Trieschmann, Hoyt & Sommer

Insurance as a Risk Management Technique

Chapter 6

©2005, Thomson/South-Western

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Chapter Objectives • Define insurance and explain how it differs from other

methods of risk transfer• Identify situations that give rise to insurable interest and

explain how this principle supports the principle of indemnity • State how the subrogation process works and how it is useful• Determine what makes a risk insurable • List the legal requirements of a contract and describe the

distinguishing legal characteristics of insurance contracts • Differentiate between insurance agents and brokers and

describe the sources for their authority• Define social insurance and explain the basic principles that

underline most social insurance programs• Describe the central costs and values of insurance to society

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The Nature of Insurance

• Insurance involves not only risk transfer but also pooling and risk reduction – Pooling: The sharing of total losses among a group – Risk reduction: A decrease in the total amount of uncertainty

present in a particular situation • Insurers accomplish this by combining a group of objects situated so

that the aggregate losses become predictable within narrow limits

• Overall risk for the group is reduced, and losses that result are pooled – Usually through the payment of an insurance premium

• Insureds transfer various risks to the group and exchange a potentially large uncertain loss for a relatively smaller certain payment (the premium)

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The Nature of Insurance

• Gambling and insurance are exact opposites– Gambling creates a new risk where none existed

before – Insurance is a method of eliminating or greatly

reducing an already existing risk • Insurance is usually implemented through legal

contracts, or policies – Insurer promises to reimburse the insured for losses

suffered during the term of the agreement – Implicit is the assumption that the insurer will be able

to pay whatever losses may occur • Important to consider the financial condition of the insurer

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Principle of Indemnity

• One of the most important precepts for many types of insurance – Particularly property insurance

• The insured may not collect more than the actual loss in the event of damage caused by an insured peril – Serves to control moral hazards that might otherwise

exist • Indemnify

– To restore insureds to the situations that existed prior to a loss

• Likelihood of intentional loss is greatly reduced

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Principle of Indemnity

• Typically contained within property insurance contracts are clauses regarding the existence of other insurance – Such causes provide that all policies covering the same loss will

share losses that occur • Some exceptions to the application of the principle of

indemnity and property insurance – Appropriate way to measure losses

• Replacement value or current value – Valued policy laws

• An insurer must pay the entire face amount of the fire insurance policy in the event of total loss

• Usually not applicable in the field of life insurance – No attempt is made to measure the amount of the loss when the

insured dies – The full amount of life insurance policy is paid

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Principle of Insurable Interest

• Holds that an insured must demonstrate a personal loss or else be unable to collect amounts due when a loss caused by an insured peril occurs

• If insureds could collect without having an insurable interest a moral hazard would exist

• Necessary to prevent insurance from becoming a gambling contract – Necessary to remove a possible incentive for murder

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What Constitutes Insurable Interest

• The legal owner of property having its value diminished by loss

• Other rights exist that are sufficient to establish an insurable interest in addition to ownership – The holder of a contract to receive royalties – Legal liability resulting from contracts – Secured creditors – Building contractors, etc.

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What Constitutes Insurable Interest

• Always presumed to exist in life insurance for persons who voluntarily insure their own lives

• However someone who purchases life insurance on another’s life must have an insurable interest in that person’s life – For instance, a business firm may insure the life of a

key employee– A husband may insure the life of his wife

• There are practical limits as to the amount of life insurance an individual may obtain

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When the Insurable Interest Must Exist • In property and liability insurance it is possible to

effect coverage on property in which the insured does not have an insurable interest at the time the policy is written – However such an interest is expected in the future

• Courts generally hold that in property insurance, insurable interest need exist only at the time of the loss and not at the inception of the policy – However, if at the time of the loss the insured no

longer has an interest in the property • There is no liability under the policy

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When the Insurable Interest Must Exist• In life insurance, the general rule is that

insurable interest must exist at the inception of the policy – It is not necessary at the time of the loss

• Courts view life insurance as an investment contract

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Principle of Subrogation

• Grows out of the principle of indemnity • One who has indemnified another’s loss is entitled to

recovery from reliable third parties who are responsible • Reasons for subrogation

– To reinforce the principle of indemnity • To prevent the insured from collecting more than the actual amount

of the loss

– Keeps insurance premiums below what they would otherwise be – The burden of loss is more nearly placed on the shoulders of

those responsible • The party that caused the loss is held financially accountable for its

actions

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Exceptions to the Principle of Subrogation • Subrogation normally does not exist in such

lines as life insurance and most types of health insurance

• Subrogation does not give the insurer the right to collect against the insured– Even if the insured is negligent

