CHAPTER 7 PRINCIPLES OF RISK AND INSURANCE

LEARNING OBJECTIVES

After completing this chapter, you should be able to do the following:

  Identify the application of insurance as a risk transfer vehicle.

  Determine client exposures to risk.

  Identify the various types and characteristics of insurance that transfer risk.

  Distinguish the methods to address risk.

Introduction

Personal financial planning always deals with the unknown. Because it is so heavily rooted in planning for future—thus, unknown—events, it’s really all about mitigating future uncertainty and taking actions today that can reduce uncertainty by ensuring specific outcomes. To this point, we have dealt with fairly concrete topics, such as estate planning and gift giving; now we will discuss the unknown—risk and insurance—and how to mitigate it.

Risk is with us everywhere we go, in one form or another. We are exposed to risk through many situations that may cause an economic loss—premature death, illness, or accident. The primary purpose of insurance is to provide economic protection against such losses. This type of protection is provided through an insurance policy, which is simply a device used by companies to accumulate enough of a reserve fund to meet these uncertain losses—and thus mitigate the risk.

In this chapter, we’ll begin by setting up a foundation of core risk management concepts, then move on to the risk management process. We’ll also show that insurance companies offer a broad range of choices for the consumer and explain how an insurance policy is a contract.

Risk Management Concepts

Before we can start learning about the risk management process, we need to build the right vocabulary to discuss basic risk management concepts.

RISK

Let’s begin with risk. Risk is the possibility of damage, injury, or loss caused by external or internal events. There are two types of risk: pure and speculative. Pure risk involves only the possibility of loss. Examples of pure risk include the following:

•Visiting a friend in the hospital—exposure to bacteria or viruses

•Intramural sports—an activity that may result in injury

•Owning real estate—potential for a casualty loss or liability claim

Speculative risk involves the possibility of loss or gain, like the stock market or gambling. Some types of risk can be mitigated through insurance. Speculative risk is not insurable, however.

Risk is also evaluated on an economic scale, comparing static and dynamic risk. Static risk is the economic loss that is caused by factors other than a change in the economy (natural disasters). Dynamic risk is the result of the economy changing (changes in the business cycle). Dynamic risks are not insurable.

How do you know when a risk can be mitigated through insurance? Exhibit 7-1 shows the four elements that must be present for a risk to be insurable.

EXHIBIT 7-1	DETERMINING IF A RISK IS INSURABLE

PERIL AND HAZARD

Related to risk are peril and hazard. A peril is the cause of an economic loss. An economic loss is the event for which insurance is purchased. Insurance provides protection against an economic loss. Examples of perils include collision, fire, hurricane, and theft. A hazard is a condition that may create or increase the chance of an economic loss arising from a given peril. See exhibit 7-2 for the three basic types of hazards.

EXHIBIT 7-2	TYPES OF HAZARDS

THE LAW OF LARGE NUMBERS AND ADVERSE SELECTION

Still related to risk but moving more toward insurance are the law of large numbers and adverse selection. The law of large numbers is the principle that the larger the number of individual risks that are combined into a group, the more certainty there is as to the amount of loss incurred in any given period. This allows insurance companies to accurately predict an approximate number of claims within a specific group during a certain period.

Adverse selection is the tendency of individuals with the greatest probability of loss to seek insurance to a greater extent than do individuals with little or no probability of loss. Insurance companies try to minimize this problem by measuring the risk and adjusting premium prices for the adverse risk. An example of an insurance company avoiding adverse risk is charging higher insurance premiums for drivers who have numerous moving violations or speeding tickets.

SELF-INSURANCE

Self-insurance is a formal program of risk retention for a business or an individual that takes on the insurance company’s role in order to cover its own risks. For a business, the self-insurance process involves the evaluation of a large number of similar potential losses, the prediction of the overall losses with some degree of accuracy, and the establishment of a formal fund for future losses, as well as possible fluctuations in those losses.

Table 7-1 shows the advantages and disadvantages of self-insurance.

