fundamentals of risk and insurance. chapter 1 the problem of risk 1. the concept of risk risk: a...
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Fundamentals of Risk and Insurance
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Chapter 1The Problem of Risk
1. The concept of riskRisk: a condition in which there
is a possibility of an adverse deviation from a desired outcome that is expected or hoped for
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Peril: a cause of a lossHazard: a condition that may create or increase the chance of a loss arising from a given peril
Three categories of hazards:Physical hazardsMoral hazardMorale hazard
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2. Classifications of risk
Pure risk and speculative riskPure risk: the situations that
involve only the chance of loss or no loss
Speculative risk: a situation in which there is a possibility of loss, but also a possibility of gain
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Chapter 2 Introduction to risk management
1. Risk managementRisk management is a scientific
approach to dealing with pure risks by anticipating possible accidental losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that do occur
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2. Risk management tools
Include two broad approaches:(1) Risk control focuses on
minimizing the risk of lossA. Risk avoidanceB. Risk reduction: loss prevention &
loss control
(2) Risk financing focuses on finding funds to meet losses
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(2) Risk financing focuses on finding funds to meet losses
A. Risk retention (assumption)Intentional and unintentionalB. Risk transferInsurance, hedging
Assume all risks that are not significant in relation to the company’s financial strength
Insure all risks not assumed
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3. Risk management process
(1) Determination of objectives(2) Identification of risks(3) Evaluation of risks(4) Considering alternatives and
selecting the risk treatment device
(5) Implementing the decision(6) Evaluation and review
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Determination of objectives
Post-loss objectives
Pre-loss objectives
Survival Economy
Continuity of operations Reduction in anxiety
Earning stability Meeting externally imposed obligations
Continued growth Social responsibility
Social responsibility
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Chapter 3The insurance device
1. The nature and functions of insurance
(1) Risk sharing and risk transferA. Transferring or shifting risk from
one individual to a groupB. Sharing losses, on some equitable
basis, by all members of the group
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(2) Insurance defined from the viewpoint of the individual
Insurance is an economic device whereby the individual substitutes a small certain cost (the premium) for a large uncertain financial loss (the contingency insured against) that would exist if it were not for the insurance
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(3) Risk reduction through pooling
The law of large numbersThe larger the sample, the more accurate
will be the estimate of the probabilityOnce the estimate has been made, it must
be applied to a sufficient large number of exposure units to permit the underlying probability to work itself out
To make the estimate more accurate, we use variance and standard deviation
The integration of inevitability and chance
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Each insured, and each class of insureds should bear the mathematically fare share of the insurance pool’s losses and expenses
(4) Insurance defined from the viewpoint of society
Insurance is an economic device for reducing and eliminating risk through the process of combining a sufficient number of homogeneous exposures into a group to make the losses predictable for the group as a whole
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(5) Elements of an insurable risk
A. There must be a sufficient large number of homogeneous exposure units to make the losses reasonably predictable
B. The loss produced by the risk must be definite and measurable
C. The loss must be fortuitous or accidental
D. The loss must not be catastrophic
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(6) The fields of insurance
A. Private (Voluntary) insuranceLife insuranceHealth insuranceProperty and liability insuranceIncluding named-peril coverage and open-
peril coverage
B. Social insurance
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Chapter 5 the private insurance industry
1. Insurers classification by legal form of ownership
A. Capital stock insurance companiesB. Mutual insurance companiesC. Reciprocals or interinsurance exchangeD. Lloyd’s associationsE. Health expense associationsF. Government insurers
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2. Marketing systems
The insurance occupationsAgentBrokerUnderwriterLoss adjusteractuary
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(1) Life insurance distribution system
A. General agentsB. Branch office system—branch
manager
(2) Property and liability distribution system (refer to the book)
A. Independent agents (U.S.A.)B. Direct writers
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Chapter 6 regulation of the insurance industry
Regulation represents the rules by which the game is played
The government as market regulator: to protect the weak group
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1. The why of government regulation of insurance
(1) Rationale for regulation of the insurance industry
A. Vested-in-the-public-interestSolvencyComplex nature of insurance
contractsB. Destructive-competition Due to the unique nature of pricing
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(2) Goals of insurance regulationsolvencyequity
