.


Chapter Two / Homeowners And Personal Property Insurance

CHAPTER 2 – HOMEOWNERS AND PERSONAL PROPERTY INSURANCE Introduction While many people first interact with an insurance agent with respect to automobile insurance, some individuals’ first experience with an insurance agent occurs when obtaining a homeowners or renters insurance policy. For some customers, the insurance professional will need to advise regarding the benefits of other property insurance products covering various types of personal property.

In this chapter, we explore homeowners insurance and many types of personal property insurance. We begin with some background regarding the history of property and liability insurance, the two major components of homeowners and personal property coverage.

The History of Property Insurance The first fire insurance company in the United States was established in 1734 and was called the Friendly Society for the Mutual Insurance of Houses Against Fire. By 1740 this firm was out of business as a result of a fire in Charles Town, South Carolina that wiped out most of the town.

Originally insurance policies were written to cover a single peril. After the disastrous fire of 1740 several other fire companies were formed. These insurers used a risk classification method basing rates on the construction materials used in the building of the dwelling. Thus a building constructed of brick would have a more favorable risk rating than one made of wood.

The early fire policies differed from company to company and from state to state. They were full of conditions and exclusions and often difficult for the average person to understand. The definition of terms varied from company to company and in general lacked uniformity.

If an insured needed additional coverage such as for wind damage or other peril, the additional coverage was written as a separate policy. Often times these additional perils were not even covered by the same company.

Many consumer complaints and court decisions eventually led to the first uniform property insurance policy called the 165 Line New York Standard Fire Policy of 1943.

This was the only insurance policy first standardized by law. This policy became the basis for all property insurance coverage and is still used as a basic form in some states.

Because the standard fire policy covers only the perils of fire, lightning, and removal of covered property from endangered premises, it is never used alone and endorsements are added to cover additional perils.

This extended coverage (EC) includes:

• Windstorm.

• Hail.

• Explosion.

• Riot.

• Aircraft.

• Vehicle Damage.


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• Smoke.

When these endorsements are added a vandalism and malicious mischief endorsement may also be added.

Although the standard fire policy offered basic protection, many insurers argued that a policy which offers broader coverage would be to the benefit of both the insured and the insurer. A policy that covered both property and liability in one policy would do much more to serve the needs of all parties.

Insurance companies felt that they would benefit from such a policy in at least three ways:

• Decreased adverse selection against the company.

• Reduction in overall administrative and underwriting costs.

• Increased policy retention.

In the late 1940’s insurers were permitted by insurance regulators to combine property and casualty perils into one policy. Many formats and combinations of coverage sprung out from this deregulation.

In 1976 the Insurance Service Office (ISO) developed a homeowners program that incorporated the pertinent provisions of the 165-line policy as part of what became known as the “Homeowners 76.”

The “Homeowner 76” simplified the language of the fire contract. The changes made the policy easier to read and created a homeowners policy with five sections:

• Definitions.

• Coverage.

• Perils Insured Against.

• Exclusions.

• Conditions.

This original policy was revised in 1982, 1984, and 1991 to arrive at the present format of the policy. Some states have approved a variation of the 1991 format, which was introduced in 1994. A further adaptation was unveiled in 2000, and many states have adopted this most recent variation of the homeowners policy.

Under the ISO Homeowners Program the basic policy covers:

• A dwelling that is owner occupied.

• A dwelling where no more than two families and not more than two roomers or boarders per family occupy the dwelling.

• The owner-occupant has purchased the full homeowners package.

• The dwelling is used only for residential purposes.

• A homeowners policy cannot be written on a property to which farm forms or rates apply.

• The policy cannot be written on a mobile home.

Additional policies have been developed as part of the ISO Homeowners Program in order to provide additional coverages for various circumstances. We will discuss these policies and coverages later in these materials.



Negligence Distinguished from actual property loss, liability losses are losses incurred by individuals as a result of their actions toward other people or their property. When an individual is required to make financial restitution to another person for loss to them or their property a liability loss has occurred.

In the civil legal system, when an individual violates the rights of another that individual has committed what is known as a tort. A tort can either be intentional or unintentional. Liability insurance provides coverage for unintentional torts.

Negligence is a key factor in determining liability. In order for a person to be liable to another, that individual must have been negligent. Negligence is defined as the lack of reasonable care that is required to protect others from the unreasonable chance of harm.

Four factors must be present in order to establish negligence:

• There must be a legal duty owed.

Legal duty owed is that obligation that we all have toward another to reasonably protect their rights and property. Within that duty there are several levels of accountability depending on the relationship and conditions.

A person invited to our home is owed the highest degree of care. An individual performing a service in our home is owed a lower degree of care. And a trespasser is owed the lowest degree of care.

• A breach of that legal duty must occur.

Breach of legal duty occurs when it is established that standard care was not taken, and that lack of precaution caused harm to another individual or their property.

• There must be “proximate cause.”

The proximate cause is the action that occurred and directly resulted in harm or damage. The action must be continuous and unbroken. If the action is interrupted by an intervening action, then this new action becomes the proximate cause.

• There must be damages.

The last element in establishing negligence is damage. If no harm came to an individual or their property then there was no negligence and therefore no claim.

When an individual either contributes or assumes some of the potential for harm, the ability to collect damages either is decreased or removed entirely. Assumption of risk is a factor that enters the picture when an individual attends a concert or a sporting event and is injured. By that individual’s presence at that event, that individual has assumed some of the risk involved in attending such an event.

When both parties contribute to the negligence, this is known as “contributory negligence” or “comparative negligence.” The degree of which each contributed is taken into account in arriving at a payment, or perhaps a non-payment, of damages.

The last factor that comes into play in determining liability for negligence is a statute of limitations. A statute of limitation requires that a suit must be filed within a specified period of time in order to be valid under the law. If the suit has not been filed within the required period of time, then a party cannot be held accountable for negligence which occurred prior to that time period.


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The Language of Liability Insurance The following terms are commonly used when discussing liability and liability insurance:

• Absolute Liability is a liability imposed by law on those participating in activities that are considered hazardous. Negligence is not a requirement for payment of damages in the event of absolute liability.

• Damages are a monetary compensation awarded by a court to an injured party.

• Declarations are that section of an insurance contract that shows who is insured, what property or risk is covered, when and where the coverage is effective and how much coverage applies to loss.

• Deductible is the dollar amount the insured must pay on each loss to which the deductible applies.

• Defense Costs are the legal expenses that must be paid by the insurer to defend suits brought against the insured.

• Degree of Care is the extent of legal duty owed by one person to another.

• Indemnity is the principle of insurance that provides that when a loss occurs, the insured should be restored to the proximate financial condition he or she occupied before the loss occurred.

• Occurrence is a loss that occurs over a specific time and place or over a period of time.

• Post-judgment interest is interest accruing on a judgment after an award has been made, but before payment is made by the insurance company.

• Pre-judgment interest is interest awarded to compensate a third party for interest he or she might have earned if compensation had been received at the time of injury or damage, rather than at the time of judgment.

• Proximate Cause is an action that, in a natural and continuous sequence, produces a loss.

• Punitive Damages are damages intended to punish the defendant in an effort to discourage others from behaving in the same manner.

• Service Bureau is an organization that gathers, pools, and analyses statistics from its member insurance companies to establish loss costs used in determining insurance rates.

• Supplementary Payments Coverage is a coverage that provides extra coverage over and above the insured’s limit of liability. Commonly included are defense costs, first aid expenses, bond premiums, and post-judgment interest.

• Third Party is the individual receiving the award in a liability case.

• Tort is a civil wrong for which monetary damages are paid.

• Vicarious Liability is liability that a person or business incurs because of the actions of others for whom they are responsible. For example, vicarious liability may cause a loss to be incurred as a result of the actions of family members or employees of the insured.

Summary Concepts of both property insurance and liability insurance combine to form the backbone of Homeowners and Personal Property Insurance. The homeowner seeks protection from both



loss of property and possible liability to third parties. With this background regarding property insurance and liability insurance, we now begin to examine Homeowners Insurance in more detail.

Homeowners Insurance – Introduction Coverage and Limits of Liability The front page or the “Declaration Page” of the homeowners insurance policy shows exactly what is covered and for how much.

The front page contains the following information:

• Name of the Insurance Company and address.

• Name and address of the insured and address of the insured property.

• The agent’s and agency name and address.

• Policy number.

• Policy period showing the effective date, expiration date, and time.

• The coverage and premium breakdown:

• Property Coverage – Section I:

• Dwelling Limits of Coverage

• Detached Structures Limits of Coverage

• Personal Property Limits of Coverage

• Loss of Use Limits of Coverage

• Section I Deductible Amount of Deductible

• Liability Coverage – Section II

• Personal Liability,

Each occurrence Limits of Coverage

• Medical Payments to others,

Each person Limits of Coverage

• Policy forms and endorsements and charges.

• Rating information.

• Mortgagee’s name and address.

• Signature of insurance company officer.

Types of Homeowners Policy Forms and Their Coverages There are several standard policies available and they contain a standardized numbering system throughout the United States, as follows:

• HO-1: Basic Form for Homeowners.

• HO-2: Basic Form for Homeowners with similar coverage available for mobile home owners.


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• HO-3: Special Form for Homeowners.

• HO-4: Renters’ or Tenants’ Insurance.

• HO-5: Comprehensive Form for Homeowners.

• HO-6: Condominium Unit owners insurance.

• (There is no HO-7 Form)

• HO-8: Market Value or Older Home Form for Homeowners.

The “HO” stands for Homeowners and the number following that designates the specific policy package.

HO-1 and HO-2 Policy These two forms are referred to as “Named Peril Policies” and in these two forms the same perils are applied to the dwelling and personal property coverage. HO-1 covers the insured against the following losses:

• Fire and lightning.

• Removing damaged property.

• Explosion.

• Hail or windstorm.

• Smoke damage.

• Riots and civil commotion.

• Damage to dwelling caused by vehicles or aircraft.

• Theft.


• Malicious mischief or vandalism.

HO-1 is becoming less and less popular due to the fact that each of the above losses is usually limited by a paragraph of numerous exclusions. Although the cost of HO-1 is low, the old adage still applies: “You get what you pay for.”

HO-2 covers the following losses:


• Removing damaged property.

• Explosion.

• Hail and windstorm.

• Riot/civil commotion.

• Damage to dwelling caused by vehicles or aircraft.

• Damage from smoke that is sudden or accidental.

• Falling objects.

• Weight of ice, sleet or snow.



• Theft.


• Collapse of building.

• Accidental ruptures of hot water heater or steam heater.

• Accidental overflow of water from a plumbing appliance.

• Freezing of heating, air conditioning or plumbing appliances.

• Accidental injury from electrical currents artificially generated.

The HO-2 form gives a more “Broad form” of coverage than HO-1 and the exclusions are not as intensive as those in HO-1.

HO-3 Policy HO-3 covers against each of the perils shown for the HO-1 and HO-2 policies above and any other peril that is not specifically excluded from coverage. As a result of the extensive perils, the HO-3 policy is the one most commonly used by homeowners. The extensive coverage is referred to as “all risk coverage” to the dwelling. The all-risk coverage significantly sets the HO-3 policy apart from the HO-1 and HO-2.

The following are examples of exclusions from coverage:

• Flood.

• Surface water.

• Waves and tidal waves from other bodies of water.

• Back-up water and sewage or drains.

• Water below the surface of the ground that flows, seeps or leaks through side walls, driveways, basements, walls, foundations, through doors, windows or floors.

• Earth movement, volcanic eruption, earthquake, landslide, mudflow, earth sinking, shifting or rising.

• Damage to air conditioning, heating and plumbing systems caused by leaking or as a result of freezing if failure to heat or shut off water.

• Wear and tear.

• Deterioration.

• Marring or scratching.

• Mechanical breakdown, inherent vice or latent defect.

• Rust.

• Wet or dry rot.

• Mold.

• Act of war.

• Smog.

• Contamination.


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• Acts of Government.

• Nuclear reactions.

• Smoke from industrial operations or agricultural smudging.

• Shrinkage, cracking, settling, bolting, expansions of walls, floors, roofs, ceilings, foundations, patios, pavement.

• Domestic animals, insects, rodents, vermin, and birds.

• Continuous leakage from within a plumbing system or seepage.

• Theft to a dwelling under construction including materials and supplies.

• Vandalism and glass breakage.

• Wind, ice, hail, snow or sleet damage to outdoor television antennas or outdoor radio antennas including towers, masts and wiring.

HO-5 Policy The HO-5 is very similar to the HO-3 policy in that again, the dwelling is covered on an all risk basis. Personal property, however, also is covered on an all risk basis under the HO-5 policy. This constitutes the major difference between the HO-3 and the HO-5. The HO-5 policy is the most comprehensive standard homeowners’ policy available. However, the coverage in this policy is quite expensive for the homeowner. This policy is rarely used today because agents prefer to attach endorsements to the HO-3 policy in order to create a custom policy serving the customer’s needs.

HO-4 and HO-6 Policies The HO-4 is a tenant’s policy designed for people who rent houses or apartments, and it also applies to owners of cooperative apartments. The HO-6 is a condominium owner’s policy. Both are very similar. Both cover personal property and improvements to the residence made by the insured. Improvements can be cosmetic such as additions, paneling or shelves. The HO-4 affords coverage of up to 10% of the policy amount for improvements. Therefore if personal property is insured for $50,000 dollars, $5,000 would cover improvements.

The HO-6 affords a straight $1,000 for improvements. Neither the HO-4 nor the HO-6 provides any coverage for building structures. In the case of condominiums, an owner’s association insures the structure and public areas, so the condominium owner need only insure the contents and limited improvements.

Both the HO-4 and the HO-6 forms are named peril forms, which means the property is insured for damage resulting from certain perils. HO-4 and HO-6 policies cover personal property against the following named perils:


• Removal.

• Windstorm or hail.

• Explosion.

• Riot or civil commotion.

• Aircraft.

• Vehicle.



• Smoke.

• Vandalism or malicious mischief.

• Theft.

• Falling objects.

• Weight of ice, snow, or sleet.

• Collapse of building.

• Damage from hot water heating systems.

• Damage from appliances or plumbing.

• Damage from freezing of plumbing appliances.

• Damage from electrical currents artificially generated.

Payment under both HO-4 and HO-6 is based on the actual cash value of the property, rather than the replacement cost.

HO-8 Policy The HO-8 Policy offers coverage for the same named perils as the HO-1 Policy, but this policy does not insure the replacement cost of the dwelling. Instead, the HO-8 Policy only provides payment in the amount of the actual cash value of the dwelling. The HO-8 Policy also provides payments in the amount of repairs to the existing dwelling, as long as those repairs do not exceed the value of the dwelling.

Homeowners Insurance – Property Coverage – Section I The Property Coverage section of each form of Homeowners Policy covers five basic areas:

• The dwelling.

• Detached structures located on the property.

• Personal property.

• Loss of the use of the structure.

• Additional coverage.

The Dwelling The dwelling consists of the home itself (the actual living structure) and includes attached structures, such as a garage. In the policy declaration page this coverage will be shown as: Section I, Coverage A.

The major portion of coverage in a homeowners policy is designed to pay the cost of rebuilding the structure. A common misunderstanding in this area of coverage is that the homeowner does not actually insure the dwelling for its value on the open market. This is because the land on which the house is built has a value, and the value of that land is not to be included in the coverage amount. Only the cost of the structure is included in the insurance amount.

A helpful way to determine the cost of the structure is to contact a Builder’s Association to find out what the cost per square foot is in the area of the dwelling’s location. By taking the total square footage of the house and multiplying it by the local per-square-foot building cost, an individual can obtain a pretty good idea of the cost required to replace the structure. Many


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homeowners follow a standard rule of thumb by insuring the structure for at least 80% of the actual cost to rebuild the structure. If the property is secured by a loan, the lender typically requires that the structure be insured for 100% of the actual cost to rebuild the structure.

Detached Structures Located on the Property These consist of structures that are on the same parcel of land, but are not attached directly to the home itself. This could be a shed for tools, a greenhouse in the yard, or some other structure that would be defined as a non-attached covered structure. Protection for these unattached structures is provided under Section I, Coverage B.

Personal Property A very important coverage under any residential insurance policy is the personal property coverage. The contents of a home such as furniture, stereos, televisions, appliances, clothing, and the like are considered personal property. These items are covered under Section I, Coverage C. Personal property will be covered as long as the insured owns the property notwithstanding where the insured uses the property. The loss to property does not have to occur at the covered dwelling. Should the insured have personal property of others that is located at the home, this too is covered under the policy.

In other words, personal property owned by a tenant in a rented house would not be covered by the homeowners policy, but personal property brought by a guest visiting the insured would be covered. It is important to know that personal property coverage is not unlimited. In fact, unless endorsements are purchased for specific coverage, the personal property protection can be rather limited.

For example, there is a limit of coverage for loss of personal property. Without further endorsements, this amount is typically 50% of the total amount that the home is insured for under Coverage A. So, if a home is insured for $100,000, the loss for personal property limits would be $50,000.

In addition, there are specific limits of liability that apply to the following personal property items:

• Money, bank notes, bullion, gold other than gold-ware, silver other than silverware, platinum, coins, and medals. Maximum liability $200. Additional dollar coverage will cause additional premiums.

• Securities, accounts, deeds, evidence of debt, letters of credit, notes other than bank notes, manuscripts, passports, tickets, and stamps. Maximum liability, $1,000. Additional dollar coverage will cause additional premiums.

• Watercraft, their trailers, furnishings, equipment and outboard motors. Maximum liability, $1,000. Since coverage is so low in this area, most homeowners choose to purchase separate boat insurance.

• Trailers not used with watercraft. Maximum liability, $1,000.

• Grave markers. Maximum liability, $1,000. This is not a frequent issue for homeowners.

• Theft of jewelry, watches, furs, precious and semi-precious stones. Maximum liability, $1,000. Many people get caught short with this coverage and need to buy endorsements to protect items worth more than $1,000.

• Loss of firearms by theft. Maximum liability, $2,000.



• Theft of silverware, silver-plated ware, gold-ware, gold-plated ware, and pewter-ware. Maximum liability, $2,500. Included here are flatware, hollowware, tea sets and trays, and trophies made of these metals.

• Property on the residence premises used for business purposes. Maximum liability, $2,500. Should an insured have an office in the home or work out of the home and have computers, desks, and other equipment, additional protection is required since the homeowners policy severely limits coverage for these business items.

• Personal property away from the residence used for business purposes. Maximum liability, $250.

The homeowners policy sets forth specific exclusions to coverage. Articles which are expressly excluded from the homeowners policy must be separately described and insured by endorsement in order to achieve coverage. If the insured elects to specifically cover these items by endorsement, the coverage will be determined by the language of that endorsement and will not be protected by Coverage C.

• Animals, birds, or fish. Although they may be invaluable to the insured, nothing will be paid for their loss under the homeowners policy.

• Motor Vehicles and all other motorized land conveyances. Normally these items are protected under an automobile insurance policy. However, there are two exceptions to this exclusion:

• The vehicle is not subject to motor vehicle registration and is used to service an insured’s residence. or,

• The vehicle is designed to assist the handicapped.

• Aircraft and their parts. The insured will need to purchase separate aircraft insurance.

• Property of roomers, boarders, and other tenants except property of roomers related to the insured. These items are covered under renter’s insurance, rather than the homeowners policy.

• Property in an apartment regularly rented or held for rental to others by an insured. Again, these items are covered under renter’s insurance.

• Property rented or held for rental to others off the residential premises. Again, renter’s insurance is required to obtain coverage over these items.

• Books of account and drawings. Included here are records of bookkeeping that are on paper, electronic data, computer software, and other paper containing business data.

• Credit cards. The basic homeowners policy does not protect the insured against the loss of credit cards or credit fraud. However, coverage can be obtained under the additional coverage section of a policy.

The following thefts are also excluded under Coverage C:

• Anything stolen by the insured.

• Anything stolen from a part of the residence rented to another person.

• Theft to a building that is under construction.

• Items stolen from a secondary residence unless the insured is living there when the theft occurs.


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• Theft of watercraft, outboard motors, trailers, or campers which occurs away from the residence premises.

Loss of the Use of the Structure A homeowners policy provides funds to compensate for the loss of the use of property in the event of damage by a peril covered under the policy. This coverage is provided under Section I, Coverage D. The insured can elect to receive compensation for loss of use in one of two ways:

• Payment for additional living expenses.

Additional living expenses usually require a higher monthly outlay than one would normally pay at home. If an individual’s home is destroyed by fire, it would be necessary to rent another residence while that home is being rebuilt. The policy will pay additional living expenses that are incurred in order to allow the household to “maintain its normal standard of living.”

• Payment for the fair retail value of the uninhabitable property.

The insured may receive a benefit that will pay the fair retail value for the residence less any expenses that do not continue while the home is not fit to live in.

Whichever benefit one chooses to receive, the benefit will only be paid for the shortest time required to replace or repair the damages to the property, or if the insured permanently relocates, the shortest time within which the individual can relocate.

Note that if the property that became uninhabitable WAS NOT the insured’s principal place of residence, the insured will only be compensated for additional living expenses as the fair retail value option is not available to the insured.

Additional Coverage As mentioned above, the HO-3 homeowners policy is the insurance policy most commonly purchased by homeowners. The following additional coverage can be obtained under the HO-3 homeowners policy:

• Property removed.

If for example, wind destroys the walls of a home and the insured wants to have this property removed, the cost to do so can be paid for under additional coverage. There is a 30-day limit for this coverage to apply.

• Service charges of the fire department.

The policy will pay up to $500 for the liability for any fire department charges incurred because the fire department was called upon to save or protect the property. In most cases, the city provides this service without charge and no payment is made by the homeowners policy, but this benefit is still made available as additional coverage.

• Reasonable repairs.

The policy covers reasonable costs incurred by the insured to make necessary repairs to prevent the property from further damage.

• Debris removal.

If it is necessary to remove debris that is created by a covered loss, the homeowners policy will pay for the removal. The amount available for debris removal is included in the



total limit of liability. Should the removal expense exceed that amount, an additional 5% of the total limit of liability may be made available as additional coverage to complete the job.

• Trees, shrubs, and plants.

Should a covered loss (other than windstorm) damage or destroy trees, shrubs, or plants the policy will pay up to 5% of the limit of liability that applies to the dwelling with a maximum of $500 for any one tree, shrub, or plant. Commercial growing is not covered.

• Forgery, counterfeit money, credit card and fund transfer card.

The HO-3 policy will pay up to $500 for the following:

• Forgery or alteration of a check that causes a loss.

• Unauthorized use or theft of an ATM card that results in a loss.

• Unauthorized use of credit cards issued in the name of the insured.

• If the insured in good faith accepts counterfeit U.S. or Canadian paper currency.

• Collapse.

Any collapse of a building or collapse of part of a building will be covered if the collapse causes the insured a direct physical loss and the collapse is caused by one of the following means:

• Hidden insect damage.

• The weight of the building’s equipment, contents, people or animals.

• Rain collecting on the roof and causing damage or collapse.

• Hidden decay.

• Defective material used in construction, renovation or remodeling, provided the collapse occurs during the course of such work.

Note – Collapse does not include any damages that may be caused by bulging, expansion, settling, cracking or shrinking.

Homeowners Insurance – Liability Coverage – Section II Coverage for liability under each form of homeowners policy is found under Section II, Coverage E – Personal Liability. This coverage provides that if a claim is made or a suit is brought against an insured for damages because of bodily injury or property damage caused by an occurrence to which the coverage applies, the insurance company will:

• Pay up to the limit of liability if the insured is legally liable; and

• Provide defense by counsel even if the suit is groundless, false or fraudulent.

In addition to the coverage for damages described in Coverage E, Coverage F of the homeowners policy specifically covers the cost of medical payments for individuals who are injured while at the insured location, as long as the injured party is at the property with the permission of the insured. Medical expenses will be paid under the homeowners policy in the following cases:

• An injury which requires medical payments arises out of a condition on the insured property or the ways immediately adjoining. For example, if a tree that is rooted in an insured’s yard has a branch that hangs over to the neighbor’s yard and that branch falls


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and hits the neighbor on the neighbor’s property, the insured’s homeowners policy will cover the neighbor’s medical costs arising out of injury from the tree branch.

• Bodily injury is caused as a result of activities by the insured. Should an insured be riding a horse on the insured property or hit a golf ball from the insured property, the insured’s homeowners policy will pay medical bills for a third party injured by that activity.

• A residence employee causes bodily injury to a party in the course of the employee’s work at the property. Maids, butlers and domestic help would fall under this category of coverage.

• Bodily injury caused by an animal owned or in the care of the insured. For example, dog bites are covered here.

Personal Liability Exclusions The liability portion of the homeowners’ policy will not cover the following:

• Bodily injury to the insured. If the insured is injured at home due to his or her own negligence, the policy will not pay any amount to the insured.

• Damages caused by failure to render professional services or by rendering professional services. If the insured is a carpenter and work performed by the insured is defective and causes damages, the homeowners policy will not pay for those damages.

• Damages caused by motor vehicles. Motor vehicle insurance must be provided by a separate motor vehicle policy.

• Damages caused by operation of an aircraft. Again, separate insurance must be carried here. On the other hand, injuries caused by model hobby planes will be covered.

• Communicable diseases. The homeowners policy does not provide liability protection for the transmission of a disease.

• War. Any damage that a war causes is specifically excluded from coverage under the homeowners policy.

• Workers’ Compensation injuries. Should an individual covered by his or her employer’s workers compensation coverage become injured while working at a home covered by a homeowners policy, the homeowners policy will not pay for damages arising from injury to that individual.

• Damages caused by watercraft. If while using the craft, damages result, they will not be paid by the homeowners policy, even if the craft is used on the insured property. Separate coverage must be obtained to insure these matters.

• Non-insured locations. If the insured own other property that is not listed on the homeowners policy, the insured will not receive liability protection under the policy from any damages which occur at the other property.

• Intentional acts of the insured. If the insured intends to harm another party, the homeowners policy will not provide liability protection for that action.

• Business activities. Should there be any damage as a result of business pursuits by the insured, the homeowners policy will not cover any such occurrence.



Filing the Homeowners Insurance Claim In general, there are four factors necessary in order for a loss to be covered by homeowners insurance:

• Losses must be accidental.

Insurance policies insure against “risks.” If a loss is certain to occur, there is no risk involved. As a result, losses must be accidental. Losses resulting from deterioration are generally thought to be the result of a certainty; after all, everything wears out sooner or later. For this reason, losses caused by deterioration are not deemed accidental and are not covered by homeowners insurance.

• Losses must be caused by extraneous factors.

This means an external cause of damage must cause the loss. As an example, an extraneous factor would include wind damaging patio furnishings. Should a loss be caused by an inherent physical condition, rather than an extraneous factor the loss would not be covered under the homeowners insurance policy.

• Losses were not caused by deliberate action on the part of the insured.

Any deliberate action by the insured which causes a loss to any insured property or liability to any third party is not covered under the homeowners insurance policy. The insured cannot deliberately destroy property that is insured and expect the insurance carrier to pay for that damage. Similarly, the insured cannot expect the insurance company to cover liability for intentional injury to a third party.

• Losses must involve covered, legal property.

Illegal items and contraband are not covered by insurance. If an insured possesses an illegal whiskey still in his home and the still is damaged by a covered peril, that loss will not be covered under the policy.

If a loss meets each of the above criteria, the insured may be able to file a claim for loss under the homeowners policy. Note that one of the elements of a valid claim is that the insured must actually sustain a loss.

When a claim needs to be filed, the following must be kept in mind:

• A policyholder normally has a strong and favorable position where claims are concerned.

• As a rule, the courts usually resolve questions on claims in favor of the policyholder (the insured).

• The overall effect of court decisions has been to broaden the coverage of homeowners policies beyond the plain language of the policy.

• Although companies differ in their approach to claims, most work to provide good service to their customers. However, the policyholder must carefully monitor the claim adjustment process in order to assure fair, proper treatment of claims.

• In approximately 80% of all claims, less than 10% of the property insured is affected by loss. Therefore, it could be said that individuals are buying insurance to only cover 10% of the property in question and coverage will be adequate 80% of the time.

Replacement Cost Coverage All homeowners policies contain a replacement cost provision that requires the insured to purchase an amount equal to 80% of the replacement cost of the dwelling. This requirement © 2006 Bookmark Education www.BookmarkEducation.com

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simplifies the determination of insurance rates across properties and allows premiums to be based on a fixed cost per $100 worth of insurance.

Calculating replacement cost for the purpose of buying insurance is somewhat different than estimating the cost of buying a new home. There are two reasons why one needs to accurately determine the replacement cost of a home. First, to be certain that the coverage is adequate and that it complies with the replacement cost requirement. Second, the insured wants to be secure in the fact that he is not being sold an excessive amount of insurance with the higher premiums that go along with that excessive amount.

Note that replacement cost coverage applies only to buildings and not the personal property covered under the policy.

The insurance company may attach a penalty to a replacement cost claim due to insufficient coverage, as the homeowners policy stipulates that payment is to be based on replacement cost less the appropriate penalty or the actual cash value of the repairs, whichever is greater. As a result, claim payment based on actual cash value of repairs may be higher than the net claim payment (factoring in the penalty) for replacement value on a property which is not adequately insured.

When claims are paid under the replacement cost coverage, the insurance company is permitted to determine its obligation three different ways and choose the method that works best for the company. These three choices are as follows:

• On policy limits. The most the company ever will pay is the amount of insurance that applies to the property covered.

• On the cost of replacement. This would be based on the cost of an equivalent building at the same location.

• On the actual amount spent in completing repairs.

Replacement cost can be defined as the cost to replace damaged property with property which is:

• Of like kind and quality.

• Similar in basic style.

• Similar in basic quality.

• Similar in basic function.

Remember that the policy provides coverage for replacement costs, not reproduction costs. Reproduction costs are defined as the costs for replacing property exactly as it was, down to the last detail.

There is one interesting loophole in replacement cost coverage: The repair work need not be performed in order to replace the actual property at the original location. In some states, reconstructing property at any location, including a different city or state, will qualify for coverage under a replacement cost claim.

Dwelling Claims When an insured has a claim for a damaged dwelling or other structure, the insured must realize that the claims process may be an involved and complicated process. There are four important steps to filing a claim on a dwelling. They are:



• Determining coverage.

The insured must first determine what is and is not covered by the homeowners policy. If there is a difference between the cost to repair and the amount of the claim, it could result in out of pocket expenses to the insured. In other words, if coverage is lacking in certain areas, it may be necessary for the insured to take measures throughout the adjustment process to cover shortages on his or her own.

• Determining the scope of repairs.

This is the insurance company’s description of work that will be included in repair estimates. It can also be referred to as the “scope of damage,” the “description of work,” or the “job description.”

The claims representative will prepare most scope of repairs documentation. The insured must review with the claims representative all of the work to be considered in the scope of repairs. Often, there are contentious aspects in determining the scope of repairs. For example, the insurance company representative (also referred to as the “adjuster”) may feel that a bedroom was not damaged enough by smoke to warrant painting it; or the representative may believe that a soiled carpet can be cleaned rather than replaced. The adjuster works for the insurance company and may try to convince the insured to accept a scope of repairs that will ultimately lower the cost of the repair.

• Determining the cost to repair.

Once the scope of repairs is determined, it must be converted into an agreed “cost to repair.” The insurance company is in a strong position compared to the position of the insured when determining the cost of repair. This is particularly true because most insurance companies use a contractor estimate to establish a cost to repair. The insurance company controls the estimate process and may receive quotes from parties which typically provide low estimates.

Notwithstanding the relative positions of strength in determining the cost to repair, the process should be handled fairly and adhere to common conventions used to determine the cost. For example, contractor profit and overhead allowances must be included in determining the cost to repair. The insurance company cannot omit this component of the repair cost.

The policyholder must be diligent in negotiating the cost to repair in order to receive the most favorable possible outcome.

• Determining the amount of the claim.

This part of the claims process is relatively easy, as the appropriate deductibles are subtracted from the agreed cost to repair. Portions of the loss that are not covered by the homeowners policy will also be subtracted from the cost to repair to determine the final amount of the claim.

Once all figures are agreed upon, including the cost to repair, the actual cash value amount of claim, and any pending replacement cost claim, the insured and the insurance company will sign documentation agreeing to the numbers and providing for payment to the insured or direct payment to contractors.

Personal Property Claims A personal property claim is very similar to a dwelling claim. The claims process follows four steps similar to those steps for processing a claim on a dwelling:


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• Determine coverage.

The insured should determine what personal property is covered by reviewing the policy and carefully reviewing the exclusions in the policy that specifically refer to personal property.

• Determine the scope of loss.

The scope of the loss determines the actual property which will be included in the claim. The insured should always complete an inventory on his or her own, rather than simply leaving this task to the insurance company representative. If the insured can present an accurate and detailed claim of loss, the insurance company will be able to more quickly determine the scope of loss. The insured must provide adequate documentation regarding lost or damaged personal property in order to facilitate the claims process.

The insured will benefit from prior records of personal property inventory. Individuals who have photographed or videotaped evidence of the existence of lost or stolen personal property will be in a good position to clearly establish the scope of loss.

Often, it may be difficult to determine whether damaged items can be cleaned or need to be replaced. If the insurance company agrees to clean the item and the cleaning is unsuccessful, the property will be replaced.

• Determine the replacement cost.

Once the parties determine the scope of loss, they may determine the replacement cost of the property. This involves a substantial amount of work obtaining cost estimates for each item of personal property included within the scope of loss. The insured must monitor this process and provide price references as necessary to help determine the appropriate replacement cost.

• Determine the amount of the claim.

The final step is determining the actual cash value of the claim. If the insured will not actually replace the property, the insurance company may only be required to pay the actual cash value of the lost or damaged item rather than the full replacement cost. Obviously, the insurance company will not be anxious to pay out the full dollar amount of the replacement cost without assurance that the insured will actually replace the property. This is particularly true because the value of most personal property significantly depreciates over time, and there may be a large dollar gap between the actual cash value and the replacement cost. As a result, the insured will likely have to show evidence of actual purchase of the replacement item in order to receive payment of the replacement cost as final settlement of the claim.

Other Homeowners Insurance Concepts An agent’s understanding of the following terms and concepts is essential to offering and describing homeowners insurance to customers.

Subrogation Subrogation is the substitution of one party in place of another party in respect to a claim or a lawful right. When one party negligently damages another person’s property, the injured party has the right to recover any damages. When the insurance company pays the injured party for the loss, the company takes over the rights of recovery that previously belonged to the injured party. In other words, subrogation permits the insurance company to step into the shoes of its insured in order to seek reimbursement for amounts which it pays to the insured



under the homeowners policy. Subrogation evolved in order to prevent injured parties from receiving a windfall by collecting from both the insurance company and the responsible party.

If an insured suffers a loss, the insurance company must pay the claim on a timely basis. The insurance company cannot force the insured to seek recovery from the responsible party. Often, an insurance company will stand aside and allow a third party to compensate an insured, but this can only occur with the consent of the insured. After the claim is paid, the insurance company will try to obtain restitution for the damages from the party which caused the damage.

Statements Under the homeowners policy, the insured is to provide certain claim statements. There are two kinds of statements which the insured may be asked to give in regards to a claim:

• An informal statement taken by the company representative upon inspection of the loss. This kind of statement is either handwritten or recorded on tape. The statement is taken in order to record facts and document the insured’s story. The existence of a recorded statement lessens the probability of an insured changing the story over time.

• A formal statement under oath. If requested by the company, a formal statement can be required under a homeowners policy. It is usually taken by an attorney and is, in effect, sworn testimony. If the insured lies in this statement, he would be guilty of perjury. If the insured refuses to give a formal statement under oath, the claim may be rendered void. The insurance company’s decision to request a formal statement usually indicates that the company believes something is suspicious about the claim.

Salvage The insurance company has the right to salvage property such as fixtures, appliances and any other part of a building as long as the insured has been paid for a total loss. Sometimes, the salvage goods will be sold back to the insured, however, the insured is under no obligation to accept this offer. For the most part, insurance companies will seek the services of a salvage company and do not care to directly involve themselves in this process. After the salvage company subtracts expenses and a percentage for profit, the balance goes to the insurance company as a return on the salvage operation.

Non-Waiver Agreement By merely investigating the facts of a case, the insurance company can sometimes lose its rights to deny a claim as a result of the legal concept of “estoppel.” In the event a company leads a policy holder to believe that a claim will be paid or implies that it will be paid in some manner, estoppel may prohibit the insurance company from denying the claim. The insurance company may be prohibited from denying the claim even if subsequently uncovered facts clearly indicate that the claim should not be covered by the policy.

To avoid the possibility of coverage by estoppel, many insurance companies investigating questionable claims require the insured to sign a non-waiver agreement that states that the insured understands that the company will not be required to pay the claim merely because the company explores the facts regarding the claim.

Cancellation The company or the insured may cancel a homeowners policy. If the company cancels, the insured is entitled to the full amount of unused premiums on a pro rata basis. The insured need only notify the company in writing to cancel the policy. The insurance company must


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provide no less than five days notice before canceling a homeowners policy. This period of time is intended to provide a window for the homeowner to obtain a new policy.

Homeowners Insurance – Concluding Thoughts For many of your prospects, purchasing homeowners or renters insurance may be their first experience purchasing insurance. As you offer homeowners and renters insurance policies to potential customers, it is important that you ask enough questions to obtain a full understanding of the insured’s needs. You should also be aware that a number of states require specific policy endorsements which are created specifically for the state.

Personal Property Insurance – Introduction As described above, the basic homeowners policy usually contains various limitations and exclusions on coverage. Therefore persons who are owners of valuable personal property often need broader and more comprehensive coverage than is provided by the basic homeowners policy. This broader and more comprehensive coverage may be obtained through appropriate personal property insurance.

Inland Marine Insurance The very first form of personal property insurance coverage was an Ocean Marine policy. The policy was written to provide financial protection for owners of ships in case their property or cargo was lost at sea.

Ocean marine policies insured the cargo from port to port. Later on, a clause was added to also insure cargo while it was being transported on land. As an end result, policy coverage extended from the original point of departure until the final destination point to include both ocean and inland transportation of those goods.

Eventually a separate policy was developed that dealt only with the insuring of the goods while being transported on land and the policy became known as an “inland” marine policy (in contrast to the “ocean” marine policy).

Inland Marine policies eventually began to provide a broad coverage for other property of a “floating” or moveable nature. Inland marine policies were offered on an “all risk basis” rather than a “named peril” basis as offered in most existing casualty policies.

Inland Marine Insurance – Definition Inland marine policies generally cover property that is transported from one place to another (excluding transfer over waterways). This property includes goods in transit and other property transported over roadways and bridges or under tunnels. Information transferred via television broadcasting towers or other communication transfer devices may also be covered by an inland marine policy.

Inland Marine Floater Characteristics Various floater policies can also be used to cover personal effects and property. The floater policy will provide coverage to items that “float” or move along with the covered property while it is changing locations.

An inland marine floater has four major characteristics.

• Tailored coverage.

A personal articles floater provides coverage for nine optional classes of personal property. We will list each of these classes later in these materials.



This type of floater permits the insured to select coverage for the class or classes of property needed. It is also possible to write each of these types of coverage on separate floaters. For example, any of the following floaters are possible:

• Jewelry floater.

• Fur floater.

• Coin collection floater.

• Stamp floater.

• Camera floater.

• Selection of policy limits.

