Risk Management for Financial Planners, 2nd Edition

Christine Barlow

• Publisher: The National Underwriter Company
• Year: 2012
• eBook ISBN: 9781938130168
• Topic: Business
• Subtopic: Insurance
• Index: Business

Delivers fundamentals of risk management as a means to complement, benefit, and promote all areas of business planning. With focus on relevant risk management basics, discover that the process involves more than the core activities of making and growing clients' assets. The planning process consists of proactively uncovering wealth preservation objectives specific to needs today's practitioner faces. Insurance, PACE, and CFP®CE Filed. Comprehensive coverage consists of: Enterprise &traditional risk management Loss control &claims management Alternative risk &contractual transfer Global exposures Disaster planning Broker &vendor relationships

CHAPTER 1

GENERAL PRINCIPLES OF RISK AND INSURANCE

DEFINITIONS AND CONCEPTS

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.

Some say that in purchasing insurance on a piece of real property (such as a home or business premises) or against the happening of some liability-producing event (such as physicians’ or attorneys’ malpractice), the purchaser is buying peace of mind, i.e., 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.” 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 be more nearly 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 (payment of 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.

This 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 (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.

Therefore, in sum, insurance promises to indemnify the customer for accidental losses caused by certain perils. In exchange, the customer promises to pay the premium.

The insurance company agrees to take on the insured’s risk of loss. In exchange, the insured promises to pay the premium. The insurer takes the premiums of the many people who buy insurance and pools them. It invests those premiums to earn more money, to pay its employees, to pay losses, and to earn a profit.

PERIL, HAZARD AND RISK

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. There is a risk. 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 a covered peril (coverage is included under the policy) or an excluded peril (coverage 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.

THE CONCEPT OF “INDEMNITY”

“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. Joe’s 2001 car (worth about $7,000) is damaged in an accident. The body shop estimates that it will cost $10,000 to fix it. If the insurer spends the $10,000 to repair the car, the insured will be better off after the loss than prior to it. When the insurer pays Joe the $7,000 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.

INSURANCE VERSUS GAMBLING

Insurance is not wagering. So how does insurance differ from gambling? When you gamble, you take a chance of losing money. That is correct, but when you gamble you also may break even or come out ahead. There are three possible outcomes: a loss, no loss, or a profit.

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.

REVIEW OF DEFINITIONS

Let’s conclude this first section with a review of some important terms:

Risk is the chance of economic loss – a chance of a fire to a home.

Insurance is a way to reduce risk by combining similar units and sharing the losses of the few among the premiums of the many. The chance of loss of a group of homeowners is pooled and the premiums paid by all of them are used to pay for the losses of the few.

Insured is the person buying the insurance – for example, the homeowner.

Premium is the consideration paid by the insured in exchange for the insurer’s promise to indemnify.

Indemnify is what an insurance policy does – it puts the insured back in the position he or she was in prior to the loss – no better off, no worse.

Losses are financial – losses of money or things worth money.

Perils are causes of loss – such as fire, wind, theft, injury, etc.

Hazards are items or situations that increase the chance of loss from a peril, such as the storage of flammable liquids.

OTHER 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 – 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 insurance.

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 – this involves either not doing something at all or getting rid of it and 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 dangerous operation, a company is avoiding future losses from that operation.

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 AND SOCIAL INSURANCE

In today’s market, there are two broad types of insurers – social and voluntary.

Social insurers are government agencies that provide “socia...

Table of contents

• DEDICATION
• ABOUT THE AUTHORS
• PREFACE
• CHAPTER 1
• CHAPTER 2
• CHAPTER 3
• CHAPTER 4
• CHAPTER 5
• CHAPTER 6
• CHAPTER 7
• CHAPTER 8
• CHAPTER 9
• CHAPTER 10
• CHAPTER 11
• CHAPTER 12
• CHAPTER 13
• CHAPTER 14
• CHAPTER 15
• CHAPTER 16
• CHAPTER 17
• CHAPTER 18
• CHAPTER 19
• CHAPTER 20
• CHAPTER 21
• CHAPTER 22
• CHAPTER 23
• CHAPTER 24
• CHAPTER 25
• CHAPTER 26
• CHAPTER 27
• APPENDIX A
• APPENDIX B
• GLOSSARY
• ANSWER KEY
• END OF CHAPTER REVIEW