2. Regulation todayThe current regulatory
structure:Legislative branchJudicial branchExecutive branch
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3. Areas regulated
(1) Solvency regulationA. Licensing of companiesB. Reporting and financial analysisC. Risk-based capitalD. Examination of companiesE. Regulation of reservesF. Investments: admitted/nonadmitted assetsG. Dealing with insolvencies
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(2) Market regulation
A. Unfair practicesB. Policy formsC. Competence of agentsD. Consumer complaints and assistance
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(3) Regulation of rates
Principles:AdequacyNot be excessiveNot discriminate unfairlyWays for rate regulation:Prior approvalNo filingFile-and-useInformational filingFlex-rating
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Chapter 7 functions of insurers
Ratemaking Methods:Judgment ratingSchedule ratingExperience rating: credibility factorRetrospective rating
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(2) Principle of the rate of premium
A. FairnessB. Solvency: avoid vicious
competitionC. Comparative stabilityD. Encouraging loss reduction
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(3) Setting of the property premium rate
Rate of loss=compensation÷insurance amount
Credibility factor: usual 10 percent(This is also the adjustment rate)Rate of property premium:Rate of lossX(1+10%)X(1+g) ÷(1+y) g: extra rate, y: investment gain.(4) Rate of life premium
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Chapter 11 introduction to life insurance
Life insurance is a risk-pooling plan
Life insurance does not violate the requirements of an insurable risk, for it is not the possibility of death itself that is insured, but rather untimely death
Life insurance is not a contract of indemnity
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1. Types of life insurance contracts
Term insurance(pure insurance protection)
Cash value insurance(protection and savings)
Term insurance Whole-life insurance
Endowment insurance
Universal life insurance
Adjustable life insurance
Variable life insurance
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(1) Reasons for difference in term and cash value insurance
(2) The level premium concept
2. Current life insurance products(1) Term insuranceRenewable termConvertible termAdvantages of term life insurance:
A. Greatest amount of protection for a given outlayB. meet temporary insurance needs
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Disadvantage: adverse selection
(2) Whole life insuranceA. Straight whole lifeB. Limited-pay whole life
(3) Universal life insuranceAdvantages of Universal Life InsuranceFlexibility of Premium PaymentsAbility to earn a great return when interest
rates riseFlexibility of death benefits
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Universal life insurance:
People buy a term policy and invest an additional amount with the insurance company.
The minimum premium is to keep a term insurance in force.
The insured is allowed to determine the amount and frequency of the premium payments within limits.
A guaranteed rate is specified in the contract, while an excess interest rate is determined by a formula or by company declaration.
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(4) Variable life insurance
A modification of universal life insuranceOne insured has two accounts: an insurance accou
nt and a separate account
(5) Adjustable life insurance(6) Endowment life insurance(7) Participating and nonparticipating life i
nsuranceThe dividends
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3. General classifications of life insurance
(1) Ordinary life insurance(2) Industrial life insuranceSmall amount but higher frequency of
premiums
(3) Group life insuranceProvided to a well-defined group of people
who are associated for some purpose other than purchasing life insurance
Generally costs less than similar individually purchased insurance
(4) Credit life insurance
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Chapter 13 The life insurance contract
1. Inception of the life insurance contract
Conditional binding receipt: usually called a binder, which is the temporary life insurance contract after the payment of a premium.
The binder has the same legal effect as the formal insurance contract
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2. General provisions of life insurance contracts
Entire contract clauseOwnership clauseBeneficiary clause: primary or
contingentRevocable or irrevocable
Incontestable clauseMisstatement of age clauseGrace periodReinstatement
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Suicide clauseAviation exclusionsWar clause
3. Settlement options(1) Interest option(2) Installments for a fixed period(3) Installments of a fixed amount(4) Life income optionsStraight life incomeLife income with period certainLife income with refundJoint and survivor income
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Example of payments under any one of the above life income options
Chapter 15 Disability income insurance
1. General nature of disability income insurance
Periodic payments to the person insured when he or she is unable to work because of injury or illness
Benefit eligibility presumes a loss of income
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(1) Types of insurersProperty and liability insurers, life insurers and specialty health insurers
(2) Methods of marketingMainly sold on a group basis
(3) Short-term versus long-term disability coverage
Short-term: up to 2 years with an elimination period (waiting period)
Long-term: from the date of disability to retirement with an elimination period. It is a logical complement to life insurance
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Chapter 16 coverage for medical expenses
The insurance product1. Traditional forms of medical expense