As we have discussed, the basic homeowners policy has limitations on coverage of certain types of valuable property. The insured must look to a floater policy in order to obtain higher limits of coverage. Also, as a rule, when a basic homeowners policy combines the value of certain types of personal property with the value of unscheduled personal property it is possible that the combined total may exceed the homeowners policy limits on personal property. Here again, the floater policy can provide higher limits.

• Extensive coverage to perils covered.

When a floater is written it usually provides coverage on a “risks of direct physical loss” basis. The floater covers all risks of direct physical loss to the property that is described except specifically excluded losses. The commonly excluded losses will be discussed later in these materials.

• Worldwide coverage.

The property described in most floaters will be covered anywhere in the world with the exception of fine arts, which are usually covered only in the United States and Canada.

Inland Marine Floater Provisions The following policy provisions appear in most Inland Marine Floater policies:

• Loss settlement.

The amount that will be paid for a covered loss will be the lowest of the following four amounts:

• The actual cash value of the property at the time of loss or damage.

• The amount for which the insured could reasonably expect to repair the property to its condition which existed prior to the loss.

• The amount for which the insured could reasonably expect to replace the property with property substantially identical to the article lost or damaged.

The insurance company can purchase much of the property insured in a floater at discounted prices. Therefore the insurance company may want to replace the lost or damaged item itself rather than provide cash reimbursement to the insured. Should the insured reject the replacement offer, the insurance company’s cash reimbursement will then be limited to the amount for which the insured could reasonably be expected to replace the item. This amount will equal the discounted price which the insurance company would have paid to replace the item, even if the insured does not have access to that same discount.


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• The amount of insurance stated in the policy.

• Loss to a pair, set, or parts.

In the event that there is loss or damage to a covered property in a pair or set, such as the loss of one earring, the amount to be paid is not based on a total loss. The insurance company may either repair or replace any part to restore the pair or set to its pre-loss value or pay the difference between the actual cash value of the pair or set before and after the loss.

• Loss clause.

The loss clause provides that the overall limit of the insurance policy will not be reduced in the event of payment of a claim, except that the overall limit of the policy will be reduced in the event of payment on account of a total loss of a scheduled item. If the amount of the insurance is reduced because of a total loss of a scheduled article, the insurance company will either refund the unearned premium or apply the unearned premium to the current premium due if the scheduled article is replaced with another item.

• Claim against others.

This policy provision is very similar in nature to the subrogation clause. If a loss occurs and the insurance company believes that the insured can recover the payment for that loss from the person or parties responsible, then the loss payment to the insured will be considered a loan that must be repaid out of any funds recovered from others. The insurance company will expect the insured to cooperate with any attempt the insurance company makes to recover from others responsible for that loss. Should the recovery attempt be unsuccessful the insured will not be required to pay the “loan” on the loss settlement.

• Insurance not to benefit others.

No organization or other person that may have custody of the insured property and which is paid for services can benefit from the insurance on the property. The purpose of this provision is to prevent a third party who caused the loss from denying liability for payment by stating that the property is insured. The statement that the insurance is not for the benefit of third parties helps to retain the insurance company’s right of subrogation and a cause of action against the negligent party.

• Other Insurance.

In the event that there is other insurance at the time of loss that applies to the property, that insurance is considered excess insurance over the primary insurance policy. The primary insurance policy will pay its benefit in full, and the insured may then turn to the second insurer.

Inland Marine Floater Exclusions As a general rule, inland marine floaters provide coverage to property on an “all-risks” basis. Physical loss to covered property is provided for all cases other than the following exclusions:

• Wear and tear.

• Deterioration.

• Inherent vice.

• Insects or vermin.



• Mechanical breakdown or failure.

• Electrical breakdown or failure.

• Repairing the property.

• Adjusting the property.

• Servicing the property.

• Maintaining the property.

In addition, inland marine floaters contain general exclusions for loss related to war, nuclear reaction, and radiation.

Personal Articles Floater The Personal Articles Floater (often referred to as the PAF) is a particular type of insurance floater which provides coverage over nine optional classes of personal property. Coverage follows the property worldwide, except for fine arts.

The nine classes of personal property that can be insured under a Personal Articles Floater are:

• Jewelry.

• Furs.

• Cameras.

• Musical instruments.

• Silverware.

• Golfer’s equipment.

• Fine arts.

• Postage stamps.

• Rare coins/current coins.

Certain newly acquired items of property such as jewelry, furs, cameras, and musical instruments will be automatically covered for 30 days without specific itemization, provided that insurance was already written on that class of property. The amount of insurance on newly acquired property is limited to the lower of 25 percent of the amount of insurance for that class of property or $10,000.00. The property must be reported to the company within 30 days of purchase in order for the coverage to continue. The insured will be charged an additional premium for coverage from the date of acquisition.

We will now examine each of the nine classes of personal property which may be covered under a Personal Articles Floater:

• Jewelry.

Coverage on personal jewels applies anywhere in the world. Each item of jewelry, including watches, necklaces, and rings, must be scheduled with a specific amount of insurance. Jewelry is very carefully underwritten by the insurance company as a result of the significant hazard of loss. As a rule, the insurance company will require either the original bill of sale or a signed appraisal before the jewelry is insured. The insured must also possess satisfactory financial resources to suggest that the jewelry was not stolen,


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and the insurance company will want to know that the insured is not in the habit of losing or misplacing articles.

• Furs.

The PAF can be used to insure:

• Personal furs.

• Items consisting principally of fur.

• Garments trimmed in fur.

• Fur rugs.

• Imitation fur.

Again, each item must be separately listed with a specific amount of insurance shown for each item. As with jewelry, furs are very carefully underwritten.

• Cameras.

A PAF can also be used to insure each of the following items. Each of these items must be individually described and valued.

• Photographic equipment.

• Cameras.

• Projection machines.

• Portable sound equipment.

• Recording equipment.

• Motion picture cameras.

• Motion picture projectors.

• Films.

• Binoculars and telescopes.

Exceptions to the rule requiring the scheduling of items would be miscellaneous smaller items, carrying cases and filters, provided that the total value of the non-scheduled (or “blanketed”) items is not more than 10% of the total amount of the insurance on cameras.

• Musical Instruments.

The following items can be covered under a PAF:


• Instrument cases.

• Sound equipment.

• Amplifier equipment.

Should a musical instrument be used and played for pay during the policy period it will not be covered unless an endorsement is added reflecting this business use. Business equipment will require a higher premium.



• Silverware.

Silverware and gold-ware may also be covered under a PAF. Silver pens, pencils and smoking implements may not be insured as silverware. These types of property instead may be insured as jewelry.

• Golfer’s equipment.

Golf equipment such as golf clubs and golf clothes will be covered. Other golf equipment may also be insured under a PAF.

Clothing contained in a locker is also covered while the insured is playing golf. Golf balls are covered only in the event of fire and burglary if there are physical marks of forcible entry into the building, room or locker.

• Fine Arts.

Fine arts can include the following:

• Paintings.

• Antique furniture.

• Rare books.

• Rare glass.

• Bric-a-brac (knick-knacks).

• Manuscripts.

Fine arts are insured on a valued basis and must therefore be on a schedule with the amount that was paid for that item. Damages are paid on an actual cash value basis up to the stated value. Newly acquired fine arts will be automatically insured for ninety days without scheduling. The insured is required to notify the insurance carrier within ninety days of acquisition and the additional premium due will accrue from date of acquisition. The limit on fine arts property is subjected to 25% of the total insurance.

Fine arts are subject to three major exclusions:

• Damage caused by repairing, or retouching.

• Breakage of art glass windows, glassware, statuary, marble, bric-a-brac, porcelains, and similar fragile articles. However, the exclusion does not apply if fire, lightning, explosion, aircraft, collision, windstorm, earthquake, flood, malicious damage or theft, and derailment or overturn of a conveyance causes the breakage.

• Loss to property on exhibition at fairgrounds or at national or international expositions is excluded unless the premises are covered by the policy.

• Stamp and coin collections.

These collections are insured for loss anywhere in the world. The stamps and coins may be insured in one of two ways: scheduled basis or blanket basis.

• The scheduled basis is suggested if the items are extremely valuable. In this way each item is specifically listed and insured.

• Under the blanket basis the insurance applies to the entire collection since each item is not separately described. In the event of a loss to a scheduled item, the amount to be paid is the lowest of the following:


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• Actual cash value.

• The amount for which the property would reasonably be expected to be repaired.

• The amount for which the property would reasonably be expected to be replaced.

• The amount of insurance.

In the event of a loss to an item covered on a blanket basis, the amount paid will be the cash market value at the time of loss. There is a $1,000 maximum on any unscheduled coin collection. There is a $250 maximum limit on any of the following:

• Single stamp or single coin.

• Individual article.

• Single pair.

• Single block or single series.

• Single sheet or single cover.

• Single frame or single card.

In addition, for any stamps or coins insured on a blanket basis, the company is not liable for a greater proportion of any particular loss than the proportion which the amount of insurance on blanket property bears to the actual cash market value of the property at the time of loss. For example, suppose that the insured owns an unscheduled coin collection which is insured on a blanket basis for $500. One coin worth $50 is stolen. At the time of theft, the entire collection has an actual current market value of $1,000. Since the proportion of insurance on the collection compared to actual cash value of the collection is 50%, the insured’s maximum recovery for the loss of the coin will be $25 (50% of the coin’s $50 cash value). Had the insured purchased $1,000 worth of insurance, the $50 loss would have been paid in full.

For stamp and coin collections, damage from any of the following causes is excluded from coverage under the PAF:

• Fading.

• Creasing.

• Denting.

• Scratching.

• Tearing.

• Thinning.

• Transfer of colors.

• Inherent defects.

• Dampness.

• Extremes of temperature.

• Depreciation.

• Damage from being handled.

• Damage from being worked on.



• Mysterious disappearance, other than in the event where the item is scheduled or specifically insured, or is mounted in a volume and the page to which it is attached is also lost.

• Property lost in the custody of transportation companies.

• Shipments by mail other than registered mail.

• Theft from any unattended motor vehicle.

Personal Property Floater This floater provides extensive coverage on personal property owned or used by the insured that is kept at the insured’s residence. This rider will also provide worldwide coverage when this property is temporarily away from the residence. The property is issued on a special all-risk basis. This means all direct losses are covered unless specifically excluded.

Scheduled Personal Property Floater This floater is used to provide coverage for personal articles and valuable items that do not fall within the nine categories previously listed for the Personal Articles Floater. Examples of such items are:

• Dentures.

• Typewriters.

• Camping equipment.

• Wheelchairs.

• Stereo equipment.

• Grandfather clocks.

This is not a complete list, as almost any kind of personal property may be insured under a scheduled personal property floater. This type of coverage is quite flexible and may be adapted to meet the needs of the individual insured.

Insurance producers will often be asked what type of personal property should be scheduled on a personal property floater. As a general rule, valuable personal property should be scheduled and specifically insured under a floater policy. Diamond rings, fur coats and other jewelry of high value should be specifically scheduled. The following types of personal property should also be considered for scheduled coverage:

• Unique objects.

• Works of art.

• Rare antiques.

• Paintings.

• Stamp collection.

• Rare coin collection.

• Portable property.

• Cameras.

• Camera equipment.


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• Sports equipment.

• Fragile articles.

• Glassware.

• Statuary.

• Scientific instruments.

• Typewriters.

• Home computers.

• Business or professional equipment.

Since the basic homeowners policy provides coverage for personal or business property only to a maximum of $2,500 on the resident premises and $250 away from the resident premises, the insurance producer may recommend that the property be more adequately insured by scheduling the property with a stated amount of insurance shown for those items.

Unscheduled Personal Property The Personal Property Floater also may be used to insure the following classes of unscheduled property:

• Silverware, gold-ware, pewter-ware.

• Clothing.

• Rugs and draperies.

• Musical instruments and electronic equipment.

• Paintings and other art objects.

• China and glassware.

• Major appliances.

• Guns and other sports equipment.

• Cameras and photographic equipment.

• Building additions and alterations.

• Bedding and linens.

• Furniture.

• All other personal property and professional books while on the residence.

Each of the above categories carries a maximum limit for recovery for the particular category. The floater also carries a maximum limit spreading across all of the categories which matches the total policy limit.

Newly Acquired Property Any newly acquired property will automatically be covered under a Personal Property Floater for up to the lower of 10% of the total amount of insurance or $2,500.



Insurance on newly acquired property may be applied to any of the enumerated categories. Newly acquired property at the principal residence of the insured will be covered for thirty days from the time the property is moved there. The coverage on the newly acquired property is subject to the amount of the insurance for each enumerated category.

Property Not Covered The personal property floater will not cover any of the following personal property:

• Animals, fish, birds.

• Boats, aircraft.

• Trailers, campers.

• Motorcycles, motorized bicycles.

• Motor vehicle equipment, motor vehicle furnishings.

• Property pertaining to a business, property pertaining to a professional.

• Property pertaining to an occupation.

• Property usually kept somewhere other than the insured’s residence throughout the year.

Additionally the personal property floater places specific limits on certain property.

For example:

• $100 limit on money.

• $100 limit on unscheduled coins.

• A $500 limit on unscheduled securities, notes, stamps, passports, tickets, jewelry, watches, and furs.

The personal property floater also excludes certain losses such as:

• Animals owned or kept by the insured.

• Mechanical or structural breakdown.

• Water damage.

• Any work on covered property except jewelry, watches, or furs.

• Dampness/extreme changes of temperature except if caused by snow, rain, hail or sleet.

• Bursting of pipes.

• Bursting of apparatus.

• Acts or decisions of any person, group, organization or government body.

• Wear and tear.

• Deterioration.

• Inherent vice.

• Insects or vermin.

• Marring or scratching of property.

• Breakage of eyeglasses.


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• Glassware.

• Fragile article.

• Lightning.

• Theft.

• Vandalism.

• Malicious mischief.

Personal Effects Floater The Personal Effects Floater (PEF) is designed for travelers who want coverage on their personal effects while traveling. The PEF will provide coverage on the personal property of tourists and travelers anywhere in the world. However, this will only be in effect while the covered property is away from the residence premises. This coverage will apply to: the insured, his or her spouse, and any unmarried children who permanently reside with the insured.

Personal Effects Coverage Property normally worn or carried by an individual comes under the heading of personal effects. Coverage for personal effects will include: luggage, clothes, cameras, and sports equipment while the insured is traveling or on vacation.

Property Excluded The following property is excluded under PEF coverage:

• Automobiles, motorcycles, bicycles or boats.

• Accounts, bills, currency, deeds, evidence of debts, or letters of credit.

• Passports, documents, money, notes, securities or tickets.

• Transportation.

• Household furniture.

• Household animals.

• Automobile equipment.

• Salesperson samples or merchandise for sale or exposition.

• Physicians/surgeons’ equipment.

• Artificial teeth.

• Artificial limbs.

• Theatrical property.

All-Risks Coverage Personal effects will not be covered on an all-risks basis. Risks of direct physical loss to a property are covered except as follows:

• Damage to personal effects from:

• Wear and tear.



• Gradual deterioration.

• Inherent vices.

• Vermin.

• Insects.

• Damage while property is being worked on.

• Breakage of articles of a brittle nature unless caused by:

• Fire.

• Theft.

• Accidents to a conveyance.

Other Exclusions In addition to the exclusions previously mentioned, the following exclusions also are present in the PEF:

• Personal effects are not covered while on the named insured’s residence premises.

• Property in storage is not covered.

• Personal effects in the custody of students while in school are not covered except for loss by fire.

Limitations on Certain Personal Effects Jewelry, watches and furs are subject to a single article limit of 10% of the total amount of the insurance, with a maximum of $100.

A careful review of the prospect’s assets and needs will help determine the necessity for any of these additional coverages.

Personal Umbrella Liability Insurance A serious personal liability lawsuit can reach catastrophic levels for the party defending the lawsuit, as the judgment may potentially exceed the individual’s insurance policy liability limits. Once these liability limits are exhausted the insured is often forced to pay a substantial amount out of his pocket. Thus, individuals may require increased protection against catastrophic lawsuits. Individuals that usually need this protection include:

• Highly paid executives.

• Physicians.

• Surgeons.

• Dentists.

• Attorneys.

Do not be misled to assume that only those listed above need this protection. Considering the increased frequency of liability lawsuits and the complexities of modern living, most people may actually require this protection.

Such additional insurance protection can be provided by a personal umbrella liability insurance policy.


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Nature of Personal Umbrella Insurance The umbrella package is designed to provide the insured with coverage in the event of:

• A catastrophic claim.

• A lawsuit.

• A judgment.

The amount of umbrella coverage can range from $1,000,000 to $10,000,000.

The contract usually covers the entire family worldwide. The umbrella typically covers liability losses associated with the:

• Home.

• Automobile.

• Boats.

• Recreational vehicles.

• Sports.

• Other personal activities.

While it is true that an umbrella policy is not a standard contract, umbrellas do have some common features such as:

• A self-insured retention which must be met with certain losses covered by the umbrella policy but not covered by an underlying insurance policy.

• The umbrella policy provides excess coverage over basic underlying policies, such as personal auto, and homeowners insurance.

• Coverage is broad and includes coverage for some losses not covered by underlying contracts.

Excess Liability Insurance The umbrella policy pays only after the limits of the underlying policy are exhausted. Some umbrella policies require that the insured carry certain minimum amounts of liability on the basic underlying contracts. For example, on an automobile policy the minimum liability coverage required on the basic contract could be:

• $100,000 per person for bodily injury liability.

• $300,000 per occurrence of bodily injury liability.

• $25,000 for property damage liability.

• A combined single limit of $300,000.

On a homeowners policy the minimum required on the basic contract could be $100,000 of personal liability. If a watercraft is involved, liability exposure requirements may be $500,000 of single limit underlying coverage.

Broad Coverage With respect to personal loss exposures, the personal umbrella policy provides broad coverage. The personal policy coverage also covers certain losses that the underlying



contract may not cover after the insured meets certain self-insured retention requirements. These losses include:

• Personal injury.

• Libel claims.

• Slander.

• Defamation of character.

• False arrest.

• False imprisonment.

• Humiliation.

Here are five specific examples of claims that may be paid by umbrella insurance companies:

• The insured slandered two police officers.

• The insured borrowed a tractor and damaged it. After a self-insured retention was met the umbrella covered the loss.

• The mast on a rented boat broke during a race and seriously injured a crewmember. Primary coverage was not available to the insured.

• The insured rents a car in England and is involved in a serious accident. The personal umbrella covered the loss since only limited underlying coverage was available.

• The insured’s spouse rents a motorcycle and is involved in a serious accident. Since the underlying automobile/homeowner contracts do not cover the ensuing third-party claim, the umbrella pays the claim.

Self-Insured Retention When an umbrella policy covers a loss which is not covered by the underlying insurance policy, a self-insured retention or deductible must be met. As a rule this deductible is at least $250 per occurrence and can be higher.

Personal Umbrella Coverages Personal umbrella coverage may include coverage for each of the following:

• Personal injury liability.

The insured’s liability for personal injury is covered under the personal umbrella policy. Personal injury is defined to include:

• Bodily injury.

• Sickness.

• Disease.

• Disability.

• Shock.

• Mental anguish.

• Mental injury.


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This definition can also include:

• False arrest.

• False imprisonment.

• Wrongful entry.

• Wrongful eviction.

• Malicious prosecution.

• Humiliation.

• Libel.

• Slander.

• Defamation of character.

• Invasion of privacy.

• Assault and battery (not intentionally committed or directed by a covered person).

• Property damage liability.

Property damage can be defined as physical injury to tangible property and includes loss of use of the injured property. The umbrella insurance company agrees to pay losses for which the insured is legally liable and which exceed the “retained limit.” The “retained limit” is either:

• The total of all applicable limits of all required underlying contracts and any other insurance available to a covered person, or

• The self-insured retention if the loss is not covered by the underlying insurance.

• Defense costs.

Typically, legal defense costs in addition to the policy limits are paid under the personal umbrella policy. Defense costs include:

• Payment of attorney’s fees.

• Premiums on appeal bonds.

• Court costs.

• Interest on the judgment.

• Legal costs.

However, some personal umbrella policies will include the cost of defending the insured as part of the total loss. It is possible that in a catastrophic judgment the insured may have to absorb part of the loss. Still, most umbrella policies will provide and pay the legal defense costs of a covered loss if that loss is not covered by any underlying insurance.

Personal Umbrella Exclusions Like other types of personal property insurance, the personal umbrella provides specific exclusions to coverage. Here are some of the more common exclusions found in personal umbrella policies:

• Worker’s compensation.



Any obligation for which the insured is legally liable under workers compensation, disability benefits, or similar law is not covered by the umbrella.

• Fellow employee.

Some personal umbrella contracts exclude coverage for any insured (other than the named insured) who injures a fellow employee in the course of employment arising out of the use of any of the following:

• Automobile.

• Watercraft.

• Aircraft.

• Care, custody or control.

Damage to property owned by a covered person is excluded under all personal umbrella contracts. Most contracts also exclude damage to a non-owned aircraft and non-owned watercraft in the insured’s possession. However most umbrellas will cover damage to:

• Property rented to the insured.

• Property used by the insured.

• Property in the care of an insured.

Note that the umbrella contract will not cover aircraft or watercraft which fall into one of the three above categories.

• Nuclear energy.

All personal umbrella policies contain a nuclear energy exclusion.

• Intentional acts.

Any act directed by or committed by a covered person with the intent to cause personal injury or property damage will not be covered by the umbrella contract.

• Aircraft.

Umbrella policies will not cover any liability arising out of ownership, maintenance, use or loading or unloading of an aircraft.

• Watercraft.

Larger watercraft are usually excluded from umbrella coverage, including:

• Inboard watercraft.

• Inboard/outboard watercraft exceeding 50 horsepower.

• Outboard motors of more than 25 horsepower.

• Sailing vessels of more than 26 feet long.

• Professional liability.

While many insurance companies do not offer this coverage and virtually all umbrella policies exclude professional liability, some companies will cover certain professional liability losses with an endorsement and by charging a higher premium.


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• Officers and directors.

This exclusion does not apply to a non-profit corporation or organization. It does exclude coverage for an act or failure to act as an officer, trustee or director of a corporation or association.

• Recreational vehicles.

Liability arising as a result of ownership or maintenance of golf carts is excluded.

Watercraft Insurance The homeowners policy only provides limited coverage for watercraft owned by the homeowner. As a result, the homeowner must obtain separate coverage under a watercraft policy in order to fully protect watercraft from loss. Watercraft insurance can cover various watercraft which range in size, such as:

• Rowboats.

• Canoes.

• Outboard motorboats.

• Inboard motorboats.

• Dinghies.

• Sailboats.

• Speedboats.

• Houseboats.

• Yachts.

Hull and Trailer Loss Exposures Watercraft as well as their equipment, trailers and furnishings may be exposed to a wide variety of theft and physical damage loss. Examples of possible damage or loss include the following:

• Two speedboats collide.

• A sailboat is overturned in heavy winds.

• A boat sinks in a severe storm.

• A sandbar strands a houseboat.

• An outboard motor falls into a lake.

• A boat trailer is stolen.

• An explosion seriously damages a boat.

Homeowners Policy Physical Damage Coverage Watercraft and trailers are covered under Section One of a homeowners policy for physical damage and theft. However this coverage is very limited. The major limitations on coverage are as follows:

• Direct loss to:

• Watercraft.



• Trailers.

• Furnishings.

• Equipment.

• Outboard motors from windstorm or hail are covered ONLY if the property is inside a fully enclosed building.

• Theft of:

• Watercraft.

• Trailers.

• Furnishings.

• Equipment.

Outboard motors away from the resident premises are specifically excluded. Watercraft and other boating property are covered only for a limited number of named perils.

• Coverage on each of:

• Watercraft.

• Trailers.

• Furnishings.

• Equipment.

… is limited to a maximum of $1,000.

Personal Auto Policy Personal Damage Coverage An automobile policy is not designed nor does it cover any physical damage to boats. The boat trailer however can be insured for physical damage loss under a personal auto policy. The trailer must be described fully in the declarations of the auto policy.

Liability Loss Exposure When an insured owns or operates watercraft, the insured may be exposed to a wide variety of liability loss exposure, such as:

• A water-skier is injured because of excessive speed.

• A boat runs into swimmers and seriously injures them.

• A boat collides with a dock causing property damage.

• Two boats collide injuring the occupants.

• A child falls overboard and drowns and was not provided a life preserver by the boat operator.

Homeowners Policy Liability Coverage Section II of a homeowners policy provides personal liability insurance and it covers certain watercraft loss exposures providing the boat is under a specified size and length. Personal liability insurance provides the insured with protection against bodily injury or property liability that arises out of the use or operation of certain owned watercraft. The liability protection can also apply on an excess basis for certain covered non-owned watercraft.


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There are however several important categories of watercraft liability that the homeowners policy excludes from coverage. These include:

• Owned watercraft regardless of size with inboard or inboard/outboard motor power.

• Rented watercraft with an inboard or inboard/outboard motor power with more than 50 horsepower.

• An owned or rented sailing vessel that is more than 26 feet in length.

• Watercraft powered by one or more outboard motors with more than 25 horsepower if the motors were owned by the insured at the inception of the policy and not declared or reported. However, watercraft powered by outboard motors with more than 25 horsepower are covered if the motors were acquired prior to the policy period and providing the insured declared them at the time of policy inception or declared them within forty-five days of acquisition.

The above exclusions do not apply when the craft is in storage.

Outboard Motor and Boat Insurance This specific type of watercraft insurance is designed for those who own motorboats and for those who have adequate personal liability coverage under their homeowners policy or under a comprehensive personal liability policy but desire broader physical damage insurance on their boat. An Inland Marine Floater can also provide this protection. Although floaters are not standard they do contain some common features such as:

• Covered property.

The insured selects the property to be insured. The floater can be written to cover the following:

• Hull.

• Motor or motors.

• Boat equipment.

• Boat accessories.

• Boat carrier.

• Boat trailer.

Covered property is written on an actual cash value basis and may contain a deductible of $25, $50, $100 or some greater amount.

• Covered Perils.

The floater can be written on named perils or risks of direct loss basis. Most floaters currently are written on the risks of direct loss basis. The coverage does not include the liability for bodily injury, loss of life, or illness of individuals.

It is assumed that the insured has proper liability insurance under a homeowners or liability policy to cover any third party bodily injury claims. The floater, however, may provide collision damage liability insurance that protects the insured from a claim for property damage from the owner of another boat if the insured’s boat happens to collide with another boat while it is afloat.



Outboard Motor and Boat Insurance Exclusions Outboard motor and boat insurance contracts do have exclusions. Some of the common exclusions are as follows:

• Business pursuits.

• No coverage will be afforded if the boat is used as a public conveyance for carrying passengers for compensation.

• No coverage will be provided if the boat is rented to others.

• Coverage is excluded for race boats or boats in speed contests.

• Repair or service. Coverage is excluded for loss or damage from:

• Refinishing.

• Renovating.

• Repair is not covered. The person who is repairing the boat would be responsible for any damage.

• General risks of direct loss. Coverage will not be provided for loss or damage from:

• Wear and tear.

• Gradual deterioration.

• Vermin.

• Marine life.

• Rust.

• Corrosion.

• Inherent vices.

• Latent defect.

• Mechanical breakdown.

• Freezing.

• Extremes of temperature.

Watercraft Package Policies Many insurance companies have developed special boat owners policies that combine liability coverage, physical damage coverage, and medical payments coverage.

These boat owners policies contain certain common characteristics:

• Physical damage coverage.

Currently most boat owners policies are written on a direct and accidental loss basis. The insurance company agrees to pay for direct or accidental loss to covered property under the physical damage insuring agreement. All losses are covered except those specifically excluded.

The physical damage covers the boat, equipment, accessories, motor, and trailer.


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In addition, if the boat collides with another boat, gets damage from heavy winds, or is stolen, the loss is covered.

• Liability coverage.

Liability insurance that covers the insured for bodily injury and property damage, liability from a neglect ownership or operation of the boat, is included in a boat owner’s policy. Should the insured accidentally damage another boat or injure swimmers, for example, protection is provided under the liability coverage.

• Medical payments coverage.

This is similar to the medical payments coverage found in an automobile insurance contract. Medical payments will be made for all medical expenses incurred within three years from the date of a watercraft accident that causes bodily injury to a covered person.

Under medical payments coverage, a covered person is defined as the insured, a family member, or any person while occupying the covered watercraft.

Under the medical payments coverage section, expenses will be paid for reasonable charges for the following:

• Medical.

• Surgical.

• X-ray.

• Dental.

• Ambulance.

• Hospital.

• Professional nursing.

• Prosthetic devices.

• Funeral services.

• Other coverage. The following may also be found in a boat owners policy:

• Cost of removing a wrecked vessel.

• Cost of removing a sunken vessel.

The following are commonly excluded from physical damage coverage under a boat owners policy:

• Wear and tear.

• Inherent vice.

• Latent defect.

• Mechanical breakdown.

• War.

• Nuclear hazard.

• Damage caused by repair (except fire).

• Damage caused by restoration process (except fire).



• Carrying persons for a fee.

• Carrying property for a fee.

• Renting covered property.

• Racing covered property (except sailboats).

• Speed testing covered property (except sailboats).

• Infidelity of persons to whom covered property is entrusted.

• Portable electronic equipment.

• Photographic equipment.

• Water sport’s equipment.

• Fishing gear.

• Cameras.

• Fuel.

• Portable radios.

• Fishing equipment.

The following are commonly excluded from medical expense coverage under a boat owners policy:

• Intentional injury.

• Intentional damage.

• Renting the watercraft to others.

• Carrying persons for a fee.

• Carrying property for a fee.

• Using watercraft in a race (except sailboats).

• Using watercraft in a speed test (except sailboats).

• Losses covered under worker’s compensation.

• Losses by a nuclear energy liability policy.

• Contractual liability.

Personal Yacht Insurance This type of policy is for larger boats such as inboard motorboats and cabin cruisers. Personal Yacht insurance provides hull insurance, protection and indemnity insurance, optional coverage and warranties.

• Hull insurance.

This protection refers to physical damage on the boat. This coverage also applies to sails, tackle, machinery, furniture, and the boat itself.

This insurance provides “all-risks” protection. For example if the boat is damaged by: heavy seas, collision, flood or sinking because of an insured peril, the loss is covered. A deductible of varying amounts will apply to all physical damage and losses.


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• Protection and indemnity insurance.

This coverage provides the boat owner with coverage for bodily injury and property injury on an indemnity basis. If for example the boat were to smash into a marina and injures several persons the loss to the dock as well as any bodily injury would be covered under Protection and Indemnity Insurance.

• Optional coverage.

The boat owner may add several options to your personal yacht policy, such as, medical payments coverage, liability of the insured to maritime workers injured in the course of employment, boat trailer insurance, land transportation insurance and a water-skiing clause.

• Warranties.

Several warranties and promises are provided with yacht insurance. If the insured violates a warranty, higher premiums may be required to be paid to the insurance company.

The major warranties on yacht insurance are as follows:

• Seaworthiness warranty.

The insured warrants that the vehicle is in seaworthy condition.

• Lay-up warranty.

The insured warrants the vehicle will not be in operation during certain periods, such as winter months.

• Navigational limits warranty.

The vessel will be used only in territorial waters described in declarations.

• Private pleasure warranty.

The insured warrants the vessel will not be hired or chartered.

Uninsured Boaters Coverage As is the case with automobile insurance where an individual can purchase uninsured motorist protection, boat packages also include an option for uninsured boat coverage. The company agrees to pay damages that a covered person is legally entitled to recover from an insured boat owner or operator due to bodily injury sustained by a covered person in a boating accident.

Uninsured Boaters Coverage – Exclusions The uninsured boater’s coverage has several exclusions. Bodily injury from the following are excluded:

• While occupying or struck by any watercraft owned by the insured or family member that is not insured under the policy.

• If the bodily injury claim is settled without the insurance company’s consent.

• While operating a covered watercraft which is carrying persons or property for a fee.

• While occupying a covered watercraft being rented to others.

• Using a watercraft without a reasonable belief that the person is entitled to do so.

• Occupying a watercraft without the reasonable belief that the person is entitled to do so.



In the event there should be a disagreement as to whether a covered person is legally entitled to recover damages from the uninsured boat owner or operator, or on the amount of damages, the coverage has an arbitration provision which states that each party selects an arbitrator. The two arbitrators then select a third arbitrator. Those arbitrators have thirty days to agree on the selection of the third arbitrator. If the two arbitrators take longer than thirty days to identify the third arbitrator, then a judge in a court of law will be permitted to appoint the third arbitrator.

Specialized Coverages As your clients become involved in business transactions, their needs for insurance will increase and may include a need to protect goods in transport.

Marine insurance is a broad term including ocean and inland marine insurance. The Nationwide Marine Insurance Definition, published by the National Association of Insurance Commissioners, includes imports, exports, domestic shipments, and means of communications, and personal and commercial property floaters as marine insurance. In this section, we will discuss various types of specialized Marine Insurance.

Ocean Marine Specialized Coverage First we cover specialized coverage which applies to Ocean Marine policies.

• Bumbershoot liability.

Bumbershoot coverage is a particular form of umbrella liability designed for accounts where the principal exposure is marine and involves the operation of vessels and use of docks.

The Bumbershoot covers: protection and indemnity; general coverage, collision, salvage charges, labor; all other legal and contractual liability including employers liability, liability under admiralty laws or the Longshoremen’s Act, automobile liability, and those hazards usually associated with general liability insurance. Insured’s net retention of at least $100,000 is usually required.

• Charter boats.

Standard protection and indemnity forms issued in conjunction with Hull insurance policies on vessels exclude coverage on the use of a boat for hire or charter. Under certain circumstances, a Protection and Indemnity form, broader in coverage than a standard general liability contract, is issued to an owner or operator of such a vessel used for carrying passengers for sightseeing, fishing, transportation, entertainment or marine observations on a fee basis.

Coverage for liability also may be arranged on a liability form with rates set in the specialty market at a surcharged rate. Vessels under 40 feet in length are rated at 50% of those over 40 feet. Coverage usually is subject to a deductible. Liability exposure is of more concern to underwriters than loss or damage to the hull.

Operation of a restaurant and serving of alcoholic beverages are also principal hazards on larger vessels.

• Ship charterer legal liability.

This insurance is designed to protect a vessel charterer against liability incurred for loss of, or damage to, the vessel. Liability is ordinarily limited to damage caused in loading or unloading or failure to provide a safe berth. Policies may be written on an open basis with a flat premium charged for each voyage, or each voyage may be written separately.


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• Ship repairer legal liability.

This coverage protects an individual ship repairer, marina or boat yard operator for legal liability to the vessel’s owner for damage to the vessel being repaired. This “care, custody or control” coverage provides only property damage liability and may be extended to include insured’s legal liability for damage to other property caused by a collision (or otherwise), while the vessel is being repaired or tested.

Inland Marine Specialized Coverage When clients become involved in business they will develop very specialized needs. Specialized coverage may also be obtained under an Inland Marine policy. Different types of specialized coverage include:

• Builders’ risk.

Builders’ Risk policies cover buildings or structures during the construction, renovation or repair process. While coverage is often tailored to meet the needs of each customer, the vast majority of policies also cover building materials destined to become a permanent part of the building or structure. This property is covered while in transit, at temporary storage locations and while stored at the job site.

Builders’ Risk policies are an important insurance product within the construction industry because the vast majority of banks require evidence of Builders’ Risk insurance prior to closing on a construction loan.

In addition, two of the most frequently used construction contracts (the Association of General Contractors and the American Institute of Architects Contract for Construction) contain specific provisions outlining requirements for Builders’ Risk insurance.

Even putting these requirements aside, few, if any, companies can afford to invest in construction without insurance protection.

Any business entity with a financial interest in property under construction, renovation or repair needs Builders’ Risk insurance. Typical policyholders include:

• Real estate developers.

• Building owners.

• Home builders.

• General contractors.

• Municipalities.

• Colleges and universities.

• Computerized business equipment.

Computerized Business Equipment policies can cover all types of automated equipment capable of accepting and processing data. While we typically think of computers as the primary subject of this coverage, automated manufacturing equipment, computerized medical equipment, flight simulators and any number of other types of specialized equipment can be eligible for coverage.

Coverage may also include the software and data used by this equipment as well as business income and extra expense exposures that may arise for a loss to such equipment or data. Coverage typically applies on-premises, while in transit and while



temporarily away from covered locations. Laptops and portable computers are covered worldwide.

Technology represents a significant investment to many businesses. Computerized Business Equipment coverage is important to any business entity that relies on technology in their daily operations. The greater the dependence on technology, the more important it becomes to purchase specialized coverage on such a critical aspect of operations.

• Contractor’s equipment.

Contractor’s Equipment Coverage can cover scheduled, leased and miscellaneous property of the contractor. In addition, this coverage may be extended to include any similar property of others for which the contractor may be liable.

This coverage can be further extended to include:

• Additionally acquired equipment coverage extending up to the policy limit for equipment which the insured buys, leases, rents or borrows for defined period of days.

• Rental expense reimbursement coverage, which pays up to a defined limit for rental expenses in the event that covered equipment is damaged in a covered loss.

• Installation floater coverage extends to property intended for installation while at a job site, at any other location, or in transit.

• Valuable papers coverage provides insurance for items such as blueprints and other documents of value to the contractor.

Contractors Equipment is owned or leased to perform a specific function. Use of the equipment is directly related to generating revenue, fulfilling a contract or providing maintenance. Without working equipment or the means to replace equipment as soon as possible, a contractor’s obligations cannot be fulfilled.

The Contractors Equipment policy helps owners expedite the repair or replacement of damaged or stolen equipment. In addition, because of the high cost of the equipment many banks and lending institutions require insurance on the equipment.

Any business entity with a financial interest in construction or other heavy equipment needs Contractors Equipment insurance.

Typical policyholders include:

• Real estate developers.

• Building owners.

• Home builders.

• General contractors.

• Municipalities.

• Street and road contractors.

• Excavation contractors.

• Port facilities.

• Warehouse operators.


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• Fine arts.

Corporations and commercial accounts may have valuable works of art not specially covered as Fine Arts under standard package policies and Marine coverage fits the bill.

Fine Arts coverage extends to works of art at a permanent location, in transit and while loaned to others. Agreed Value Fine Arts coverage ensures that collections are treated properly with a form that addresses the specific collection needs, with availability of breakage coverage, special pairs and sets coverage, and flood and earthquake coverage.

For significant corporate collections, or for artwork and collectibles in commercial settings, insurers offer comprehensive coverage for a broad spectrum of paintings, sculpture, prints and multiples, as well as more specialized collections of historical, cultural or technological significance.

• Installation coverage.

Installation policies insure building materials and components, machinery, and specialized equipment while being installed in a building or structure or erected or fabricated at a specific location. Typical types of property include heating, ventilating, air conditioning and electrical systems; and wallboard, tile, carpeting and other interior finish material.

More specialized installations include wastewater treatment facilities and controls, pipelines, electrical, telephone and cable television lines; and radio and cellular telephone towers.

Coverage is typically effective from the time the customer’s financial interest in the property begins until the interest ceases, including while the property is in transit, at temporary storage locations and while stored at the job site.

The vast majority of Installation policies are written for subcontractors (trade subcontractors in particular). Any business entity having a financial interest in property being installed, erected or fabricated may have a need for Installation coverage.

Typical policyholders include:

• Specialty contractors.

• Government authorities and municipalities.

• Utilities (water, gas, telephone, electrical).

• Manufacturers, wholesalers, and retailers of machinery, equipment and materials, who also install what they sell.