• It is not uncommon for an insurer to waive rights of subrogation under certain circumstances – Where, by doing so, there is no violation of the

principle of indemnity

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Exceptions to the Principle of Subrogation• A waiver can be performed by inserting a waiver-of-

subrogation clause – Such clauses are common

• An insured who acts in such a way as to destroy or reduce the value of the insurer’s right of subrogation violates the provisions of most subrogation clauses – Forfeits all rights under the policy

• Insurer’s subrogation rights also cannot be avoided by a settlement between the primary parties after the insurer has paid under the policy

• The insurer is entitled to subrogation only after the insured has been fully indemnified – If the insured has borne part of the loss, the insurer may claim

recovery only after these costs have been repaid • Exception: The insurer is entitled to legal expenses incurred in pursuing

the subrogation process against a negligent third party

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Principle of Utmost Good Faith

• A higher standard of honesty is imposed on parties to an insurance agreement than is imposed through ordinary commercial contracts

• Casts a very different light on the interpretation of insurance agreements than many persons often suppose

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Representations • Statements made by an applicant for insurance before the

policy is issued – Usually embodied in a written application

• If the representation is relied on by the insurer in entering into the contract and if it proves to have been false at the time it was made or becomes false before the contract is signed – There exists legal grounds for the insurer to avoid the contract

• Avoiding the contract does not follow unless the misrepresentation is material to the risk – If the truth had been known, the contract either would not have been

issued or would have been issued on different terms – If the misrepresentation is inconsequential, its falsity will not affect the

contract • Generally, even an innocent misrepresentation of a material

fact is no defense for the insured if the insurer elects to avoid the contract

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Warranties

• A clause in an insurance contract stating that before the insurer is liable – A certain fact, condition, or circumstance

affecting the risk must exist

• Creates a condition of the contract, and any breach of warranty, even if immaterial, will void the contract – This is the central distinction between a

warranty and a representation

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Warranties

• Express warranties – Stated in the contract

• Implied warranties – Not found in the contract but are assumed by the

parties to the contract • Promissory warranty

– Describes a condition, fact, or circumstance to which the insured agrees to be held during the life of the contract

• Affirmative warranty – One that must exist only at the time the contract is

first put into effect

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Concealments

• Silence when obligated to speak

• Has approximately the same legal effect as the misrepresentation of a material fact

• The applicant must volunteer material facts – Even if disclosure of facts might result in

rejection of the application or the payment of a higher premium

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Concealments

• The important question about concealment lies in whether the applicant knew the fact withheld to be material

• The tests of the concealment are – Did the insured know of a certain fact? – Was this fact material? – Was the insurer ignorant of the fact?– Did the insured know the insurer was ignorant of the fact?

• The test of materiality is especially difficult because often the applicant is not an insurance expert – Is not expected to know the full significance of every fact that

might be of vital concern to the insurer • Final determination of materiality

– Would the contract be issued on the same terms if the concealed fact had been known?

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Mistakes

• When an honest mistake is made in a written contract of insurance – Steps can be taken to correct it after the

policy is issued

• Generally a policy can be reformed if there is proof of a mutual mistake – Or mistake on one side that is known to be a

mistake by the other party • Where no mention was made of it at the time the

agreement was made

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Requisites of Insurable Risks

• Not all risks are commercially insurable • Requisites of insurable risks

– Characteristics of risks that make it feasible for private insurers to offer insurance

• Should be viewed as guides or standards that are not always completely attained in practice

• Even when their absence makes it impossible for insurance to be offered by private insurers – Government agencies may offer some protection

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Large Number of Similar Objects

• Probable loss must be subject to advance estimation

• Number of insured objects must be sufficiently large – The objects themselves must be similar enough to

allow the law of large numbers to operate • Nature of the objects must be enough alike so

that reliable statistics on loss can be formulated • Sometimes insurers act as risk transferees even

when it is impossible to obtain a sufficiently large number of exposure units to allow the law of large numbers to operate

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Accidental and Unintentional Loss

• There must be some uncertainty surrounding the loss• Insurers normally exclude in all policies any loss caused

intentionally by the insured – If the insured knew that the insurer would pay for intentional losses

• A moral hazard would be introduced – Causing losses and premiums to rise

• Adverse selection – Tendency of insureds who know that they have a greater than average

chance of loss to seek to purchase more than an average amount of insurance

– Asymmetric information • When an insured possesses knowledge about likely losses that is

unavailable to insurers • Its existence is one cause of adverse selection

• Underwriting – Process of selecting and classifying insureds from among the many

applicants

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Determinable and Measurable Loss

• The loss must be definite in time and place

• Even if it is clear that a loss has occurred it may not be easy to measure it – For example, what is the loss from “pain and

suffering” of an auto accident victim?