TABLE 7-1	ADVANTAGES AND DISADVANTAGES OF SELF-INSURANCE

ADVANTAGES	DISADVANTAGES
•the avoidance or reduction of premiums for commercial or personal insurance •the creation of financial reserves that can be invested in cash, or cash equivalents, and later used by the business or individual when the insurance is no longer needed	•the business or the individual is exposed to a potential catastrophic loss •the administrative services provided by the insurance company are assumed by the business or the individual •income taxes may be due on the income created by the financial reserves

EXAMPLE

Managing Risk

Now that we have established some basic risk- and insurance-related terms, let’s take a closer look at risk and how to manage it. To manage risk, you have to understand how to respond to it. On a personal level, some people like to take risks and some people do not. From a personal financial planning perspective, there are only two fundamental responses to risk: controlling it and financing it.

CONTROLLING RISK

Risk may be controlled in one of three ways: avoidance, diversification, and reduction.

Risk avoidance occurs when a business or an individual refuses to accept risk by not engaging in an action that creates or gives rise to a risk. Examples of risk avoidance include not living in an area prone to hurricanes, not living in a neighborhood known for frequent burglaries, and not traveling to countries with a high incidence of kidnappings.

Risk diversification, also known as risk sharing, is a method of controlling risk in which the total exposure to risk is shared with another party. Risk diversification strategies include a business’s servers being housed in different geographic locations; individual limited liability companies being created to hold real estate, as opposed to one limited liability company holding several pieces of real estate; and hedging contracts.

Risk reduction is the process of reducing or eliminating risk through the implementation of loss prevention and control programs, and the utilization of safety features, like seat belts. Examples of risk reduction programs include medical wellness programs, smoke detectors, sprinkler systems, and security guards.

FINANCING RISK

Of the fundamental responses to risk, risk financing is the most familiar to consumers. With risk financing, the risk of economic loss is either retained or transferred.

Risk retention is the act of accepting risk. The retention of the risk may be involuntary (a poor driving history mandates high deductibles) or voluntary (the choice to have a high deductible because of an exemplary driving record). No action is taken to avoid, diversify, or reduce risk with risk retention. Examples of risk retention include self-insurance, and coinsurance and deductible limits in insurance contracts.

Risk transfer is a method of controlling risk in which the economic risk is transferred to another party more able to bear the economic loss. An insurance contract is the most widely used application of risk transfer.

THE RISK MANAGEMENT PROCESS

When performing a personal financial planning engagement, you will need to analyze your client’s exposure to different types of risk. Once you understand the types of risk involved, you can then set about determining how best to respond to those risks. This is risk management.

The objective of risk management is to effectively choose among the various methods of addressing risk in order to avoid a catastrophic loss. As shown in exhibit 7-3, the risk management process has six distinct steps which mirror the personal financial planning process.

EXHIBIT 7-3	THE RISK MANAGEMENT PROCESS

When presenting recommendations for an individual’s plan for risk management, essential insurance coverage—such as health insurance—should be addressed first; non-essential insurance should be addressed last and purchased with discretionary dollars. In the risk management process, severity is more important than probability. The probability of death or a chronic illness is low; however, the economic loss to a family would be catastrophic.

RISK MANAGEMENT MATRIX

The personal financial planner, much the same as an insurance company, will use a risk management matrix to formulate a response to risk in a client’s personal financial plan. The matrix is a summary of the frequency-severity method, which is a tool for determining the expected number of claims that an insurer will receive during a given time period and how much the average claim will cost. The frequency-severity method uses historical data to estimate the average number of claims and the average cost of each claim.

Frequency refers to the number of claims that an insurer anticipates will occur over a given period of time. If the frequency is high, it means that a large number of claims is expected to occur. Severity refers to the cost of a claim. A high severity claim is more expensive than an average claim and, conversely, a low severity claim is less expensive than an average claim. The average cost of claims is estimated based on historical data.

In personal financial planning the matrix may be used as follows:

A client is contemplating the purchase of an expensive home on the beach near Miami. This area of the Florida coast averages one hurricane per year. The potential destruction of the home would present a significant economic loss. According to the matrix, a high severity or high frequency risk should be avoided, and the home should not be purchased.

On the other hand, the client may choose to self-insure the home. The fact pattern has now changed. According to the matrix a low severity or high frequency risk should be reduced. Examples of risk reduction techniques would be metal straps in the attic to connect the roof to exterior walls, impact rated doors and windows, or storm panels and shutters.

Table 7-2 shows the most effective method of addressing the type of risk, based on frequency and severity.