Marine underwriting specialists have written all types of installation projects, including low hazard residential electrical systems and tenant finishes, helicopter assisted tower installations, and the delicate relocation of a lighthouse threatened by erosion.

Standard programs offer coverage against risks of direct physical loss or damage (subject to certain policy exclusions), or coverage tailored to a specific, complex project.

• Manufacturers coverage.

A Manufacturers Output Policy includes coverage for the personal property of a business at specific, as well as unnamed, locations, including while in transit.

Personal property coverage includes such items as machinery, equipment, furniture, fixtures and stock, improvements, and includes any other similar property of others for which an insured is liable.



Coverage extensions include: Accounts Receivable and Valuable Papers coverage, and Fire Protection System Recharge Expense coverage.

• Motor truck cargo legal liability.

Motor truck cargo policies insure common and contract carriers for loss or damage to cargo in their care, custody or control.

Coverage is provided on a legal liability basis as determined by the contract of carriage between the motor carrier and the shipper (pursuant to a bill of lading or other specially negotiated contract). Generally, a carrier is liable for the safe delivery of the property entrusted to it, not only while on the carrier’s vehicles, but also while temporarily at terminals awaiting shipment.

An insurer’s Motor Truck Cargo Legal Liability policy is designed to cover that liability on behalf of the carrier.

• Museum coverage.

Some Marine policies offer coverage developed specifically to insure museum-quality objects.

The policy insures museum owned property at scheduled locations, on exhibition or on loan to other organizations. The policies also offer coverage for property in transit and the property of others for which the policyholder is legally liable.

Coverage is available for art, history, natural history, science and technology and sports museums.

Some insurers also offer coverage for specialized institutions such as aviation and automobile museums.

In the United States, there are more than 12,000 museums eligible for this coverage. The market is expected to expand as the number of specialty museums and local historical societies continues to grow. Many of these smaller museums have no coverage for their collections because they perceive that one-of-a-kind objects are invaluable and therefore uninsurable.

Although an exact replacement is not available, insurance can offer curators the opportunity to supplement the remaining collection with artifacts of the same genre to keep and preserve the mission of the museum.

• Scheduled property.

Scheduled Property coverage is designed to cover property that is unique or unusual or which is not typically covered under any other marine or property coverage. Coverage is available to protect against risks of direct physical loss or damage (subject to certain inland marine exclusions).

Any commercial property owner with property that travels from location to location or who needs coverage for other than real property or contents is a candidate for Scheduled Property coverage.

Scheduled Property coverage is desirable for any business entity that wants insurance protection for unique property ranging from structures outdoors to movable property.

Some of the unusual types of risks eligible for this coverage include:


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• Circus rides.

• Locomotives and rail cars.

• Voting machines.

• Transit systems.

• Water storage tanks.

• Antique cars and race cars.

• Ski lifts.

This type of coverage may be tailored to the specific property. Coverage applies to property wherever it is located - at a specific location, in transit or at a temporary location. Valuation options of all types are available including agreed amount, actual cash value or replacement cost.

• Transportation.

Transportation insurance typically covers a shipper’s interest in property while in transit by public motor carrier, contract carrier, railroad, air carrier, or while on the shipper’s own vehicles.

The coverage form is often extended to provide insurance for loss to property while it is being loaded and unloaded.

A Transportation policy pays up to the limit of insurance, regardless of the extent of the carrier’s legal liability or the carrier’s ability to meet its financial obligations. In today’s fast paced world, insureds don’t necessarily have time to spend collecting reimbursement from a carrier in the event of a loss, so the transportation policy covers these losses up front. Some Transportation policies also pay for certain losses even when the carrier may not be liable, such as Acts of God (flood, earth movement, etc.). And if the insured cannot collect the invoice amount from a consignee because of loss or damage during a shipment, the policy will cover the insured’s interest in the lost or damaged property.

Any business that deals in a moveable product needs coverage for incoming and outgoing shipments, whether the business is a manufacturer, a wholesaler, a retailer or a distributor.

Ocean Marine Insurance Ocean marine policies were the first form of insurance coverage. They were written to provide financial protection for the owners of ships and cargoes in the event their property was lost at sea.

The cargo was insured from port to port. Ocean marine policies still offer this coverage today and include Ocean Cargo, Commercial Hull, Hull Builders Risk, Marina Operators, Boat Dealers, Ship Repairers, Stevedores, Wharfingers and Charterers.

Marine policies can be written to cover the movement of any legal goods. The property insured is not itemized in the policy, which is written generally to cover “goods and merchandise.”

Certain types of property are not included under the general category of “goods and merchandise” and need to be specifically covered. These excluded items include livestock, frozen foods, refrigerated meats, poultry, game, as well as bullion, securities and similar property.



The marine policy may be written not only to cover the value of the shipped goods but also import duties and freight charges.

Hazards Covered

• Perils of the sea.

Under this coverage fall all perils which are peculiar to transportation and which cannot be prevented by any reasonable efforts of humans. Perils of the sea must be fortuitous; in other words, due to an uncontrollable action of the sea, not within the control of any person.

• Fire.

Fire is not a peril of the sea, but the policy covers this risk. On the other hand, there is no coverage against fire which is due to the inherent combustibility of the goods being carried. Combustible cargoes sometimes are insured with special, additional coverage specified in a policy.

• Barratry of the master.

Violation of trust of the master is covered provided it is not done in concert with the ship owner. “Barratry” is a specific term used to describe this type of maritime treachery.

• Assailing thieves.

Although petty thievery is not covered by the policy, theft accompanied by violence is covered.

• Jettison.

Cargo thrown overboard is covered if the property was thrown overboard in order to attempt to preserve the property from loss.

• All other perils.

The policy covers “all other perils which shall come to the hurt, detriment or damage” of the goods. The clause would appear to make the policy cover against all risks, which is definitely not correct. It means only perils of a character similar to those insured.

• Explosion.

Most marine policies specifically cover the risk of explosion, whether on land or sea.

• Latent defects in machinery, hull, appurtenances.

Most marine policies are extended to cover damage caused by bursting of boilers, breakage of shafts or through any latent defects in the machinery, hull or equipment, and through faults and errors in navigation or management of the vessel.

Other Types of Ocean Marine Coverage In addition to the specific perils listed above, Ocean Marine Policies may be modified to include each of the following types of coverage:

• Charterers legal liability.

When a shipper contracts with a ship owner to use the owner’s vessel, this arrangement is considered a charter.

Depending on the type of charter, the charterer is held legally responsible for certain liabilities and properties of the vessel. Depending on the type of contract the charterer


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enters into, the charterer may become liable for certain exposures related to the operation of the vessel. There are three types of commonly used charters:

• Voyage charter.

A charterer who contracts the entire vessel for a single voyage or series of consecutive voyages is considered a Voyage Charterer. In a Voyage Charter, the shipper in most cases is liable for a safe berth, loading and the unloading. The ship owner retains the responsibility for navigation, operation of the vessel and all expenses.

• Time charter.

A charterer who contracts to hire the entire vessel for a specific period of time is called a Time Charterer. In a Time Charter, the shipper is responsible for paying for the ship’s fuel and for providing a safe berth at the port of delivery. The ship owner remains responsible for navigation and the expenses of operating the vessel.

• Bareboat charter.

A charterer who contracts to hire the entire vessel without a crew, stores or provisions is called a Bareboat Charterer. In a Bareboat Charter, the ship owner is liable for the full operation of the vessel.

• Hull protection and indemnity coverage.

Hull policies cover physical damage losses to the vessel arising out of numerous perils, while protection and indemnity policies cover the liability of the vessel owner for bodily injury (including death) or property damage arising out of specific types of accidents.

Hull and Protection and Indemnity coverage is often tailored for each customer. Typically hull coverage is written together with the protection and indemnity coverage.

Hull policies are a necessary part of the shipping industry. Without hull coverage, a prospective buyer of a vessel will be unable to obtain a loan to finance the purchase. Hull coverage will protect the interests of the bank and the vessel owner if a loss does occur.

Protection and Indemnity policies are also necessary. Without protection and indemnity coverage, most vessels would not be permitted to sail. The majority of labor unions require that a fleet have coverage for the crewmembers in case they become ill, injured, or are killed while employed by the vessel. Without evidence of adequate Protection and Indemnity insurance, the vessels would not be manned and cargo would not leave the ports. Any commercial ship owner and/or operator of an inland/ocean-going vessel needs Hull Protection and Indemnity insurance. Typical policyholders include:

• Container vessel owners.

• Bulk-carrying vessel owners.

• Tanker vessel owners.

• Barge owners.

• Ferry owners.

• Heavy lift vessel owners.

• Marina operators legal liability.

Marinas provide a number of services to the owners of private pleasure crafts including renting dock space, fueling, storage, launching and hauling.



The marina must exercise the appropriate care to protect its customers’ pleasure craft, equipment on board and motors that are in the marina’s care, custody or control. If negligent in such duties, a marina may be held liable for any loss or damage to their customer’s property.

Marina Operators Legal Liability covers the insured’s liability for loss of or damage to customers’ private pleasure watercraft, equipment on board and motors that are in the marina’s care, custody or control. Any individual or any entity with a financial interest in a marina or yacht club should obtain Marina Operators Legal Liability. Typical policyholders include yacht club owners and marina owners.

• Ocean cargo.

Ocean Cargo policies cover physical loss or damage to goods and merchandise that are shipped by various types of carriers; i.e., rail, air, water, and motor truck. Besides just covering goods while in transit overseas, the coverage form can be broadened to cover the goods while temporarily stored at international and domestic warehouses, while being shipped domestically or while at a domestic or foreign processor.

Ocean Cargo coverage is tailored to meet the needs of each customer. Ocean Cargo policies are a necessary part of the shipping industry. Without Cargo coverage, international transactions would not take place.

When a bank finances the purchase of goods, the buyer is required to provide evidence of adequate insurance prior to any advancement of money.

Once proof of adequate insurance has been given to the bank, the shipment of the goods can commence. Ocean Cargo insurance typically protects the interests of the bank, the seller of the goods and the buyer of the goods.

Any individual or any entity with a financial interest in goods or merchandise being shipped internationally should obtain Ocean Cargo insurance. Typical policyholders include:

• Multi-national companies.

• Wholesalers and distributors.

• Manufacturers and processors.

• Shipping companies.

• Importers and exporters.

• Ship repairers legal liability.

A shipyard performing repairs on a vessel has certain responsibilities to the vessel owner for the safety of their property. The shipyard must anticipate the hazards to which the property is subject and must exercise the appropriate care to protect this property. If negligent in such duties, the shipyard may be held liable for loss or damage to this property.

When a shipyard is repairing a customer’s vessel, there is a bailment between the shipyard and vessel owner while the vessel is in the care, custody, or control of the shipyard. This bailment makes the shipyard liable for certain damages and the shipyard must exercise an ordinary degree of care to protect its customer’s property.

The Ship Repairers Legal Liability coverage form provides liability coverage for this exposure.


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Ocean Marine Specialists must work with each customer to develop a coverage form that fits the specifications of the customer. The insurer’s ocean marine claim surveyors, adjusters, and settling agents must all work together providing the customer the best coverage available to meet the customer’s requirements.

• Stevedore’s legal liability.

When a vessel enters a port, its cargo needs to either be loaded or unloaded safely and expeditiously so the vessel can set sail again with limited delays.

An independent contractor called a Stevedore is usually responsible for the loading and unloading operations at a port.

The Stevedore can be legally liable for damage to vessels, cargo, and property located on the premises they are conducting their operations on. Coverage provides protection to the Stevedore for their ordinary liability to exercise an appropriate degree of care for vessels, cargo and property in their care, custody or control.

• Terminal operator’s legal liability.

A terminal operator can perform many functions including warehousing services such as “pick and pack” operations, labeling, inventory control and local trucking. In addition, the operator may provide a safe berth for vessels and have employees that load and unload vessels.

One common exposure that exists in all of these operations is the terminal operator’s legal liability exposure while goods and property of others are in their care, custody or control.

A terminal operator provides an extended range of services that can include operations provided by a Wharfinger, Stevedore and Warehouseman. When determining coverage needs, it is important to examine the services that the insured provides their customers.

• Wharfingers legal liability.

When a vessel enters a port it must have a safe berth before it can be loaded or unloaded. The Wharfinger (pronounced “war-fin-jer”) provides the vessel owner with a safe berth, watches over the vessel, and exercises the appropriate care to protect the vessel from loss or damage.

The Wharfinger is held liable for the vessel while it is in their care, custody or control. They also have certain responsibilities for the safety of the vessel. This liability is the principal exposure covered by a Wharfingers policy.

Conclusion – Personal Property Insurance As an insurance agent, you can offer an incredible variety of services and products to customers seeking personal property insurance. You can inform the customer that protection need not be confined to the standard homeowners policy, as inland marine, ocean marine and umbrella coverage can be tailored to provide the specific protection which the customer requires. If the customer is involved with a business enterprise, you and the customer must consider additional forms of coverage.

By understanding the various options available to the customer and the multiple types of personal property insurance coverage, you will be able to better service each of your customers and offer valuable counsel to existing and potential new clients.


Chapter Three / Underwriting Property And Casualty Insurance

CHAPTER 3 – UNDERWRITING PROPERTY AND CASUALTY INSURANCE Knowledge of the insurance products to be offered to customers is essential for any insurance producer. The insurance producer must also understand the underwriting process by which insurance companies determine whether to offer insurance to a particular individual. Your customer may ask you specific questions regarding the underwriting process, and your answers may help that customer decide that your products and services are worthy of his/her investment.

In this chapter we examine the underwriting of property and casualty insurance. Many underwriting practices have been in place for hundreds of years; however, changes to these practices are inevitable. Traditional underwriting practices may continue to appear perfectly logical to an experienced underwriter, but newer laws and regulations are forcing changes to some of those practices as longtime underwriting practices must give way to new concepts.

Major Underwriting Goals Underwriting of all types is designed to accomplish three major goals.

• Underwriting helps the company to achieve “underwriting gains.”

• Underwriting positively contributes to society.

• Underwriting assists in maintaining a strong, solvent industry which can serve the public in the future.

Each of these goals must be recognized and understood before changes in practices can be successfully adapted to new regulations and pressures.

Underwriting Gains The first goal of underwriting is to help to achieve underwriting gains.

In stock insurance companies, these gains can be called “profits.” For mutual insurance companies, the gains result in increased dividends or surplus. In all cases, the goal is to be able to show a gain after paying claims and expenses.

Underwriting contributes to these gains by selecting applicants who fit within the parameters of the rates which have been developed. Every rate structure contemplates a certain type or class of risk.

Underwriting has the responsibility of accepting and retaining those properties and exposures which fit the expected pattern. Underwriting gains cannot be achieved by accepting applicants whose probability of loss is greater than that which is anticipated by the rates.

Applying contract provisions which are contemplated by the rate structure, can make a further contribution. Coverage cannot be unduly broadened, exclusions cannot be removed and conditions cannot be waived without jeopardizing the expected underwriting gains.

Rates, contracts and selection are closely related. Improper use of any of these factors can destroy all hope of underwriting gains. If any of the three is inadequate, one or both of the others must be adjusted accordingly, or underwriting losses will occur.

Total responsibility does not fall on the underwriters. Those who promulgate rates and those who draft contracts carry a share of the burden. But in the final analysis, it is the underwriter who must select applicants who fit the rates and contract provisions which have been designed to produce underwriting gains. If artificial restraints are imposed on underwriting, © 2006 Bookmark Education www.BookmarkEducation.com

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either rate must be increased or contracts restricted; otherwise underwriting gains cannot be realized.

Contribution to Society Insurance contributes a great deal to society. In fact, it is difficult to imagine how our civilization could exist without insurance. Society benefits from insurance by the reduction in uncertainty which insurance provides. With this lessening of uncertainty, people can buy and furnish houses, establish manufacturing and processing firms, stock warehouses and retail establishments, and conduct the distribution of goods.

If this uncertainty was not reduced, people would not necessarily be willing to embark on these ventures. Perhaps more importantly, lending institutions would not be able to finance these enterprises, so anything beyond a cottage-type of business would be almost impossible. Most of the recent strides in industrial and technological fields would have been unthinkable, and most consumers would not have been able to accumulate the volume of goods which help mark the affluence of society.

Insurance companies supply a good share of the funds which finance long-term investments. The insurance companies’ accumulation of capital, which is needed to guarantee the payment of future losses, can be used to promote expansion in home ownership as well as in business and industrial fields.

Another major benefit of insurance is the promotion of competition which results from the stability and reduction of uncertainty which are present in our economy. Small firms can compete with large enterprises because they do not need to accumulate large sums of money to help survive disasters. The protection given through insurance permits every firm to survive both heavy losses to property and claims for liabilities. Thus funds can be used for growth, and society benefits from the resulting competition.

Underwriters are the focal point through which most of the benefits of insurance are supplied to society, as the underwriters arrange to protect almost every conceivable type of loss in a manner which meets society’s needs. When new exposures to loss arise, underwriters develop methods of insuring those exposures.

Two important aims of underwriters are to support activities which will benefit society, and to oppose changes which will tend to restrict these benefits. Underwriters must not only analyze the immediate results of changes but also their long-range effects. Every underwriting action and every underwriting rule or guide should be considered in light of the ultimate effect on society as a whole.

Maintaining a Strong Insurance Industry The greatest contribution that underwriters can make to their companies and to society is to help maintain a strong and solvent insurance industry.

Underwriting gains, as discussed earlier, are an essential element in maintaining this strength. Another factor is steady, solid growth; this requires an analysis of markets and a selection of applicants who represent a broad, desirable spread. Still another element is an ability to meet the needs of buyers of insurance, for only in this way can insurance companies survive.

In all of these areas underwriting contributes best when it classifies and accepts applicants on the basis of reasonable criteria, equitably applied. A constant objective of underwriting must be to analyze selection standards, change the standards and classifications when conditions require and administer them fairly in daily activities.



Society benefits directly from the existence of strong and stable insurance companies. Only this type of insurer can meet the needs of the public. The future demands of a changing society will place new burdens on the insurance industry.

New energy requirements, advanced technologies, the challenges of space travel, the opportunities for increased leisure activities, the opening of markets in undeveloped lands and all of the other possibilities which will be presented by changing world will require even more insurance protection than is available today. A strong, solvent insurance industry is a necessity if artificial brakes are not to be applied to these many new possibilities for fortune and growth.

Underwriters must develop appropriate analysis of characteristics of applicants in order to find meaningful factors upon which to base underwriting selection. This is the challenge of the future for underwriters. Laws and regulations will impose new rules. But underwriting must survive if a strong insurance industry is to exist. This will require adaptation by underwriters, through the use of revised approaches which will achieve the established objectives.

Individual and Class Underwriting Underwriters can react in many different ways to newly adopted rules and regulations. If the underwriter does not carefully consider the ultimate consequences of that reaction, the underwriter may react in ways which will damage the underwriter’s reputation. In the long run, the damage will be irrevocable and will affect the entire insurance industry.

Underwriting Individuals The only really viable alternative is to underwrite by applying the underwriter’s intelligence and knowledge. This will include securing more facts, evaluating applicants as individuals, making objective analyses and taking prompt action in conformity with the laws and regulations.

As a starting point, underwriters must know why certain underwriting rules or guides were used in the past. For example, an applicant’s occupation may frequently be used as one underwriting factor. The applicant’s occupation is not a factor because there is anything inherently wrong with people who are engaged in the particular occupation. They are not wicked, dishonest nor abhorrent. Rather, experience has likely shown that persons in that particular occupation tended to be unstable with respect to location, frequently moving from place to place.

This instability can be a problem to insurers, so caution will historically have been used in determining whether to accept applicants who were engaged in that occupation. The occupation should not have been a firm rule but just a guide (although it is likely that some underwriters always used it as an unacceptable factor).

Suppose that a new law or regulation provides that occupation will be prohibited as a factor in underwriting. The instability of the applicant may still be a problem to the insurer, so the application may still need to be rejected by the underwriter. The reason for the rejection will not be the occupation, but the instability of the applicant’s residency. This instability can be indicated by factors other than occupation and may only be discovered by more intensive investigation by the underwriter.

Occupation cannot be used as a reason for underwriting action, but it can still point out the need for more facts which may make the application unacceptable. If unstable conditions are not found, and other negative factors are not present, the application should be accepted.


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The key to better underwriting will be to secure all relevant information about the applicant. No longer will it be enough to find out a few facts, such as occupation, and then take action. Instead, the underwriting process will have to focus on the residency of the applicant and the likelihood for frequent movement.

Both objective and subjective information can be secured by the underwriter, depending upon the circumstances and the management of the insurer.

• Objective information.

The most reliable data is that received from objective outside sources. Motor vehicle reports and accident information from the file are the most common forms of objective data for vehicle insurance. The condition of the property, photographs, a doctor’s report of physical impairments and the length of driving experience are other examples for various lines.

• Subjective information.

Purely personal and private information may be used under some circumstances. Ordinarily, this is best if secured from the applicant, not from outside sources. The application, telephone verification and a renewal questionnaire are devices which are used to obtain facts from applicants and policyholders.

Some insurers have used psychologically oriented self-completion questionnaires as investigative tools for new applicants, particularly for personal automobile insurance. Some of these sources may arouse antagonism from applicants or producers, but they are illustrations of the sources that are available to the underwriter.

Right to privacy laws and other restraints imposed by government can restrict the information available to the underwriter. Such laws certainly make the underwriter’s job more difficult and require more innovation to locate permissible data.

Underwriting By Class As described above, the first step in underwriting requires that the underwriter secure as much relevant information about the individual as is necessary or available. The second step is analysis of that information. There are two different ways of analyzing an insurance application: by class and by individual risk.

Traditionally, personal lines have been subject to class underwriting. This means that classes or groups are identified as being problems and are not written as a general rule. Underwriters recognize that some individuals in each class would be acceptable; however, it would be more expensive to find these individuals through the underwriting process, and there is usually not much information readily available upon which to make the decision. If an exception is made and a loss occurs, criticism may result. On the other hand, there will be no criticism if the applicant is rejected.

Commercial lines more commonly use individual risk underwriting. More complex factors are present, and premiums are high enough to permit more investigation. In most companies, even under individual risk underwriting, certain groups are identified as presenting problems, and these groups may be placed on an unacceptable risk list. Still, exceptions are made for meritorious applicants based on individual characteristics. This pattern is common among larger commercial risks; smaller ones may be handled more on a strict class basis.

This traditional difference between class and individual risk underwriting is disappearing in today’s social and regulatory climate. People no longer tolerate being handled as members of a class without regard to individual characteristics. Many newer laws and regulations are



aimed at precisely this factor. Since some physically impaired people are good drivers, it is no longer permissible to reject them simply because other physically impaired people may be problem drivers.

Rather, the rules prohibiting the use of certain characteristics require that each person be considered on the basis of individual factors alone.

The analysis of applicants, under government regulations, must include a study of individual characteristics, not just the group to which the applicant belongs. This does not necessarily involve a great deal more time and expense. Rather, it takes only a little more effort to consider whether the applicant is different, in some relevant way, from the other risks of the same type. If so, the differences must be analyzed.

This type of analysis is new for most underwriters, particularly those handling personal lines. Education, training and frequent audits will be needed to make underwriters more familiar with these processes of analysis.

After obtaining and analyzing information, the third step in underwriting is to make a decision and take action. This can be a perilous part of the process, or it can be a golden opportunity to serve the public and the industry.

The manner in which underwriting guides are written and the way that the reasons for adverse action are stated can be very important. This is the point at which the true intentions of the insurance companies are measured. Underwriters should avoid using words like “location,” “sex,” “age” and “marital status” when rejecting or canceling insurance. These may be factors to be considered in the evaluation, but they cannot be used as the primary reason for rejection. Reasons must be given, and these reasons should be specific.

Underwriters should stop using such general terms as “condition of the property.” The public insists upon knowing why adverse action is taken. The reasons must be clearly explained. Action must be taken promptly. Restrictions place a burden on underwriters to avoid procrastination. Many states prohibit cancellation of new policies after a “discovery period” – usually about 60 days.

Non-renewals are often permitted only if notice is sent to the policyholder well in advance of the expiration date. These rules require prompt and firm action, preventing the delays which previously marked the decision-making process of some underwriters.

In summary, underwriters must avoid the specific use of factors which are prohibited, although these factors may be used as indicators along the path. Applicants and policyholders must often be analyzed as individuals, not as members of a class or group. Actions must be taken promptly, and always in compliance with the laws. Rejection or cancellation may be taken only for relevant reasons, and never because of factors which are prohibited. The reasons must be explained in specific terms.

The previously mentioned approaches are the general approaches which must be followed by underwriters under government restraints. As a first step, management of the company should outline general principles, indicating how underwriting is to be conducted. These principles, which should be stated in broad terms, will give the necessary guidance to underwriters.

It is obvious that compliance with all laws and regulations should be the cornerstone of these principles. General statements are needed as to the degree of investigation to be followed, the method of communicating decisions, and the handling of complaints. Such a statement of principles will supplement the underwriters with knowledge of general approaches to be used and will provide a broad base of guidance for future underwriting.


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Specific Underwriting Factors and Practices Desk underwriters need specific instructions on practices to be followed when they encounter problematic applications. While general statements are helpful, they are inadequate for the day-to-day handling of individual risks.

Statements of general principles must first be developed and adopted by insurance company management. Such statements are needed before desk underwriters can make decisions which follow the wishes of management. Without such statements, underwriters can be expected to continue the old practices which have led to an atmosphere of public criticism of underwriting and demands for change.

In addition to the company’s statement of general principles, underwriters must learn the laws and regulations affecting the insurance being underwritten. Controls must be established to be certain that both new and existing laws and regulations are communicated to all underwriters. Next, supervisors must conduct enough audits to be certain that underwriters are following the statement of principles and all of the applicable laws and regulations.

Much more than this is needed, however, if underwriting is to survive as it is known today. The spirit as well as the letter of laws and regulations must be followed. Most rules have loopholes if someone looks hard enough for them. If underwriters find loopholes in laws or regulations and underwrite on that basis, further restrictions will be adopted by government to close the loopholes.

Complaints and criticisms must be heard and addressed by the insurance industry. When reasonable adaptations to underwriting practices can be made to meet those objections, this should be done. The difficult problem is to separate those comments which are reasonable and logical from those which are not. The application of these principles will not be easy. The reasons for each type of criticism must be understood in order to allow for proper changes to exiting standards.

The following sections list factors used by insurance companies to determine underwriting decisions. These sections describe information regarding each factor and suggest certain recommendations for handling some of the complaints which have been lodged against the insurance industry’s underwriting practices related to these factors.

Loss History The record of past losses remains as one of the best factors which underwriters can use in the selection process. It is factual, relevant and well accepted as a factor which reasonably separates one risk from another.

At the same time, underwriters must realize that not all losses can be considered as factors. Some losses are perceived by the public as being of types which do not reflect adversely on the individual involved. If the loss was not recent, or if the applicant was not at fault, its importance is diminished or removed.

Accident Record Automobile underwriters should continue to use accident records as one of the primary underwriting selection tools. When facts are available, most accidents are reliable indicators of desirability and are generally accepted as such.

Modifications in some past rules or guides are needed, however. Underwriters must not consider those types of accidents which do not have a clear relationship to possible future



accidents. Also, they must not use the types of accidents which are specifically prohibited by statute or regulation.

Fault The question of fault is most important. Although statistical studies do not separate accidents by fault, and automobile insurance underwriters, for example, may feel that all accidents indicate a driving pattern, the public generally does not see the relevance of not-at-fault accidents in the underwriting process.

Most underwriters, for some time, have given little weight to the most obvious of the not-at-fault accidents. They disregard those where an applicant was struck while legally parked or while stopped for a traffic signal. In the future, the definition of not-at-fault accidents will likely be expanded.

An applicant who recovers in full from another party is of the firm opinion that no fault should be affixed to his or her behalf. Underwriters should take such factors into account and not consider those accidents where an applicant was not charged with fault.

The determination of fault is not easy, particularly with accidents that occur before risk is insured. Sometimes the determination can be made only by securing a copy of a police report or by contacting the previous insurer. These sources may be expensive and may even be prohibited by law. This leaves the underwriter with no alternative but to accept the description of the accident as given by the applicant, subject to verification by an official motor vehicle accident report, as much as possible.

Modern traffic conditions lead to many accidents where fault is difficult to ascertain. Events happen quickly and each party may feel that the other person was completely at fault. Applicants who feel that they were without fault in an accident will resent being underwritten on the basis of an at-fault accident. This resentment could be translated into legislation which would deny all accident information in the underwriting process.

Underwriters will likely view the value of past accidents as predictors of the future as too great to jeopardize by making arbitrary decisions on some “close calls.” As a result, if fault does not appear to fall on the applicant, the underwriter will generally ignore that accident.

Number of Accidents Underwriters not only consider every accident, they sometimes decide that one accident in the experience is too many to permit acceptance. Companies attempting to set predetermined standards may state that an applicant is unacceptable if there have been any accidents during the past two or three years. This approach may be too severe for the future. The traffic congestion of today, especially in the larger cities, makes it extremely difficult to avoid an occasional small accident.

A blind spot during a lane change, vision obscured by a wet window in the rain, a sudden change in a traffic signal, an unexpected stoppage of traffic – all can result in accidents. A driver who is usually very careful and who has been accident-free for years may incur one incident of this type. All that is required is a moment’s inattention or carelessness.

It would not be reasonable to refuse insurance to an applicant who has incurred just one loss of this type. Two or more accidents might be; but only one accident, perhaps in many years, does not make a driver a poor risk in the minds of most people.

The solution is to consider more carefully the type of loss rather than just the number. If that one loss occurred shortly after midnight on a Saturday night and was the result of apparent high speed and possible drinking, the underwriter would be justified in being concerned. On


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the other hand, if the loss happened at 5:15 on a Tuesday evening and was a small rear-end accident on a crowded expressway, it is difficult to maintain that this is a good indication of possible future accidents.

Underwriters must stop playing a “numbers game” and start analyzing the losses. Two or three small accidents scattered over a three-year period may be less indicative of future loss involvement than one recent accident where the circumstances indicate that a driving problem exists.

No known legislation has attempted to control the number or type of accidents which can be considered in underwriting. This situation does not mean that these factors can be disregarded. Abuse of the privilege of considering accidents in the selection process may lead to restrictions.

Automobile underwriting today requires more than a simple statement on the maximum number of accidents permitted during a specified period. Underwriters must secure all pertinent information concerning details of accidents from whatever sources are reasonably available. They then must analyze the losses to see if an indication of a poor driving pattern exists. If it does, underwriting action can be taken with little fear of challenge. But if it does not, there may be severe criticism of action taken solely because the loss is on record. Continuing action of the latter type may lead to restrictive legislation or regulation.

Commercial/Personal Risks When an individual drives a vehicle as part of his or her job, it raises an additional underwriting issue: Should accidents occurring as part of the job be included when underwriting a personal automobile policy? The analysis of individual losses, rather than merely counting the number, will take care of the problem of differentiating between commercial and personal risks in most cases. An applicant, who incurs accidents because of poor driving, whether in a truck or a car, should bear the responsibility under all types of vehicle insurance.

If the underwriter looks at the facts surrounding each loss, most of the pressure to disregard accidents from another line of insurance will disappear. Naturally, where laws prohibit consideration of accidents from another line, such as “emergency vehicles,” there is no opportunity to use such losses in the selection of risks.

Property Losses Consideration of the degree of fault or responsibility should be a part of the underwriting process on property as well as automobile claims. The type of loss and the circumstances surrounding the loss are clues to the degree to which the applicant could have prevented the loss. Although there is no known legislation on the use of property losses, underwriters should not take advantage of this situation. Reckless disregard of factors causing a loss could lead to restrictions, and these probably will be stricter than those which underwriters would impose on themselves. Thus, isolated losses from factors beyond the control of the applicant should be disregarded or used with care. If conditions have changed, this fact should be part of the analysis. Intelligent underwriting requires nothing less.

At the same time, a pattern of losses may reveal conditions which are likely to lead to future losses. Repeated windstorm or hail losses may indicate that the location of property is in a “pocket” where such losses are common. Repeated crime losses may show that the neighborhood is conducive to those types of losses and that the pattern can be expected to continue.



Normal underwriting practices should continue, but these must be tempered with careful consideration of the circumstances surrounding the loss, not just a tabulation of the number of losses.

Liability Losses Both personal and commercial liability losses should be handled much the same as property losses. Laws have not yet been enacted to regulate the use of these losses, but unreasonable application of underwriting rules could lead to controls.

The facts surrounding losses should be analyzed carefully. If there is no pattern, and the loss was beyond the control of a reasonable person, the underwriter should not make the decision on that loss alone. On the other hand, a pattern of loss, or failure to take normal precaution against injury, is valid underwriting criteria.

Recommendations for Improvement Property and liability losses often are the result of unsafe conditions. Rather than refuse insurance because of these conditions, or raise the premium, it would be better for underwriters to recommend improvements which would reduce future losses.

This approach recognizes a responsibility on the part of underwriters to furnish insurance whenever possible and also to reduce losses and injuries.

Underwriters who analyze losses often are able to see conditions which should be corrected. If these are not obvious, engineers or inspectors can be used to identify unsafe practices, and their reports can be part of the analysis of the cause of the loss. In addition, such reports can be the basis of recommendations for improvement.

The underwriter, wishing to serve the public and avoid undue regulation, must do more than accept or reject applications. An effort must be made to write insurance, tailoring the contract and the rate to the risk. An important part of this approach is to discover areas where conditions can be improved and to recommend action to the applicant.

Additional expense will be incurred by this approach; however, more business will be written and fewer losses may be incurred. More importantly, this approach will help to fulfill the duty of supplying coverage in the most economical fashion to every deserving risk. Universal use of this approach will go a long way toward limiting future adverse legislation and regulation.

Traffic Violations Underwriters can continue to use traffic violations in selection and rating. This use is subject to specific state laws or regulations which limit the use of certain types of violations by underwriters. Where possible, however, underwriters should use judgment in their consideration of violations. The emphasis should be on those convictions which appear to have some element of future accident predictability.

Equipment violations should be given little weight; on the other hand, they may indicate a careless attitude, an “I-don’t-care” approach to automobile safety. Where this appears to be the case, further investigation is needed to determine the facts. In other cases, equipment violations should be ignored. Each case must be separately evaluated by the underwriter.

Non-Verifiable Record The term “non-verifiable” driving record relates to the practice of refusing to insure newly licensed drivers because they do not have any past driving record, good or bad.

Rules determining the definition of a “verifiable” record must be applied in a reasonable, nondiscriminatory fashion. The time period must not be excessive; three years is a maximum © 2006 Bookmark Education www.BookmarkEducation.com

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period in most cases. If used the rule must apply to all applicants and not be used as a screening device for youthful operators.

For example, assume there is a middle-aged couple with a clean accident and conviction record but with only one of them who drives. If the non-driving spouse then gets another car and starts to drive, the non-verifiable rule must be applied, exactly as it would be if the new driver were a youth just starting to drive.

Sources of Information In determining the record of traffic violations, it is crucial that underwriters use all reliable sources of information. Motor vehicle reports (MVRs) are the best source of information. They must be secured where it is important to see the traffic record. Arrangements should be made to secure MVRs as quickly and inexpensively as possible.

Arrangements can often be made to secure MVR information directly from the computers of the state motor vehicle departments, either directly by the insurer or through a service organization. Prompt information is of great value in effective selection of applicants.

Some traffic violation information, like some accident data, is not always available through an MVR. For example, some traffic courts have adopted the procedure of sending violators to a traffic school. Upon completion of the course, the record of the violation is destroyed. No entry is ever made on the MVR.

This procedure may be effective from the standpoint of law enforcement officials, but it destroys the concept of underwriting on the basis of past driving performance. Underwriters must establish techniques for securing information on all traffic violations as much as possible. Proper questioning on the application is one source. Effective investigation technique is another.

Driving Record The most significant factor which can be used in underwriting and rating of motor vehicle insurance is the driving record. Traffic violations are the major component of driving records, although accidents are usually included. Almost everyone who agrees that some type of selection and rating differences are justified will concur that the driving record is most critical.

A risk should not be accepted if a driver’s license is suspended or revoked. To supply insurance to such persons is to encourage them to drive in violation of law. When investigation reveals that the license of a driver is not valid, the application should be rejected.

The only exception is a case where it is represented that the person without a license will not drive. If this is verified, the factor can be disregarded. After the license is reinstated, the underwriter should analyze the reason for suspension or revocation and not reject the applicant only because of the previous action by licensing authorities.

Condition of Property Underwriters have more opportunity to practice individual risk selection on the basis of property condition than on most other factors. By avoiding arbitrary rules and looking at specific risk characteristics, underwriters can improve their selection practices and still avoid the objections of regulators. Both automobile and property lines are subject to underwriting on the basis of property condition.



• Condition of automobile.

Good underwriting requires consideration of the automobile’s condition. It is important that judgment be applied uniformly and that only relevant conditions be taken into account. Mechanical deficiencies should be handled carefully.

If critical functions are involved, such as brakes or lights, the risk should not be accepted. Public safety, as well as insurance principles, requires that automobiles with serious deficiencies such as the foregoing should not be encouraged to operate on the streets.

The proper underwriting technique is not to merely reject insurance. Such action may cause the owner to drive without insurance or to seek another insurer which may not discover the problem. Rather, the underwriter should point out the deficiency, suggest that it be corrected and offer to write the insurance when correction is made. In this manner, the financial exposures of the public and the owner will be protected, and the insurer will write another policy.

Before this corrective action can be taken, the condition must be identified. If the facts are reported on the application, the underwriter can act immediately. If not, the condition can be determined only by an inspection on a new submission if it is economically feasible to do so.

On existing policies, a claims report may indicate the existence of problems. In either case, it is important that the underwriter secure the facts. Then the alternatives can be considered and one of these should certainly be to recommend correction of the mechanical deficiency as a condition to writing or continuing insurance.

Unrepaired damage can be handled in the same way. Minor damage can be ignored, except perhaps to note its existence so that it is not included again under the settlement of a later loss. More serious damage can be dangerous to pedestrians or occupants. Again, the best procedure is not to reject coverage automatically, but to be certain that the facts are correct and to then recommend correction. If repairs are made, the risk will be satisfactory from that standpoint, and a policy might be saved.

Underwriters should not conclude that, as a class, people who do not correct mechanical defects or repair body damage are undesirable. There may be many reasons why improvements have not been made.

If the specific condition of an individual automobile is poor, insurance should not be written. But if the correction is made, this factor should be disregarded. Underwriting consideration should be given to the actual condition of the vehicle, not the underwriter’s opinion as to why the deficiency was not corrected until an underwriter made a demand.

Altered cars, or those decorated, do not necessarily indicate an undesirable risk. Some operators of these vehicles are inclined to speed and take chances in close situations, but others are good, safe drivers. The fact that a person likes a showy car does not mean that person also drives in a careless fashion. This is a factor which should be checked carefully but then underwritten on the facts of each individual case.

When underwriters of automobile insurance are considering a vehicle’s condition, two rules must be followed. The first is to get the facts, to find out what is actually the case on a specific risk rather than to make assumptions based on experience with the class.

The second rule is to apply judgment to each risk based on its individual characteristics, and not because it is a member of a group of risks. As with the driving record, the


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condition of a specific risk being considered is a critical factor. This applies to the mechanical condition, any un-repaired damage and any showy alterations.

• Condition of buildings.

The condition of buildings must be carefully underwritten. Deficiencies which present an abnormal degree of risk must be corrected before insurance can be written. On the other hand, underwriters must guard against taking action solely on the basis of outward appearances.

