The Tools & Techniques of Insurance Planning and Risk Management, 3rd Edition

Stephan R. Leimberg , Kenneth Price

• Publisher: The National Underwriter Company
• Year: 2016
• ISBN:
  9781941627969
• Topic: Betriebswirtschaft
• Subtopic: Finanzwesen

This is the third edition of our popular professional resource specifically tailored for non-insurance professionals. Financial planners, tax advisors, and estate planners have all found this book to be invaluable in their practices because it provides the insights, understanding and tools to guide clients as they seek to manage risk and properly plan insurance coverage.

GENERAL PRINCIPLES OF RISK AND INSURANCE

CHAPTER 1

INTRODUCTION

What is insurance? The insurance transaction is a purchase of a contract (called the insurance “policy”) that on behalf of the purchaser pledges the payment of a sum-certain amount (the “premium”) in exchange for a promise on behalf of the other party (the insurance company, or insurer) to provide restitution or indemnity arising from the occurrence of a loss. That is, the insurance transaction guards against the financial or economic repercussions arising from that occurrence.

Insurance is not wagering. When you gamble, you take a chance of losing money, but you also may break even or come out ahead. With insurance, on the other hand, there are only two possible outcomes: a loss or no loss. When you insure a home, it will either burn down or it won’t burn down. If you have insurance on it and there is a fire, the insurance will put you back in the same position you were in prior to the fire.

Some say that in purchasing insurance on a piece of real property (such as a home or business premises) or against some liability-producing event (such as physicians’ or attorneys’ malpractice), the purchaser is buying peace of mind with the knowledge that the economic hardship of a loss will be transferred to another party – the insurance company selling the coverage.

One classic definition of insurance is “a device for reducing risk by combining a sufficient number of exposure units to make their individual losses collectively predictable.”¹ In other words, the losses of the few are shared among the premiums of the many.

This is an illustration of the “law of large numbers” which is the primary underpinning to the insurance mechanism. This is the principle that allows insurance to operate. The rule says that the more exposure units in the mix, the easier it becomes to predict the group’s losses. Flip a coin three times and it might turn up heads each time. Flip a coin one million times and it will likely be more evenly split between heads and tails. Take thousands and thousands and thousands of similarly situated units (like home owners, for instance) and you will be able to predict the losses that will occur in the group – and create a pool of financial resources (paid premiums) that allows for payment of the individual members of the group’s losses – and allows the insurer to turn a profit on the transaction.

The law of large numbers mechanism highlights the risk-transfer aspect of insurance. Another aspect of the definition of insurance says that insurance is a risk management technique – a means of budgeting a relatively small, known amount up-front cost (the premium) in place of a large – and possibly catastrophic – unknown future event (a possible loss). Therefore, an adequate definition must include the transfer of risk to a third party (the insurer), the accumulation of a fund to pay the losses, and a large enough number of similar exposure units (the insureds).

Another element to introduce into the insurance mix is the idea of fortuitousness. Non-fortuitous loss (those losses that are certain to occur) may not be insured. It is the concept of fortuitous acts that are insurable – a loss may or may not occur, so it may be insured; if the loss is certain to happen, it generally may not be the subject of an insurance policy.

In sum, insurance companies promise to indemnify the customer for accidental losses caused by certain perils. In exchange, the customer promises to pay the premium. On an aggregate level, insurers receive premiums from many people who buy insurance and pool them. They invest those premiums to earn more money, to pay its employees, to pay losses, and to earn a profit.

USEFUL DEFINITIONS

The following definitions are terms that are commonly used in every type of insurance policy. Their meanings in the insurance context may be similar to, but slightly different from how one might use them in everyday language.

A policy is the document that describes the types of coverage offered to the person who purchased the insurance (who are in turn referred to as “insureds” or “policyholders”). The description of the coverage is often dense and technical, and includes definitions of the coverage provided as well as declarations by the policyholder about who and what will be covered in the event of a loss.

Indemnify is an important part of the insurance definition. It means, “to make whole again.” In other words, insurance puts the person back in the same position he or she was in prior to the loss – no better, no worse.

Example. Will’s 2012 Lexus (worth about $22,550) is damaged in an accident. The body shop estimates that it will cost $24,000 to fix it. If the insurer spends the $24,000 to repair the car, the insured will be better off after the loss than prior to it. When the insurer pays Will the $22,550 he is indemnified for his loss – he is paid an amount equal to what he lost. It’s a fair general statement that an item of property cannot be insured for more than it’s worth.