TABLE 7-2	ADDRESSING THE TYPE OF RISK

	LOW FREQUENCY	HIGH FREQUENCY
Low Severity	Risk Retention	Risk Reduction
High Severity	Risk Transfer	Risk Avoidance

Insurance Policy and Company Selection

The most common—and familiar—form of risk management is the transfer of risk to an insurance company. The selection of an insurance company is a complex and difficult task. Insurance companies come in a variety of business forms (including mutual, stock, and fraternal); and the spectrum of financial ratings is broad. In addition, the variety of insurance products that are created to manage risk is vast. The selection of an insurance company involves the following areas:

•Purpose of coverage

•Duration of coverage

•Participating or non-participating policies

•A cost-benefit analysis

•Industry ratings

•Underwriting criteria

Fundamental to the selection of an insurance company is the purpose of the insurance coverage. What is the risk being transferred? No insurance company insures all risks. Insurance carriers tend to specialize in specific risks: boat and yacht insurance, long-term care insurance, and so on.

Once the purpose, or type, of insurance product is selected, then the duration of the insurance coverage needs to be determined. Is the need temporary, like term insurance, or is the need on a more permanent basis, like the funding of a buy-sell agreement?

Deciding to purchase a participating or non-participating insurance policy is critical to the selection of an insurance company. A participating insurance policy allows the insureds to participate in the profits of the insurance company—the profits are paid in the form of an income-tax free dividend. The dividend is income-tax free because it is considered a willful overcharge and a return of excess premium paid by the insured.

With some exceptions, an insurance company is either a stock insurance company or a mutual insurance company. A stock insurance company is a publicly traded corporation, and it is owned by its stockholders. The objective of a stock company is to make a profit for the stockholders through the payment of dividends and appreciation in the value of its stock. A mutual insurance company is not publically traded and is owned by its policyholders. The objective of a mutual insurance company is to provide insurance benefits to policyholders and their beneficiaries.

Finally the selection of an insurance company should include its industry ratings. There are a variety of companies that rate insurance companies, including A.M. Best Company, Inc., Fitch Ratings, Moody’s Investor Services, and Standard & Poor’s Insurance Ratings Services. Each of these companies has its own rating scale and rating standards. The ratings agencies often disagree as to an insurance carrier’s financial strength, and more than one agency should be used in the selection of an insurance company.

An insurance policy may be sold by an agent or a broker. A broker represents the insured—the purchaser of the insurance policy—and acts as an intermediary between the insurance company and the proposed insured. In contrast, an agent is a legal representative of an insurance company, and is usually an employee of the insurance company whose product is being purchased. An insurance agent is authorized to offer the sale of its goods and services. An agent’s authority to legally bind the insurance company arises from three sources of authority: express, implied, or apparent—further described in exhibit 7-4.

EXHIBIT 7-4	AGENT’S AUTHORITY TO BIND

Types of Insurance

A look at insurance policy and company selection soon shows that the type of insurance available to the consumer is almost limitless. The spectrum of insurance products covers a wide area of potential economic loss. Everything from damage to a cell phone to the loss of life may be insured. The more common types of economic risk which may be insured against are: premature death, disability, long-term care, chronic illness, living too long, and property damage and liability claims.

LIFE/HEALTH/DISABILITY

There are many types of economic risks addressed by insurance. Insurance which involves risk to the individual are: life, disability, long-term care, health, and annuity.

•Life Insurance: Life insurance protects against the economic loss created by premature death. This type of economic loss is referred to as mortality. Life insurance provides income to surviving dependents, retires debts, pays for funeral expenses and for children’s college costs. Life insurance provides a principal sum to replace the lost income of the insured.

•Disability Insurance: Disability insurance replaces income that is lost as a result of the insured’s disability. This type of economic loss is referred to as morbidity. The disability may be the result of an injury, illness, or both. The monthly benefit amount is approximately 60 percent to 70 percent of the insured’s gross compensation. The reason that the monthly benefit amount is not 100 percent of the insured’s gross compensation is twofold: first, it protects the insurance company by providing an incentive for the insured to return to work; second, because the benefit is received income tax free, a 100 percent benefit would result in the insured making a profit by being disabled.