Uncut grass and peeling paint may be indicative of a careless attitude which may also be reflected in frayed wiring and overloaded circuits. These conditions may also indicate a temporary illness of the applicant or a temporary financial reversal, neither, of which has adverse implications from an underwriting standpoint.

The underwriter would be justified to refuse writing insurance where the condition of property is so poor that the chance of loss is materially increased; however, the underwriter would not be justified to reject a risk because the condition of the building does not measure up to the standard of neatness which an underwriter feels is desirable. Neither the property application itself nor a related line such as automobile should be rejected merely because the housekeeping is poor by an underwriter’s standards, provided the condition does not really increase the chance of a loss.

Furthermore, outright rejection is undesirable in cases where the condition of property is so poor that insurance cannot be written. Rather, the underwriter should point out the types of improvements which could be made to achieve acceptability. Reasonable demands for improvements will benefit all parties and are perfectly legitimate. Again, however, the demands must be reasonable and not arbitrary.

Underwriters must recognize that standards of neatness vary by individuals, and only those repairs which actually affect the exposure to losses must be demanded. When problem areas such as poor wiring and other so-called faults of management are identified, the property owner should be notified. This gives the owners an opportunity to correct the problem. Then, if correction is made, the coverage can be written.

This approach accomplishes several things: more business is written, property owners are educated on proper methods of maintaining buildings and public relations are improved. This course of action is much better than merely rejecting the risk, if the condition is one which can be improved.

The facts must be obtained before such decisions can be made. Sometimes the answers on the application are sufficient, particularly if a photograph of property is also available. Other times, an inspection is needed. The producer, a field underwriter or special agent, or an inspection company can perform these inspections. Regardless of the method used, it is essential that the underwriter have the facts available before taking action on the condition of the property.

As a matter of procedure, the facts should be obtained, usually by physical inspection, before rejecting a risk because of poor condition, whether this involves actual unsafe conditions or poor maintenance of the building.

Age of Buildings The age of a building on its own is not a reliable indication of its desirability as an insurance risk. After a few years, deterioration sets in, but repairs or renovation can offset this. Age may be a preliminary indication that there may be problems with the property. An older



home, perhaps one over 25 years of age, certainly should be checked carefully. There may be problems in wiring, overloading of circuits or in the heating system.

On the other hand, each of these potential problems can be corrected. A house can be rewired, new circuits can be added and a new heating system can be installed. With such improvements, a 40-year-old house may be safer than one which is 25 years old. Only proper inspection can determine if these improvements have been made.

The acceptability of a property risk should not be based on its age alone. If it is older, but the critical parts have been modernized and the building has been maintained properly, the age should not be a factor.

Two areas may be affected by the age of a building. One is the rate and the other is the type of coverage being offered.

Rates can vary by the degree of exposure to loss. A 40-year-old house which has not been modernized is ordinarily more susceptible to fire losses than a five-year-old house, and the rates can vary.

Value of Buildings It is imperative that underwriters determine the approximate value of buildings before writing property insurance. Securing the proper insurance-to-value ratio is the key to the profitable writing of property insurance. By encouraging property owners to insure property for close to its full insurable value, the insurance company increases the overall amount of insurance purchased across its portfolio. As a result, the insurance company is able to offer a lower premium rate to consumers while maintaining higher overall profitability by expanding its customer portfolio.

A coinsurance clause helps to discourage the customer from under-insuring property. The coinsurance clause provides that the insurance company pay a reduced benefit on a claim if the amount of insurance carried by the insured is less than a required amount stated in the policy. This amount may be 100% of the replacement value of the property or some lesser percentage.

Under many homeowners policies, insurance companies require that the property is insured for no less than 80% of the replacement cost. As a result, underwriters will not write a policy for less than 80% of the replacement cost. This may present a problem for low-income applicants who cannot afford the premium on 80% of the replacement cost of the property. This underwriting guideline has come under criticism from parties who believe that the insurance company is arbitrarily denying coverage to low income consumers.

As a result of the impact on profits, underwriters do not want to write a policy for less than 80% of replacement cost. At the same time, there is strong pressure to offer homeowners coverage to all people who desire that coverage, as the practice is viewed as unfair discrimination toward low income consumers. As an answer to this criticism, the insurance industry has worked to develop a homeowners policy that does not contain the replacement cost provision; instead, structures can be insured for actual cash value.

An actual cash value homeowners insurance policy includes basic coverage of fire, extended coverage, vandalism and malicious mischief, burglary or crime coverage, and liability coverage. The policy provides replacement cost coverage on partial losses up to the actual cash value of the covered property.

Even under an actual cash value policy, there still may be a conflict between the insurer and the consumer regarding the minimum amounts of insurance which must be written. Reasonable minimum amounts must be agreed upon because minimum amounts of © 2006 Bookmark Education www.BookmarkEducation.com

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premium are needed to cover expenses, and there is a point below which property is simply uninsurable other than in a specialty market.

A strong tendency exists for underwriters to keep pushing the minimum amount of insurance upward. As building costs increase, the cut-off point for desirability rises; values rise with building costs.

Some people feel that special handling should be taken with owners of small or low-valued homes so as to be accommodated in the regular market. Underwriters should resist the tendency to set ever-increasing minimum values and should try to offer insurance to most risks. Rates and minimum premiums may need to be raised if the statistics justify this action, but acceptability should not be affected. The value of a building, above a reasonable minimum, should not be a factor in underwriting. The risk should be eligible, and acceptability should be based on other factors.

Just as the underwriter tries to avoid under-insurance, they must also avoid over-insurance in order to reduce or eliminate the temptation for arson. This can be accomplished only by an inspection of every structure on which there is any suspicion that the amount of insurance requested is in excess of the value.

Occupancy of Buildings Underwriters are justified in considering the occupancy of buildings in determining whether to write a policy, provided the considerations are based on fact and are not arbitrary.

Dwelling risks with commercial types of occupancies present different characteristics than those with only residential occupants. Some of these business pursuits may have little impact on desirability, but others can substantially increase the chance of loss.

Underwriters who have identified the differences and who feel that some exposures are greater than appropriate can consider these occupancies as unacceptable. Little criticism can be expected by the underwriter if the rules are based on objective factors. However, a preferable course of action would be to accept the risk and charge a higher premium if this can be accomplished.

Tenant-occupied dwellings may well require different rates than owner-occupied dwellings. As for acceptability, there may be reasons for refusing to write a policy on tenant-occupied property; for example, if theft losses on such occupancies are higher than justified by the rates typically used to handle the exposure.

The problem with underwriting rules regarding types of occupancy is that they may appear to actually be based on other factors, such as the location of the neighborhood in which the property is located. Still, rules regarding type of occupancy generally are satisfactory if based on actual experience and if applied uniformly to all such risks.

Vacancy can be a problem in both personal and commercial risks. Extended vacancy of a building can lead to deterioration, vandalism and a temptation for arson. Underwriters are justified in rejecting applications for insurance where extended vacancy exists at a property.

This action is even permitted by state regulatory plans where very few underwriting criteria are allowed in order to protect high-risk insurance consumers and high-risk properties. However, this rule must be tempered with reason, and no declination is justified if the vacancy is for a limited time only between changes of occupants.

Commercial risks must be written on the basis of occupancy. Nevertheless, this should just be the starting point. Almost all occupancies can be improved by the use of protective



measures. The blanket listing of occupancies as being unacceptable, without consideration of the individual risk characteristics, can only lead to criticism and more regulation.

It would be much better for underwriters to try to find a means of accepting every applicant rather than to exclude some risks by type of occupancy alone. This approach means that more inspections will be needed along with a careful preparation of recommendations and verification that they have been completed.

If reasonable and necessary improvements are not made, the underwriter will not be forced to accept the risk. But if substantial compliance with recommendations is verified, the risk should be accepted. Rates may need to vary by occupancy, but the insurance should be made available.

The use of protective devices can be encouraged by underwriters. Underwriters should require alarms, dead bolts, barred windows or other devices where these devices will improve borderline risks.

Underwriters should consider the actual occupancy of each applicant and the problems associated with that commercial occupancy. Inspections may be required to secure all of the necessary information, although detailed information may already be available from local insurance services offices which hire inspectors and engineers for that purpose.

Recommendations for improvements should be made, but only where needed and never on an indiscriminate basis. The conditions and hazards of each risk should be analyzed, and the insurance should be written if a means could be found to do so. Only in this way will underwriters discharge their duties to both the public and to their companies.

Neighborhood Insurance practices based on risk location must change. If revisions are not made voluntarily, they will be mandated by government decree. Both risk selection and rating will be affected. The unethical practice of underwriting discrimination based upon risk location is referred to as “redlining.” More specifically, redlining has been referred to as a practice which results in significant fair or unfair geographic discrimination in terms of rates, extent of coverage or availability of coverage.

Whatever reasons underwriters use to explain subjective selection based on geographic location, the public and the regulators simply will not tolerate the practice. Selection must be based on the characteristics of the risk itself, not the neighborhood.

This approach must also extend to the evaluation of producers to be employed by insurance companies. A company should not refuse to appoint a producer because of the latter’s office location or the location of his or her customers. Existing producers should not be terminated or restricted because of location either.

Age of Insured Underwriters have long felt that since accident frequency of youthful drivers, as a class, is considerably above the average, special attention should be given to all members of that class. Young people have been driving only a relatively short time; too brief a period to have established their own patterns. Individuals may have good driving records, but this may stem from their limited access to an automobile and to careful driving because they know they are being watched. The only safe approach is to limit acceptability of the class members and to charge higher rates to all of them until they have reached enough maturity to establish their own driving patterns.


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Elderly drivers have been viewed in much the same fashion as youthful operators. They are mature and have demonstrated their method of driving, but some loss of ability is common as a person ages.

Again, the uncertainty concerning the class is present. Knowing that some persons lose some of their driving ability above age 68 or 70, underwriters tend to reject all such applicants. In some instances this practice has continued even while actuaries have determined that elderly drivers are better than the average driver, and reduced rates have replaced the former surcharges.

Individuals in both of the aforementioned groups argue that they should be evaluated on their own performance. They resent being grouped with other drivers of similar ages, some of who have poor driving records.

Sex Underwriters have been having difficulty in adjusting to the concept of ignoring sex in both selection and rating.

Statistics have seemed to support different rates and selection patterns by sex, particularly in youths. Even though some later statistics appear to erase many of the differences, these statistics are not yet concrete enough to convince underwriters to change voluntarily.

Where statistics are credible and irrefutable, insurers may be able to use different classifications for a time, although this may disappear in the near future. Where data is not so certain, underwriters should probably drop all consideration of these factors; any continuation under these circumstances will only lead to further laws and regulations with respect to underwriting.

Marital Status Marital status virtually has been eliminated as an underwriting factor. This factor is expressly prohibited in many states. In addition, single, separated, widowed and divorced persons represent such a large share of the market that the industry has determined that any underwriting rejections based solely on marital statuses would cause considerable harm to the insurance policy sales.

Occupation The occupation of the applicant is not considered to be a valid selection factor. Its use is prohibited in some states. In other states, the trend is the same, and most observers agree that a reasonable approach to underwriting requires that occupation not be used as a selection device.

This is not to say that occupation must be completely ignored.

It might be a clue to other factors which should lead to rejection of the application. The occupation may indicate a risk which needs to be investigated in certain respects in order to determine acceptability. The characteristics of the individual applicant should be the guide, not the occupational group in which the applicant falls. If some occupations are marked by certain undesirable traits in many cases, the individuals who bear those traits may need to be rejected.

On the other hand, those who do not show those traits should not be rejected simply because they work in that occupation. Specific examples, using traditional groups, illustrate the practices which should be used.



• Travel.

There is no doubt, that some people who travel extensively are more exposed to theft and loss than normal. This increased exposure can be caused by the merchandise carried, the type of transportation used, the geographic area traveled, the type of living quarters used while traveling and the attitude of the applicant toward protecting property.

If an applicant has a history of losses because of these characteristics, the application may need to be rejected, or limited in perils or by deductibles, because of those losses. In such cases, the underwriting action is taken because of loss history, not the occupation itself.

An applicant who travels in the course of work but who has not had any such losses is apparently not subject to these adverse traits exhibited by others. A good loss history can be due to many factors. If such is the case, an individual should not be rejected on the basis of the occupational hazards.

Each individual applicant should be underwritten on other aspects of loss exposures, not just the fact that travel is an inherent part of the occupation.

• Transients.

Exactly the same type of approach should be used during the underwriting of applicants whose occupations are historically considered to be held by transients. Many of these people are in the restaurant, hotel and other such service based industries and may drift from job to job, but many others are just as steady as office workers.

Most of the potential underwriting problems of people in these occupations can be specifically identified. Excessive usages of alcohol or drugs, high incomes that attract lawsuits and poor premium payment records are major concerns. Each of these may be justification for taking underwriting action.

When a person in one of these transient-type occupations is found to present a specific problem, action should be taken on that basis. On the other hand, if an individual applicant does not present these problems, action should not be taken solely because of occupation. The emphasis should be on the individual characteristics of the applicant, not on the general characteristics of the group in that occupation.

• Other factors.

The same type of handling is desirable on applicants in other occupations. Military, students, ministers and other groups which concern some underwriters, can include both acceptable and unacceptable risks. The underwriter should get the facts about the specific qualities of each applicant and make a decision on that basis, not on the occupation itself.

Illegal activities are the exception. No government agency would require the writing of insurance on known illegal activities. Where the facts show that the applicant is engaged in such activities as smuggling or maintaining a house of ill repute, rejection is the only reasonable course of action.

Stability An applicant’s “stability” is not a reliable underwriting factor without further clarification of the term. Factors which indicate stability or instability must be used carefully, as some may be prohibited by law or common practice as underwriting factors. Some of these are discussed in other sections, such as marital status and occupation. Other factors which are sometimes applied are the period of time on the job or in the area, the number of jobs or addresses


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during recent years (such as five years) and transient types of living quarters (hotels or motels, for example).

Underwriters can use such factors if they can prove that the chance of loss is increased in such cases. Some companies may have statistics on policyholders with hotel or post office box addresses. With adequate proof of an impact on losses, such rules can be used.

Without statistical proof, underwriters should not use these stability factors as primary selection rules. However, information on these items can be gathered because they might point to other types of problems.

Tenants may offer particular problems. The loss ratio on tenants’ homeowner policies may be worse than for policies which insure the dwelling as well as contents and personal liability. If certain groups of tenants can be identified as being worse than the average, such as those who have lived in four or more locations during the past five years, this could be used as a selection factor. In the absence of such specific statistics, rate adjustments are a more logical solution than merely assuming that all tenants are unstable.

Commercial underwriters could justify the use of a years-in-business rule for acceptability, based on statistics showing failures and bankruptcies. Such an arbitrary rule, particularly if it is longer than one year, will restrict sales and may be considered unreasonable. It would be preferable to use this as a guide, but to look at the work history and experience of the applicant in making the final decision.

Social Maladjustment The involvement of applicants with such social agencies as welfare and public health clinics may be statistically proven to increase loss frequencies. However, this factor should never be used as a sole reason for taking underwriting action. As with other factors, this type of involvement may indicate other problems.

When such is the case, action may be required because of these other factors. Underwriters should disregard any apparent social maladjustment in applicants, especially if this is indicated by contacts with social agencies, unless other adverse factors are present.

Attitude Underwriters are interested in every factor that may affect the chances of loss involving applicants and policyholders. Thus, underwriters could be expected to use study results which show that certain “attitudinal characteristics” have been present in a large number of fatal accidents. The use of these characteristics has not been prohibited. At the same time, underwriters should be aware that abuses of a factor such as this could lead to restrictions.

Underwriters wanting to use the attitude of the applicant as a selection tool will have difficulty in securing accurate information. An investigation report is virtually the only source which can be used to underwrite prospective new clients. With these reports, there is always the danger of a personality clash between the investigator and the applicant or a set of circumstances which the investigator might read incorrectly.

A neighbor may bear a grudge toward a person and will accuse that person of belligerence or argumentativeness. Caution must be exercised in using information secured from a single source when it involves a factor of this type.

Information on existing policyholders may be secured from claims reports. This may be the best source to learn about attitude because it is at the time of a loss that verbal accusations, negativism, belligerence and similar traits are most likely to be revealed. The potential



problem of a personality clash is present here too, so care must be taken in using this information.

When adverse attitudes have been verified, underwriters may take action on that basis. They must realize that such a decision is subject to challenge and perhaps reversal by a regulator. On a case-by-case basis though, this factor may be very relevant and defensible.

Too much use of this factor can lead to problems. Taking action on borderline cases, or without proper verification, could cause regulations to be imposed. Therefore, this characteristic should be employed only in serious cases, and then only with other types of problems which indicate the desirability of underwriting actions.

Criminal Record Underwriters who become aware of an applicant’s criminal record must give serious consideration to this factor. Certain types of past criminal activity, combined with the temptations and opportunities of many lines of insurance, could substantially increase the chances of loss. On the other hand, other types of past criminal activity may have no relationship to the exposures of a particular line of insurance. Where this is the case, no underwriting action is justified.

The individual circumstances of each case are extremely important. The date of the crime may govern; a conviction for car theft by a youth may not be relevant to the exposures when that person has grown to middle age.

The type of crime may be important; assault and battery may be no problem for fire insurance but critical to automobile insurance. A record of petty theft or shoplifting may not concern an automobile underwriter but may be very important to a commercial underwriter.

In every case, the underwriter must secure all of the relevant factors when a criminal record is discovered. This factor may justify a rejection. Many cases, however, will not be affected by this factor, and no action is warranted. Where circumstances do not call for underwriting attention, a setting aside of this information will both help sales and assist in keeping outside restrictions to a minimum.

Mental Incompetence Underwriters cannot ignore evidence of mental incompetence of applicants. This condition can be very serious, particularly while driving a car. The pressures of driving, or even of living under many conditions, are great enough for normal people without adding the extra factor of mental instability.

This condition is difficult to measure. There are many degrees of incompetence. Some people can respond to treatment, resulting in complete recovery. A blanket approach is not valid.

The facts of each case must be obtained. When they indicate a non-harmful degree of incompetence, or a full recovery, the factor may be ignored. When the facts indicate potential problems, careful consideration must be given.

All of the available facts about each such case must be analyzed. The decision must be based on these facts, whether to accept or reject. When care is taken, and the decision is based on a careful weighing of the facts, underwriters can expect support for their actions, rather than criticism.


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Physical Impairments Studies have shown that physically handicapped drivers are generally no worse than average drivers. In many cases, they are better.

In the face of these indications, underwriters must abandon their long-held impression that driving problems are expected when insuring applicants with physical impairments. Where laws prohibit the use of these factors in the selection of risks, naturally these laws must be followed. In other states, judgment must be used, but with consideration of each individual case, not a blanket refusal to write such applicants.

The only line of property/liability insurance in which the physical condition of the applicant has been used by underwriters is automobile insurance, both personal and commercial. The problem, then, is to determine those characteristics which actually affect driving ability. Different types of disabilities can offer different types of concerns for underwriters.

• Orthopedics.

The orthopedic group includes those physically handicapped persons who do not have use of one or more extremities because of loss, paralysis or serious deformity. The underwriter may need to secure and verify additional information about these disabled drivers.

• Medical.

Physical impairments which might be called “medical” or “seizures” include heart ailments, diabetes, and epilepsy. Although studies have not been detailed on each of these, indications are that these persons generally have better driving records than the average. This means that underwriters are not justified in automatically rejecting applicants having these conditions. At the same time, underwriting is concerned with individual applicants, and some persons having these impairments may be subject to driving problems. Doctor statements can be particularly helpful to the underwriter in these cases.

• Hearing impairments.

There are many types and degrees of hearing impairments. Most people with hearing impairments can hear traffic noises, often with the use of hearing aids, even though many of them cannot distinguish words. It is this ability to hear traffic sources that is crucial to automobile underwriters.

Studies conducted in some states have indicated that people with impaired hearing are better drivers than the average. Other studies have arrived at the opposite conclusion. There is only one-way to for the underwriter to reconcile these conflicting reports; underwrite on an individual basis. Undoubtedly, some hearing impaired people are excellent drivers while others have poor driving records. This is the same as for any other group. A blanket rule for all members of a group simply does not fit.

• Impaired sight.

Different degrees of impaired sight also are found in the population. Many drivers wear glasses and most of these drivers enjoy adequate correction to permit normal living.

Fire insurance, health insurance and other lines probably should not apply underwriting selection because of total or partial blindness, unless actual experience indicated that such action is justified. Some states have adopted laws or regulations which refer to the “physically handicapped” or the “partially sighted.” These terms would apply to impaired sight unless specifically excluded.



Where these controls are in effect, underwriters must not use these factors in the selection process, of course. In other states, each individual applicant should be considered on the merits of the case. Serious impairment of sight could be justification for refusing to write automobile insurance, but it seldom would be justified on other lines.

If the impairments are not serious, the applicant should be accepted.

Alcohol and Drugs Underwriters are justified in being concerned about the use of alcohol and drugs by drivers. Studies have indicated that usage is increasing and is a contributing factor in accidents. Alcohol is estimated to be involved in roughly one-half of all highway fatalities, according to various surveys conducted by the National Safety Council and others.

Drugs are being identified as a factor in an ever-increasing number of accidents. The picture is not yet clear as to the volume of cases involving only drugs or those involving both alcohol and drugs.

Foreign Born The national origin or ancestry of an applicant should not be a cause for rejection. Both laws and the present climate prohibit taking underwriting action because of this factor.

Most applications for insurance no longer request information on national origin or ancestry. Seldom do they request answers concerning the ability of the applicant to read, speak or understand English. In spite of suspected underwriting problems because of these deficiencies, the information simply is not available on most new submissions.

However, these facts will come to the attention of underwriters in some cases.

Producers concerned about a language deficiency might add comments to applications. Often, a claim will reveal the problem, and the adjuster may point this out to the underwriter. Where language or comprehension difficulty is discovered, the underwriter should not take action solely on that fact. This is prohibited in many states and would be criticized in others.

At the same time, this information does not need to be ignored. Further investigation might be conducted to determine if there are other potential problems. Some persons with language difficulties may be found to have poor driving records, whether related to this factor or not. Other problems may also be found and the combination of borderline items may be enough to justify declination or cancellation.

Underwriting action should never be taken solely because of the national origin or ancestry of an individual. This factor can be used as one item in the total picture, and may point to other deficiencies which would require action.

Related Business Underwriters should no longer require the purchase of other policies with the same company before a requested coverage is written. The economies in investigation and underwriting expenses, and the desire for a more profitable coverage to offset an unprofitable one, simply cannot be justified. Each line should be priced so that it can stand on its own.

Current underwriting standards discourage requiring an applicant to purchase additional policies as a condition to approval. Regulators agree that potential insureds have a right to purchase the coverage’s they desire, from the companies they desire, without any requirements of related business by the insurer. The requirement may be aimed only at efficiency, but it comes across poorly to applicants.


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Prior Insurance Underwriters are taught to secure as much information as possible in order to select applicants intelligently. One item of information which was used regularly was the name of the prior insurer, if any. This practice could continue if its only purpose was to verify the accident record from the prior insurer.

While some insinuations have been made about “exchanges of privileged information” and some underwriters feel that the Fair Credit Reporting Act (including related state laws) may prohibit this practice, this is probably a valid source of reliable information.

Unfortunately, it is difficult for underwriters to ignore other facts which reach them. If the prior insurer is a substandard writer, an underwriter may find it difficult to overlook this. If no insurance is reported to have been carried, it is a natural tendency to wonder if something is being hidden. This related use of the information that arouses suspicions among regulators.

Underwriters have only two possible paths of action in such cases. Use the name of the prior insurer only as a means of securing facts about the losses which have occurred and disregard all other possible uses of the information. Underwriters should not even request data about the prior insurer.

Prior Cancellation In the previous section, it was indicated that underwriters might want to continue to secure specific information concerning a prior insurer. Regardless of most information, it is obvious that no action should be taken solely because of a previous rejection or cancellation.

Severe criticism will result from underwriting decisions based solely on the actions of others. Underwriting rules are presumed to be different by company. One of the quickest ways to arouse antagonism is to reject or cancel coverage solely because another underwriter took similar action.

This does not mean, however, that an underwriter should ignore the actions of prior insurers. In fact, this may be the most valuable item of information which is secured by finding out about the previous insurer. This factor is one of the best examples of how “balanced underwriting” can be practiced. The secret is how underwriters use the information that a prior insurer had obtained to reject or cancel the coverage.

The wrong course is to automatically reject the applicant. Not only will this bring down the wrath of regulators, it may also cause the rejection of some business which would be perfectly acceptable since insurers aim at different sectors of the market.

The right course is to use the fact of a prior cancellation as another warning flag. A smart underwriter will immediately start to secure more information about the applicant. Such investigation may reveal a poor driving record or other such factors which would be adequate cause for rejection.

This last factor to be discussed, the rejection or cancellation by a prior insurer, is a good illustration of how underwriters can continue to select risks under the watchful eye of govern-mental regulators. Factors which have caused concern to underwriters in the past, need not be ignored. However, they should not lead to a blind reaction based on past practices.

Rather, these factors can point out the need for the securing of more facts before accepting an applicant. Then, based on complete information, a decision can be made which complies with the laws and regulations and still senses the needs of the company and the public.



Conclusion As an insurance producer, you are likely to be asked significant questions by your customers regarding the underwriting process and the likelihood of your customer obtaining a policy. The preceding description of the multitude of issues involving property and casualty underwriting should help you identify many of the concerns which can be expected from customers. Underwriting will continue to evolve in a manner which balances fairness with the profit-taking nature of the business of insurance.


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Chapter Four / Life Insurance

CHAPTER 4 – LIFE INSURANCE Having already examined automobile insurance, homeowners insurance and personal property insurance and the underwriting issues associated with those property and casualty policies, we now turn to a discussion of life insurance. Many individuals will turn to his insurance producer for advice regarding the sensitive subject matter of life insurance. While customers may be hesitant to discuss the purchase of an insurance policy which contemplates their demise, life insurance is one of the most important products which an individual must consider obtaining in order to provide financial security to loved ones.

The Life Insurance Policy Life insurance is a contract between an individual and an insurance company. In this contract, the insurance company agrees to pay a stated amount of money to a beneficiary, under certain conditions, in exchange for a sum of money called the premium.

It is important that you understand that a life insurance policy, like any other insurance policy, is in fact a legal contract. In other words, it is an agreement between the parties that the insurance company shall perform in exchange for the premium that is paid to the company.

Uses of Life Insurance Life insurance is primarily used to function in personal and family situations.

As a rule a person’s death creates an immediate need for money. The following is a list of some of the needs that might be created from a person’s death.

• Expenses created by final illness.

• Burial and funeral expenses.

• Debts that are due at time of death.

• Costs to administer the estate.

• Federal and state death taxes.

• Inheritance taxes.

Money may also be needed to provide for the following:

• Payoff mortgages or purchase a new home.

• Provide an education for children.

• Meet unexpected financial needs.

Life insurance can also provide benefits for business situations. Here are a few examples:

• Loss caused by death of a key employee.

• Collateral for loans.

• Buy-out of the business interest of a deceased owner.

• Fringe benefits for employees.

Life Insurance as a Property Very few people consider the fact that life insurance is a property. Where else could an individual make a premium payment of $100, and create an immediate estate or property valued at $250,000? Of course, that is possible with life insurance.



Here are some advantages of life insurance as property:

• As an asset it is very secure.

• There is no managerial care required for the property.

• It can be purchased in any desired amount.

• It provides a reasonable rate of return.

• Proceeds are payable immediately upon death of the insured.

• The insured chooses the method of payment for premiums.

The Life Insurance Application Three Parties to an Application A life insurance application contains three parties:

• The Proposed Insured. This is the person whose life is being insured by the life insurance policy.

• The Applicant. This is the person that is making application to the insurance company for the life insurance and may or may not be the proposed insured.

• The Policyowner. This is the person that usually pays the premiums and the person who retains all rights to any values or options contained in the policy.

The great majority of policies are issued on the application of the person to be insured who is also the owner of the policy.

In the typical situation, the policyowner, the applicant, and the insured will be the same person. There are, however, many policies issued where someone other than the insured applies for and owns the policy. The situation in which someone other than the insured is the policyowner is referred to as “Third party ownership.” This type of arrangement is often found in family situations where, for example, a wife will insure her husband, or vice versa, or a parent will insure children. Third-party ownership is also often found in business situations, where a business insures the life of a key employee, for example. Another common third-party ownership arrangement is where a creditor owns a policy on the life of a debtor.

Insurable Interest For a life insurance policy to be issued, an “insurable interest” between the insured and the policyowner must be present. In this regard, it is necessary to examine insurable interest from two standpoints. First, we’ll look at the situation in which a person applies for insurance on the life of another. Then, we’ll look at insurable interest when a person applies for insurance on his or her own life. We will examine the conditions that must be present to satisfy the insurable interest requirements in each of these situations.

Again, to purchase life insurance on the life of another, an insurable interest in the life of the proposed insured must exist. The policyowner must benefit, either emotionally or financially, by the insured continuing to live. Generally, for an insurable interest to exist, the potential emotional loss must arise from love and affection which grows from a close blood relationship, or marriage. And, of course, where one’s own life is concerned, each person has an unlimited insurable interest in his or her own life.

Suppose that a life insurance policy could be sold when no insurable interest requirements existed. If a person could apply for insurance on the life of another without this interest, then the policyowner would stand to gain, and suffer no emotional loss, by the insured’s death. As © 2006 Bookmark Education www.BookmarkEducation.com

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such, a life insurance policy would constitute a mere wager which would be clearly against public policy, and therefore illegal.

An insurable interest may arise out of a close blood relationship, but being the relative of a potential policyowner does not automatically establish an insurable interest. For example, under most circumstances, a person would probably find it difficult to establish an insurable interest in an aunt, uncle, or cousin unless the policyowner could show that a significant financial or emotional loss would result upon the death of the relative.

There is another important aspect of insurable interest; the relationship between a policyowner and a creditor. This relationship brings about another type of insurable interest.

A creditor can establish an insurable interest with a debtor. For instance, assume a bank loans $5,000 to an individual. Obviously, the bank will suffer financially if the debtor dies before the loan is repaid. This fact establishes the insurable interest between the bank and the debtor. For this reason, the bank can purchase life insurance on the life of the debtor and receive the death benefit of the life insurance policy, but only in an amount which reflects the balance of the unpaid loan, should the debtor die prior to repaying the loan.

Insurance purchased by a creditor on the life of a debtor must be in an amount that approximates the size of the debt. So, if a debtor owes a creditor $1,000, the creditor could not purchase a $10,000 life insurance policy on the life of the debtor.

For this reason, most credit life insurance purchased on the life of a debtor has a reducing death benefit, which keeps pace with the diminishing loan balance. Therefore, if a debtor owes $5,000 to be repaid over a period of five years, the death benefit might begin at $5,000 to match the original amount of the loan. However, this policy would eventually reduce to $0 at the end of five years when the loan has been repaid.

The Application Form In order for a person to purchase life insurance they must make a request to the insurance company of their choice. The form on which this request is made is the application.

Most companies now require that the proposed insured be physically present in front of the agent while the questions on the application are answered. The application is crucial in that it provides the data that the underwriters and insurance company will use to determine whether to issue a policy.

The application is a life insurance company document containing questions and information, which the company uses in evaluating the insurance risk and in properly preparing the policy if one, is issued. The agent completes the application by asking the applicant the questions.

The information requested on the application generally includes items such as the applicant’s full name and address, age, sex, marital status, occupation, medical and family histories, present physical condition, and a description of the type and the amount of insurance applied for. It also includes the name of the person who is the beneficiary of the insurance along with data on other insurance owned and applied for, as well as whether or not the applicant was ever refused life insurance.

In view of the importance of the application, it is essential that the application be completed fully and accurately. If the application is incomplete, the underwriting process and policy issue will be delayed until the necessary information is obtained. The company depends upon accurate information to make a proper evaluation of the proposed insured.

When the proposed insured signs the application, it constitutes a formal request to the company that a policy be issued on the proposed insured’s life. In addition, the signature on



the application indicates that the information is true and correct to the best of the knowledge of the proposed insured.

Minor Applications In most states a person is not considered an adult until the person is 18 years of age.

As a rule, minors are not permitted to enter into contracts. However, life insurance is the exception in that a person is a minor only until age 15.

In the event that the proposed insured is younger than age 15, one of the following persons must sign the application on behalf of that child:

• The mother or father.

• A court appointed guardian of the minor.

• The child’s grandparent.

Correcting Applications Should it be necessary to correct a mistake regarding information given on the application, the proposed insured must initial any and all changes on that application. Mistakes on the application can be costly especially when the company is usually paying an outside reporting service to conduct an inspection.

Any changes that are made on a completed application must have the approval of the proposed insured. The normal procedure is to return the incorrect application to the agent who in turn will take it to the insured to have the corrections initialed.

Incorrect or Incomplete Applications Should an application contain incorrect or incomplete information it should not be taken lightly. In the event that the company has already made a decision on a risk based on these inaccuracies, it could result in a serious loss.

If the error is discovered after the issuance of a policy, the company can cancel or rescind the entire contract from the date of issue.

Of course, this must take place before the incontestability clause of the contract takes effect. The incontestability clause provides a date after which the insurance company cannot contest the information in the application.

Representations and Warranties All statements on applications are regarded as representations. When a person makes a statement that person believes to be true, the person is in effect making a representation of the truth. While it is possible that a representation may be found to be untrue, a person who makes a representation believes it to be true.

A warranty on the other hand is a statement made with such absolute certainty that it is guaranteed to be true. No statement on an application is considered a warranty.

A false representation can be defined as a misrepresentation.

Fraud There are three elements necessary to constitute a fraud. They are:

• A person makes an intentional misrepresentation of what is known to be a material fact.

• The person has intent to gain advantage from the misrepresentation.


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• A person relies upon that misrepresentation and suffers a loss.

Concealment Concealment is closely akin to misrepresentation when it comes to information included on a policy application.

While misrepresentation as stated earlier is something known to be untrue, concealment is withholding of facts that the applicant should have given to the insurance carrier at the time of application.

Conditional Receipt It is best to always collect the first full premium from the applicant at the time of application.

The receipt that is located at the bottom of the application is called a conditional receipt. The word “conditional” is very important because the agent is not guaranteeing that the policy will be issued. Issuance of the policy is subject to the full approval of the insurance carrier.

The conditional receipt serves two functions:

• It acknowledges the first full premium.

• It states in very clear terms that the policy acceptance is subject to the approval of the carrier.

In the event the proposed insured dies before the policy is issued, the premium will be returned to the beneficiary.

Policy Effective Date / Backdating Full protection takes effect as of the policy effective date. The policy effective date is the date on which the contestable period begins. The policy effective date also is the date on which the suicide clause in the life insurance policy begins to run. The suicide clause provides that a beneficiary will not be paid a benefit under the life insurance policy if the insured commits suicide within a certain period of time following the policy effective date.

Policies can be backdated a certain number of months. As a rule, the maximum is to backdate six months. Most companies allow backdating for sales reasons. For example:

• Often, backdating can save an age by one year for the proposed insured and this can result in a lower premium for the proposed insured.

• Backdating is useful to assist the policyowner in coordinating dates to fit their income pattern. Perhaps the backdating may change the policy premium due date to closely match payday.

• Occasionally some policy forms have minimum and maximum age limits and backdating may help to put the applicant’s age within the window of acceptable age limits.

How Much Life Insurance Do I Need? As an insurance agent, you will undoubtedly be asked the question: “How much life insurance do I need?” This is an important question to answer because the majority of families in America are inadequately insured.

As a general rule it is said that a person should carry life insurance equal to five or six times their annual earnings.



Types of Life Insurance There are many types of life insurance available. We will discuss the following:

• Term insurance.

• Whole life insurance.

• Universal life insurance.

• Variable life insurance.

• Adjustable life insurance.

• Modified life insurance.

• Family life insurance.

Term Insurance This is the most basic type of life insurance. Some of its characteristics are as follows:

• Term Insurance provides only temporary protection from one to twenty years or until the insured reaches a specified age. Should the insured be alive at the end of the term period the protection expires.

• Term Insurance has no cash value or savings element. It is strictly pure protection.

• Term Insurance can be renewable and/or convertible. Renewable means that you can continue the coverage for additional periods without proof of insurability. As a rule, the premium increases each time the policy is renewed based on the age of the insured at the time of renewal. Convertible means that the term policy can be exchanged for some type of cash value insurance without proof of insurability.

• The premium for a term insurance policy is based on a person’s age, health, whether or not he or she smokes and the amount of coverage. Term insurance premium prices are easier to understand than other life insurance policies. One simply pays a specified price for each $1,000 of death benefits.

Term Insurance comes in a variety of policies. These include:

• Yearly renewable term.

This type of policy is issued for a one-year period and the policyowner has the right to renew coverage for successive one-year periods. If term insurance is not renewable, the company selling the policy can require a medical examination when each period begins.

• Five, ten, fifteen or twenty year term.

Although a one-year term is the least expensive, term insurance can be purchased for a specific period such as five, ten, fifteen or twenty years, and in some instances even longer periods. The premium remains level during the policy term, and the premium will increase if the policy is renewed at the end of the term.

• Term to age sixty-five or seventy.

In this instance the term insurance is provided to a stated age. The premium remains level during the policy term and the insurance expires when the stated age is attained. As a general rule, the insured has the right to convert this term insurance to a cash value policy; however the policy must be converted sometime prior to the expiration date.


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• Decreasing term.

With a decreasing term policy, although the premiums remain level during the policy term, the face amount of insurance gradually decreases over time. For example a $100,000 policy issued for a decreasing term of 30 years could decline to $50,000 by the end of the twentieth year and zero by the end of the thirtieth year.

• Re-entry term.

With this policy the premiums are based on a low-rate schedule. Under the terms of this policy, however, the insured must repeatedly demonstrate evidence of insurability, usually every one to five years.

Whole Life Insurance Whole life insurance is so named because it lasts for the insured’s whole life. The premium stays the same forever. Critics of whole life state that the policyholder overpays for that protection during the younger years of the insured, which would negate the savings during later years.

Whole life insurance contains the basic elements of term insurance, with an investment element added. The insured pays a premium amount greater than the premium which would be paid for term insurance, and that portion of the payment is invested for accumulation over the life of the insurance policy. The growth on that investment is not taxable to the insured. This favorable treatment of return on investment is unique to life insurance and offers a substantial wealth accumulation vehicle.

Traditional whole life is different from term insurance because it offers both protection and cash value. With a whole life policy, the cash value builds slowly. Life insurance companies stress it as a positive for its value as a savings account. Cash value is money that would be paid to a policyholder when the policy is surrendered. This is sometimes called the surrender value of the policy.

With whole life, part of the premium buys the insurance, and part goes toward the cash value. This interest is tax-deferred and remains tax free if a person never utilizes the cash value before his or her death.

Some examples of whole life insurance include:

• Ordinary life insurance.

Ordinary life insurance is a form of whole life insurance. Lifetime protection is provided until age 100 and the premiums remain level. In the event the insured is still alive at age 100, the full-face amount will be paid without death having to occur.

• Limited payment life insurance.

This is another form of whole life insurance. Although the premiums are level, they are only paid for a certain number of years. After that payment period the policy becomes fully paid up. Limited-payment policies can be issued for ten, twenty or thirty years.

A policy that is paid up at age sixty-five or seventy is also available. The premiums for

limited-payment policies are higher than an ordinary life insurance policy but the cash value is also higher.