insurance:(1) Base plan coverageHospitalization, surgical expense coverage
and physician’s coverage are written together
Covers the costs of both hospitalization and outpatient
First dollar coverage: base plan coverage policies often have no-deductible provision
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A. Hospitalization insuranceBlue Cross service plans provide a semiprivate room in a participating hospital for a stated number of days, rather than a cash benefit
Hospital expense policies offered by commercial insurers reimburse some or all of the cost of room and board when the insured is confined to a hospital
Policies of both Blue Cross and commercial insurance companies cover incidental hospital expenses
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B. Surgical expense insurance Specify a maximum amount of coverage. If one patient needs more than one procedures, the most expensive treatment determines the payment
UCR charges
C. Physician’s expense insurance
(2) Major Medical InsuranceMajor medical policies have a substantial
deductible provisionMajor medical policies have a participation
provisionMajor medical policies have a high limit of
liabilitySee the example
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2. Exclusions under health insurance policies (12 exclusions)
3. Coordination of benefitIn the double-income family, one or both
partners may be covered under two policiesThe coordination of benefit is to eliminate
double payment when two policies existAn individual’s policy applies before the
spouse’s policyChildren are covered under the policy of the
parent whose birthday is earliest in the year
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Chapter 19 the automobile and its legal environment
Automobile coverage is a type of property insurance with the apparent elements of life insurance
The purchase of the automobile coverage is not a mere personal choice, instead, it is a social obligation
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1. A brief overview of automobile coverages
(1) Automobile liability insurance (also called the third party liability), which covers the injuries to other persons and damages to caused
Single limit of liabilitySplit limits of liabilityInsureds---the named insured and her consentient
s Exclusions
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(2) Medical payments coverageIt is written with a maximum limit per person per accident
(3) Physical damage coverage, also called damage to the auto
Insures against loss of the policyholder’s own automobile
The coverage is written under two insurance agreements: A. other than collision B. collision
Exclusions
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(4) Uninsured motorists coverage
Purpose: protect people from the loss of accident caused by another uninsured motorist
Uninsured motorist: Drivers without insurance Drivers with less insurance than the minimum r
equired by the state law Hit-and –run Drivers Drivers with coverage provided by insolvent ins
urers
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2. The no-fault concept
No-fault vs. tort systemThe no-fault insurance provides one more option t
o the insureds so that it is more flexibleUnder the no-fault system, there is no attempt to f
ix blame or to place the burden of the loss on the party causing it
All parties receive compensation from their own insurer, regardless of who caused the accident
No-fault insurance is to speed the compensation in less serious traffic accidents
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(1) Pure no-fault proposalsthe tort system would be abolished for bodily injuries arising from auto accidents
(2) Modified no-fault proposalsTort action would be retained for losses
above the amount recovered under first-party coverage
(3) Expanded first-party coverageNo exemption from tort liabilityMost important, the responsibility of the
negligent driver is retained by permitting subrogation by the insurer paying the first-party benefits
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3. Cost of automobile insurance
Most automobile rating systems begin with three basic factors
A. Age and sex of the driverB. Use of the automobileC. The driver’s recordIn China, the region in which the
automobile is used is also considered
Poor vs. rich, plain vs. mountainous
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Chapter 20 commercial property insurance
Can be classified into 7 broad categories:
1. Commercial property insurance2. Boiler and machinery insurance3. Transportation insurance4. Crime insurance5. Commercial liability insurance6. Commercial automobile insurance7. Workers compensation and employers’
liability insurance
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Commercial Package Policy:Insureds must purchase at least two of the package’s components, and as many as they need
1. Commercial property direct loss coverage
(1) Building and Personal Property Form
A. Property Covered:BuildingYour Personal PropertyPersonal Property of others
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B. Perils insuredbasic form, broad form, special form
C. Other provisions:property excluded from coverage,
deductibles, actual cash valueD. Coinsurance Guard against the possible
intentional inadequate coverage
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E. Reporting form coverage
Reporting forms are designed to meet the needs of business firms whose stocks of merchandise fluctuate over time
The insured must report 100 percent of the values of the property insured. Late reports or underreporting of values, intentional or otherwise, may result in a penalty at the time of a loss
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2. Commercial property coverage for indirect loss
Commercial property forms do not provide coverage for the indirect loss resulting from damage to the insured property.