•Long-Term Care Insurance: Long-term care insurance provides a benefit to individuals who are either cognitively impaired or who are unable to perform two (or three) of the activities of daily living: eating, bathing, dressing, toileting, transferring (walking) and continence. There are two types of long-term care insurance: indemnity, which is like disability insurance and provides income for long-term care services; and expense reimbursement which provides a daily amount for services to assist with the activities of daily living.

•Health Insurance: A major concern for many consumers is the financial impact of a chronic illness. A chronic illness is a condition or disease that is persistent or long-lasting in its effects. An injury or disease lasting for several months could have a potentially devastating financial impact on the insured. Traditional health insurance does not replace income like disability insurance does; rather, it covers the financial risk of unexpected medical costs.

•Annuity: Superannuation is the financial risk of living too long and running out of money. It is the economic risk of outliving the insured’s income and accumulated assets. This financial risk is addressed with an insurance product called an annuity. An annuity provides a guaranteed income stream, either immediately or at some point in the future.

PROPERTY RISK AND INSURANCE

Life, health, and disability insurances often come to mind first, when the consumer is mindful of insurance. However, insuring against economic loss to the individual is only part of a larger risk assessment in the personal financial plan. The next type of insurance involves property risk.

Property

The purpose of property insurance is to protect against economic loss as the result of theft or destruction of the insured’s personal property. Personal property could be almost anything over which the insured exercises dominion, use, or control. In the event of an economic catastrophe like a fire or theft, property insurance covers the cost to repair or replace property that was damaged, destroyed, or stolen. There are two types of property: real and personal.

Generally, real property refers to land. Land includes not only the surface of the ground but everything of a permanent nature over or under it. This includes natural structures and minerals located on or beneath the surface of the land. Raw land is usually uninsurable; however, an umbrella liability insurance policy is strongly encouraged for owners of real property. For example, a landowner is required to exercise reasonable care to eliminate any dangers that pose an unreasonable risk of death or serious bodily harm to trespassing children. Failure to do so may make the landowner liable for gross negligence or willful misconduct.

Personal property is property that can include any asset other than real estate. The distinguishing consideration between personal property and real property is that personal property is movable. Examples of personal property include vehicles, furniture, boats, and collectibles. Automobile insurance, homeowner’s insurance and renter’s insurance are the most common type of personal property insurance. Personal property insurance is not a maintenance contract. Personal property insurance is meant to cover a sudden and accidental loss, not a loss associated with the lack of proper maintenance or upkeep of the personal property. As shown in exhibit 7-5, there are three methods of settling a loss for personal property: guaranteed replacement cost, replacement cost, and actual cash value.

EXHIBIT 7-5	METHODS OF SETTLING A LOSS

Liability

Liability insurance coverage is designed to provide an economic benefit against a financial loss created by claims made by a third party (someone who is not a party to the insurance contract). It differs from traditional insurance in that the payment (claim) is made to a third party and not to the insured. Liability insurance is designed to provide an economic benefit to cover unintentional injuries or damages to other people or their property. Injuries caused by negligence are insured risks, while intentional injuries caused by the insured are not covered. Negligence is the failure to use a reasonable standard of care that results in damage or injury to another. It is the omission of performance by a reasonably prudent person if there is some duty to act. There are five elements required to establish negligence, as follows:

1. A legal duty to exercise reasonable care.

2. A failure to exercise reasonable care.

3. Physical harm as a result of negligent conduct.

4. Actual damages.

5. Harm done is within the scope of the insured’s liability.

STRICT LIABILITY

Legal Aspects of Insurance

While assessing the types of insurance and selecting companies and policies, remember: An insurance policy is a contract of indemnity. Indemnity is the principle that the insurance company will reimburse the insured up to the lesser of the insured’s economic loss, or the specified amount of coverage. The purpose of an indemnity contract is to return the insured back to his or her original financial position. In order for an insurance contract to be valid, there must be an insurable interest. An insurable interest is a relationship between the applicant and the subject matter being insured. The individual seeking the insurance contract must be subject to an economic loss upon the damage or destruction of property, or the disability, death or illness of an insured.

The five following elements are required for a contract to exist and be legally enforceable:

1. Offer and acceptance

2. Adequate consideration

3. Competent parties

4. Legal purpose

5. Legal form

If an insurance contract lacks one of the five elements of a valid contract, the contract will not possess legal effect and cannot be enforced by either party.