• Endowment insurance.

This is the third basic type of whole life insurance. An endowment pays policy proceeds to the named beneficiary if the insured dies within a certain period. If the insured survives to the end of the stated period, the policy proceeds are paid to the policy owner.

Universal Life Insurance This variation upon whole life insurance became extraordinarily popular after its introduction. Universal life policies are sold as investments that combine insurance protection with savings. Actually, a universal life policy can be defined as a flexible premium deposit fund that is combined with monthly renewable term insurance.

Here’s how it works:

FIRST – An initial specific premium is paid. Then expenses are deducted from the gross premium and the balance is credited to the policy’s initial cash value.

SECOND – A monthly mortality charge is deducted from the cash value to pay for the pure insurance protection.

FINALLY – The remaining cash value is then credited with interest at a specified rate.

Universal Life has the following basic characteristics:

• Protection, savings, and expense components are separated.

• There is a stated investment return.

• The plan offers considerable flexibility to the insured by permitting the insured to increase or decrease the premium and the corresponding death benefit during the life of the policy.

• Cash withdrawals are permitted.

In some states, universal life is referred to as “flexible-premium adjustable life.” This describes many of its benefits. Universal life can be a useful tool to meet changing needs. It can also be useful if one’s income fluctuates from year to year. A person can vary his or her premium if he or she has a year with lower income. When someone varies his or her premium, the death benefit will fluctuate along with it.

Universal life offers tax advantages to the insured because the investment value grows without current taxation. The tax on the interest is deferred while the policy is in force and until the funds are withdrawn.

Variable Life Insurance With a variable life insurance policy, the face amount of insurance varies according to the investment experience of a separate account that is maintained by the insurer. This is the perfect solution to the problem of inflation quickly eroding the real purchasing power of life insurance.

Under the variable life insurance policy the premiums are invested in equities or other investments. Should the investment experience be favorable, the face amount of insurance is increased. However, should the experience be unfavorable, the amount of insurance is


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reduced. In no event, however, can the amount of insurance be reduced below the original face amount.

The variable life insurance policy was designed to maintain the real purchasing power of the death benefit.

Variable life is not just another name for whole life. Variable life combines many features of traditional whole life with the new element of investment choice. That element is for the insurance purchaser who can live with elements of risk.

Along with the freedom of choosing one’s own investments comes the inevitable risk. Variable life insurance can offer higher investment yields than a traditional whole life policy, but one must assume a greater degree of risk. Variable life might be justified if the minimum death benefit guaranteed by the policy satisfies a person’s needs, and he or she can afford to play with the policy in the hopes of achieving a better-than-average return for his or her family.

Adjustable Life Insurance This variation on the whole life policy permits changes to be made in the following areas:

• Amount of life insurance.

• Period of protection.

• Amount of premium.

• Duration of premium-paying period.

This type of insurance is frequently called “Life Cycle” insurance because policy changes may be made to conform to different periods in the insured’s life.

Within certain limits, the policyowner can make the following adjustments as the situation warrants:

• Reduce or increase the amount of insurance.

• Shorten or lengthen the period of protection.

• Increase or decrease the premiums paid.

• Lengthen or shorten the period for paying of premiums.

A cost of living provision can also be attached to the adjustable life policy and this will in fact maintain the real purchasing power of the insurance.

Modified Life Insurance This is a type of life insurance policy in which the premiums are reduced for an initial period of three to five years and then the premiums increase thereafter:

The initial or reduced premium as paid in the beginning is slightly higher than term insurance rates but substantially lower than the premium paid for an ordinary life policy issued at the same age.

There are different types of modified life insurance:

• Under one type the term insurance is used for the first three to five years and then automatically converts into an ordinary life policy at a premium that will be higher than what would have been paid for a regular ordinary life policy issued at the same age.



• Under another type, the approach is to redistribute the premiums by charging lower premiums during the early years of the policy but higher premiums thereafter.

Modified life insurance can be attractive to individuals who expect their incomes to increase in the future.

Family Life Insurance This is a variation upon the whole life policy designed to insure all family members in one policy. This policy is sold in units that state the amount and types of life insurance on the family members.

One unit for example may consist of the following:

• $5,000 of ordinary life on the head of the family.

• $2,000 of term to sixty-five on the spouse.

• $1,000 of term Insurance on each child up to stated age.

As a rule, term insurance under the family life policy can be converted to some form of permanent insurance. Typically the children’s protection can be converted up to five times the face amount without proof of insurability. There is no additional premium if another child is born, and newborn children are usually automatically covered after a fifteen-day waiting period.

This type of policy is no longer very common.

Types of Insurance Companies Having examined types of life insurance policies, we now examine the structure of the life insurance companies offering those policies. Life insurance companies can be organized in several ways; however, most are organized either as stock companies or as mutual companies.

Stock Life Insurance Company A stock life insurance company gets its name from its basic ownership characteristic. The stockholders, people who have bought stock in the company, own a stock company. The stockholders may or may not also be policyowners. The sole function of the stockholders is to elect a board of directors who in turn will guide the operation of the company. If the company is successful financially, the stockholders will receive dividends, which are paid for each share of stock owned. A stock life insurance company is in business to make a profit for the stockholders.

Mutual Insurance Company A mutual insurance company is also a corporation, and it also derives its name from its basic ownership characteristic. Unlike a stock company, which is owned by its stockholders, a mutual company has no stockholders. Control in a mutual company rests with the policyowners who “mutually” own the company. The policyowners elect a board of directors, and any “profits” are returned as dividends to the policyowners in the form of reduced costs for insurance.

It should be mentioned here that dividends from a mutual company are not profits in the mercantile or commercial sense but rather the return of an “overcharge” of premium.

For example, a mutual life insurance company might sell life insurance at one specific age for $20 per $1,000 of face amount. Once a dividend has been declared, each policyowner might


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then receive credit on the premium statement in the amount of $2 per $1,000. Thus, the ultimate cost for the insurance is $18 per $1,000 of face amount.

While not true in every case, mutual insurance companies usually issue “participating” life insurance policies. The term “participating” means that if the company realizes a savings in death claims due to a lower mortality rate, or an increase in the interest earned, or if it realizes some efficiency in its operation which reduces expenses, these savings or “profits” are passed along to the policyowner in the form of policy dividends. Thus, the policyowner in a mutual life insurance company “participates” in any savings or “profits” enjoyed by the company.

Insurance agents should not imply to clients that a stock company is better from an organizational standpoint than a mutual company, or vice versa, or that participating policies are better than nonparticipating ones. Both types of companies and both policies are acceptable.

Before any life insurance company can sell insurance in any state, it must be licensed to sell insurance or, as it is called, “admitted” to that state. An insurer that is admitted to a state is authorized to do business in that state. If an insurer is not admitted to a state, it is unauthorized to do business in that state.

Fraternal Benefit Society Another type of insurer with which you should be familiar is the fraternal benefit society, also known as a “fraternal.” A fraternal insurer is a social and benevolent organization, which provides, among other services, life insurance benefits for members.

Each state defines and provides for the regulation of fraternal benefit societies in its insurance laws. But, although the exact definition of a fraternal may differ from state to state, an organization usually must have certain characteristics to qualify as a fraternal benefit society. First, the organization generally must exist only for the benefit of its members and of their beneficiaries and be non-profit. Second, it must be organized without capital stock.

A third characteristic is that the society usually must be organized on a lodge system. This means that the organization must have local lodges or chapters, which hold regular meetings to carry on the activities of the society.

Finally, the organization must have a representative form of government. There must be a governing body chosen by the members directly or by delegates, in accordance with the organization’s bylaws or constitution.

Government Insurance Programs Government Insurance Programs have been established for a variety of reasons throughout history. Social insurance programs have been created to allow the government to make compulsory a program lacking equity in order to cover fundamental risks and to redistribute income. Government insurance programs have been created when private insurers would have been subjected to adverse selection or were incapable of meeting society’s needs.

By its administration of various Federal insurance programs, the U.S. government has become the largest insurer in the world. These various programs include Social Security, Medicare, and the railroad retirement, disability, and unemployment programs.

Reciprocals Reciprocals are groups of individuals (called “subscribers”) who are insured under an arrangement where each subscriber is both an insured and an insurer. In other words, the



other members of the group insure each subscriber. However, the liability of each subscriber is limited.

The administrator of the reciprocal is the “attorney-in-fact.” He or she is granted this power by the subscribers through a broad power of attorney and receives a percentage of the gross premiums paid by the subscribers. Other than this payment to the attorney-in-fact and administrative expenses, the cost to the reciprocal is limited to the amount of the losses that occur. Any unused premiums are returned to the subscribers.

Lloyd’s of London Lloyd’s of London is a name familiar to many in the insurance industry. However, perhaps the most interesting fact about Lloyd’s of London is that it is not an insurer nor does it issue policies. Rather, Lloyd’s of London is an association of members who write insurance for their own accounts. The New York Stock Exchange bears the same relationship to stock purchases as Lloyd’s bears to the purchase of insurance.

Like the New York Stock Exchange, Lloyd’s provides quarters for its members as well as procedures for business transactions. Though neither organization engages in trade, each provide facilities and rules that govern how its members will pursue trade. In addition, Lloyd’s maintains worldwide underwriting information and a complete record of losses. It also aids in loss settlements and supervises salvage and repairs throughout the world.

At Lloyd’s, an insurance transaction begins when a proposal is placed before the underwriting members, or their agents, by a licensed broker. The broker prepares the policy and submits it to the Policy Signing Office where the policy is examined. If the policy conforms to agreed-upon rules, it is submitted to the underwriters. Those underwriters who wish to participate in the policy affix their signatures or “underwrite” the risk. American Lloyd’s associations operate under the same principles and methods as Lloyd’s of London.

Insurer’s Financial Status Changing economic conditions and highly publicized failures of financial institutions (from savings and loan companies to insurance companies) have focused much attention on the financial status of private insurers. Independent rating services provide ratings consumers can use to measure the status of an insurance company and compare it to others.

The two most popular rating services are A.M. Best Company and Standard and Poors. The A.M. Best Company looks at profitability, leverage, and liquidity and assigns ratings from A++ (Superior) to C (Fair) and below. Standard and Poor’s focuses on the claims paying ability of an insurer and offers ratings from AAA (Superior) to D (Insurers placed under an order of liquidation).

In most cases, insurance companies pay a fee to be rated by a rating service. Other rating services include Moody’s Investors Service (measuring financial strength), and Duff and Phelps (measuring claims paying ability and managerial soundness). In addition to private rating services the National Association of Insurance Commissioners measures company performance and prepares analytical reports as part of the Insurance Regulatory Information System (IRIS). Agents have access to IRIS ratios, which serve as indicators of a company’s financial condition in various areas.

Life Insurance – Policy Provisions It may surprise people that many insurance agents have never read the required policy provisions that are contained in every policy that they sell.


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It is important that you realize that policy provisions are in fact contractual provisions and govern what the policyowner can and cannot do with the policy you have sold them.

Here is an overview of the list of provisions and then we will discuss them individually.

• Ownership clause.

• Entire contract clause.

• Incontestable clause.

• Suicide clause.

• Grace period.

• Reinstatement clause.

• Misstatement of age.

• Beneficiary designation.

• Change of plan provision.

Ownership Clause The owner of a life insurance policy can be the applicant, the insured, or the beneficiary. In most cases, the applicant and insured are the same person.

Under the ownership clause, the policyowner possesses all contractual rights in the policy while the insured is still alive. These rights include the selection of a settlement option, naming and changing the beneficiary designation, election of dividend options, and other rights. These contractual rights typically can be exercised without the beneficiary’s consent.

In addition, the ownership clause provides for a change in ownership. The policyowner can designate a new owner by filling out an appropriate form with the company. The insurer may require that the life insurance policy be endorsed to show the name of the new owner.

Entire Contract Clause The entire contract clause states that the life insurance policy and attached application constitute the complete contract between the insurer and policyowner.

No statement can be used by the insurer to void the policy unless the statement is a material misrepresentation and is part of the application. In addition, any officer of the company cannot change the terms of the policy unless the policyowner agrees to the change.

Incontestable Clause Under the incontestable clause, the company cannot contest the policy after the policy has been in force two years during the insured’s lifetime. The insurance company has two years to discover any irregularities in the contract, such as a material misrepresentation or concealment.

If the insured dies after that time, the death claim must be paid. For example, if John conceals a cancer operation when the application is filled out and dies after expiration of the incontestable period, the death claim will be paid.

The purpose of the incontestable clause is to protect the beneficiary if the insurance company tries to deny payment of the death claim years after the policy is issued. Since the insured is dead, allegations by the insurer concerning statements made in connection with



the application cannot be easily refuted. After the incontestable period has expired, with few exceptions, the company must pay the death claim.

Suicide Clause A typical suicide clause states that the face amount of the policy will not be paid if the insured commits suicide within two years after the policy is issued. The only payment is a refund of the premiums.

The purpose of the suicide clause is to reduce adverse selection against the insurer by providing the insurer some protection against an individual who purchases a life insurance policy with the intention of committing suicide.

Grace Period A grace period is another important contractual provision. A typical grace period gives the policyowner thirty-one days to pay an overdue premium.

The life insurance remains in force during the grace period. If death occurs during the grace period, the overdue premium usually is deducted from the policy proceeds.

Reinstatement Clause If the premium is not paid during the grace period, a life insurance policy may lapse for nonpayment of premiums.

The reinstatement clause allows the policyowner the right to reinstatement of a lapsed policy under certain conditions:

• The insured must provide evidence of insurability, a condition that insurers often waive for lapses of less than two months.

• All overdue premiums plus interest must be paid.

• A policy loan must be repaid or reinstated.

• The policy must not have been surrendered for its cash value.

• The lapsed policy must be reinstated within five years.

If the policyowner wishes to continue the same type of life insurance coverage, it usually is more economical to reinstate a policy than to buy a new one. This is because a new policy is likely to have a higher premium, since it will be issued when the insured is older than at the time of issuance of the first policy.

Misstatement of Age The insured’s age may be misstated in the application. Under the misstatement clause, the amount paid is the amount of life insurance that the premium would have purchased at the insured’s correct age.

For example, assume that Mary’s correct age is thirty but is incorrectly recorded in the application as age twenty-nine.

Assume that the premium for an ordinary life application at age twenty-nine is $14 per $1,000 and $15 per $1,000 at age thirty. If Jane has $15,000 of ordinary life insurance and dies only 14/15ths of the proceeds will be paid, or $14,000.

Beneficiary Designation The beneficiary is the person or party named in the policy to receive the policy proceeds.


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There are numerous beneficiary designations in life insurance.

They include the following:

• The primary beneficiary is the first party who is entitled to receive the proceeds at the insured’s death.

• The contingent beneficiary is the beneficiary entitled to the policy proceeds if the primary beneficiary is not alive.

• A revocable beneficiary designation means that the policyowner has the right to change the beneficiary designation without the beneficiary’s consent.

• An irrevocable beneficiary designation means that the policyowner cannot change the beneficiary without the irrevocable beneficiary’s consent.

• A specific beneficiary designation means that the beneficiary is named and can be identified. For example, Martha Smith may be specifically named to receive the policy proceeds if her husband should die.

• A class beneficiary designation means that a specific individual is not named but is a member of a group to whom the proceeds are paid. One example of a class beneficiary designation would be “children of the insured.”

Change of Plan Provision The change of plan provision allows the policyowner to exchange the present policy for a different one.

If the change is to a higher premium plan, such as exchanging an ordinary life policy for an endowment at age sixty-five, the policyowner must pay the difference in cash values between the two contracts plus interest at a stipulated rate.

Since the net amount at risk is reduced, evidence of insurability is not required.

Some insurers also allow the policyowner to change to a lower premium policy, such as exchanging an endowment contract for an ordinary life contract. The insurer refunds the difference in cash values to the policyowner. However, evidence of insurability is required since the net amount at risk is increased.

Exclusions and Restrictions Life insurance policies contain very few exclusions and restrictions. The more common ones are as follows:

• Certain activities which are considered dangerous such as flying, hang-gliding, auto racing or skydiving may either be excluded or covered if an additional premium has been paid.

• The suicide clause described above, which excludes payment of the face amount in the event of suicide within two years of the issue date.

• An aviation exclusion may be present in the policy and would exclude death coverage from an aviation accident other than as a passenger on a regularly scheduled airline.

• The war exclusion is designed to control adverse selection during times of war and may be inserted to exclude payment if death occurs as a result of war.

Premiums There are two basic ways to purchase a life insurance policy.

• The first is by paying the entire cost in one lump-sum payment. This is the “single premium” method.



• The second method of purchasing a policy is by the payment of periodic premiums. Rather than making a single payment for the insurance, the policyholder makes annual, semi-annual, or more frequent payments.

A single premium policy is seldom purchased because of the large lump-sum payment that is generally required. The typical policyholder finds the periodic payments much easier to make.

A second reason why single premium policies are seldom purchased concerns the cost of the policy if the insured dies in the early years of the contract. In this situation, the amount paid for the insurance under the periodic method will be less than the single premium amount.

Parts of the Premium There are three basic factors which affect the premium charged for a life insurance policy.

• The first factor is mortality. Mortality refers to how many people within a given age group will die each year.

• The second factor is interest. Interest refers to the earnings the company receives on the premium dollars it invests.

• The third factor is expenses. Expenses are all of the costs the company incurs in selling, issuing, and servicing its policies.

We said earlier that as one grows older, the cost of insurance increases. The reason for this is that as one grows older, the chance of death increases. Insurance companies use mortality tables and other statistics to determine the number of insureds within each age group, who will die each year. What would happen if more people died in a year than the company had predicted? The company will pay out more for death claims than was anticipated.

Another factor which influences the cost of insurance is the interest income that the company earns from its investments. Insurance companies receive millions of dollars each month in premium dollars. And, while each company has death claims and other expenses, the costs for these claims and expenses should be less than the total premiums received.

By law, a life insurance company is permitted to invest this extra money to obtain additional revenue in the form of interest. Most life insurance companies invest in stocks, bonds, construction projects, and in a variety of other ventures designed to provide a return on their investment. The principal, as well as the interest earned, on these investments establishes a fund to pay all death claims as they occur and also helps to offset the cost of insurance.

Naturally, the insurance company is not permitted to keep all the money it receives. Expenses, of course, have to be paid. In addition to death claims, expenses include such items as:

• Agent’s commissions.

• Salaries.

• Advertising.

• Physical examinations.

• Legal costs.

• Policy issue costs.


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Here is a very simple formula which indicates how these factors affect premium costs:

Death claims + Other expenses - Investment interest earned = Premium to be charged.

Keep in mind that no company determines the premium to be charged by the simple method we have described above. This simplified approach merely describes the important relationship between these factors.

Net and Gross Premium The premium that a company charges for a life insurance policy is called the “gross” premium.

When a company is calculating the premium for a policy, it begins by determining the “net” premium. Once the net premium has been computed, the company then adds the expense factor, or “loading,” to this net premium to arrive at the gross premium.

Mortality An insurance company obviously cannot know when a particular insured will die. However, by using the mathematical concept of probability, the company can predict with a great deal of accuracy the number of insureds who will die each year. This prediction of future mortality is made on the basis of past mortality experience and assumes that future experience will parallel past experience. But, if past mortality is to be a reliable basis for prediction, accurate data must be kept on a large group of representative individuals for a sufficiently long period of time.

Information on past mortality is analyzed and arranged in a table called the “mortality table” which shows probable death or mortality rate at a specific age. Beginning with a given number of individuals at a given age, the mortality table shows the number of people out of the group who probably will die at each age and the number who will survive.

Remember that even if the mortality rates and the mortality table are accurate, a company which wants a reliable estimate of future mortality must apply the rates to a large enough group of individuals for the “law of averages” to operate.

Level Premiums and Reserves Since few policies are purchased by the single premium method, once the net single premium is computed, the company then converts that premium into a “net level premium”. Let’s now turn to the concept of level premiums.

The early renewable term premium, also called “natural or step-rate” premium, increases each year as the insured ages and the risks of mortality increase. The premium rises rather gradually during the younger ages, but increases sharply for the older ages. As a result, the premiums can become prohibitively expensive for most insureds at the older ages.

To overcome the problem of annually increasing premiums, companies develop the level premium plan. With this plan, the premium remains the same during the premium payment period rather than increasing as the probability of death increases. This level premium is higher than the natural or yearly renewable term premium in the early years of the policy, but it is lower than the natural premium in the later years.

Under the natural premium plan, the net premium charged policyowners each year is just sufficient to pay the expected claims for the year. This is not true for the level premium plan. The net level premium payments made in the early years of the contract are greater than the amount needed to pay the policy claims during those years.



By investing the excess part of the premium in the early years, the company accumulates funds to cover the deficiency which occurs in the latter years. These funds which the company holds to meet future policy obligations constitute the policy reserve or simply the “reserve.”

The reserve is the amount that, together with future premiums and interest earnings, will be sufficient for the company to pay all future policy claims, based on the company’s mortality and interest assumptions. Thus, the reserve is a liability - future obligation to the company.

Because a company’s ability to fulfill its contract obligations depends upon sufficient policy reserves, each state requires a company to maintain certain minimum reserves.

State laws specify the mortality table and the assumed rate of interest to be used in calculation of the legal minimum reserves.

Because of these state regulations, reserves are often called “legal reserves.”

Insurance Age Premium charged for life insurance depends upon the insured’s age. This is true because the mortality factor is one of the three basic elements of the premium and the mortality factor varies with an insured’s age.

However, the age used to determine the premium is the insured’s insurance age. The insured’s insurance age may, or may not, be the same as his or her actual or chronological age.

A company may use one of two methods of determining an insurance age:

In the first method, an insured’s insurance age is his or her age at the insured’s nearest birthday. If the insured turned age 30 less than 6 months ago, the insured’s age would be 30. However, if the insured’s 30th birthday was more than 6 months ago, the insurance age would be 31 since the next birthday would be nearer than the last.

Although the nearest birthday is the more commonly used method, some companies may use the insured’s last birthday to determine the insurance age. The insurance age under this method is the same as the insured’s actual age, regardless of the number of months since his or her last birthday.

Payment of Premiums The policyholder of a life insurance contract has a choice regarding how to pay premiums. Premiums generally can be paid annually, semiannually, quarterly, monthly or through monthly bank drafts.

The company usually offers a discount for paying the premiums annually. The most popular method of payment is monthly bank draft.

Settlement Options When benefits are paid following the death of the insured the payments of benefits is referred to as “settlement of the policy.”

The following is an overview of the settlement options and then we will review them one at a time.


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They are:

• Lump sum settlement.

• Proceeds and interest.

• Fixed years installments.

• Life income.

• Joint life income.

• Fixed amount installments.

• Other mutually agreed methods.

Lump Sum Settlement This is when the beneficiary receives the policy proceeds in a single payment following the death of the insured.

Proceeds and Interest Under this option the insurance company will hold the policy proceeds and make interest payments to the beneficiary. The minimum interest rate is spelled out in the policy and the company may pay a higher rate at its discretion.

The beneficiary still has the right to withdraw all or part of the proceeds of the policy at any time.

Fixed Years Installments With this option the insurance company pays the proceeds in equal monthly payments. The recipient of the proceeds chooses the number of years for which payments will be made.

The amount received monthly depends on three factors:

• Policy proceeds.

• Number of years for which payments are to be made.

• Interest rate paid by the insurance company.

Again, under this settlement option the beneficiary still has the right to withdraw all or part of the proceeds at any time.

Life Income Under this settlement option the beneficiary will receive equal monthly payments for the life of the beneficiary.

The amount of monthly payments depends on four factors:

• Policy proceeds.

• Beneficiary’s sex.

• Beneficiary’s age at time payments begin.

• Period certain for which payments are guaranteed.

When payments are guaranteed for a period certain, such as ten years, payments will be made for the specified number of years regardless or whether the beneficiary lives to the



end of that period. Should the beneficiary die during the period certain payments will continue to the beneficiary’s designated successor.

For example:

A beneficiary is going to receive $500.00 a month for 10 years certain. This means that should the beneficiary live the entire ten years he will receive $500.00 a month.

After ten years there are no more benefits paid.

However, if the beneficiary dies in the sixth year the remaining four years of $500.00 per month will go to his designated successor.

Joint Life Income When this option is chosen, equal monthly payments will be made so long as either payee is alive.

This option may be used when an insured contributes to the support of his or her parents. In the event of the insured’s death, the parents, as beneficiaries, would receive monthly income for the rest of their lives.

The amount of the monthly benefits would depend on two factors:

• The policy proceeds.

• Parents’ ages at time they begin to receive benefits.

However, under this option the beneficiaries typically do not have the right to discontinue the monthly payments and receive the balance in a lump-sum settlement.

Fixed Amount Installments Using this settlement option, the insurance company makes equal payments per month, or at longer intervals, in an amount chosen by the policyowner or beneficiary.

All proceeds held by the insurance company will earn interest. If the monthly payment is greater than the monthly interest earned, the balance of the proceeds held by the insurance company decreases each month until the total proceeds and interest due are paid out.

Under this option the beneficiary may withdraw the unpaid balance at any time.

If the beneficiary dies before the installment payments are completed, the unpaid balance is paid to the beneficiary’s estate.

Other Mutually Agreed Method On occasion a life insurance company may allow the policyowner to designate other payment methods. An example of this may be that the proceeds and interest are to be paid to the insured’s spouse for the spouse’s lifetime and, upon the spouse’s death, a lump-sum settlement is to be made to the insured’s children.

Non-Forfeiture Options Life insurance policies contain non-forfeiture options. They are designed to give the insured ways in which he or she may gain continued value from a policy in the event the insured is unable to continue premium payments.

The five non-forfeiture options are as follows:

• Cash surrender value.

• Reduced paid-up insurance. © 2006 Bookmark Education www.BookmarkEducation.com

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• Extended term insurance.

• Automatic loan provision.

• Dividend accumulations to avoid lapse.

We will now discuss each of these non-forfeiture options.

Cash Surrender Value If the policyowner is unable to continue paying premiums, he or she may surrender the policy and request that the company pays the cash surrender value of the policy, if any.

As a rule most policies have no cash value whatsoever for the first two to three years.

The cash surrender value usually consists of the following:

• The policy cash value.

• Cash value of paid-up additions.

• Dividends.

The cash surrender value can be reduced by:

• Any policy loans that are outstanding.

• Accrued loan interest on outstanding policy loans.

It is important to know that all coverage ceases when the policy is cash surrendered.

Payment is usually made in one lump sum and in some cases in accordance with one of the other policy settlement options already discussed.

Reduced Paid-Up Insurance Under this option the policyowner may request that the cash value of the policy be used to keep a reduced amount of paid-up insurance in force under the same policy.

Usually the policy has a table contained in it that shows the amount of reduced insurance in any given year which the cash value would purchase in that year.

Although the policy has had its face reduced, the policy will continue to earn cash value and pay dividends if applicable.

Extended Term Insurance This option allows the same face amount of the policy to remain in effect for a specified number of years and days. Again, as with reduced paid-up insurance the policy will contain a table showing how long in years and days the original face amount will remain in force during any given surrender year.

The length of time in years and days is calculated by taking the policy’s cash surrender value, the insured’s age and sex at the time premiums were discontinued, and using that cash surrender value to purchase term insurance for a specified amount of years and days.

Under this option the policy does not continue to earn cash value or pay dividends.

Automatic Premium Provision It is possible for the insured to authorize the insurance company to make an automatic loan from the policy’s cash value to pay any premium not paid by the grace period.



Dividend Accumulations to Avoid Lapse When the policy pays a dividend, the dividend accumulations may be applied to any premium not paid by the end of the grace period. In the event the amount of accumulated dividends is not enough to pay the entire premium coverage will then be extended in proportion with the amount of premium paid by the accumulated dividends. As a result of this a new grace period will start at the end of extension coverage.

Dividend Options If a life insurance contract is a participating policy that means that the policyowner is entitled to an annual dividend paid by the insurance company. Participating policies afford the policyowner the opportunity to participate in the earnings of the insurance company through these dividend payments.

The following are ways in which a policyowner may use his or her dividends:

• Cash payment.

• Reduction of premium.

• Accumulation of interest.

• Paid-up additions.

• One-year term.

Cash Payment Under this dividend option the insurance company sends the insured a check equal to the amount of the declared dividend payment.

Reduction of Premium The premium due on the policy for the upcoming year will be reduced by the amount of the current years declared dividend and the balance becomes the new premium due for the upcoming year.

Accumulation of Interest The dividend may be held by the insurance company to accumulate interest paid at the rate that is specified in the contract. The insured has the right to withdraw the accumulated dividends at any time.

Should the accumulated interest and dividend be on deposit with the company at the time of the insured’s death, the accumulated interest and dividend will be paid along with the policy proceeds.

Paid-Up Additions This option enables the insured to receive additional amounts of life insurance by using the dividend to purchase paid-up additions. The additional insurance will be the same kind and subject to the same provisions as the original policy.

Again, on the insured’s death, paid-up additions of insurance will be paid along with the policy proceeds.

One-Year Term Some policies permit dividends to purchase additional one-year term coverage.


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The amount of the one-year term coverage would be added to the face amount of the base policy in the event of the insured’s death.

Life Insurance Policy Riders Most insurance agents are familiar with the term “endorsement.” However in life and health insurance policies the word “rider” is used in lieu of the word “endorsement.”

The effect is the same in that riders modify the coverage of the basic policy the same as an endorsement would.

The most commonly used riders in life insurance policies are:

• Waiver of premium.

• Accidental death and dismemberment.

• Guaranteed purchase option.

Waiver of Premium This rider protects the insured in the event he or she becomes totally disabled.

The waiting period is usually six months, and if the insured continues to be disabled after the six-month waiting period, the premium payments on the policy will be waived by the insurance company. Many policies will also refund the premium that was paid by the insured during the six-month waiting period.

The cost for this coverage is a bargain to the insured, and no policy should be sold without this rider.

Accidental Death and Dismemberment The amount paid in the event of accidental death of the insured is usually twice the policy’s regular face amount. This benefit is often referred to as “double indemnity.”

As a rule the accidental death rider is very carefully worded to define exactly under what circumstances this benefit will be paid.

The most liberal of the definitions is “accidental bodily injury.” The less favorable wording would be that death must occur “by accidental means.”

For example, with the language “by accidental means,” if an insured died from a broken neck after intentionally diving into the shallow end of a swimming pool the policy would not pay the accidental death benefit because the action of diving into this pool wasn’t accidental. However, if the insured accidentally fell into the pool and drowned the benefit would be paid.

On the other hand, under the “accidental bodily injury” definition, even the intentional diving into the pool would have been paid because the broken neck was an accidental injury notwithstanding the intentional dive into the shallow water.

Normally the death caused by the accident must consummate itself within ninety to one hundred eighty days of the incident in order for the double indemnity benefit to be paid under the rider.

While the accidental death benefit is paid to the beneficiary after the death of the insured, the dismemberment portion of the rider provides that the dismemberment benefit will be paid directly to the insured, rather than the beneficiary.

Dismemberment benefits typically are paid for:

• Loss of sight.



• Loss of hand or hands.

• Loss of foot or feet.

Regarding the loss of hand or foot, the loss typically must involve “complete severance through or above the wrist or ankle joint.”

Loss caused by amputation is excluded unless medically necessary and as the result of an accidental injury.

Guaranteed Purchase Option This rider is used most frequently with whole life insurance rather than term insurance.

Under this option the company guarantees the insured that he or she may purchase additional amounts of coverage without evidence of insurability.

These additional purchases are usually made at specific time intervals or upon events that change the insured’s family status. For example, some policies permit additional purchases of life insurance under the following circumstances:

• Every fourth policy anniversary year.

• The insured purchases a new home.

• The insured gets married.

• The birth of a new child.

The premium charge for the additional coverage is typically based on the type of insurance purchased and the insured’s age at the time of exercising the option.

Life Insurance Underwriting The ultimate purpose of life insurance underwriting is to develop a profitable book of business for the insurance company.

In order to accomplish this goal the life insurance underwriter attempts to provide coverage for a diversified group of insureds whose expected death rate is the same or lower than what is expected of the population as a whole.

Underwriting Factors for Individual Coverage Life insurance is priced on a class basis. Perspective clients of the insurance company are classed on the basis of a number of factors that help to predict expected mortality rates.

The principal rating factors are:

• Age.

Mortality rates are measured in terms of deaths per one thousand persons, and this of course increases with age.

Thus the older you are the more life insurance costs because you are closer to death than a younger person.

• Sex.

On average, women in the United States live approximately seven years longer than men. Therefore cost for life insurance on a woman is lower than on a man of the same age.

For example a thirty-year old male may pay the same premium as that of a thirty-three-year old female.


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• Health.

The health of an individual as well as the health history of that individual’s family helps the underwriter to determine if the applicant presents an average or better than average risk to the insurance company.

In evaluating an insured’s health the company will consider whether the applicant or family members have had any of the following illnesses:

• Cancer.

• Heart disease.

• Hypertension.

• Diabetes.

As a general rule, persons whose health history include the above diseases will likely have a higher than normal mortality rate.

Most insurance companies are now offering discounted rates to non-smokers due to the link between smoking and lung and heart disease.

• Occupation and avocation.

Since certain occupations and avocations pose hazards, such as flying and scuba-diving, applicants who engage in these hobbies are likely to have a higher than normal mortality rate.

• Personal habits.

If a life policy is for a large amount of coverage the insurance company will more than likely investigate the personal circumstances of the insured’s life. For example areas such as alcohol or drug use, poor driving record or financial problems may be taken into consideration.

• Foreign travel or recent immigration.

People who travel or reside outside the United States may be exposed to diseases not commonly found in this country.

Additionally, mortality rates vary from country to country. Therefore if a person is applying for life insurance shortly before leaving the country, special medical tests or a postponement of coverage may take place.

Underwriting Actions Based on the information that the underwriter receives from the applicant, one of three actions may be taken.

They are as follows:

• Rate the applicant standard and charge the normal premium.

• Rate the applicant substandard and charge a higher premium.

• Decline the coverage.

In addition to the above three actions many insurance companies recognize preferred risks and they will actually reduce premiums for those preferred risks.



Delivering the Policy Policy Effective Date The effective date of a life insurance policy is very important since this is the date on which coverage actually begins for the insured. As discussed earlier in these materials, the policy effective date will also have significance with regard to the incontestable and suicide clauses.

To determine the effective date of the policy, we must examine the principle of contract law known as “offer and acceptance.”

If a proposed insured signs the application and submits it with the first premium to the company, an offer to buy insurance has been made by the proposed insured.

If the insurance company issues the policy, as applied for, then offer and acceptance occurs. That is, the proposed insured has made an offer to purchase a life insurance contract, and the insurance company has accepted that offer.

So far, we have assumed that the premium was submitted with the application. However, there are two other possibilities to consider regarding the effective date of the policy.

The first occurs when an application is submitted without the premium. In this case, the applicant has made no offer. The applicant has only extended an invitation to the company to make an offer.

The insurance company makes the offer when it issues a policy as applied for and delivers it to the applicant. Further, the offer is accepted when the applicant pays the premium, assuming any other conditions have been fulfilled. The date of payment of the premium becomes the effective date of the policy.

In situations where the initial premium does not accompany the completed application, most companies state in the application that the proposed insured must be in good health at the time of policy delivery before coverage becomes effective.

So, before accepting the initial premium and leaving the policy with the insured, the agent must obtain a signed statement of the prospective insured’s continued good health. This statement and the initial premium are then transmitted to the company.

The final possibility occurs when the premium is submitted with the application but no receipt is given. If this is the case, then the policy’s effective date is generally the date that the policy is issued and delivered.

Delivery Delivery of the policy constitutes the company’s acceptance of the applicant’s offer – the application and initial premium.

A policy is considered delivered when one of the following three events occurs:

• The policy is actually handed over in person.

• The policy is mailed to the policyholder.

• The policy is mailed to the agent for unconditional delivery to the policyholder.

Delivery, then, does not usually have to be accomplished by the manual transfer of the policy to the policyholder. Delivery accomplished by means other than a manual transfer is called “constructive delivery.”

If a policy is not, or cannot, be delivered, then the policy is not in effect, as policy delivery has not been accomplished. © 2006 Bookmark Education www.BookmarkEducation.com

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Two other situations should be noted:

• When the applicant wants to examine the policy for a time before paying the initial premium, and the policy is left with the applicant for inspection, he or she should sign a receipt for the policy, referred to as an “inspection receipt.” This acknowledges that the policy is in the insured’s possession for inspection purposes only and that the initial premium has not been paid and that the insurance is not in effect.

• An applicant may ask the company to give the policy for which they are applying a date earlier than the application date. The reason for this “backdating” is usually to obtain a lower premium. Premium paid for life insurance depends, among other factors, on the insured’s age. So, in order to obtain a lower insurance age, and, as a result a lower premium, backdating is used.

Agents Responsibilities Regarding Delivery The agent should deliver the policy to the client as soon as possible after the policy is issued. This is especially important when no premium was submitted with the application, because the coverage will not become effective until the policy is delivered and the first premium paid during the continued good health of the proposed insured.

The agent also has a responsibility to explain the policy’s provisions, riders, and exclusions at the time of delivery of the policy.

Income Tax Benefits of Life Insurance By building income tax benefits into life insurance, public policy encourages individuals to purchase life insurance and obtain income security in the event of death. Specific income tax benefits of life insurance include the following:

• Death benefits are income tax-free.

The primary advantage of life insurance is that the policyowner contributes a sum as a premium amount, and when he or she dies the whole death benefit amount is passed on to the insured’s beneficiaries tax-free. This is good for the beneficiaries as well as society since these beneficiaries do not become financially dependent upon society as a result of the death of the insured. The death benefits of life insurance policies have been exempted from income taxation in order to promote this societal benefit.

• Current earnings and gains not currently taxed.

The second advantage of life insurance is that during the insured’s lifetime, and while the policy is in force, all interest earned, dividends earned and/or capital gains realized on the policy investments are not subject to current income tax. The taxation is deferred until the gains are taken from the policy by the policyowner. All investment life insurance policies enjoy tax-deferral on this buildup and a possibility of total tax-exemption on investment returns within the contract, which occurs when the proceeds are disbursed as death benefits. In other words, if the policyowner never takes the gains from the policy, there will never be tax on the policy’s investment gains and the death benefit will be paid to the beneficiaries tax-free.

• Policy tax basis includes amounts paid for life insurance and expenses.

The third income tax benefit of life insurance containing investment capital is that the amount of money which the insured recovers tax-free when surrendering a life insurance policy includes all the life insurance costs that the policy has charged during the time the



policy has been in force. These costs are paid on a pretax basis even when a policy is surrendered.

• Tax-free use of untaxed earnings and gains.

The fourth income tax benefit of life insurance depends on whether or not the insured incurs taxation as a result of using the monies accumulated within the life insurance policy while it is still in force.

The insured could use these monies by withdrawing them, borrowing them from the insurance company or pledging the policy as collateral for a loan.

The tax code permits tax-free use of these funds up to certain prescribed levels. Any insured should always obtain competent tax advice before accessing insurance policy funds in order to confirm that the use will be permitted free from tax.

Annuities Before concluding our discussion of life insurance, we will turn to another product frequently sold by life insurance companies: Annuities. An annuity is an investment contract between an individual and the insurance company. The individual receives a return on his or her investment that supplements the individual’s contribution. At some point in time, the individual can choose to “annuitize” the investment to provide income for a specified period of time in the person’s lifetime.