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Loss Not Subject to Catastrophic Hazard • Conditions should not be such that all or most of the

objects in the insured group might suffer loss at the same time and possibly from the same peril – For instance, large fires, floods, earthquakes, hurricanes in

particular major geographical areas • Most insurers reduce this possibility by dispersion of

insured objects• Insurers themselves may purchase insurance against the

possibilities of excessive losses – Called reinsurance

• Following the 9/11 terrorist attacks many firms had difficulty obtaining insurance for trophy properties

– Due to the recognition by insurers of the catastrophic loss potential associated with these buildings

• Effectively eliminates many speculative risks from the possibility of being insured

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Large Loss

• The maximum possible loss must be relatively large – A requisite from the standpoint of the insured

• States that businesses and individuals should ensure potentially serious losses before relatively minor losses – To do otherwise is uneconomical

• Small losses tend to occur frequently and are very costly to recover through insurance

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Probability of Loss must not be too High • Probability of loss must be reasonable

– Else the cost of risk transfer will be excessive

• Insureds are often willing to pay more to avoid a loss than the true expected value of that loss – If it were not for this phenomenon, insurance

could not exist – Insurers must always charge more for their

service than the expected value of a loss

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Table 6-1: Examples of Requisites of Insurable Risks

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Requirements of all Valid Contracts

• Agreement must be for legal purpose • Parties must have legal capacity to contract • There must be a valid offer and acceptance

– In property and liability insurance, it is the custom to give local agents authority to accept offers of many lines of insurance on the spot

• The agent will bind the insurer – A legal offer by an applicant for life insurance must be supported

by a tender of the first premium • Usually the agent gives the insured a conditional receipt

– Provides that acceptance takes place when the insurability of the applicant has been determined

• Promises must be supported by the exchange of consideration – The value given to each contracting party

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Distinguishing Characteristics of Insurance Contracts • Aleatory contract

– Values exchanged by the contracting parties are not necessarily equal

• Due to the fact that the outcome of the contract depends on the risk of whether a loss will occur

– If a loss takes place during the policy period, the amount paid by the insurer usually will exceed the premium paid by the insured

– If no loss occurs, the premium exceeds the amount paid by the insurer

• Conditional contract – Insureds must perform certain acts if recovery is to be made – If the insured does not adhere to the conditions of the contract,

payment is not made even though an insured peril causes a loss • Typical conditions

– Payment of premium – Providing adequate proof of loss – Giving immediate notice to the insurer of loss

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Distinguishing Characteristics of Insurance Contracts• Contract of adhesion

– Any ambiguities or uncertainties in the wording of the agreement will be construed against the drafter—the insurer

– Insurer had the advantage of writing the terms of the contract to suit its particular purposes

– Insured has no opportunity to bargain over conditions, stipulations, exclusions

– Doctrine of reasonable expectations • Coverage should be interpreted to be what the insured can reasonably

expect • Limitations and exclusions must be clear and conspicuous

• Unilateral contract – Only one of the parties makes promises that are legally enforceable – Insureds cannot be forced to pay premiums or adhere to conditions

• If the insured does what has been promised, the insurer is legally obligated to perform in the event of a covered loss

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Role of Agents and Brokers

• An agent is a person given power to act for a principal, who is legally bound by the acts of its agents

• General agent – Person authorized to conduct all of the principal’s business of a

given kind in a particular place

• Special agent – Authorized to perform only a specific act or function

• In a legal sense, insurance agents do not necessarily have to serve in the channel of distribution for insurance – Although that is the most common use of the term insurance

agent

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Role of Agents and Brokers

• An insurance agent should be assumed to be the legal agent of the insurer – Unless information to the contrary is known

• An insurance broker is the legal agent of the prospective insured – Is engaged to arrange insurance coverage on the best possible

terms – Free to deal with any insurer that will accept the business – Cannot bind any insurer orally to a risk unless the broker has an

agency agreement with the insurer – When dealing with a broker one should not assume coverage the

moment the insurance is ordered • The distinction between an agent and a broker is not

always clear – In some situations a person may simultaneously be both an agent

and a broker

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Authority of Agents and Brokers

• Agency agreement – Sets forth the specific duties, rights, and

obligations of both the insurer and the agent

• Ratification – If an agent performs some act outside the

scope of the agency agreement to which the insurer later assents

• The agent has achieved additional authority through ratification

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Authority of Agents and Brokers

• Waiver – Intentional relinquishing of a known right

• Estoppel – Operates when there has been no intentional relinquishing of a

known right – Operates to defeat a “right” that a party technically possesses

• Waiver is based on consent – Estoppel is an imposed liability – Often these two doctrines are not clearly distinguished even in

court actions • Sometimes they’re used interchangeably

• Waiver and estoppel situations often arise when the insurance policy is first put into force