OFFER AND ACCEPTANCE

First, a contract must be established with a definite, unqualified offer by one party and the acceptance of the contract’s terms by the other party. As regards insurance contracts,

•an offer is made when the applicant submits the application with an initial premium; and

•an acceptance is confirmed when the insurance company accepts the offer and issues an insurance contract. As a result of underwriting, the insurance company may make a counteroffer. The applicant then has a choice to accept or reject the counteroffer.

If an application is made to an insurance company without an initial premium, then the roles of offer and acceptance are reversed. The insurer can respond by issuing an insurance policy (the offer) that the applicant can accept by paying the planned premium when the policy is delivered.

ADEQUATE CONSIDERATIONS

Second, in order for an insurance contract to have legal force, there must be an exchange of value. Adequate consideration is the value given in exchange for service. The submission of an insurance application and the initial premium payment (the consideration) to the insurance company generally creates a legally enforceable contract. The one caveat is that the proposed insured fulfill the underwriting requirements of the contract.

COMPETENT PARTIES

Third, the parties to a legally enforceable contract must be competent. An insurance company, one of the parties to an insurance contract, is considered competent if it is licensed or approved by the state in which it conducts business. An applicant, the other party to an insurance contract, is presumed to be competent. However, a minor (with some exceptions) or an individual under the influence of alcohol or drugs is considered not competent and unable to enter into a legally enforceable contract. The contract executed by someone who is incompetent may be voided under contract law.

LEGAL PURPOSE

Fourth, the subject of an insurance contract must be for a legal purpose. A contract for an illegal activity is not enforceable, just as a contract for the purchase of illegal goods or services is not legally enforceable.

A contract must have legal form in order to be enforceable. Contract law is state specific, and contracts entered into must follow the laws and guidelines of the state or jurisdiction in which they are entered.

LEGAL FORM

Fifth and lastly, a contract must have legal form to be enforceable. That is, it must be written in a form that complies with applicable contract laws. Contract law is state specific, and contracts must follow the laws and guidelines of the state or jurisdiction in which they are entered. The elements of legal form include the following:

•Aleatory Contract. Outcome is affected by chance, and amount of dollars given up is typically unequal (like a gambling contract). Insurance is an aleatory contract, inasmuch as an insured may pay a large premium and receive no proceeds from the policy. Conversely, an insured may pay only a small premium and receive a large claim settlement from the insurer.

•Unilateral Contract. Contracts of insurance are considered unilateral because only the insurance company has made a binding promise under the contract. The insurer promises to pay a benefit upon the occurrence of a specific event (such as an automobile accident, death, or disability). The applicant has not made a binding promise. The applicant may choose to stop paying the insurance contract premiums. However, the insurance company has the right to cancel the policy if premiums are not paid.

•Conditional Contract. A contract for insurance is a conditional contract: The payment of a benefit by the insurance company is conditioned upon the owner of the contract paying the premium.

•Contract of Adhesion. A contract is accepted “as is” or not at all. An insurance contract is considered to be a contract of adhesion because the owner of the contract must adhere to the terms of the contract. The contract is prepared by one party (the insurance company) and accepted by the other party (the insured). There is no negotiation of contractual terms between the two parties. As a result, in the event of a dispute between an insurance company and the insured over contract language, the courts are more likely to rule in favor of the insured and against the insurer.

•Incontestability Clause. The incontestable clause is a feature found in life and disability insurance contracts. With the exception for fraud, after a period of two years, life insurance and disability contracts may not be canceled by an insurance company.

Chapter Review

In large part personal financial planning is about mitigating economic risk. Whether it is the risk of outliving financial resources or an automobile fender bender, risk is with us everywhere we go, in one form or another. One way to address risk in a personal financial plan is through the purchase of insurance. However, personal financial planning, can mitigate or eliminate risk, without the purchase of insurance if accomplished correctly. The personal financial planner should bring an actuarial eye to each client’s personal financial plan and consider ways in which risk might be avoided, reduced, retained or transferred based on individual facts and circumstances.

CASE STUDY REVISITED

Susan, Rick and the family are taking on a great deal of risk for their big wedding anniversary:

 

•It is a celebration, and most likely some type of adult beverages will be served. Liability will inure to the Johannsen’s should a driver have an accident returning to their home from the party.

•The regatta will require insurance for the event. Both the yacht club and the family will share liability for the event.