The earnings on an annuity can grow without being diminished by taxes. These earnings are not taxable until the individual withdraws them, and they are spread out over a number of years. When an individual begins receiving income from an annuity, only part of the income is taxable because the individual receives both interest and a partial return of the invested principal.

To make the best use of the positive tax advantages of an annuity, individuals also must be aware of potential tax problems. The IRS imposes a penalty on withdrawals unless an individual is over age 59 1/2 when withdrawing money from the annuity or cashing it in. There is a 10 percent penalty on any earnings withdrawn, along with the tax owed on the withdrawal. These charges are in addition to any insurance company fees that might be imposed upon the withdrawal.

Customers should be advised to approach the purchase of an annuity with the expectation that they will not draw on it until they are older than age 59 1/2. To fully exploit the tax advantages, the individual should plan on holding the annuity for many years so that the earnings can grow without current taxation. No matter what the tax advantages of an annuity are, the individual still must pay close attention to the rate of return on the investment.

Types of Annuities There are many different types of annuities offered by life insurance companies, including the following:

• Qualified annuities.

Qualified annuities are purchased with funds generated from qualified retirement plans. Contributions to qualified plans generally are not subject to current taxation when they are contributed to the plan. Examples of qualified retirement plans include Individual Retirement Accounts (IRAs), IRAs that qualify for an income tax deduction are qualified plans as are Simplified Employee Pension Plans (SEPs), 401(k) plans, profit-sharing plans and pension plans.


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These qualified plans are unique because in addition to enjoying the deferral on the earnings within the plan which is enjoyed with all annuities, an individual and his or her employer may also make capital investments into these plans without having to pay taxes on the amount of investment in the year of contribution. These qualified plans are usually among the best investment opportunities available.

• Finite term annuities.

The finite term annuity is sometimes called a certificate of annuity because of its resemblance to a certificate of deposit (CD). An individual may purchase a finite term annuity with a variety of maturity dates and may choose when to pay taxes. The minimum investment is usually $5,000 or $10,000. The yield is usually slightly less than a bank CD. When the maturity date arrives, the individual may withdraw the money and pay taxes on the gain. If the individual does not need the money and does not want to pay the taxes at that point in time, he or she can roll the money over into a new finite term annuity.

This annuity investment is an advantage for someone who is over 59 1/2. It is not ideal for someone younger than that, due to the 10 percent early-withdrawal penalty, along with the tax on the gain. There is also a question of safety. It’s not quite as safe as a bank CD, although choosing an A+ or A rated insurance company can bridge the safety gap.

• Fixed annuities.

One key appeal of annuities is that they offer the prospect of a guaranteed annual income after retirement, no matter how long one lives. Fixed-rate annuities guarantee a particular interest rate for a specified period of time; for example, ten years. After that period of time, only a minimum yield is guaranteed.

Annuities are often called “life insurance in reverse.” While life insurance creates an estate immediately upon the insured’s death, an annuity protects against “living too long.” While many people agree that a long life is a blessing, they also acknowledge that they do not wish to outlast the savings they have accumulated upon retirement. This concern underlies one of the basic attractions of annuities. By assuring continued payments for an unlimited number of years, annuities guarantee that the insured will not deplete his or her source of income.

The payments one makes for an annuity are referred to as premiums. Premiums, like money placed in a deposit account, earn interest, and these amounts increase in value while the insurance company invests them. The annuity contract also specifies the interest rate that the insurance company will pay on the accumulated fund. A specific interest rate may be guaranteed for one or two years and sometimes as long as five or ten years. After the guaranteed-rate period expires, the contract may call for the rate to be reviewed at specified intervals, such as quarterly or annually. At that time, the insurance company adjusts the rate in accordance with changes in the general interest rates.

Many insurance companies use the rate paid on Treasury bills as an index for setting the rate paid on annuities. Sometimes indexes such as consumer prices or cost-of-living calculations are used. Most insurance companies also guarantee that the interest rate paid on annuities will never be lower than a particular rate specified in the contract.

When an insurance company receives premiums on a fixed annuity, it invests them along with other funds it holds. However, not all dollars a contract owner pays are invested, since some are used for sales commissions and fees. These charges may vary between companies and contracts. Some companies charge only surrender fees. However, should the insured die before the cash value stated in the contract equals the amount of



premiums paid in, most contracts provide for a payment to the beneficiary of at least the amounts paid in, regardless of sales charges.

• Immediate annuities.

An immediate annuity provides for payments to commence shortly after the purchase date according to the preference of monthly, quarterly, semiannual or annually under the annuity contract.

• Deferred annuities.

With a deferred annuity, the contract is arranged for a specific date for annuity payment to begin, also referred to as the maturity date. The time prior to maturity is referred to as the accumulation period. The time following the maturity date during which payments are made to the annuitant (purchaser) is called the liquidation or distribution period. Accordingly, the annuitant will receive payments according to the contract schedule.

Premium Options Premiums for annuities are usually paid for in one of the following methods:

• Lump sum premiums.

In this method, the customer pays a single, lump sum premium when the contract is signed initially. Lump sum premiums can be paid for either immediate or deferred annuities.

• Scheduled premiums.

This method pertains to deferred annuities only. The customer pays premiums on a regular set schedule whether it be annually, semiannually, quarterly or monthly until the date on which benefit payments begin.

• Flexible premiums.

This method again pertains to deferred annuities only. Flexibility is permitted in the timing and amount of premium payments. This flexible premium annuity may be preferred by annuitants who want a program in which they can vary the amounts they save each year.

Settlement Options Settlement options refer to the various ways funds will be distributed from an annuity. Terms are agreed upon by the annuitant and the insurance company determining when the owner wishes to begin receiving income from the annuity.

• Single lump sum.

This settlement may be made in a single lump sum. The lump sum includes both the amount the owner paid in premiums, and the interest those funds have earned.

• Interest only payments.

The annuitant may wish to receive interest only payments until a later date on which another settlement option may take effect.

• Designated dollar amount.

The annuitant may elect to have the settlement paid in a specified number or dollar amount payment over a number of years.


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• Life income option.

The life income option is the most common payment associated with annuities. With the life option, the annuitant receives payments until he or she dies. Payments may or may not continue after the annuitant’s death. Three life income options are straight life, period certain and refund.

• Straight life.

A straight life annuity contract provides for guaranteed periodic payments that terminate upon the death of the annuitant. No remaining balance is paid to a beneficiary or to the annuitant’s estate after the annuitant dies.

• Period certain and refund options.

Some individuals do not want to use the duration of their lives as the factor that determines whether they will profit, break even, or perhaps even lose money on their investments. Therefore, straight life annuities do not interest them. Period certain and refund options guarantee a minimum amount that the insurance company will pay on an annuity. Both of these options can be regarded as types of death benefits, since they provide for payment to be made to designated beneficiaries upon the annuitant’s death.

Number of Annuitants An annuity contract may be written to provide for one or more annuitants. If there is only one annuitant named in the contract, the insurance company agrees to provide that person with income beginning on a specific date and to continue for an agreed-upon period, which is normally the duration of the individual’s life.

Some contracts cover more than one person. A popular contract of this type is the joint and survivor annuity. With this arrangement, two people are insured, most commonly the husband and wife. Beginning on the date in the contract, payments are made to the annuitants. The payments are guaranteed to continue to the surviving spouse upon the other spouse’s death. Depending on the contract terms, the continuing payments will either be in the same amount as when both the annuitants were alive or to be reduced.

Two types of joint and survivor annuities are most commonly used. With a joint and two-thirds survivor option, the surviving spouse receives two-thirds of the income paid to the original annuitant. With a joint and one-half option, the surviving spouse receives half of the income.

Surrender Terms Another set of annuity contract terms which is important to an investor are the surrender charges. The word surrender describes the termination of an insurance contract, such as an annuity, by the owner. When an individual surrenders a contract, he or she turns in to the insurance company the documents stating the contract terms. In return, the company gives the owner a sum of money which is known as the surrender value.

The surrender value is the cash sum that the insurance company agrees to pay the owner in the event the owner surrenders the policy prior to maturity. The surrender value of a policy increases in proportion to the number of premiums paid, but it does not always equal the amount that the contract owner has paid. The surrender value may be lower than the total premium amount, because under some circumstances insurance companies will impose surrender charges. Although these surrender charges vary among insurance companies, most annuities stipulate a period of about seven years during which some penalty is imposed.



Surrender charges are one reason that consumers should not attempt to use annuities as short-term, liquid investments in the same way they might deposit accounts. Some annuity contracts do offer loan privileges where the policy owner may borrow against the contract instead of accepting a distribution of cash. However, this may not be helpful, since the loans carry interest charges that vary according to company regulations. Besides this negative, a policy loan is also considered taxable income.

Determining the Mathematics of Fixed Annuities The cost of an annuity’s benefit is included in the premium paid for the annuity. Insurance companies use demographic projections as well as complex mathematical calculations to develop and price the annuity products they sell. A company must use projections on average life expectancies when it prices its products, because the number of years people will live directly relates to the amount that the company pays out on its annuities. In turn, statistical projections on the average number of people who will die at different ages influence the amount a policy owner must pay for an annuity.

One important mathematical device insurance companies use for pricing annuities is a mortality table. A mortality table is a mathematical tool used to calculate the frequency of deaths that will occur between successive birthdays. The numbers in a mortality table are calculated through the use of mathematical equations that express the probability or likelihood of the occurrence of a specific event.

Mortality tables are developed by actuaries. Actuaries are insurance specialists who are experts in mathematics. Actuaries calculate risks, premiums, reserves, and other mathematical factors for insurance companies.

The numbers in a mortality table allow an insurance company to project its likely future obligations to annuitants. Similarly, the company uses the mortality table to project how many dollars will be released to it by annuitants who die. This information, together with statistics the company gathers on the interest it can earn on its holdings, is then used to calculate the premiums to be charged for annuities as well as their other products.

Investor Considerations – Fixed Annuities The promise of a guaranteed lifetime income during retirement may be attractive to many investors. However, a guaranteed income is only one factor that should be considered when considering annuities. Among the other issues that should be examined carefully are risk, liquidity, earnings, and taxes.

• Risk.

Annuities are relatively safe investments. While they are not covered by federal deposit insurance, the principal and interest an individual invests in a fixed annuity contract are provided by the rigid state and federal regulations that govern insurance companies’ operations. However, these regulations do not protect an investor from all potential problems.

If the insurance company that sold an annuity to an individual experiences severe business problems and becomes insolvent, other insurance companies doing business in the same state will be required to help meet that company’s remaining obligations. However, the annuitant may face extra paperwork and delays in attempting to obtain funds.

Additionally, it is a good idea to research the soundness of the insurance company before purchasing an annuity from it.


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• Liquidity.

Annuities are relatively liquid investments because they provide ways for individuals to surrender their contracts and withdraw their funds during the accumulation period. They are not completely liquid, however, since investors may not receive the full amount that they have paid in premiums if they decide to withdraw from their annuities. The amount that an individual would lose depends on the surrender fees and penalties assessed by the insurance company. These charges are described in the annuity contract.

• Earnings.

Interest earnings on annuities have attracted many current investors. Guarantee periods vary with different insurance companies. Some will pay an initial rate for one or two years followed by subsequent annual guarantees. Others will peg their rates to formulas based on Treasury bill or consumer price indexes.

A desirable feature that a careful buyer will seek in an annuity is the bailout provision. With this provision, the contract owner may bail out without paying any surrender charge if the rate falls below a certain designated percentage from the original rate, even if the initial guarantee period has expired.

For example, assume the initial guaranteed rate is 8 percent for a period of one year. The contract promises a 1 1/2 percent bailout provision. The contract also says that a surrender charge is made upon a premature withdrawal anytime within seven years from the purchase date.

After the initial one-year period of the contract, the company announces the next year’s interest rate will be 6 1/2 percent. Since this rate dropped 1 1/2 percent from the initial rate, the customer is entitled to avoid any surrender charges if the contract is cashed in.

• Income Tax.

One of the main appeals of deferred annuities is the income tax advantage that is offered investors. Investors pay no taxes on the earnings during the accumulation period; taxes are deferred until the liquidation period. Once payouts to the annuitant begin, only a portion of each payment is taxed as income. The remaining portion, which is not subject to income taxes, is considered as a return of the money that the investor paid into the annuity during the accumulation period.

The portion of an annuitant’s income that is subject to taxes is determined through a calculation required by the U.S. Department of the Treasury. This complex calculation is based on the projection of the amount the annuitant will receive in annuity income if he or she lives to life expectancy. This total income is referred to as the expected return. Once an expected return is determined, the next step is to calculate the percentage of the amount that was invested in the contract. Once the percentage is calculated, it is used each year to determine how much of the annual annuity income should be considered return of capital and how much should be regarded as taxable income.

There are certain income tax penalties related to annuities. In particular, there is a 10 percent penalty which applies to lump sum withdrawals from annuities before age 59 1/2. This penalty applies whether the amount is taken as a loan or an outright withdrawal. (There is an exemption to this 10 percent penalty if the amount of withdrawals before age 59 1/2 is part of a series of approximately equal periodic payments over a lifetime. Also, exempt are such payments in the event of death or disability.)



An important exception exists in the case of business-owned annuities. If a business entity, such as a corporation, partnership, or trust, owns an annuity on an employee’s life, any interest earnings or annual gains in the contract are subject to current income taxes. Annuities that are part of qualified plans, such as pensions and similar employee benefit programs, are exempt from the ruling. Immediate annuities are also exempt. (In addition to employer pension plans, the exclusion of taxable earnings on annuities applies to IRAs and other tax-sheltered annuities sponsored by certain nonprofit corporate employers.)

Variable Annuities Like the fixed annuity, the variable annuity is a contract between an individual and a life insurance company. With both types, the owner contributes premiums that, along with their earnings, are accumulated within the policy contract. At an agreed-upon time, the insurance company begins making payments to the annuitant. Payments are made over the individual’s lifetime or for some other stipulated period.

The basic difference between fixed annuities and variable annuities is the way in which accumulated funds are invested and the resulting payout. With fixed annuities, the accumulated funds are combined with the insurance company’s general investments. These investments help form the basis for the guaranteed cash values of life insurance and conventional annuity contracts. In general, insurance companies invest funds for their fixed products in long-term bonds and other non-speculative issues.

The premium payments made on a variable annuity are not combined with the insurance company’s general investments. They are placed in stocks, government securities and other types of fluctuating investments. These investments have a better growth potential than those that underlie investments, but also are subject to a greater degree of risk. The investments make up a portfolio that is managed in much the same way as a typical mutual fund. When the annuitant is ready to receive payment, he or she can choose the best payout option.

For many years, marketers of annuity products as well as savings institutions emphasized the advantages of conservative and secure investments. During the 1930s, when the U.S. economy was experiencing only moderate inflation rates, many people purchased annuities for retirement in the belief that they insured a comfortable, guaranteed income for life. A successful insurance company advertisement of the late 1930s enthusiastically proclaimed, “Retire for life on 300 dollars a month!”

Then rising inflation rates began to affect the average person’s standard of living. Beginning in the 1960s, people became aware that they had to plan for more retirement dollars just to keep pace with anticipated increases in living costs. Savers sought financial instruments that could more readily keep up with inflation. Individuals of even average means were turning to the stock market for an increasing portion of their investments. Like savings institutions, insurance companies looked for ways to improve their traditional products. In an attempt to combine traditional annuity guarantees with the growth potential of a securities investment, the variable annuity was developed.

Variable annuities generally are divided into two basic types. The difference between them lies in who has control over investing the money deposited into the annuity. With the first type, the company-managed variable annuity, the insurance company determines how the annuity funds are invested. With the second type, which could be referred to as a self-directed variable annuity, the annuity owner has substantial control over the investment of funds.


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• Company-managed variable annuity.

The original variable annuities which were introduced in the 1950s were company-managed types. In this type of annuity, premiums paid in by contract owners are pooled and placed in a separate account designated by the insurance company. This method serves to distinguish these investments from the company’s other invested funds. (One advantage of a variable annuity is if the insurance company runs into financial problems, the funds in the separate account are beyond the reach of the company’s creditors. This is also true for the portfolios in self-directed plans.) The account is organized like a mutual fund in that it is made up of various investments – usually stocks, bonds and government securities. The insurance companies’ investment managers buy and sell these investments on a continuing basis.

Like mutual fund managers, the insurance company tries to invest the money wisely and profitably so that it will generate a competitive return for its investors. In addition, the insurance company must meet both state and federal regulations regarding investment practices for these products. (Variable annuities are subject to regulation by the Securities and Exchange Commission, Internal Revenue Service, and state regulatory bodies.)

One of the better known company-managed annuities is the College Retirement and Equities Fund, or CREF. Designed by the Teachers Annuity and Insurance Association, it was the first variable annuity, appearing on the market in 1952. Because of CREF’s relatively long history, it has been the subject of many detailed studies.

• Self-directed variable annuity.

With the self-directed annuity, the contract owner can choose from several investments, each with different objectives. The selection of investments may be made during both the accumulation and distribution periods. In effect, the contract owner may construct a personal investment portfolio within the annuity. The owner selects investments based on his or her investment objectives in much the same way that a mutual fund investor does.

The annuity application form lists the selection of investments that the insurance company offers. For an example of a hypothetical self-directed variable annuity, consider there are five selections available. These include four mutual funds with differing objectives, plus a fixed account. The fixed account offers guaranteed safety of principal and specifies a fixed interest rate. (Interest rates on the fixed account may be guaranteed for periods ranging from one calendar quarter to one or two years or even longer.) Customers choose from among these options according to their investment objectives.

On the annuity application the customer indicates, usually in percentage units, how each premium is to be allocated among the selected accounts. Most contracts allow an unlimited number of percentage combinations. The applicant can even allocate the entire premium to a single investment choice.

One distinguishing characteristic of self-directed annuities is the owner’s ability to change the composition of the annuity portfolio.

Three major factors that affect how individuals invest their assets are their investment objectives and philosophies, their financial standing and economic conditions. Since each of these factors may change over time, it is advantageous to the investor to be able to change the way in which his or her money is invested.

As an individual progresses through life his or her investment philosophy and objectives often change. Many people who previously might have been inclined to take investment risks may become more cautious as they grow older. For the owner of a variable annuity, a



change to more conservative investments may mean moving money from stock funds to funds composed of government securities or even a fixed fund. The typical self-directed variable annuity offers the contract owner the opportunity to redirect the investment of funds as his or her investment objectives change.

Changes in one’s financial standing may also alter an individual’s willingness to accept risks. For example, some individuals may invest in more aggressive and risky funds only after they have accumulated what they consider an adequate nest egg. Similarly, some individuals move their variable annuity funds into conservative options if they experience losses in their other investments.

Economic conditions and forecasts may also lead an individual to take advantage of a variable annuity’s flexibility. When stock prices are expected to fall, some individuals direct their money out of stock funds and into other types of funds. When yields on other investments are falling, investors often move their money into bond funds because these generally are considered good investments during such period. Thus, variable annuities allow the investor to react in the face of changing market conditions.

Choosing an Annuity Type Determining which type of variable annuity is suitable for an investor depends mainly on two factors. One is the potential purchaser’s investment sophistication. The other is the extent to which the person wishes to become involved in investment decisions.

• The first consideration applies to the inexperienced investor with limited knowledge of the stock market. In this case, a company-managed variable annuity is probably the better choice, since the insurance company will make all the investment choices and manage the portfolio.

• The second factor concerns whether the contract owner wishes to continually monitor changing economic conditions and be responsible for changing the direction of investments in the annuity portfolio. With the self-directed type of variable annuity, the investor decides on the mix of investments in the portfolio. It is the contract owner’s responsibility to periodically review these investments to see whether their performances are still in tune with his or her investment objectives and adjust the portfolio accordingly. The self-directed plan is probably more suited to an investor who is accustomed to making these types of decisions.

The investor should also be aware of the various charges that the insurance company’s fund managers impose. Each annuity contract has its own schedule of fees and other charges, and the investor should carefully assess these before making a purchase.

One charge that is commonly imposed is a surrender charge. This is similar to the surrender charge for fixed annuities.

Typically, the surrender charge limits the amount of money that may be withdrawn during the early years of the contract. Some policies have a declining charge. For example, the charge might be 6 percent for the policy’s total value in the first year and decrease by a percentage point each year thereafter. Thus, no surrender charge would be imposed on withdrawals made after the sixth year.

For funds invested in company managed accounts, companies usually impose management charges. Funds held in a fixed account usually escape the investment management fees. The insurance company typically justifies these fees by providing for a guaranteed death benefit and covering the administrative expenses involved in providing a life income.


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Accumulation Units During the years in which premiums are paid into the annuity contract, the annuity owner acquires accumulation units. Accumulation units have a designated initial price at the time of the annuity purchase but fluctuate in value thereafter. In the case of company-managed products, the changing values will correspond to the performance of the pool of investments. This is similar to the way mutual fund values are expressed. With a mutual fund share, each accumulation unit of a variable annuity has a designated value on a given day. In the case of self-directed annuities, the values of the fund or combination of funds the policy owner has chosen are totaled. The value of each accumulation unit is then calculated from this total.

Under both company-managed and self-directed plans, each premium payment purchases a certain number of accumulation units. The number of units varies according to the unit’s current market values. The number of units continues to increase, as additional purchases are made, although each unit’s value will vary over the life of the contract according to its worth in the marketplace. This, too, is similar to the manner in which mutual fund share values are calculated.

Annuity Units In order for the insurance company to begin paying out income from the annuity, accumulation units are converted into annuity units. An annuity unit is a measure of value that an insurance company uses when it calculates the amount of income to be paid to an annuitant. At retirement, the annuitant is credited with a designated number of annuity units.

The exact number of annuity units to be credited depends on four basic factors.

• The first factor is the annuitant’s age. The insurance company calculates from its mortality tables all charges in order to provide a designated amount of lifetime income at a specified age.

• The second factor is the number of guaranteed payments. If the annuitant chooses a period certain life income option, the extra charge for that benefit will be reflected in the calculation of the annuity unit.

• The third factor is the interest rate that the insurance company projects. If the company predicts a fairly high interest rate, the annuity unit will have a greater value than it would with a lower rate. Interest rates typically are projected annually to determine the projected investment return.

• Finally, there are administrative expenses to be incorporated into the unit cost calculation.

The calculated number of annuity units remains constant over the payment period. The annuitant has the option of choosing a fixed or a variable payment, or, as is often the case, a combination of both. With the variable payment, the annuity unit’s value may fluctuate just as it does during the accumulation period. The value will continue to vary according to the performance of the underlying investment portfolio and the general administrative costs that the company incurs. Obviously, the amount of periodic income also will fluctuate.

There are two important reasons for the continued fluctuation in variable annuities after the retirement income period begins:

• The first is that the portfolio’s value constantly changes to reflect current market conditions.

• The second is that the investments funding the annuity contract also change continually, just as they do during the accumulation period. The various stocks, bonds and other



financial instruments that make up the portfolio continue to change based on the decisions of the fund managers who supervise this process. In a self-directed plan, the contract owner may frequently change the contents of the portfolio.

Risk Considerations for Variable Annuities The variable annuity, with its combination of traditional guarantees and investment flexibility, offers great promise as a financial planning tool. It has the potential to be more responsive to economic trends than the conventional savings account or even the traditional fixed annuity. However, the savings customer who has basically considered only fixed investments should be aware of the special risk concerns connected with the purchase of a variable annuity.

There are two important points to keep in mind regarding the risks of variable annuities. One concerns the insurance company that issues the annuity and the second concerns the investment’s fluctuating nature.

Regarding the first point, it is essential to note that, while both fixed and variable annuities may be marketed by savings institutions, neither product is covered by the federal insuring agencies. The investment is backed only by the guarantee made by the insurance company that sells the annuity contract.

The second area of risk is the fluctuating nature of the variable annuity. Investors should recognize that whenever they place money in variable annuities, the dollar value of their investments is subject to both upward and downward changes. An investor should assess his or her tolerance for risk when selecting a variable annuity and composing the annuity portfolio.

Particular caution is needed during the retirement period when the contract owner may be contemplating changing investment strategies. Many owners like a more conservative investment position at the time when they were making deposits and accumulating funds. While it is possible to increase income payments by making the right investment choices, it is also possible to make the wrong decisions. Unlike during the accumulation period, when there is sufficient time to make up for a temporary loss, once retirement begins, it is difficult to recoup any losses resulting from investment mistakes.

Life Insurance Terms and Definitions Having reviewed the background, provisions, underwriting and tax benefits of life insurance policies and annuities, we now provide an alphabetic listing of many of the important terms and definitions which you will encounter with respect to life insurance. Many of these terms have been used during our discussion of life insurance, while some of these are additional terms which may be helpful to supplement your understanding of life insurance.

AGE CHANGE – The point in the 12 months between natural birthdays at which the individual is considered to be of the next higher age for the purpose of insurance rates. Most life insurers consider that point as halfway between birthdays. Health insurers frequently use the age at last birthday until the next birthday is actually reached.

AGE LIMITS – The ages below or above which an insurer will not issue a given policy.

AGENT – An individual appointed by an insurer to solicit, negotiate, effect or countersign insurance contracts on its behalf.

ALIEN COMPANY OR INSURER – An insurer organized and domiciled in a country other than the United States.

APPLICANT – The party submitting an application to an insurer for an insurance policy.


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ATTAINED AGE – The age an insured has reached on a given date.

BENEFICIARY – A person, who may become eligible to receive, or is receiving, benefits under an insurance plan, other than as an insured.

BENEFICIARY CHANGE – A change in the policy which alters the previous beneficiary designation. Must be made by formal application to the insurer. Compare to Beneficiary, Irrevocable.

CANCELLATION – Termination of the insurance contract by voluntary act of the insurer or insured, effected in accordance with provisions in the contract or by mutual agreement.

CARRIER – The insurance company that “carries” the insurance. Generally, the term “insurer” is preferred.

CASH SURRENDER VALUE – In life insurance, the value in a policy that is the legal property of the policyowner, and which the policyowner may receive if the policy is surrendered for cash. Synonymous with cash value.

CLAIM – The demand of an insured or his or her representative or beneficiary for benefits as provided by an insurance policy.

COMMISSION – The portion of the premium stipulated in the agency contract to be retained by the agent as compensation for sales, service, and distribution of insurance policies.

CONCEALMENT – The withholding, by an applicant for insurance, of facts that materially affect an insurance risk or loss.

CONDITIONAL RECEIPT – Provides that if the premium accompanies the application, the coverage is in force from the date of the application (whether the policy has yet been issued or not) provided the insurer would have issued the coverage on the basis of facts as revealed by the application and other usual sources of underwriting information.

CONTINGENT BENEFICIARY – Person or persons named to receive benefits if the primary beneficiary is not alive at the time the insured dies.

DEATH BENEFIT – The policy proceeds to be paid upon the death of the insured.

DEATH CLAIM – A formal request for payment of policy benefits occasioned by the death of the insured. Should be made through the agent, but may be made directly to the home office. Requires a copy of the death certificate as proof of death and is made by the beneficiary.

DECLARATION PAGE – The portion of an insurance policy containing the information regarding the risk.

DECREASING TERM INSURANCE – Term insurance for which the initial amount gradually decreases until the expiration date of the policy, at which time it reaches zero.

DOMESTIC COMPANY – An insurer formed under the laws of the state in which the insurance is written.

DOUBLE INDEMNITY – Payment of twice the basic benefit in event of loss resulting from specified causes or under specified circumstances.

EFFECTIVE DATE – The date on which an insurance policy goes into effect.

ENDORSEMENT – Technically, a change made directly on the policy form by writing, printing, stamping or typewriting and approved by an executive officer of the insurer. In general use, also may refer to a change made by means of a form attached to the policy.

ESTATE – Assets of an individual comprising total worth.



EXCLUSIONS – Stated exceptions to prior provisions in a policy. Common exclusions in health policies include pre-existing conditions, suicide, self-inflicted injuries, and many others. In life policies, common exclusions are death through flying in a private airplane, riot, or act of war.

EXPIRATION – The date upon which a policy’s coverage ceases.

FACE AMOUNT – The amount indicated on the face of a life policy that will be paid at death or when the policy matures.

FAMILY PLAN POLICY – An all-family plan, usually with permanent insurance on the father’s life, with mother and children automatically covered for a lesser amount.

FOREIGN COMPANY – An insurer organized under the laws of a state other than the one where the insurance is written.

FRAUD – An intentional misrepresentation made by a person with the intent to gain an advantage and relied upon by a second party which suffers a loss as a result.

GRACE PERIOD – A period of time after the premium due date during which a policy remains in force without penalty even though the premium due has not been paid. This period is commonly 30 or 31 days in life insurance policies.

HOME OFFICE – The place where an insurance company maintains its chief executives and general supervisory departments.

INSURABILITY – The condition of the proposed insured as to age, occupation, physical condition, medical history, moral fitness, financial condition and other factors that makes the individual an acceptable risk to an insurance company.

INSURABLE INTEREST – In life and health insurance, the interest of one party in the possible death or disability of an insured that would result in a significant emotional or financial loss. Such an interest must exist in order for the party to purchase insurance on the life or health of another.

INSURANCE DEPARTMENT – A governmental bureau in each state or territory charged with administration of the insurance laws, including licensing, examination, and regulation of agents and insurers. In some jurisdictions, the department is a division of some other state department or bureau.

INSURED – The party to an insurance contract to whom, or on behalf of whom, the insurer agrees to indemnify for losses, provide benefits, or render service.

INSURER – The party to an insurance contract that undertakes to indemnify for losses provides other pecuniary benefits, or renders service. Also called insurance company and sometimes-insurance carrier.

IRREVOCABLE BENEFICIARY – A named beneficiary whose status as beneficiary cannot be changed without his or her permission.

LAPSED POLICY – A policy for which the policyholder has failed to make the premium payment during the grace period, causing the coverage to be terminated.

LIFE EXPECTANCY – Average number of years of life remaining for persons at any given age.

LIFE INSURANCE – Insurance that pays a specified amount upon the death of the insured to the insured’s estate or to a beneficiary.


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LOAN VALUE – The amount of cash value in a policy which may be borrowed by the insured.

MISREPRESENTATION – Falsely representing the terms, benefits, or privileges of a policy on the part of an insurer or its agent. Falsely representing the health or other condition of the proposed insured on the part of an applicant.

MORTALITY RATE – The average number of people in a particular class who die each year.

NON-FORFEITURE OPTION – A legal provision whereby the life insurance policyowner may take the accumulated values in a policy as (1) paid-up insurance for a lesser amount (2) extended term insurance; or (3) lump-sum payment of cash value, less any unpaid premiums, or outstanding loans.

NON-PARTICIPATING POLICY – A policy that does not provide for the policyowner to share in dividends. Also called a nonpar policy.

NON-RESIDENT AGENT – An agent licensed in a state in which he or she is not a resident.

PAID-UP INSURANCE – A non-forfeiture option in life insurance policies under which insurance exists and no further premium payments are required.

PARTICIPATING POLICY – A policy in which the policyowner receives a share of policy dividends. Also called par policy.

PERMANENT INSURANCE – Life insurance with some type of cash value accumulation.

POLICY LOAN – A loan to the policyholder from the insurer using the insurance cash value as collateral.

PRE-AUTHORIZED CHECK PLAN – An arrangement under which the policyowner authorizes the insurer to draft his or her bank accounts for the (usually monthly) premium.

PRIMARY BENEFICIARY – The beneficiary named first to receive proceeds or benefits of a policy that provides death benefits.

PROOF OF DEATH – A usual requirement before paying a death claim is that a formal proof of death form of some type be submitted to the insurer.

REINSTATEMENT – Putting a lapsed policy back in force, sometimes requiring the payment of back premiums and evidence of insurability. Provision is usually made for a method of reinstating the policy to its original amount.

RIDER – An amendment attached to a policy that modifies the conditions of the policy by expanding or decreasing its benefits or excluding certain conditions from coverage.

SETTLEMENT OPTION – A method of receiving life insurance proceeds other than a lump sum.

STANDARD RISK – A risk that meets the same conditions of health, physical condition and morals as the risks on which the rate is based without extra rating or special restrictions.

SUICIDE CLAUSE – In a life insurance policy, states that if the insured commits suicide within a specified period of time, the policy will be voided. Paid premiums are usually refunded. The time limit is generally one or two years.

TERM INSURANCE – Life insurance that normally does not have cash accumulations and is issued to remain in force for a specified period of time, following which it is subject to renewal or termination.



WAIVER OF PREMIUM PROVISION – When included, provides that premiums are waived and the policy remains in force if the insured becomes totally and permanently disabled.

WHOLE LIFE – Permanent life insurance on which premiums are paid for the entire life of the insured.

Conclusion Any insurance agent selling life insurance policies to customers must maintain solid knowledge of the types of life insurance policies and the provisions of each policy in order to answer any questions and offer competent service to customers. By demonstrating command of the subject matter, the insurance agent will benefit from additional referrals and recommendations from satisfied, happy clients. The customer may also inquire regarding the life insurance company’s annuities, and working knowledge of these products should accompany the agent’s understanding of life insurance.


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Chapter Five / Regulation Of Insurance

CHAPTER 5 – REGULATION OF INSURANCE State vs. Federal Regulation The history of insurance regulation has its roots in 17th century England; however, the controversial and highly contested route of its development has resulted in a regulatory structure that is uniquely different than that found in other industries. There is no question, however, that the activities of American insurance companies are highly regulated, and few other businesses are guided by the strict controls and guidelines found in this industry.

To illustrate, an insurance company cannot establish operations without specific and regulated levels of operating funds. Other businesses do not have these start-of-business requirements. Similarly, insurance products must be sold by only state approved licensees, while other businesses may market their goods and services through whatever means they elect. Only the insurance industry must have its rates approved by the state in which it is operating, while other businesses are free to set their own prices and rates. Finally, regulations require insurance companies to maintain certain levels of funding (reserves) for the protection of their consumers.

Generally, in most other industries, the state regulatory focus becomes secondary to federal regulation as an industry matures, but the insurance industry in the United States has moved away from a centralized federal regulatory structure and the concentration of regulation has been passed to state governments.

Although the states exerted little control over insurance businesses prior to the Civil War, several states established statutes requiring charters for the insurers selling products within their boundaries. These charters and their provisions restricted insurance company activities and offerings, specified reserves, and established parameters regarding investments.

In some states, chartering bodies directed insurance companies to make their financial standings public, while others required insurers to publish annual reports. Companies in Massachusetts were mandated to make these reports public as early as 1818. Other states soon followed this lead, asking for annual reports from state-based insurance companies, and requiring insurers outside the state to make statements of their financial condition available. Other than these parameters, the insurance businesses of the time were allowed to operate as they chose.

While these chartering mechanisms provided regulatory guidelines for the industry, little was done to enforce these guidelines. The states were adept at issuing charters and often appointed various departments to tax their earnings from premiums, but the administrators assigned to regulate insurance businesses in certain states were not always effective in policing the industry in regards to legislation.

As a result, some companies made poor investment decisions and squandered their funds. Others simply went bankrupt. Still others used deceptive and unfair policy provisions. This roller coaster track record made it obvious that some type of regulation was necessary for the protection of the public. It also indicated a need for regulation to balance business activities and sustain the industry.

In an effort to more efficiently empower state regulatory offices, New Hampshire was the first state to establish a three-seat insurance commission in 1851. The board was later reorganized to include a single commissioner in 1869. Other states followed, and today, state insurance commissions continue to exercise substantial influence within the insurance industry.


In 1855, the state of Massachusetts established the first department of insurance and in 1858 appointed mathematics professor Elizur Wright as insurance commissioner. Wright would later be credited as the person who contributed most to the future of insurance supervision, due to his concept of regulation as a means to promote insurer solvency.

Shortly after New Hampshire created the first insurance commission, the U.S. House of Representatives proposed a bill to establish a national bureau of insurance as an adjunct of the Treasury Department. Two years later, the Senate proposed a similar bill. Both were defeated, however. The reason for the failure of the two bills, it was speculated, was because the country was not yet ready to embrace the idea of federal control of the insurance industry.

In the early 1900s, the effectiveness of the regulation of the insurance industry was studied by two separate committees. The New York legislature appointed a committee (the Armstrong Committee) for the purpose of studying the life insurance industry in 1905. The committee reported finding several areas of abuse regarding financial reporting and other wrongdoings resulting from the lack of effective regulation.

In 1910, the New York legislature appointed the Merritt Committee to investigate non-life insurance lines. This committee reported that price competition would result in rate wars that would be devastating to the industry. It noted that insurers that had only marginal operations would be forced to offer coverage at a slightly lower rate and that those insurers with stronger operations would respond to these decreases by lowering their rates. Eventually, this would create a problem for the margin insurers, which would result in bankruptcies. This study reported that cartel insurance pricing was acceptable for the public good as well as for the good of the industry.

In most states, the insurance department is part of the executive branch of state government, and it is under the direction of the insurance commissioner. In a few instances, this is an elected position. However, in other states, the governor appoints the commissioner. The commissioner’s main duty is to administer the insurance laws of the state, with the assistance of staff members. In most states, the insurance department is represented by a force of anywhere from 50 to 100 persons.

National Association of Insurance Commissioners Paramount to the success of the state departments of insurance is the National Association of Insurance Commissioners (NAIC), a nongovernmental body developed to coordinate the activities of the individual state insurance departments. Founded by George W. Miller, the second superintendent of insurance for the state of New York, the early goals of the NAIC were those of uniformity of examination practices, annual reporting statements, and laws.

The first meeting of the body was in 1871 and included the insurance commissioners of each state. It became a voluntary organization, and through the guidance of the NAIC, the state departments began to avoid the confusion of uncoordinated operations. Today, the NAIC meets twice yearly, with regional meetings scheduled between meetings of the entire NAIC body. Various committees from the organization work throughout the year on specific topics. Many committees focus on standardization procedures and formats, but others have developed information included on policies and policy statements.

As a body, the group is committed to the development of legislative recommendations. Once the need for a new law is identified, a specific committee studies the situation and makes a recommendation to the larger group. If the group can pass the measure, it is submitted to the legislatures of the states involved in the form of a model bill for discussion. Although some


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states eventually reject some of these legislative proposals, the process has resulted in a growing uniformity of the industry’s regulation throughout the country.

The NAIC continues to study the problems and changes within the industry. Task force groups use advisory committees made up of insurers and the public-at-large to investigate issues and ideas to improve the industry as a whole. For example, one NAIC task force gave primary attention to the use of gender and marital status as classification factors used in automobile insurance ratings and comprehensive health insurance coverage. Another looked at the question of state versus federal insurance regulation and ways to detect insurer insolvency before it actually occurred.

The NAIC’s statement of intent highlights that the NAIC is committed to modernize insurance regulations to meet the realities of an increasingly dynamic and internationally competitive financial service market. Ultimately, the NAIC is committed to work cooperatively with governors, state legislators, federal officials, consumers, companies, agents, and other interested parties in order to facilitate and enhance this new evolving marketplace.

The Financial Services and Modernization Act of 1999, which is known as the Gramm-Leach-Bliley Act (GLBA), established a comprehensive framework to permit affiliations among banks, securities firms, and insurance companies. GLBA acknowledged that states should regulate the business of insurance. However, Congress also called for state reforms to allow insurance companies to compete more effectively in the newly integrated financial service marketplace and to respond with innovation and flexibility to increasingly demanding consumer needs.

Working with governors and state legislators, the NAIC has undertaken a thorough review of respective state laws to determine needed regulatory or statutory changes to achieve functional regulation as outlined by GLBA.