A premium is the amount of money that a policyholder pays the insurance company to provide a certain amount of coverage. Premiums are sometime paid all at once for coverage over a set period of time, or can be paid periodically to ensure ongoing coverage as described in the policy.

Peril, Hazard, and Risk: Not the Same Thing

Before proceeding, the terms peril, hazard, and risk should be defined. Although these three terms are often used synonymously by practitioners in the field, they do have differing technical meanings.

• Risk may refer to uncertainty as to the outcome of an event when two or more possibilities exist, i.e., a building may stand or it may burn down. In property insurance, risk may also mean the physical units of property insured or the physical units of property at risk. For example, some might say, “the only risk the underwriter wants to take is fire on pig iron under water,” or “that fireproof concrete block building is a good fire risk.”

• A peril, in property & casualty insurance terms, is a cause of a possible loss. For example, fire is a peril in property insurance, as is water damage, mold, earth movement, etc. A peril may be covered (coverage for the event is included under the policy) or excluded (coverage for the event is specifically excluded under the policy).

• A hazard is a specific situation that increases the probability of the occurrence of loss arising from a peril or that may influence the extent of the loss. For example, fire, flood, and explosion are property perils – and liability itself is a peril under liability policies. Slippery floors, congested aisles, and oily rags in the open are hazards.

Non-Insurance Responses to Risk

People buy insurance to help them manage the risks in their lives. However, insurance is only one way to handle those risks. Some other methods of risk management are:

Retention – occurs when one does not purchase insurance and decides to assume the risk on his or her own. If a loss does not happen, the person saves the money that he or she would have spent on premiums.

A good example of retention is the decision not to purchase collision insurance on an older car. Retention requires that the insured do a careful analysis of what he or she can afford to lose. Some corporations use large retentions as a financial risk management strategy. For example, insurance coverage does not kick in until a loss has exceeded $25,000 or more. The insured saves on premium but has coverage for disastrous losses.

Avoidance – involves either not doing something at all or getting rid of it or not doing it any more. By relying on public transportation, one avoids the physical damage and liability risks of car ownership. By selling off a casino, a company is avoiding future losses from legislative changes that could negatively affect the casino.

Control – is the minimizing of hazards, the things that increase the chance of loss. By putting a burglar alarm in the car, the owner is using the technique of control.

Non-insurance transfer – is the transfer of risk to someone other than an insurer.

Example. When renting tools, the customer signs a form promising to bring them back in the same condition. If he or she does not, the storeowner will charge the customer for those tools. The storeowner has used a non-insurance transfer to protect his property.

VOLUNTARY INSURANCE

In today’s market, there are two broad types of insurers – social and voluntary. Voluntary insurers are insurers that offer types of insurance that are not mandatory, and cover a wide variety of risks. These are what most people think of as “insurance companies,” and they offer the most common types of commercially available insurance:

• Property insurance protects policy holders against damage to their property from loss events such as fires, natural disasters, and accidents.

• Liability insurance protects policy holders against liability that may be imposed on them through the legal system, such as liability arising from their driving conduct or actions they take as employers.

• Health, disability, and long-term care insurance protect policyholders against the financial consequences of ill health. This can include payment of medical bills, rehabilitation services, and replacement of income lost due to illness.

• Life insurance provides financial benefits to loved ones (or entities such as employers or charities) after the policyholders death. Due to the long time horizons involved in life insurance, policies have also grown to include investment-like vehicles including annuities.

These types of insurance can be purchased separately or together. For instance, a typical homeowners insurance policy (see Chapter 12) includes significant coverage against both property and liability risks. The art of insurance planning involves helping clients choose (1) which insurance products to buy, and (2) how to purchase them.

Types of voluntary Insurers

The voluntary market provides an endless variety of coverages that are designed to meet almost any need. The four types of voluntary insurers are governmental, cooperative, self, and for-profit.

1. Governmental insurers offer voluntary coverage on risks that the private market may find too hazardous to insure. Such offerings include flood insurance, earthquake insurance, crime and fire insurance in the inner city, windstorm insurance in coastal states, crop insurance, and private passenger auto insurance for persons with very poor driving records. As examples, the National Flood Insurance Program offers flood insurance, California Earthquake Authority offers earthquake insurance, and the Texas Windstorm Insurance Association provides windstorm insurance to Gulf Coast property owners in Tex...