•The fireworks show is a substantial risk to all parties involved. The manufacturer of the fireworks will have liability, as well as the family. The liability will be not only for direct injury caused by an explosive, but also potential fires created by the sparks.

•Valets driving someone else’s automobile create liability for the valet and the owner of the automobile (what if the valet was under legal age and you gave them your automobile to park and someone was injured?).

•Alice’s raptor idea opens both the zoo and the family to strict liability.

•Kayaks, paddle boats and a dock create limitless liability by providing the boats and allowing guests to swim off the dock.

ASSIGNMENT MATERIAL

REVIEW QUESTIONS

1. A condition that may increase either the severity or frequency of an economic loss is:

A. Adverse selection.

B. Hazard.

C. Peril.

D. Risk.

2. Which of the following are considered moral hazards?

I. Driving while intoxicated.

II. Failing to lock your front door, which results in the theft of a computer and other personal effects.

III. Reporting excess damage from a hailstorm in order to collect additional insurance benefits.

IV. Stealing an acquaintance’s automobile in order to file a theft claim and split the claims with the acquaintance.

A. I, II.

B. II, III.

C. I, II, III.

D. I, III, IV.

3. Which of the following risks are considered insurable risks?

I. Investment risk.

II. Peril risk.

III. Pure risk.

IV. Speculative risk.

A. I, IV.

B. II.

C. II, IV.

D. II, III.

4. Which of the following is an element of insurable risk?

A. The loss must be unexpected or accidental.

B. The loss must be catastrophic.

C. The loss produced by the risk cannot be measurable.

D. The loss must be damage related.

5. Wearing a seat belt when driving an automobile is which of the following responses to risk?

A. Risk avoidance.

B. Risk transfer.

C. Risk retention.

D. Risk reduction.

6. Which of the following is the most suitable response for risks that involve high loss severity and low loss frequency?

A. Risk avoidance.

B. Risk diversification.

C. Risk reduction.

D. Risk transfer.

7. Which of the following is an example of a hazard?

A. Bringing a new product to market in Chicago.

B. Building a residence on the Intracoastal Waterway in Miami.

C. Making a bet while visiting Las Vegas.

D. Purchasing a new residence in Indianapolis.

8. Which of the following is not an element of an insurable risk?

A. A sufficiently large number of homogeneous exposure units.

B. Catastrophic loss.

C. A definite loss.

D. A fortuitous loss.

9. With regards to self-insurance which of the following is/are true?

I. A concentration of risk exposures is a fortuitous loss.

II. The law of large numbers will not operate.

III. The possibility of higher income taxes exists.

IV. The self-insured must replace the services provided by an insurer.

A. I, IV.

B. I, II, IV.

C. II, III, IV.

D. Ill, IV.

10. There is a 5 percent probability of loss (theft) each month for hotel towels. How would this loss be described using the frequency-severity method, and what is the appropriate response?

A. High severity/High frequency/Risk transfer.

B. High frequency/Low severity/Risk retention.

C. Low severity/High frequency/Risk reduction.

D. Low frequency/Low severity/Risk avoidance.

INTERNET RESEARCH ASSIGNMENTS

1. Download A Shopper’s Guide to Long-Term Care Insurance by the National Association of Insurance Commissioners (2013). What resources in the guide did you find to be of the greatest benefit?

https://www.ltcfeds.com/epassets/documents/naic_shoppers_guide.pdf

2. Visit your state’s Department of Insurance website. What resources are available to consumers? List six resources and why you found them valuable.

3. Visit the National Association of Insurance Commissioners’ website. Download State Insurance Regulation: History, Purpose and Structure. (In case you have trouble finding this document, here is the direct link: http://www.naic.org/documents/consumer_state_reg_brief.pdf.) What famous historical figure “helped found the insurance industry in the United States in 1752?”

4. Go to the A.M. Best website (http://www3.ambest.com/ratings/default.asp) and search for the rating for your automobile insurance. What is the ratings history for your automobile insurance company?

5. Search the Internet for the registration history of your insurance agent or broker. The following keywords should generate the necessary information: name of your state + insurance agent + search. Each state’s Department of Insurance website has different links to obtain this information.

6. Visit the Society of Actuaries website. It is the largest actuarial professional organization. What are the requirements for membership?