The NAIC is committed to uniformity in producer licensing and the creation of uniform licensing standards. As a necessary interim step, the NAIC has adopted the Producer Licensing Model Act for consideration by state legislatures. The model act provides specific multi-state reciprocity provisions to comply with the requirements of GLBA. Seeing reciprocity as only a short range solution, the NAIC has empowered the Insurance Regulatory Information Network to develop recommendations for a streamlined national producer licensing process that will reduce the cost and complexity of regulatory compliance related to the current multi-state process.

According to the NAIC, the model act creates uniformity in agent licensing procedures, defines the exceptions to licensing; simplifies the licensing process; promotes the Insurance Regulatory Network and Producer Database; creates reciprocity while preserving states’ rights; eliminates the regulation of business relationships through key commission-sharing provisions; and eliminates retaliatory fees.

The NAIC is in the process of refining their risk-based approach to examining the insurance operations of financial holding companies to place greater emphasis on a company’s unique risk exposures and how it manages those risks.

The NAIC is committed to enhance communication and coordination among all functional regulators and is reviewing the role of NAIC resources in supporting such communication and coordination. The NAIC is committed to pursue development of a group wide approach to regulating insurer groups and enhancing coordination among states.


Gramm-Leach-Bliley Act Historic legislation affecting the banking industry in the United States intended to keep banks out of businesses that would be risky and thereby put the depositors’ funds at risk.

The National Banking Act of 1864 gave banks the power to carry out tasks directly necessary and incidental to banking business, however insurance was not considered incidental to the banking business and therefore a prohibited activity.

The stock market crash of 1929 caused the public to lose confidence in the banking system. Congress passed the Glass-Steagall Act of 1933 in an attempt to restore confidence in banks. The Glass-Steagall Act prevented a commercial bank from affiliating with any entity that was principally engaged in the sale of securities. However, banks were still allowed to operate holding companies. Through these holding companies and their affiliates banks were able to avoid some of these restrictions and became involved in the securities and insurance businesses.

Over the years decisions made by regulatory agencies that oversee banks (such as the Federal Reserve, the Office of the Controller of Currency, and the Office of Thrift Supervision) effectively allowed banks to enter into insurance and other financial businesses.

Additional legislation in 1985 and 1986 continued to eliminate the barriers intended to keep banks out of the insurance business. In 1985 the Controller of Currency declared insurance a general investment product, thereby allowing banks to become involved in the insurance business. Additionally, over the years if a bank was located in a town with a population of 5,000 people or less, the bank was allowed to sell insurance. In 1986 the Controller’s office expanded this loophole and permitted banks to sell insurance products in towns with populations over 5,000 so long as the transaction was conducted through a subsidiary of the bank or branch located in a town of under 5,000. The insurance industry challenged these decisions in court but the challenges were ineffective and banks were allowed to continue entering the insurance business.

When BankAmerica acquired Charles Schwab and Company in 1981 and Citicorp and Travelers Group merged in 1988 it became obvious banks were in the securities and insurance businesses to stay. Congress now realized that there was a need for legislation that recognized this change and which would provide necessary safeguards to protect the public’s interests.

Through the 1980s and 1990s Congress debated the deregulation of financial industries a number of times; however, each time there was an attempt to pass legislation removing the barriers or regulating the entry of banks into financial investment and insurance businesses, the legislation failed to pass. In 1999 Congress realized it was time to take action and passed the Financial Services and Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act (GLBA), which was signed into law by President Clinton on November 12, 1999.

GLBA impacts the insurance industry in two key ways. First, GLBA brings federal regulation to insurance sales primarily through the regulation of insurance producers. This is to be accomplished first and foremost by creating uniformity in the regulation of producers throughout the nation. The second major impact is the protection of personal financial information.

In taking the steps to comply with GLBA most states found it necessary to update and amend existing legislation and pass some new laws. For example, Illinois amended both its license law and its administrative code provisions affecting insurance law.


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Creating Uniformity in the Regulation of Insurance Producers Subtitle B of Title III of the GLBA sets forth the national standards required for insurance producer licensing. To insure swift action by the states to comply with the new regulations, GLBA actually set forth an ultimatum. If the requirements were not met within a specified time frame the NAIC was to oversee the creation of a group named the National Association of Registered Agents and Brokers (NARAB).

The purpose of the NARAB would be to provide a mechanism through which uniform licensing, appointment, continuing education, and other insurance producer sales qualification requirements and conditions would be adopted and applied on a multistate basis, while preserving the right of states to license, supervise, and discipline insurance producers and to prescribe and enforce laws and regulations with regard to insurance-related consumer protection and unfair trade practices.

The legislators that put these rules together felt so strongly about the need for uniformity and reciprocity to truly meet the goals of GLBA that the law even goes on to create steps that would be taken toward creation of NARAB if the NAIC did not take action on these issues.

The NAIC moved swiftly to take action and the creation of NARAB has not and will probably never be required. However, the text of this portion of GLBA appears here.

GRAMM-LEACH-BLILEY ACT

Subtitle C—National Association of Registered Agents and Brokers

SEC. 321. STATE FLEXIBILITY IN MULTISTATE LICENSING REFORMS.

(a) In General.--The provisions of this subtitle shall take effect unless, not later than 3 years after the date of the enactment of this Act, at least a majority of the States

(1) have enacted uniform laws and regulations governing the licensure of individuals and entities authorized to sell and solicit the purchase of insurance within the State; or

(2) have enacted reciprocity laws and regulations governing the licensure of nonresident individuals and entities authorized to sell and solicit insurance within those States.

(b) Uniformity Required.--States shall be deemed to have established the uniformity necessary to satisfy subsection (a)(1) if the States

(1) establish uniform criteria regarding the integrity, personal qualifications, education, training, and experience of licensed insurance producers, including the qualification and training of sales personnel in ascertaining the appropriateness of a particular insurance product for a prospective customer;

(2) establish uniform continuing education requirements for licensed insurance producers;

(3) establish uniform ethics course requirements for licensed insurance producers in conjunction with the continuing education requirements under paragraph (2);


(4) establish uniform criteria to ensure that an insurance product, including any annuity contract, sold to a consumer is suitable and appropriate for the consumer based on financial information disclosed by the consumer; and

(5) do not impose any requirement upon any insurance producer to be licensed or otherwise qualified to do business as a nonresident that has the effect of limiting or conditioning that producer’s activities because of its residence or place of operations, except that countersignature requirements imposed on nonresident producers shall not be deemed to have the effect of limiting or conditioning a producer’s activities because of its residence or place of operations under this section.

(c) Reciprocity Required.--States shall be deemed to have established the reciprocity required to satisfy subsection (a) (2) if the following conditions are met:

(1) Administrative licensing procedures.--At least a majority of the States permit a producer that has a resident license for selling or soliciting the purchase of insurance in its home State to receive a license to sell or solicit the purchase of insurance in such majority of States as a nonresident to the same extent that such producer is permitted to sell or solicit the purchase of insurance in its State, if the producer’s home State also awards such licenses on such a reciprocal basis, without satisfying any additional requirements other than submitting

(A) a request for licensure;

(B) the application for licensure that the producer submitted to its home State;

(C) proof that the producer is licensed and in good standing in its home State; and

(D) the payment of any requisite fee to the appropriate authority.

(2) Continuing education requirements.--A majority of the States accept an insurance producer’s satisfaction of its home State’s continuing education requirements for licensed insurance producers to satisfy the States’ own continuing education requirements if the producer’s home State also recognizes the satisfaction of continuing education requirements on such a reciprocal basis.

(3) No limiting nonresident requirements.--A majority of the States do not impose any requirement upon any insurance producer to be licensed or otherwise qualified to do business as a nonresident that has the effect of limiting or conditioning that producer’s activities because of its residence or place of operations, except that countersignature requirements imposed on nonresident producers shall not be deemed to have the effect of limiting or conditioning a producer’s activities because of its residence or place of operations under this section.

(4) Reciprocal reciprocity.--Each of the States that satisfies paragraphs (1), (2), and (3) grants reciprocity to residents of all of the other States that satisfy such paragraphs.

(d) Determination.-

(1) NAIC determination.--At the end of the 3-year period beginning on the date of the enactment of this Act, the National Association of Insurance Commissioners (hereafter in this subtitle referred to as the ‘‘NAIC’’) shall determine, in consultation with the insurance commissioners or chief insurance regulatory


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officials of the States, whether the uniformity or reciprocity required by subsections (b) and (c) has been achieved.

(2) Judicial review.--The appropriate United States district court shall have exclusive jurisdiction over any challenge to the NAIC’s determination under this section and such court shall apply the standards set forth in section 706 of title 5, United States Code, when reviewing any such challenge.

(e) Continued Application.--If, at any time, the uniformity or reciprocity required by subsections (b) and (c) no longer exists the provisions of this subtitle shall take effect 2 years after the date on which such uniformity or reciprocity ceases to exist, unless the uniformity or reciprocity required by those provisions is satisfied before the expiration of that 2-year period.

(f) Savings Provision.--No provision of this section shall be construed as requiring that any law, regulation, provision, or action of any State which purports to regulate insurance producers, including any such law, regulation, provision, or action which purports to regulate unfair trade practices or establish consumer protections, including countersignature laws, be altered or amended in order to satisfy the uniformity or reciprocity required by subsections (b) and (c), unless any such law, regulation, provision, or action is inconsistent with a specific requirement of any such subsection and then only to the extent of such inconsistency.

(g) Uniform Licensing.--Nothing in this section shall be construed to require any State to adopt new or additional licensing requirements to achieve the uniformity necessary to satisfy subsection

Sections 322 through 335 of GLBA go on to establish the alternative if the goals of section 321 are not met. The formation of the National Association of Registered Agents and Brokers would accomplish these goals.

SEC. 322. NATIONAL ASSOCIATION OF REGISTERED AGENTS AND BROKERS.

(a) Establishment.--There is established the National Association of Registered Agents and Brokers (hereafter in this subtitle referred to as the ‘‘Association’’).

(b) Status.--The Association shall-

(1) be a nonprofit corporation;

(2) have succession until dissolved by an Act of Congress;

(3) not be an agent or instrumentality of the United States Government; and

(4) except as otherwise provided in this Act, be subject to, and have all the powers conferred upon a nonprofit corporation by the District of Columbia Nonprofit Corporation Act (D.C. Code, sec. 29y-1001 et seq.).

SEC. 323. PURPOSE.

The purpose of the Association shall be to provide a mechanism through which uniform licensing, appointment, continuing education, and other insurance producer sales qualification requirements and conditions can be adopted and applied on a multistate basis, while preserving the right of States to license, supervise, and discipline insurance producers and to prescribe and enforce laws and regulations with regard to insurance-related consumer protection and unfair trade practices.


SEC. 324. RELATIONSHIP TO THE FEDERAL GOVERNMENT.

The Association shall be subject to the supervision and oversight of the NAIC.

The NAIC created the NARAB Working Group to help states implement the requirements of Section 321 of Subtitle C and avoid the formation of NARAB as called for in Sections 322 through 335.

William J. Kirven III, Co-Chair of the Working Group testified before a subcommittee of the United States House of Representatives stating “NAIC and State insurance regulators wholeheartedly support the licensing goals endorsed by Congress in NARAB. We (the insurance commissioners) do not, however, believe NARAB is necessary. Moreover, we believe the creation of NARAB as a separate organization would undermine the legal authority of State insurance departments to protect consumers throughout the United States. If NARAB were to prevent States from exercising their full range of powers to regulate insurance for the benefit of consumers, there would be nobody to perform this vital function.”

Reciprocity and Uniformity Requirements Subtitle C of the GLBA provides the states with two approaches to avoid creation of NARAB. The first is for states to recognize and accept the licensing procedures of other states on a reciprocal basis so agents will not be required to meet different standards in each state. In order to achieve reciprocity under the NARAB provisions, a majority of states and United States territories must have laws and regulations that guarantee reciprocal treatment for non-resident agents doing business in more than one state. The required reciprocity will be reached if a majority of states and territories do all of the following:

• Permit a producer licensed to sell insurance in his or her home state to sell in non-resident states after satisfying only minimum requirements such as submission of a licensing application and payment of all applicable fees.

• Accept the satisfaction by a producer of his or her home state’s continuing education requirements.

• Do not limit or condition producers’ activities because of residence or place of operations (except that counter-signature requirements are still permitted).

• Grant reciprocity to all other states meeting reciprocity requirements.

Alternatively, the States can avoid the creation of NARAB by adopting uniform laws and regulations regarding non-resident agent licensing. Laws and regulations will be deemed to be uniform under the NARAB provisions if the states do each of the following:

• Establish uniform criteria for integrity, personal qualifications, education, training, and experience of licensed insurance producers.

• Establish uniform continuing education requirements.

• Establish uniform ethics course requirements.

• Establish uniform criteria regarding the suitability of insurance products for specific customers.

• Do not limit or condition producers’ activities due to residency or place of operations.

The Producer Licensing Model Act Prior to passage of the GLBA, the NAIC was working on an improved Producer Licensing Model Act to promote uniformity and efficiency among the States. NAIC moved quickly to


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amend this model legislation to incorporate the NARAB reciprocity provisions required by the GLBA.

The NAIC’s Producer Licensing Model Act has been used as the primary vehicle for the States to implement the GLBA requirements for licensing reciprocity. Adoption of the Model Act by a majority of states assured that the NAIC and the industry would be in compliance with the NARAB reciprocity requirements. The NAIC further asserts that adoption and implementation of the Model Act does much more than simply satisfy the minimum requirements of the GLBA. The Model Act creates a foundation for achieving the ultimate goal of uniformity among the States for agent licensing.

As of August 2004, 49 states and Guam had passed the Producer Licensing Model Act (PLMA) or other licensing laws with the intent of satisfying the reciprocity licensing mandates of GLBA.

42 states have been certified by the NAIC as meeting the requirements for producer licensing reciprocity under GLBA.

The NAIC states that the only significant barriers to national reciprocity are fingerprinting and surplus lines bond requirements for nonresident producers, as these represent core consumer-protection issues to the states that have them in place. However, the NAIC indicates that a state that is reciprocal is not precluded from extending reciprocity to states that maintain these consumer protection requirements, which may further expand the scope of reciprocity.

30 states plus the District of Columbia are processing non-resident applications electronically through the National Insurance Producer Registry (NIPR) gateway.

The Uniform Non-Resident Application is now accepted in 49 states and the District of Columbia.

The states under the guidance of NAIC have made great progress in implementing the requirements of GLBA and thereby have seemingly made the creation of the NARAB unnecessary.

Illinois has been an active participant in the dialog and planning during this transitional period and has passed its own legislation to bring the state into compliance. Illinois adopted a new licensing act incorporating the necessary elements of the Producer Licensing Model Act on August 16, 2001.

Protecting Privacy When GLBA expressly allowed financial institutions that had operated as separate companies to be combined or owned by the same entity (for example, banks owning or operating as insurance brokers), it opened new opportunities for the use of information gained from operations in one business area to be used by other segments of the business.

To protect against the possibility of these intertwined business relationships intruding on individual privacy rights, GLBA includes provisions to protect consumers’ personal financial information held by financial institutions. There are three principal parts to the privacy requirements:

• The Financial Privacy Rule.

• The Safeguards Rule.

• The Pretexting provisions.


The GLBA gives authority to eight federal agencies and the states to administer and enforce the Financial Privacy Rule and the Safeguards Rule. These two regulations apply to “financial institutions,” which include not only banks, securities firms, and insurance companies, but also companies providing many other types of financial products and services to consumers. Among these services are lending, brokering or servicing any type of consumer loan, transferring or safeguarding money, preparing individual tax returns, providing financial advice or credit counseling, providing residential real estate settlement services, collecting consumer debts, and an array of other activities. The previously unregulated non-traditional “financial institutions” are regulated by the Federal Trade Commission (FTC).

The Financial Privacy Rule governs the collection and disclosure of customers’ personal financial information by financial institutions. It also applies to companies, whether or not they are financial institutions, who receive such information.

The Safeguards Rule requires all financial institutions to design, implement, and maintain safeguards to protect customer information. The Safeguards Rule applies not only to financial institutions that collect information from their own customers, but also to financial institutions, such as credit reporting agencies that receive customer information from other financial institutions.

The pretexting provisions of the GLBA protect consumers from individuals and companies that obtain their personal financial information under false pretenses, a practice known as “pretexting.” An example of pretexting would be a phone survey claiming to be gathering information to allow insurance companies the opportunity to create new policies that will be better for all insureds, when in truth the information will be used to better organize a presentation to sell insurance to the consumer being questioned, or in a worst scenario, to use the information to steal a person’s identity.

Financial Privacy Rule Protecting the privacy of consumer information held by “financial institutions” is at the heart of the financial privacy provisions of the GLBA. The GLBA requires companies to give consumers privacy notices that explain the institutions’ information-sharing practices. In turn, consumers have the right to limit some, although not all, sharing of their information.

The GLBA applies to “financial institutions” that offer financial products or services to individuals. This of course includes insurance businesses. The law requires that financial institutions protect information collected about individuals; it does not apply to information collected in business or commercial activities.

A company’s obligations under the GLBA depend on whether the company has consumers or customers who obtain its services.

• A consumer is an individual who obtains or has obtained a financial product or service from a financial institution for personal, family, or household reasons.

• A customer is a consumer with a continuing relationship with a financial institution. Generally, if the relationship between the financial institution and the individual is significant and/or long-term, the individual is a customer of the institution.

For example, a person who purchases an insurance policy from an insurer is considered a customer of the company and the insurance producer that assisted in the purchase, while a person who makes application or discloses personal financial information during an interview is considered to have a consumer relationship with the company and producer.


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The difference between consumers and customers is important because only customers are entitled to automatically receive a financial institution’s privacy notice. Although there are some exceptions, consumers are entitled to receive a privacy notice from a financial institution only if the company shares the consumers’ information with companies not affiliated with it. Customers on the other hand, must receive a notice every year for as long as the customer relationship lasts.

The privacy notice must be delivered to individual customers or consumers by mail or in person; it may not be posted on a wall with the mere hope that the customer sees it. Reasonable methods to deliver a notice may depend on the institution’s business. For example, an insurance company taking applications at its website may post its privacy notice on its website and require online consumers to acknowledge receipt as a necessary part of an application.

The privacy notice must be a clear, conspicuous, and accurate statement of the company’s privacy practices; it should include each of the following:

• Information the company collects about its consumers and customers.

• The parties with whom it shares the information; and

• The manner in which it protects or safeguards the information.

The notice applies to the “nonpublic personal information” the company gathers and discloses about its consumers and customers. In practice, that may be most or all of the information a company has about consumers and its customers. For example, nonpublic personal information could be information that a consumer or customer puts on an application, information about the individual from another source, such as a credit bureau, or information about transactions between the individual and the company, such as an account balance. Indeed, even the fact that an individual is a consumer or customer of a particular financial institution is nonpublic personal information. But information that the company has reason to believe is lawfully public, such as mortgage loan information in a jurisdiction where that information is publicly recorded, is not restricted by the GLBA.

Consumers and customers have the right to opt out of or say no to allowing their information to be shared with certain third parties. The privacy notice must explain how and offer a reasonable way for the party to opt out. For example, providing a toll-free telephone number or a detachable form with a pre-printed address is a reasonable way for consumers or customers to opt out; requiring someone to write a letter as the only way to opt out is not acceptable.

The privacy notice also must explain that consumers have a right to say no to the sharing of certain information including credit report or credit application information, with a financial institution’s affiliates.

An affiliate is an entity that does one of the following:

• Controls the company.

• Is controlled by the company.

• Is under common control with the company.

The GLBA does not give consumers the right to opt out when the financial institution shares other information with its affiliates, and the GLBA provides no opt-out right in several other situations. For example, an individual cannot opt out if:


• A financial institution shares information with outside companies that provide essential services like data processing or servicing accounts.

• The disclosure is legally required.

• A financial institution shares customer data with outside service providers that market the financial company’s products or services.

Safeguards Rule The Safeguards Rule was adopted in May of 2000. These rules are written in an understandable and relatively brief format. Therefore we have included most of the actual rule below. We have removed some of the specific references to sections of law that will not affect your understanding of the rule, and we have also added some short clarifying remarks, although the rule is primarily self explanatory.

STANDARDS FOR SAFEGUARDING CUSTOMER INFORMATION 1. Purpose and scope (a) Purpose. This part, which implements sections 501 and 505(b)(2) of the Gramm-

Leach-Bliley Act, sets forth standards for developing, implementing, and maintaining reasonable administrative, technical, and physical safeguards to protect the security, confidentiality, and integrity of customer information.

(b) Scope. This part applies to the handling of customer information by all financial institutions over which the Federal Trade Commission (‘‘FTC’’ or ‘‘Commission’’) has jurisdiction. This part refers to such entities as ‘‘you.’’ This part applies to all customer information in your possession, regardless of whether such information pertains to individuals with whom you have a customer relationship, or pertains to the customers of other financial institutions that have provided such information to you.

2. Definitions (a) In general except as modified by this part or unless the context otherwise requires, the

terms used in this part have the same meaning as set forth in the Commission’s rule governing the Privacy of Consumer Financial Information.

(b) Customer information means any record containing nonpublic personal information … about a customer of a financial institution, whether in paper, electronic, or other form, that is handled or maintained by or on behalf of you or your affiliates.

(c) Information security program means the administrative, technical, or physical safeguards you use to access, collect, distribute, process, protect, store, use, transmit, dispose of, or otherwise handle customer information.

(d) Service provider means any person or entity that receives, maintains, processes, or otherwise is permitted access to customer information through its provision of services directly to a financial institution that is subject to this part.

3. Standards for safeguarding customer information (a) Information security program. You shall develop, implement, and maintain a

comprehensive information security program that is written in one or more readily accessible parts and contains administrative, technical, and physical safeguards that are appropriate to your size and complexity, the nature and scope of your activities, and the sensitivity of any customer information at issue. Such safeguards shall include


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the elements set forth in section 4 of this rule and shall be reasonably designed to achieve the objectives of this part, as set forth in paragraph (b) of this section.

(b) Objectives. The objectives of … the Act, and of this part, are to:

(1) Insure the security and confidentiality of customer information;

(2) Protect against any anticipated threats or hazards to the security or integrity of such information; and

(3) Protect against unauthorized access to or use of such information that could result in substantial harm or inconvenience to any customer.

4. Elements In order to develop, implement, and maintain your information security program, you

shall:

(a) Designate an employee or employees to coordinate your information security program.

(b) Identify reasonably foreseeable internal and external risks to the security, confidentiality, and integrity of customer information that could result in the unauthorized disclosure, misuse, alteration, destruction or other compromise of such information, and assess the sufficiency of any safeguards in place to control these risks. At a minimum, such a risk assessment should include consideration of risks in each relevant area of your operations, including:

(1) Employee training and management;

(2) Information systems, including network and software design, as well as information processing, storage, transmission and disposal; and

(3) Detecting, preventing and responding to attacks, intrusions, or other systems failures.

(c) Design and implement information safeguards to control the risks you identify through risk assessment, and regularly test or otherwise monitor the effectiveness of the safeguards’ key controls, systems, and procedures.

(d) Oversee service providers, by:

(1) Taking reasonable steps to select and retain service providers that are capable of maintaining appropriate safeguards for the customer information at issue; and

(2) Requiring your service providers by contract to implement and maintain such safeguards.

(e) Evaluate and adjust your information security program in light of the results of the testing and monitoring required by paragraph (c) of this section; any material changes to your operations or business arrangements; or any other circumstances that you know or have reason to know may have a material impact on your information security program.

5. Effective dates (a) Each financial institution subject to the Commission’s jurisdiction must implement an

information security program pursuant to this part no later than May 23, 2003.

(b) Two-year grandfathering of service contracts. Until May 24, 2004, a contract you have entered into with a nonaffiliated third party to perform services for you or functions on


your behalf satisfies the provisions of 4(d), even if the contract does not include a requirement that the service provider maintain appropriate safeguards, as long as you entered into the contract not later than June 24, 2002.

These rules are issued by the FTC specifically for those businesses that are under its jurisdictions regarding oversight of the provisions of the GLBA. Although the insurance business is not under the control of the FTC there is a potential that businesses that fall under these rules could be involved in an insurance transaction.

To recap, the GLBA includes as non-public personal financial information; names, addresses and phone numbers; bank and credit card account numbers; income and credit histories; and Social Security numbers.

The Safeguards Rule applies to businesses, regardless of size, that are “significantly engaged” in providing financial products or services to consumers. In addition to developing their own safeguards, financial institutions are responsible for taking steps to ensure that their affiliates and service providers safeguard customer information in their care. This is why it is good business to check out the practices of firms you do business with to see that they are in compliance with these rules.

Adequately securing customer information is not only the law, it makes good business sense. When you show customers that you care about the security of their personal information, you increase their level of confidence in your business. Poorly-managed customer data can lead to identity theft. Identity theft occurs when someone steals a consumer’s personal identifying information to open new charge accounts, order merchandise, or borrow money.

Implementing Safeguards The Safeguards Rule requires financial institutions to develop a written information security plan that describes their program to protect customer information. The plan must be appropriate to the financial institution’s size and complexity, the nature and scope of its activities, and the sensitivity of the customer information it handles. As part of its plan, each financial institution must do each of the following:

• Designate one or more employees to coordinate the safeguards.

• Identify and assess the risks to customer information in each relevant area of the company’s operation and evaluate the effectiveness of the current safeguards for controlling these risks.

• Design and implement a safeguards program, and regularly monitor and test it.

• Select appropriate service providers and contract with them to implement safeguards.

• Evaluate and adjust the program in light of relevant circumstances, including changes in the firm’s business arrangements or operations, or the results of testing and monitoring of safeguards.

These requirements are designed to be flexible. Each financial institution should implement safeguards appropriate to its own circumstances. For example, some financial institutions may choose to describe their safeguards programs in a single document, while others may memorialize their plans in several different documents, such as one to cover an information technology division and another to describe the training program for employees. Similarly, a company may decide to designate a single employee to coordinate safeguards or may spread this responsibility among several employees who will work together. An insurance producer should be aware of how and where they fit into the safeguards of the companies with which they work. © 2006 Bookmark Education www.BookmarkEducation.com

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In addition, a firm with a small staff may design and implement a more limited employee training program than a firm with a large number of employees. A financial institution that doesn’t receive or store any information online may take fewer steps to assess risks to its computers than a firm that routinely conducts business online.

When a firm implements safeguards, the Safeguards Rule requires it to consider all areas of its operation, including three areas that are particularly important to information security: employee management and training; information systems; and managing system failures. Firms should consider implementing the following practices in these areas:

Employee Management and Training The success or failure of an information security plan depends largely on the employees who implement it. A company may want to:

• Check references prior to hiring employees who will have access to consumer or customer information.

• Ask every new employee to sign an agreement to follow the organization’s confidentiality and security standards for handling non-public financial information.

• Train employees to take basic steps to maintain the security, confidentiality and integrity of customer information, such as:

• Locking rooms and file cabinets where paper records are kept.

• Using password-activated screensavers.

• Using strong passwords.

• Changing passwords periodically, and not posting passwords near employees’ computers.

• Encrypting sensitive customer information when it is transmitted electronically over networks or stored online.

• Referring calls or other requests for customer information to designated individuals who have had safeguards training.

• Recognizing any fraudulent attempt to obtain customer information and reporting it to appropriate law enforcement agencies.

• Instruct and regularly remind all employees of your organization’s policy - and the legal requirement - to keep customer information secure and confidential and post reminders about their responsibility for security in areas where such information is stored.

• Limit access to customer information to employees who have a business reason for seeing it. For example, grant access to customer information files to employees who respond to customer inquiries, but only to the extent they need it to do their job.

• Impose disciplinary measures for any breaches.

Information Systems Information systems include network and software design, and information processing, storage, transmission, retrieval, and disposal. Here are some suggestions from the FTC on how to maintain security throughout the life cycle of customer information - that is, from data entry to data disposal:


• Store records in a secure area. Make sure only authorized employees have access to the area. For example:

• Store paper records in a room, cabinet, or other container that is locked when unattended.

• Ensure that storage areas are protected against destruction or potential damage from physical hazards, like fire or floods.

• Store electronic customer information on a secure server that is accessible only with a password - or has other security protections - and is kept in a physically-secure area.

• Don’t store sensitive customer data on a machine with an Internet connection.

• Maintain secure backup media and keep archived data secure, for example, by storing off-line or in a physically-secure area.

• Provide for secure data transmission (with clear instructions and simple security tools) when you collect or transmit customer information. Specifically:

• If you collect credit card information or other sensitive financial data, use a Secure Sockets Layer (SSL) or other secure connection so that the information is encrypted in transit.

• If you collect information directly from consumers, make secure transmission automatic. Caution consumers against transmitting sensitive data, like account numbers, via electronic mail.

• If you must transmit sensitive data by electronic mail, ensure that such messages are password protected so that only authorized employees have access.

• Dispose of customer information in a secure manner. For example:

• Hire or designate a records retention manager to supervise the disposal of records containing nonpublic personal information.

• Shred or recycle customer information recorded on paper and store it in a secure area until a recycling service picks it up.

• Erase all data when disposing of computers, diskettes, magnetic tapes, hard drives or any other electronic media that contain customer information.

• Effectively destroy the hardware.

• Promptly dispose of outdated customer information.

Managing System Failures Effective security management includes the prevention, detection, and response to attacks, intrusions or other system failures. Consider the following suggestions:

• Maintain up-to-date and appropriate programs and controls by:

• Following a written contingency plan to address any breaches of your physical, administrative or technical safeguards;

• Checking with software vendors regularly to obtain and install patches that resolve software vulnerabilities;

• Using anti-virus software that updates automatically;


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• Maintaining up-to-date firewalls, particularly if you use broadband Internet access or allow employees to connect to your network from home or other off-site locations; and

• Providing central management of security tools for your employees and passing along updates about any security risks or breaches.

• Take steps to preserve the security, confidentiality, and integrity of customer information in the event of a computer or other technological failure. For example, back up all customer data regularly.

• Maintain systems and procedures to ensure that access to nonpublic consumer information is granted only to legitimate and valid users. For example, use tools like passwords combined with personal identifiers to authenticate the identity of customers and others seeking to do business with the financial institution electronically.

• Notify customers promptly if their nonpublic personal information is subject to loss, damage, or unauthorized access.

Permitted Disclosure of Nonpublic Personal Information The GLBA puts some limits on how anyone that receives nonpublic personal information from a financial institution can use or re-disclose the information. Take the case of an insurance company that discloses customer information to a service provider responsible for mailing premium notices, where the consumer has no right to opt out. The service provider may use the information for the limited purpose of mailing the notices. It may not sell the information to other organizations or use it for marketing.

However, it’s a different scenario when a company receives nonpublic personal information from a financial institution that provided an opt-out notice when the consumer didn’t opt out. In this case, the recipient steps into the shoes of the disclosing financial institution, and may use the information for its own purposes or re-disclose it to a third party, consistent with the financial institution’s privacy notice. That is, if the privacy notice of the financial institution allows for disclosure to other unaffiliated financial institutions – like insurance providers – the recipient may re-disclose the information to an unaffiliated insurance provider.

Other GLBA Provisions Other important provisions of the GLBA also impact how a company conducts business. For example, financial institutions are prohibited from disclosing their customers’ account numbers to non-affiliated companies when it comes to telemarketing, direct mail marketing or other marketing through e-mail, even if the individuals have not opted out of sharing the information for marketing purposes.

As we mentioned above, another provision prohibits “pretexting.” Pretexting is the practice of obtaining customer information from financial institutions under false pretenses. The FTC has brought several cases against information brokers who engage in pretexting.

Under the GLBA it is illegal for anyone to:

• Use false, fictitious, or fraudulent statements or documents to get customer information from a financial institution or directly from a customer of a financial institution.

• Use forged, counterfeit, lost, or stolen documents to get customer information from a financial institution or directly from a customer of a financial institution.

• Ask another person to get someone else’s customer information using false, fictitious, or fraudulent statements or using false, fictitious, or fraudulent documents or forged, counterfeit, lost, or stolen documents.


Pretexting can lead to “identity theft.” Identity theft occurs when someone hijacks personal identifying information to open new charge accounts, order merchandise, or borrow money. Consumers targeted by identity thieves usually don’t know they’ve been victimized until the hijackers fail to pay the bills or repay the loans, and collection agencies begin dunning the consumers for payment of accounts they didn’t even know they had.

According to the FTC, the most common forms of identity theft are:

• Credit card fraud - a credit card account is opened in a consumer’s name or an existing credit card account is “taken over.”

• Communications services fraud - the identity thief opens telephone, cellular, or other utility service in the consumer’s name.

• Bank fraud - a checking or savings account is opened in the consumer’s name, and/or fraudulent checks are written.

• Fraudulent loans - the identity thief gets a loan, such as a car loan, in the consumer’s name.

GLBA – Summary The insurance industry will continue to feel the impact of the GLBA as the most important federal law affecting the insurance industry in recent years; the GLBA has already provided significant benefits with respect to multi-state coordination and reciprocity. The financial privacy and safeguards rules have also been widely implemented and provide significant additional information to the consumer which was not available just a few years ago.

Legal Cases and Implications Regulation of the insurance industry is ultimately triggered by the fact that the insurance industry is “affected with a public interest.” This concept was initially developed by the British jurist Lord Matthew Hale in 1676. The U.S. Supreme Court used Hale’s concept as a basis for writing its own decisions and determined that the insurance industry was deemed “affected with a public interest” because of its role in many other business and industry activities.

Paul v. Virginia The case of Paul v. Virginia in 1869 determined the legal basis for state regulation of the insurance industry. Samuel Paul was a Virginia insurance agent for several New York fire insurance companies. In Virginia at that time, insurance agents representing out-of-state companies were required to provide certain information to the state controller’s office. Paul had not met these requirements. The result of his noncompliance was a $50 fine. When Paul appealed the fine, he argued that the insurance business was commerce, and in his case, interstate commerce. The U.S. Constitution, by his interpretation, controlled interstate commerce, and according to Paul, Virginia’s requirement’s of the insurance industry were highly unconstitutional.

The Supreme Court rejected Paul’s argument, ruling that selling insurance policies was not commerce. The court said these were personal contracts and did not fall into the same category as merchandise being shipped from one state to another. In their ruling on Paul v. Virginia, the Supreme Court upheld the Virginia laws and ruled that insurance companies were not to be regulated by the federal government, but by the states. Paul ultimately lost his fight and had to pay the $50 fine. This case is important to our discussion because it determined that it was the right of the government to regulate insurance companies, a ruling that was held intact for the next 75 years. © 2006 Bookmark Education www.BookmarkEducation.com

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In part, the ruling stated:

“Issuing a policy of insurance is not a transaction of commerce. The policies are simple contracts of indemnity against loss by fire, entered into between the corporations and the insured, for a consideration paid by the latter. These contracts are not articles of commerce in any proper meaning of the word.

“They are not subjects of trade or barter offered in the market as something having an existence and value independent of the parties to them. They are not commodities to be shipped or forwarded from one state to another and then put up for sale. They are like other personal contracts between parties that are completed by their signature and the transfer of consideration. Such contracts are not interstate transactions, though the parties may be domiciled in different states. The policies do not take effect and are not executed contracts until delivered by the agent in Virginia. They are, then, local transactions, and are governed by the local law. They do not constitute a part of the commerce between the states any more than a contract for the purchase and sale of goods in Virginia by a citizen of New York whilst in Virginia would constitute a portion of such commerce.”

Munn v. Illinois In 1877, in the case of Munn v. Illinois, the Supreme Court further determined that insurance companies were businesses affected by the public interest. In its ruling, the Court recognized the states’ rights to regulate “properties” affected with the public interest, but protected these “properties” or businesses by further stating that the courts, not the legislature, would be responsible for determining “reasonableness.”

Munn v. Illinois became a landmark ruling because it specified that property was “clothed with a public interest when used in a manner to make it of public consequence and affects the community at large.” However, no specific consequences were delineated in the ruling, and in its final form, the public interest concept became a dynamic one that would vary with court opinions through the years.

The 20th Century In the early 1900s, it was proposed that certain aspects of the insurance industry be placed under federal regulation. However, the judiciary committee advised the U.S. Congress to refrain from passing such legislation, basing their arguments on the fact that Paul v. Virginia and other cases had determined that the federal government had no documented authority over the industry. It was not until 1944 that the Supreme Court reversed its Paul v. Virginia decision and ruled in the South-Eastern Underwriters Association case that the insurance industry was indeed commerce.

In 1945, however, the U.S. Congress passed the McCarran-Ferguson Act. This act stated that the states should continue to regulate the insurance industry because it was in the public interest, and further specified that federal antitrust laws only apply to the insurance industry in instances where state regulation is not effective. If the state regulatory body is strong and adequately regulates the industry in that state, federal antitrust laws would not be applicable.

The McCarran-Ferguson Act was accompanied by a report from the House Judiciary Committee, which stated:

“Nothing in this bill is to be so construed as indicating it to be the intent or desire of Congress to require or encourage the several states to enact legislation that would make it compulsory for any insurance company to become a member of rating bureaus or change uniform rates. It is the opinion of the Congress that competitive rates on a sound financial basis are in the public interest.”


The South-Eastern Underwriters Association In 1944, the Supreme Court ruled on a case involving the South-Eastern Underwriters Association (SEUA) and, in a surprise move, reversed the Paul v. Virginia decision. The SEUA was a rating bureau with approximately 200 members (representing about 90 percent of the fire insurance lines) and was located in Atlanta, Georgia. The SEUA had been charged with violating the Sherman Antitrust Act because it was believed that it was monopolizing the fire insurance business.

The indictments brought against the SEUA included those for restricting interstate commerce by fixing noncompetitive rates on fire and other related insurance lines and monopolizing commerce in insurance. The SEUA also had charges against it for fixing commissions, compelling consumers to buy only from SEUA members, and using boycotts.

Attorneys for the SEUA argued that, based on Paul v. Virginia insurance was not commerce and therefore not governed by the Sherman Antitrust Act. The court determined that insurance was indeed commerce and subject to control by the federal government. This ruling, in turn, subjected the insurance industry to the terms of the Sherman Antitrust Act, and the court determined that cooperative pricing by the 200 rating bureau members was illegal.

It is important to note that the Supreme Court received criticism for deciding a question about the U.S. Constitution without a majority vote by the nine justices; however, with a vote of 4-3, the decision stood. The insurance industry was now officially subject to federal regulation.

The opinion itself concluded:

“Our basic responsibility in interpreting the Commerce Clause is to make certain that the power to govern intercourse among the states remains where the Constitution placed it. That power, as held by this Court from the beginning, is vested in the Congress, available to be exercised for the national welfare as Congress shall deem necessary. No commercial enterprise of any kind that conducts its activities across state lines has been held to be wholly beyond the regulatory power of Congress under the Commerce Clause. We cannot make exception of the business of insurance.”

The confusion caused by the SEUA decision led to the belief that there was a penalty in disobeying state laws that require rate-making organizations, but going along with them would cause one to be in violation of the Sherman Antitrust Act. Nothing could be further from the truth, however. In fact, only state laws that did not run counter to federal legislation applied because the rest were nullified by the ruling of the SEUA. One fact was made clear: the states’ rights to regulate insurance were never challenged by the SEUA ruling.

In his written opinion, Justice Black pointed out:

“Another reason advanced to support the result of the cases that follow Paul v. Virginia has been that, if any aspects of the business of insurance be treated as interstate commerce, ‘then all control over it is taken from the states and the legislative regulations that this Court has heretofore sustained must now be declared invalid.’ Accepted without qualification, that broad statement is inconsistent with many decisions of this Court. It is settled that, for constitutional purposes, certain activities of a business may be intrastate and therefore subject to state control, while other activities of the same business may be interstate and therefore subject to federal regulation. And there is a wide range of business and other activities that, though subject to federal regulation, are so intimately related to local welfare that, in the absence of Congressional action, they may be regulated or taxed by the states.”