Such protection must be obtained under a separate form for an additional premium
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(1) Business interruption insurance
Business income formsBusiness income coverage (and extra expense)Business income coverage (without extra
expense)
If the business is interrupted, payment is made for the loss of business income, defined as the net profit that would have been earned and the necessary expenses that continue during the period of restoration
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(2) Contingent business interruption and extra expenses
A. Contributing propertyB. Manufacturing propertyC. Recipient propertyD. Leader property
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3. Transportation coverages
(1) Ocean marine insuranceA. Hull insuranceProtects the owner of a vessel against loss
to the ship itselfThe coverage is written on an open-perils
basisB. Cargo insuranceMain form of ocean marine insurance,
written separately from hull insuranceC. Freight insuranceD. Protection and indemnity
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Perils insured---open perils agreementValuation
Average conditions: particular average & general average
(2) Inland marine insuranceNot limited to the transportation in the
rivers6 forms of coverage
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4. Insurance against dishonesty
(1) Employee crime coverageAlso called fidelity bondsA. Schedule bondsCover the specific person or position
that is listed in the policyB. Blanket bondsCover all the employees, regardless
of position
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(2) Nonemployee crime coverageprotect against burglary, robbery, theft, forgery, some of which with evidence
Chapter 21 commercial liability insurance
1. Employers liability and workers compensation
To protect both the employees and the employer
The largest firms self-insure
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(1) Workers compensation insurance
A. The insuring agreement obligates the insurer to pay the benefits for which the insured is liable under the workers compensation law
B. There are no exclusions under the coverage and no maximum limit on the insurer’s liability
C. It makes the insurer directly and primarily liable to employees who are entitled to benefits
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D. The insurer’s obligation to employees is not affected by any default of the insured
E. The insurer’s liability to the employees is governed by the workers compensation law, the insurer’s obligation to the employer is governed by the policy terms
(2) Employer liability insuranceIf an injured employee brought suit,
the legal principles generally favored the employer
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2. General liability insurance
Protect the firm against the peril of legal liability that involves injuries to persons other than employees of the insured
(1) General liability exposureEvery business firm is subject to one or a
combination of the following liability exposures
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A. Ownership and maintenance of premises
B. Conduct of business operationsC. Products: Negligence, breach of warranty, strict
liabilityD. Completed operationsE. Contingent liabilityF. Contractual liability
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3. Commercial automobile insurance
Four commercial automobile forms:Business auto coverageGarage coverageTruckers coverageMotor carriers coverage
(1) Business auto coverage formSimilar in all the aspects with that of
the personal auto policy
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(2) Garage coverage form
To provide comprehensive liability coverage for garages, sales agencies, repair shops, service stations, storage garages and public parking places
Hazards covered:Premises and operationsProducts and completed operationsAutomobile liability
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(3) Truckers coverage form
A modified version of the Business Auto Coverage Form designed to meet the special needs of truckers.
Extend the coverage from the licensed truckers to the independent owner-operators
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4. Aviation insurance
Purchased by the owners and operators of aircraft, airport operators, and by companies building and supplying parts for aircraft, but not passengers
Including planes, helicopters, hot air balloons, hang gliders and space satellites
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(1) Aircraft liability insurance
A. Passenger B. Bodily injury excluding passengersC. Property damage liability (2) Hull coverage
The core problem facing aviation insurers is the weakening of law of large numbers
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Chapter 22 surety bonds and credit insurance
Both are designed to protect against financial losses from default by someone on whom the insured depends
1. Surety bondsIt is reserved for the nonfidelity field
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One party (the surety) agrees to be held responsible to a second party (the obligee) for the obligations of a third party (the principal)
The principal buys the surety bond. The surety lends its name and credit to guarantee the obligation of the principal. If the principal fails to perform, the surety is responsible to the obligee for the amount of the bond.
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(1) Suretyship distinguished from insurance
A. The most frequently stated distinction is that a surety bond is a three-party contract, whereas the insurance policy is a two-party contract
B. The most important distinction is one of the basic philosophy regarding losses. In the insurance field, the insurer generally expects losses. In the surety field, no losses are expected.
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C. Whereas actuarial science is the basis for insurance rates, the fee for a surety bond is a payment for investigation and certification
The main categories of surety bonds:Contract bondsCourt bondsLicense and permit bondsPublic official bondsMiscellaneous bonds
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2. Credit insurancePurchased by the creditor
It is sold only to manufacturers and wholesalers, which protects against loss resulting from the inability to collect accounts due to insolvency or unwillingness or inability to pay by the purchasers
Back coverage policies: cover losses arising out of defaults during the policy period
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Forward coverage policies: cover losses stemming from sales during the policy period
(1) Types of policiesA. Extraordinary coverageGenerally purchased by companies that
deal with a limited number of buyers.It is issued after an investigation of the
individual debtors and acceptance of each one by the insurer.
The insurer is permitted to cancel coverage as to future shipments to any debtor.
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B. General coverageIt includes protection on all policyholder’s customers with a credit rating
Investigation of the individual customers is not needed because the coverage on each account is determined by a table of mercantile ratings, selected by the insured and incorporated into the contract.
Only debtors whose credit rating comes within the limitations of the ratings adopted by the insured are covered.
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(2) Coinsurance and the normal loss
The insured shall assume two proportions of each net loss:
A. Coinsurance percentage (10% or 20%)
B. Annual deductible (known as the primary loss or normal loss)
It is calculated from the previous experience of the firm insured or as a percentage of the firm’s net sales from tables that express bad debt ratios for various industries
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Loss settlement is made on an annual basis, with the coinsurance percentage applied to each loss before the application of the normal loss deductible
(3) Collection serviceThe collection service is one of the most
attractive aspects of credit insuranceIf the insured is required or permitted to
turn past due accounts over to the insurer, accounts that are overdue a stated period under the original terms of sale are turned over to the insurer for collection. If the insurer succeeds, a small service charge is made for the collection. If it is unsuccessful, the account becomes a loss under the policy.
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3. Credit enhancement insurance
Also called financial guarantee, is a combination of suretyship and insurance
The insurer “insures” the purchaser of bonds and other debt instruments that the debt will be paid and substitutes its financial strength for the financial strength of the borrower
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