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Principles of Social Insurance • Social insurance is offered through some form of government

– Usually on a compulsory basis • Designed to benefit persons whose incomes are interrupted by an

economic or social condition – That society as a whole finds undesirable and for which a solution is

generally beyond the control of the individual• Examples include crime, poverty, unemployment, mental disease, ill

health, dependency of children or aged persons, drug addictions, industrial accidents, divorce, economic privation of a certain class – Insurance is not an appropriate method of solution for many of these

problems because the peril is not accidental, fortuitous, or predictable • Following the 9/11 attacks firms could not secure terrorism insurance

in the private insurance market – Leading to calls for a government role in providing such coverage

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Principles of Social Insurance• Compulsion

– Necessary that everyone involved cooperate • Set level of benefits

– Little if any choice is usually given as to what level of benefits is provided

– All persons covered under the plan are subject to the same benefits schedules

• Floor of protection – Aims to provide a minimal level of economic security against perils that

may interrupt income • Subsidy

– Losses of the unfortunate few are shared with the fortune many who escape loss

– It is anticipated that an insured group may not pay its own way • It will be subsidized either via other insured groups or by taxpayers

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Principles of Social Insurance

• Unpredictability of loss – Cost of benefits under social insurance

cannot usually be predicted with great accuracy

– Therefore the cost of some types of social insurance is unstable

• Conditional benefits – For example, if one earns more than a

specified amount, various social insurance benefits may be lost

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Principles of Social Insurance

• Contributions required – A public program should require a contribution,

directly or indirectly, from the persons covered, the employer, or both

– Social insurance does not include public assistance programs

• Wherein the needy person receives an outright gift and must generally prove inability to pay for the costs involved

• Attachment to the labor force – Most social Insurance plans cover only groups that

are or have been attached to the labor force • Nearly all such plans are directed at those perils that

interrupt income

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Principles of Social Insurance

• Minimal advance funding – Social insurance usually does not provide

large accumulations for advance funding • If, for example, a future retirement benefit is

promised, the full cost of paying for this benefit is not set aside in the year which the promise is made

– Instead, the benefit is paid from future revenues at the time the benefits must be paid out to the retiring worker

• Social insurance programs and the revenues to support them are expected to continue indefinitely and require no advance funding

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Social and Economic Values

• Reduced reserve requirements – One of the chief economic burdens of risk is the necessity of

accumulating funds to meet possible losses – One of the great advantages of insurance is that it greatly

reduces the total of such reserves necessary for a given economy

• Because the insurer can predict the losses in advance– Needs to keep readily available only enough funds to meet those

losses and to cover expenses • If each insured had to set aside such funds, there would be need for

a far greater amount

• Capital freed for investment – Cash reserves that insurers accumulate are made available for

investment – Insurers as a group, and life insurance firms in particular, are

among the largest and most important institutions collecting and distributing the nation’s savings

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Social and Economic Values

• Reduced cost of capital – Because the supply of investable funds is greater

than it would be without insurance • Capital is available at a lower cost than would otherwise be

possible • Brings about a higher standard of living because increased

investment will raise production and cause lower prices than would otherwise be the case

• Reduced credit risk – Insurance has been called the basis of the nation’s

credit system – An entrepreneur is a better credit risk if adequate

insurance is carried

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Social and Economic Values

• Loss control activities – Although the main function of insurance is not to reduce loss but

to spread losses among members of the insured group • Insurers are nevertheless vitally interested in keeping losses at a

minimum • Otherwise losses and premiums would have a tendency to rise

– Illustrations of loss prevention and control in the field of property and liability insurance

• Investigation of fraudulent insurance claims • Research into the causes of susceptibility to loss on highways • Recovery of stolen vehicles and other auto theft prevention work • Development of fire safety standards and public educational

programs • Provision of leadership in the field of general safety • Provision of fire protection and engineering counsel for oil producers • Investigation and testing of building materials to see that fire

prevention standards are being met

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Social and Economic Values

• Business and social stability – For example, if adequately protected, a

business need not face the prospect of liquidation following a loss

– Similarly, a family may not break up following the death or permanent disability of one or more income producers

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Social Costs of Insurance

• The costs for an insurance institution include – Operation of the insurance business

• Mainly labor to operate the business – Average annual overhead of property insurers accounts for

about 27% of their earned premiums but ranges widely

– Losses that are caused intentionally • If it were not for insurance, certain losses would not occur

– Losses that are caused intentionally by people in order to collect on their policies

– Losses that are exaggerated • Tendency for some insureds to exaggerate the extent of

damage that results from purely unintentional losses