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Public Law 15 The states’ authority to regulate the insurance industry was clarified through the SEUA decision, but while the opposing sides awaited the Court’s opinion, Congress introduced the Bailey-Van Nuys bill to establish their intentions for the states to continue to regulate insurance, making the industry exempt from the Sherman and Clayton Antitrust Laws. The members of the rating bureaus supported the bill because they did not want the antitrust laws to apply to their activities. Members of the NAIC and the “independents” (nonmembers of the rating bureaus) wanted to do away with the monopolistic activities they perceived in the industry, so they were against the bill. The bill did not make it past the Senate and ultimately failed, but later, other proposals followed that were eventually the McCarran-Ferguson Act, or “Public Law 15.”

This law stated that the states’ regulation of the industry was, indeed, in the public interest, and for this reason, the industry was exempted from the provisions of the antitrust laws until July, 1948 – the date fair trade and antitrust laws were applicable to those parts of the industry not regulated by the states. However, according to Section 3(b) of Public Law 15, “... nothing in this act should render the Sherman Act inapplicable to any agreement to boycott, coerce or intimidate, or act of boycott, intimidation, or coercion.”

The report accompanying the act stated:

“Nothing in this bill is to be so construed as indicating it to be the intent or desire of Congress to require or encourage the several states to enact legislation that would make it compulsory for any insurance company to become a member of the rating bureaus or charge uniform rates. It is the opinion of Congress that competitive rates on a sound financial basis are in the public interest.”

Some interpreted this law to mean that only insurance companies volunteering to become part of a rating bureau in a state-regulated environment were sanctioned. However, the Allstate, et al. v. Lanier, et al. case ruled that the law requiring that all automobile insurance companies in the state of North Carolina become members of the North Carolina Rating Office was not in conflict with the McCarran-Ferguson Act. In this ruling, the U.S. District Court stated that the state was so “authorized” and could go into further depths of regulation if the legislature decided to do so. Therefore, the states were given the right to limit competition if they chose to do so. The Supreme Court declined to review the case.

The U.S. v. Insurance Board of Cleveland Before the SEUA case, certain rules were locally enforced which would be illegal under the Sherman Act. These rules, which were introduced by stock agents’ associations included boycott, coercion, and intimidation. Both insurers and agents were affected by these rules that effectually curbed competition. Among other limitations, insurance companies were allowed to have a certain number of agents in an area. Further, they were limited to reinsuring member insurers. Members were also not allowed to represent non-stock insurance companies, insurance companies that wrote policies directly (bypassing agents), companies selling established below-bureau rates and companies whose agents were not members of the association.

Although the National Association of Insurance Agents decided to refrain from reinforcing these rules, certain local associations continued to use the rules, causing challenges from the Justice Department. Such was the rationale behind The U.S. v. Insurance Board of Cleveland and a similar case pitting the Justice Department against the New Orleans Insurance Exchange.


The two boards said that the tenets of the McCarran Act had nullified the antitrust laws, but the court rebutted that nothing in the McCarran Act had suggested that the Sherman Act was not applicable, particularly in instances of boycott, coercion, or intimidation for the purposes of limiting competition.

Purposes of Regulation In the objective examination of insurance regulation, the primary purpose is the protection of the consumer public.

In all areas of the insurance industry, public confidence in the established system is required to maintain success. If the public should lack confidence in the industry because of experiences with fraudulent and incompetent insurers, the system would eventually fail. This lack of confidence would occur if the insurer became unable to provide the coverage promised. In cases of insolvency, the consumer would not only forfeit the price of the policy, but also the expected reimbursement for loss of property, disabilities, medical expenses or the support of dependents.

To establish and maintain consumer confidence, certain regulatory goals have been developed to combat negative and unscrupulous business activities within the industry in order to:

• Prevent insurer insolvency.

• Prevent fraud.

• Assure reasonable pricing.

• Increase the availability of insurance.

Each of these goals is explained in more detail below.

• Insurer insolvency.

One of the primary goals of insurance regulation is to prevent insurance companies from going into bankruptcy.

To this end, controls have been established through government regulations unique to the insurance industry. These controls require insurance companies to maintain certain levels of operating capital, as well as specified reserves and surplus levels to underwrite “the future services” agreed upon in the policies issued by that company. The government requires insurance companies to meet these levels because of the far-reaching effects of an insurance company going bankrupt.

When any other business fails, investors in that business lose their money and people lose their jobs, but the bottom line of a business failure is something called competition – a major aspect of our free enterprise system. Sometimes a business goes bankrupt because it is not offering the goods and services at a reasonable price to the consumer. When a business folds, the competition absorbs its customers and may adjust goods and prices to remain within the good graces of the consumer public. In this scenario, both the competitor and the consumer benefit. When an insurance company fails, there are no similar beneficiaries.

The other major aspect to be considered in understanding regulations for the prevention of bankruptcy of insurance companies is that insurance premiums are based on the insurer’s estimate of the cost of future services. If the estimated costs of these services or losses are lower than the actual costs, the result is that rates are set too low and policies are under-priced.


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Several decades ago, the industry underestimated the necessity of raising rates in liability claims for property and casualty policies. A few years later, this area of the industry experienced significant losses because of the under-pricing.

Because the industry must estimate future trends and activities, there is always the possibility that rates may be inadequate to cover losses. This fact, when coupled with the far-reaching impact of insurance company failure, forms the logic of regulation as a necessary means to protect the industry from insolvency.

• Prevention of fraud.

The prevention of fraud is also a primary goal of government regulation because it protects the consumer against being misled or misinformed by an insurer. As has often been pointed out by the industry, as well as public advocates, insurance policies are highly complex, technical documents that few laypeople actually understand. Without regulation, the possibility would exist that, at some time, an unscrupulous insurer could include certain phraseology that would mislead the insured and save the insurer from paying a particular claim.

The second aspect of regulation for the purpose of preventing fraud concerns an insurance company’s continuing solvency. Attempting to strengthen its consumer base, a struggling company will advertise itself as a strong and reliable firm, with well-invested funds. To provide the consumer with some protection against fraudulent claims of this type, states monitor a firm’s operations to assure that no false claims may be made.

• Reasonable pricing.

A third goal of regulation is to protect the insurance consumer against excessive rates.

Like regulations to protect the consumer from fraud, this type of regulation is also unique to the insurance industry. If an insurer decides to increase rates, it must first file its intentions to raise rates with the state commissioner. If there are objections, no rate increases may occur.

Since the insurance industry’s pricing is based on past experience and certain statistics, the assumption is that the future will be much like the past. Rates, therefore, are based on the past experiences of many insurers. These collective rates, of course, would be more reliable than the rates based on the past experiences of a single insurer.

In view of this assumption, the insurance industry is not required to comply with the anti-price fixing aspects of antitrust laws but, instead, may establish its prices based on its collective experience. With rates established through regulation, the resulting competition works to maintain reasonable pricing within each state’s industry.

• Insurance availability.

Making insurance available to all who need coverage is the final goal of regulation.

This pledge to the consumer public is the basis for the establishment of automobile insurance pools in states to make liability insurance available to those drivers considered to be high-risk and not otherwise able to obtain insurance from standard insurers.

Insurance is also made available to a broad-based market through federal programs reinsuring those companies that offer property and crime insurance in high-risk situations. And because increasing liability claims have raised the cost of professional malpractice insurance, government regulations have also been put into place to continue making this insurance available to all who require it.


As years go by more insurance is becoming necessary for individuals and families. There is an ongoing debate as to whether insurance companies should be regulated to the point that they have no choice as to whom they insure. Some argue that the government should underwrite protection, such as Medicare, particularly for those deemed to be too great a risk for a private insurance company to insure. The opposing view believes that insurance companies should be forced to make coverage available to all who require it. The debate continues.

Major Categories of Regulation From its beginnings, the insurance industry has had ample time and opportunity to diversify itself regarding products, services, and methods of marketing. Today, it provides various services to its patrons, delivering these in a variety of formats that respond to the various and emerging needs of the public it serves. All, however, are strictly regulated, and, within the industry today, the complexities of its business are divided into three major areas of regulation:

• Financial strength of the insurer.

• Products.

• Sales and sales practices.

The Financial Strength of the Insurer In order to protect the solvency of the insurer, numerous regulations are required to control aspects of the business, such as rates, expenses, investments, surplus, dividends, organization, annual reports and liquidation of insurers. Specific levels of capital and surplus are required before insurers can open their doors for business. Once these requirements have been met, regulators have ongoing expectations of the insurer to maintain an adequate cushion of operating capital and surplus to respond to any unexpected declines in investments or burden of claims.

All insurers are regulated to prohibit investments that are highly speculative or that fall in the high-risk category. This type of regulation limits the percentage of any insurer’s assets that may be committed to investments in stock or real estate. This, in turn, may also limit the company’s ability to build capital at a rapid rate.

A company’s reserves are also regulated and must always be adequate to meet obligations that may arise in the future. Each state has its own formula for calculating reserves to cover each type of policy.

Financial regulatory laws affect not only the reserves and assets of the insurance companies across the country, but also the basic organization of the companies, their investments, valuation of assets and rate setting mechanisms.

Regulation of Products Over the years, the insurance industry has become so complex that policies are often the subject of court interpretation. Because of these complexities, it is difficult for the average policyholder to understand even a basic policy, which allows for unscrupulous agents to write policies that may not be in the best interest of the insured. In some cases, even honest insurers may inadvertently include exclusions and special provisions that may be misleading or unfavorable to the policyholder.

Because of this situation, and because it is generally felt that most insurance policies are difficult to understand, there has been a movement in place for several years to simplify


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policy formats. One rate advisory bureau filed a homeowners policy reducing the narrative by about 40 percent and increasing the size of the type used in the policy by 25 percent. More white space was also allowed between the lines. More readable policy guidelines have also been instituted for automobile, business, personal, life, and health insurance policies.

Certain state insurance commissions have also instituted guidelines regarding insurance policy forms. In doing so, they are attempting to protect both the policyholder, as well as reputable insurers, against policies that are ambiguous, deceptive, or so difficult to understand they could be misleading. Certain formats of life and health insurance policies are prohibited from use, and commissions reserve the right to disapprove policies that contain unjust, inequitable, deceptive, or misrepresentative provisions.

Regulation of Sales and Sales Activities The purpose of this type of regulation is, at first glance, to protect the consumer from unreliable services and disreputable agents. However, the regulation also serves to provide a balance of fair competition within the environment. In this area of regulation, the states regulate how insurers obtain new policyholders, the ethical standards within the industry and the standards required of insurance sales professionals.

Most of the states statutes regulate not only the qualifications for those that sell insurance but also prohibit misrepresentation of the facts about a policy and its coverage. Some statutes also cover the parameters of the relationship between the insured and the insurer.

In the insurance industry, the term “twisting” refers to the misrepresentation of the facts by an agent in order to manipulate the policyholder into substituting one contract for another. Twisting also includes failure to include all the facts when policies are represented.

Because of regulations against twisting, agents are discouraged from making recommendations that may include dropping one policy in favor of another. Some regulations provide that any insurer of a policy that could be replaced would have the ability to evaluate and rebut any comparative information received by the policyholder.

Rebating is another regulated sales activity. Rebating occurs when an agent refunds part of the premium to the policyholder. This practice is intended to skirt around the rate requirements established by a state. In most states, anti-rebating regulations have been established for the purpose of protecting the public interest. Rebating is difficult to prove and, therefore, few cases of rebating are ever heard in court.

Government and Self-Regulation Historically, self-regulation was the first type of formalized insurance regulation and continues to be the most powerful form of industry regulation in both the United States and Great Britain. This form of regulation has maintained its power because of the fear of more public reaction against individual insurers. Therefore, it has been advantageous for industry professionals to seek and obtain additional self-regulatory powers that support the public interest.

Under the current system, the insurance industry is also subject to three distinct types of regulation executed by the three branches of the democratic form of government – legislative, judicial, and executive. These three methods of regulation, plus the self-regulatory structures, oversee specific areas of operations within the industry and distribute regulatory powers between state and federal regulatory agencies. The following paragraphs will examine and explain the distinctions of each of the four categories.


Legislative Regulation State legislatures create insurance codes which govern the insurance industry within that state. Insurance codes address the licensing of insurance companies and producers in order to regulate the conduct of the companies and their agents and employees. The laws also focus upon the specific products permitted to be sold within a state. Each state may implement different variations upon the common themes which mold the regulation of the insurance industry.

Judicial Regulation Through their interpretation of legislation and other questions, the judicial branch of each state plays a major role in the legislation of the insurance industry. Although their involvement is often indirect in its nature, the courts are also employed to settle disputes between parties involved in insurance contracts. The written ruling of the court for each case, therefore, becomes a part of the body of regulation affecting insurance.

Executive Regulation As the insurance industry became more diversified and complex, it became obvious, that the industry’s regulation should be supervised by knowledgeable and experienced individuals. No longer could lawmakers be charged with regulating this rapidly-growing business alone. To fill the administrative needs, each state has established an insurance department headed by a commissioner. Commissioners help to create and enforce rules, called administrative law, to assure the successful operation of the industry within their state.

The duties of state insurance commissioners are broad and varied, but each state insurance department has certain basic duties. These include licensing of insurance companies and agents working within the state, monitoring the activities of licensed agents, and screening these activities regarding good business practices. In some cases, the commission is required to mete out certain penalties for unscrupulous behavior, such as the revocation of licensure or the closing of businesses who fail to meet regulatory requirements regarding reserves, capital, and surplus.

Since 1818, when the Massachusetts insurance department required filing of the first annual financial reports, state commissions have required the filing of annual statements; furthermore, they act as a depository for securities in states with laws governing securities and require an evaluation of corporate assets on a regular basis.

The commissions also regulate trade practices and oversee and approve policy contracts. In its role as a regulatory body, the commission may also monitor rates to assure against discrimination.

Self-Regulation Once regulations were in place from governmental sources, the instrument of self-regulation reemerged from a growing consciousness or awareness by special groups of the disadvantages of intrusive outside interpretation and regulation. In view of this, the insurance industry has continued to be a self-regulated industry to a certain degree. Through associations of insurers and agents, these self-regulatory groups have exerted some degree of control through strict codes of ethical conduct and other cooperative agreements. These groups continue to function, generally out of the fear that more public regulation would impair the industry and its purposes.


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Specific Types of Regulation We now examine specific types of regulation which states may enforce in order to permit the prosperity of the insurance industry and protection of consumers.

Regulation of Insurer Expenses The regulation of insurer expenses is a typical area of financial regulation. With the SEUA decision, organizations control commission rates, and if rate wars occur, it is within the jurisdiction of the state insurance commissioner to regulate the situation. Life insurance expenses are regulated in several states, with the New York law being the most complex. This law places caps on expenses and the cost of acquisitions, and affects approximately 70 percent of the life insurance sold in the United States. The New York law features:

• Restricted commission and fees on individual policies.

• Controls on awards or prizes for volume business.

• Complex limits on field expenses.

• Maximum caps placed on renewal commissions and service fees.

• Training allowances for new agents that are commission-approved.

Regulation of Admitted Assets The solvency of an insurance company is measured by the amount by which admitted assets surpass the company’s liabilities. This measurement is taken by state regulators. Valuations for the company are highly regulated, a feature unique to the insurance industry compared to most corporations.

In most situations, “admitted assets” are those assets held by the company that include legal portfolio investments. Admitted assets always include office buildings and real estate (some states also allow computer equipment), but do not include operational assets for the firm. Assets such as automobiles, supplies, furniture and other capital expenditures, or secured or unsecured loans and advances to agents are not included in calculating admitted assets.

It is often easier to value some admitted assets than others. For example, cash and bank accounts are valued at face amount, but there are other criteria for most other holdings.

Examples of these criteria include:

• Real estate – valued at book value or market value.

• Mortgage and collateral loan – valued at amount of outstanding debt.

• Bonds – amortized value if they are secured by earning power.

• Bonds in default – market value as instructed by the Committee on Valuation of Securities of the NAIC.

• Stocks – values prepared by the Committee on Valuation of Securities of the NAIC and equal actual market value as of December 31 of that year.

• Open accounts and premiums to be collected – valued at book value less an estimate of bad debts.

With these guidelines, it is not the insurer who is able to pay claims within a reasonable period that is deemed solvent, but rather the insurer whose admitted assets are equal or exceed their liabilities.


Regulating Rates While the rates on individual life policies, most health policies, and ocean marine insurance are not regulated, there is a minimum rate level set for group life by several state insurance departments. Property and liability rates are controlled by model rating laws.

These regulations are based on historical records of prospective loss and expense, as well as the occurrence of catastrophic events and hazards within a certain area. When there is regulation of this sort, an insurance company must file premium rates, rating plans, coverage, and rules for approval by the commissioner or a special committee. In this filing, the company must also provide support of any calculations with documentation.

Some insurers will go through a licensed rating organization rather than filing directly with the state commissioner; however, the commissioner can also disapprove any filing, as long as he or she specifies reasons why the filing was disapproved.

Each state commission must also approve a rating organization, and each rating organization must allow any qualified insurance company to take advantage of its services, without any discrimination toward the company. There are technical requirements built into methods of recording and reporting loss and expense experience, exchange of rating plan data, and consultation with other states, and the state commissioner usually taps a rating organization to collect this data.

Unless a company files an application for deviation, each subscriber must follow the rating organization’s rates and policies; but, the commissioner may also disapprove these applications for deviation if there is a hint of inadequate, excessive, or discriminatory rates.

Regulating Automobile Insurance Rates Observers of the insurance industry have often pointed out that the regulation of automobile insurance rates has taken on a political aspect, because state department commissioners are more focused on whether the standard is excessive as opposed to the standard being adequate. It was the suggestion of one such observer that the political careers of the regulators in one state were obviously more important than the financial solvency of insurers in that state.

The problem arises when the public pressure for lower auto insurance rates takes precedence over the required financial strength of the insurance companies, and therefore, some states continue to walk a tightrope between these two priorities. Notably, in one state, when a commissioner voted to increase automobile insurance rates, that person was quickly fired by the incumbent governor who was running for another term.

Regulating Property and Liability Insurance Rates In the area of property-liability insurance, many states no longer favor direct regulation of these rates. This is because there is an abundance of data and research behind the rates of this coverage, and because of strong competition, there is no danger either of excessive or inadequate rating.

Because some insurance companies could charge inadequate rates in an effort to become more competitive, the state commissions are now sophisticated enough to detect those companies who could be bordering on insolvency. Because of these and other situations that are unique to property-liability rating, numerous proposals have been set forth to remove regulators from the pricing of this coverage.

These proposals have resulted in two types of rating laws:

• File-and-use rating laws. © 2006 Bookmark Education www.BookmarkEducation.com

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• No-file rating laws.

With file-and-use rating laws, a company could request a rate change with the documentation to support it, and then use the new rate until it is disapproved by the state commission. Under the no-file laws, the insurer can request a new rate without statistical documentation and then use that rate before notifying the commissioner. In most states, there is a specified period in which the commission is notified regarding the no-file rates.

Regulating Life and Health Insurance Rates Valuation rules applying to the insurer’s reserve liability operate in lieu of regulation of life insurance rates, and the reserve requirements are not related directly to the premium structure of life insurers. An inadequate structure will cause inadequate assets to offset the required reserves. In this branch of insurance coverage, discriminatory prices are prohibited, just as they are in property-liability insurance, yet unit prices may vary with the policy size and the insurability of the policyholder.

In other branches of the industry, competition has been an effective tool for regulation; however, in the life and health insurance branches, competition is not regarded as a useful regulatory tool because purchasers have no basis for comparison of rates and no tools to technically analyze these comparisons.

Because of past abuses among life and health insurers, these rates are monitored by most state insurance departments. All states require that insurance companies file annual reports of loss ratios on health insurance because the public interest requires tracking of these statistics; however, the state insurance departments are not well-enough staffed to consistently check insurance company rates against the benefits offered.

Regulating Reserves This, too, is a controversial area of regulation and is probably discussed more than most of the other financial regulation categories. Those companies that write property and liability insurance should maintain both loss reserves and unearned premium reserves. The loss reserve is the liability for claims and settlement costs the insurer estimates. The unearned premium reserves are those which at the time of valuation represent all policies outstanding and their gross premiums.

Medical malpractice, automobile, and workers’ compensation loss reserves use the formula or loss ratio method for computing the minimum reserve, based on the previous three years and the expected loss ratio, which is 60 percent for medical malpractice and auto, and 65 percent for workers’ compensation.

The sticky point which most concerns regulators about loss reserves is that most insurance companies estimate loss reserves lower than practicable, and, in turn, this may lead to insolvency when the insurer is pressed for payment. Conversely, when insurers set reserves too high, they also increase their rates to excessive proportions. Because most state insurance departments do not have the trained personnel to “police” these areas of a firm’s operations some insolvencies have occurred as insurers have been able to hide the exact circumstances for setting their reserve percentages.

Life insurers have one principal reserve known as the policy reserve. This reserve is calculated to meet all policy obligations, as well as premiums and assumed interest. The valuation on this reserve may be different from premiums charged by an insurer because it does not include an allowance or expenses and in fact may be calculated based on a different set of interest and mortality assumptions.


The Modified Reserve Standard is used by some life insurers because the bulk of the expense a company incurs is during the first year the policy is in effect. These expenses include premium taxes, general expenses on the part of the insurer and mortality costs. This leaves little of the premium left for the insurer, and is definitely not enough to cover the reserve for the end of the first year.

Regulation of Dividends The payment of dividends to policyholders is usually a matter of judgment on the part of the insurer. Still, some state insurance departments attempt to control this decision by limiting the surplus amount accumulated by the insurer; for example, not to exceed 10 percent of the policy reserve. By this type of limitation, the insurance departments effectively prevent the accumulation of a large surplus while dividends are lower or not paid at all. This type of regulation, according to insurance commissioners, also curbs inefficient use of a large store of assets.

Regulation of Capital Stock/Surplus Accounts The surplus of an insurance company will be made up of surplus that is paid-in and surplus that is earned. A capital stock insurer also has capital that is paid-in.

The capital-stock account of an insurance company is the dollar value that has been given to shares owned by stockholders. In most states, these shares are issued at a premium, or, in other words, the stock has a value that is less than the money paid by the stockholders. This creates the paid-in surplus.

Mutual insurance companies are required to have a paid-in fund minimum, but because there is no capital stock in a mutual insurance company, the fund is entirely made up of paid-in surplus.

Regulation of Business Capacity If an insurance company writes new business at a fast pace, there is the possibility that this increase in business could exhaust the insurer’s surplus and lead to insolvency. At the end of World War II, for example, several insurance companies actually “sold out” their products because they wrote as much business as they could without bringing their surplus accounts down to below acceptable levels. Because they could not raise enough capital in a short period of time, the companies had to quit issuing new policies. Some insurers decided to become selective in who they insured, favoring the more profitable companies. The less profitable businesses were left without insurance. This “capacity problem” is particularly important in discussions of property-liability insurance.

Currently, the state insurance departments guard against this problem by using a rule of thumb that net premiums should not exceed twice the policy owners’ surplus. In some circles, a ratio of 3-to-1 is used, and some states even allow ratios as high as 4-to-1.

The branch of the insurance industry that does not seem destined for “capacity problems” is life insurance. The need for a large surplus is not as immediate in life insurance, and many states limit the accumulation of surplus by those companies who sell participating policies.

Regulation of Investments With the exception of property-liability insurers, who experience a majority of problems in the area of underwriting, most other branches experience most of their financial problems as the result of problems with their investments. Because of this fact, most states regulate investment of the assets of insurance companies. These restrictions may be either quantitative or qualitative, dealing with the types of investment media, the amount of security


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required, the percentage of admitted assets to be invested, and the percentage of admitted assets dedicated to a single area of investment, among others.

Requirements for Organizing and Licensing Insurers Each state has insurance codes that guide the development of new companies in the insurance business.

These codes are in place to protect the public from being misled, from being the victims of unscrupulous business people and from people who want to profit from the sale of the insurance company’s stock.

State insurance commissions have the right to regulate the types of insurance to be offered by new insurance companies, as well as the types of coverage available from this insurance.

The states issue a license to write insurance for domestic, foreign, and alien insurers, and then establish strict guidelines by which all insurers must do business in that state. The licenses issued to domestic insurance companies are usually permanent, but foreign and alien licenses are subject to renewal each year.

The state insurance commissions believe that their licensing requirements are effective in controlling the activities of all insurance companies, assuming that they are complying with minimum statutory standards of financial solvency, and eliminating fraud or dishonesty among the insurers.

There are two laws that currently deal with unauthorized insurers (those who are unlicensed in a certain state or mail-order insurers). One of these is the Unauthorized Insurer Service of Process Act. In this act, the commissioner serves as the agent for foreign companies for service of process (the summons that brings a defendant to court for legal jurisdiction). The second act is the Uniform Reciprocal Licensing Act. Under the Uniform Reciprocal Licensing Act a domestic insurance company’s license may be taken away if it operates in another state that has a reciprocal licensing act without obtaining a license. A state may also control unauthorized insurers by limiting their business to that of licensed surplus lines or licensed brokers.

Liquidation of Insurers When an insurance company becomes technically insolvent, the state commission of insurance takes over the company for liquidation, rehabilitation, or conservation. The commissioner may take over operations at any time if the company is not being operated in the best interests of those holding policies with that company. An insurance company suspected of nearing insolvency has a right to a hearing by the commission, but when an order to liquidate is issued, the assets of the company become vested in the commission. At that point, if the need for a takeover is not sufficiently supported, the assets are returned to the company’s management.

The Uniform Insurers Liquidation Act provides a uniform procedure in liquidation cases where insurers have done business in more than one state. This gives equal rights to each adopting state in the handling of claims and the final distribution of the insolvent company’s remaining assets.

Regulation of Products To maintain a certain amount of control over the policies offered by various insurers, each state commission must approve policy forms. This makes it difficult for companies to either mislead or deceive the consumer with statements that contain highly technical terminology or ambiguous descriptions of coverage. For certain types of insurance coverage, including fire


and workers’ compensation, a standard form is required. Other coverages, such as life and health, forbid the use of gimmickry in their forms and verbiage.

The commissioner, upon reviewing a new policy format, may overrule any type of wording in provisions that may be deceptive or misrepresent the “real” coverage. The unfortunate aspect of this particular type of regulation is that most state insurance departments have neither the funds nor the trained personnel to review every form that is used for insuring individuals in that state.

Taxes Like any other industry, insurance companies in America pay local, state, and federal taxes and fees. The bulk of these taxes are levied by the state; however, some communities and municipalities collect taxes as well. These mandatory payments include income taxes, property taxes, license and filing fees for annual financial statements, and fees for taking the insurance licensing exam. Companies also pay taxes on franchises (if they apply), premium taxes (although some states tax insurance companies as an alternative to premium taxes), and special taxes on workers’ compensation and various other types of insurance.

Applicable Rates and Rules While state taxation varies according to state requirements, federal income taxes are levied according to formulas found in the Internal Revenue Code, and taxation on real estate and property are the same as for any other taxpayer. In some states, taxes levied on fire insurance premiums go to support local fire departments. Likewise, the taxes on workers’ compensation insurance are used to establish the system, security funds, and funds to underwrite programs for employing handicapped individuals.

One of the most unique and most controversial of taxes paid by insurance companies is the premium tax. At one time, the proceeds from this form of taxation were used to pay the costs of regulation; however, state insurance companies today receive only a small portion of the premium tax, with the greater part of the proceeds used to fund other services provided by the state. This particular tax has brought an outcry from the insurance industry, with objections centering around the seeming inequity in taxing one industry without taxing others. The bottom line of the premium tax is that it is ultimately paid by insurance subscribers, and no state has reported any problems in collecting the premium tax.

The truth of the matter is that the premium tax is a bone of contention within the industry. First of all, the states vary taxation rates between 1.7 percent and 4 percent, with 2 percent being the most widely used. In some states, U.S. companies are taxed at a lower rate than foreign companies, a situation that the NAIC has worked to eliminate.

To strike some type of balance, a large majority of the states charge what is called a retaliatory tax, which equalizes the domestic tax rate for companies operating outside the state. In some states, too, the premium tax varies according to the line of insurance, based on whether or not the insurance company may have some of its assets invested in that state. The states also vary their formulas for calculating the premium tax. In some cases, the insurance company is allowed to deduct its policy dividends from its tax base, but few states allow this deduction.

Today, some states are considering an income tax in place of a premium tax (or, in some instances, in addition to the premium tax). The difficulty in determining a company’s income is most often cited as a reason for not going forward with this idea. It is also important to know that formulas to measure income presently differ among the states.


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Pricing of Insurance Rates Although most insurance rates are derived by extremely complicated formulas, a simplified explanation is that insurance rates are a determination of a policyholder’s percentage of responsibility for loss expenses. The premium to insure a home or automobile is the rate per unit of coverage multiplied by the number of units purchased.

Here are some examples: A customer wants to purchase a homeowners policy. A unit would be 100 square feet within the building. Depending on the particular circumstances, the unit may be $100 or $1,000 of coverage purchased.

Once the cost per unit is established, the insurer must look into the future to determine the percentage chance that the homeowner will suffer a loss, based on past experience and the rate of probability that a homeowner will file a claim. This historical experience plus the influence of new trends and developments, such as improved building materials, are also taken into consideration to determine the final rate to be paid.

Historically, insurers calculated each policy on a separate basis. But, as business increased, this system proved to be too cumbersome, and insurance companies also found some glaring deficiencies in their existing methods. Rate setting (sometimes referred to as rate making) soon became a group effort in order to make rates both profitable for the companies and fair to the policy buyers. These rates were published, and if variances were appropriate, the established rates became the basing point for these variations. The various lines of insurance began setting their own rates, and today, the industry trends suggest that independent rate making is the rule for all types of insurance coverage.

Rate Regulation Objectives When a rate filing is submitted to the state insurance department by an insurance company, the data submitted is evaluated by the department, with three objectives in mind:

• To prohibit excessive rates for coverage.

• To maintain the financial solvency of the company.

• To avoid unfair discriminatory rates.

The strictness and meticulousness with which new rates are evaluated depends upon the state. In some states, for example, property and casualty rates require explicit approval by the insurance commission, prior to the use of new rates. In other states, the “open competition” condition exists, and it is assumed that the competition will regulate costs much more effectively than the insurance commission. In the “open competition” states, the commissioner of insurance may curtail the use of certain rates, particularly those violating rating standards, but rates do not have to be filed and approved, as is the practice in the more rigidly controlled states.

It is worth noting here that anyone having a grievance against an insurance agent or insurance company is invited to file a complaint and is entitled to a hearing. However, the burden of proof that rate filings actually comply with the law is on the shoulders of the insurance company or the rating bureau.

Life insurance rates are not regulated in the same manner that other rates are regulated. The control of these rates is indirect, or, in other words, based on supervision of mortality tables, dividends and interest rates used to compute the reserves of life insurers. When these controls are combined, the result is an indirect regulation of life insurance rates that are inadequate, excessive, or discriminatory.


Within the regulation of life insurance, there is one central controversy involving “cost disclosure.” Since life insurance rates do not reflect the true costs of the policy to the company, it is entirely possible that a policy having a low premium may be very costly to the issuing insurer, or the opposite may be true – a policy with a high premium may require very little from the insurer, cost-wise. To provide consumers with a better understanding of life insurance rates, and to give them a better tool with which to compare the costs of various policies and coverages, the industry has turned to the interest-adjusted method for computing policy costs. Indeed, the NAIC has recommended that the states require life insurance companies to provide detailed information to consumers about the costs of a policy. Some states have agreed to this suggestion. Others vehemently oppose this concept. Ultimately, some consumers have agreed, saying that the interest-adjusted computation is just as difficult to understand as other methods, and that they will rely on their agents for guidance in purchasing adequate coverage for their individual needs.

The State Insurance Commissioner’s Role In terms of regulating rates, the state insurance commissioner decides whether or not to approve a rate. In some states, the commissioner is assisted by appointive rating organizations to collect and maintain data regarding rates. The commissioner also has access to rating laws that involve the technical requirements of methods for recording and reporting losses and expenses over certain periods, as well as exchange of rating plan data and the experience and advice of other states.

Rates for life insurance lines are regulated individually by guidelines applicable to the insurer’s reserves and the liability of these reserves. However, the reserve requirements do not relate to the premium charged. As an example, if the insurance company charges a premium on a life insurance policy that is inadequate to cover its exposure, the company’s assets will soon be smaller than the liability of the coverage it will have to eventually pay.

The thinking among insurance industry leadership and regulators alike has been that competition would ward off excessive rates, but because the consumer public has neither the technical knowledge nor general understanding of the industry, it is questionable that competition actually serves as an effective regulator of life insurance.

To serve as a guide for charging rates, the industry has developed price indexes based on formulas developed within the industry. The indexes are used by a large number of companies. The states have also entered into the educational area of the industry by publishing buyers’ guides showing the prices of a number of life insurance lines.

In the case of health insurance lines, there are several states that require these lines to file a schedule of their rates with the insurance commissioner. Other states allow the commissioner the ability to disapprove health insurance forms, particularly if benefits and premiums are not proportionally balanced.

Some states require that insurers file a listing of expected losses associated with the claims filed on health insurance. In addition, all states require that insurance companies file reports of their loss ratios. While the public interest automatically requires close scrutiny of each case in point, the states cannot provide enough professionals to review or supervise every health insurance policy. In fact, so many different health insurance policies now exist that it is impossible to check their rates against benefits. This makes the agent’s role extremely important since the public is generally unable to fully understand the many variables between policies.


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Conclusion Although it may seem that most regulation applies to the insurance companies rather than the individual producer, it is the producer that the client sees and therefore the person most responsible for the image the public will have of our industry. Rules and regulations can only go so far to create the proper business environment. Ethical standards are also a necessary element in guiding a producer’s conduct. The next section of study will focus on ethics and ethical behavior for insurance producers.


Appendix A – Final Examination

Below is the Final Examination for this course. You may enroll in this course and complete an online version of this exam at our website:

www.BookmarkEducation.com

Your certificate will be issued immediately upon successful completion of the course.

Insuring Individual Risks

1. ________ insurance contains the basic elements of term insurance, with an investment element added.

A. Whole life B. Traditional C. Premium D. Batch

2. The ________ of an insurance company is measured by the amount by which admitted assets surpass the company’s liabilities.

A. success B. decline C. solvency D. regulation

3. As a general rule, inland marine floaters provide coverage to property ________. A. that cannot be moved B. on an “all-risk” basis C. on a “named peril” basis D. at sea

4. A typical suicide clause states that the face amount of the policy will not be paid if the insured commits suicide within ________ after the policy is issued.

A. one month B. six months C. two years D. ten years

5. All of the following are forms of government regulation of the insurance, EXCEPT: A. Legislative regulation. B. Judicial regulation. C. Consumer group regulation. D. Executive regulation.


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6. ________ determines the formula for calculating reserves to cover each type of policy. A. The federal government B. The National Board of Consumers C. Each state D. Every insurance company

7. All insurers are regulated to prohibit investments that are ________. A. highly speculative B. low risk C. in any type of real estate D. in any type of stock

8. The only line of property/liability insurance in which the physical condition of the applicant has been used by underwriters is ________.

A. crime insurance B. homeowners insurance C. inland marine insurance D. automobile insurance

9. The underwriter would be justified to refuse writing insurance where: A. the condition of property is so poor that the chance of loss is materially increased. B. the property does not measure up to desirable standards of neatness. C. the property is over ten years old. D. the property is newly constructed.

10. ________ refers to the misrepresentation of the facts by an agent in order to manipulate the policyholder into substituting one contract for another.

A. Larceny B. Theft C. Blockbusting D. Twisting

11. In life and health insurance policies the word ________ is used in lieu of the word “endorsement.”

A. “rider” B. “waiver” C. “term” D. “add-on”

12. Part A of the Personal Auto Policy provides liability coverage for ________ different categories of parties.

A. two B. three C. four D. five


13. Auto damage coverage EXCLUDES coverage of: A. all collision losses. B. normal maintenance costs. C. all other-than-collision losses. D. breakage of glass.

14. For a life insurance policy to be issued, ________ between the insured and the policy owner must be present.

A. an insurable interest B. an application C. an adult guardian D. a contract

15. Stamps and coins may be insured in one of two ways: scheduled basis or ________. A. blanket basis B. article basis C. premium basis D. homeowner basis

16. Control in a mutual insurance company rests with the ________. A. insureds B. stockholders C. policyowners D. goverment

17. ________ cannot be used as a reason for underwriting action. A. Accident fault B. Occupation C. Property condition D. Number of accidents

18. The difference between consumers and customers is important because only customers are entitled to automatically receive ________ under the Gramm-Leach-Bliley Act.

A. compensation B. a financial institution’s privacy notice C. safeguards D. employee training

19. ________ is the substitution of one party in place of another party in respect to a claim. A. Tort B. Salvage C. Cancellation D. Subrogation


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20. In most states, a person is not considered an adult until the person is ________ years of age. A. 13 B. 18 C. 21 D. 25

21. The HO-6 policy is a ________ policy. A. renter’s B. condominium owner’s C. all-risk D. premium free

22. No action should be taken solely because of a ________. A. misrepresentation B. fraudulent act C. history of drug abuse D. previous rejection or cancellation

23. The HO-5 policy is very similar to the ________ policy. A. HO-1 B. HO-2 C. HO-3 D. HO-8

24. An example of executive regulation, the basic duties of state insurance departments include: A. licensing of insurance companies and agents working within the state. B. creating insurance codes. C. settling disputes between parties to insurance contracts. D. self-regulation.

25. The umbrella policy pays only after the limits of the underlying policy are ________. A. established B. broken C. modified D. exhausted

26. A stock life insurance company is in business to make a profit for the ________. A. insureds B. stockholders C. policyowners D. goverment


27. ________ life insurance permits changes to be made during the policy’s lifetime. A. Term B. Adjustable C. Universal D. Whole

28. The most significant factor which can be used in underwriting and rating of motor vehicle insurance is ________.

A. driver occupation B. family size C. automobile size D. driving record

29. ________ means that the term policy can be exchanged for some type of cash value insurance without proof of insurability.

A. Convertible B. Whole life C. Universal D. Adjustable

30. ________ offers tax advantages to the insured because the investment value grows without current taxation.

A. Health insurance B. Key man coverage C. Term life D. Universal life

31. The following are principal parts of the privacy requirements of the Gramm-Leach-Bliley Act. A. The Financial Privacy Rule. B. The Regulation of Sales. C. The Safeguards Rule. D. The Pretexting provisions.

32. Under a Personal Auto Policy, the company will pay all reasonable medical and funeral expenses incurred within ________ years from the date of the accident.

A. two B. three C. four D. five

33. ________ requires financial institutions to develop a written information security plan that describes their program to protect customer information.

A. The Safeguards Rule B. The Pretexting provision C. Reciprocity D. The Producer Licensing Model Act


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34. Under a Personal Auto Policy, the insurance company will NOT provide liability coverage for any person:

A. who intentionally causes “bodily injury” or property damage.” B. driving a “covered auto.” C. legally responsible for an auto accident. D. owning a trailer.

35. Forms HO-1 and HO-2 are referred to as ________. A. Named Peril Policies B. All Risk Policies C. Condominium Policies D. Market Value Policies


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