Class 4 Insurance and Risk Management

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Class 4Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2006

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Review Definition of Insurance

• Pooling of fortuitous losses by transfer of such
  risks to insurers, who agree to indemnify
  insureds for such losses, to provide other
  pecuniary benefits on their occurrence, or to
  render services connected with the risk.

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Definition Adverse Selection

• The tendency of persons with a higher-than-average
  chance of loss to seek insurance at standard
  (average) rates, which if not controlled by
  underwriting, results in higher-than-expected
  loss levels.

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Adverse Selection and Classification

• Adverse selection occurs when the insurer cannot
  classify, but the policyholders know their risk
• At a given price,
• high risk people will buy more coverage
• low risk will buy less coverage

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IIHS Statistics
3 years experience
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Heterogeneous Buyers

• Two groups of buyers
• One Group (MAPs middle aged professionals)
• Possible Loss Probability
• 0 0.95
• 10,000 0.05
• Another Group (YUMs young unemployed males)
• Possible Loss Probability
• 0 0.90
• 10,000 0.10

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Implications of Heterogeneous Buyers

• Our initial assumptions are that
• Equal number of each type
• Losses are Independent
• Full Insurance is mandatory
• Costless to distinguish MAPs from YUMs

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Implications of Heterogeneous Buyers

• Initial Scenario
• Equal Treatment Insurance Company is only insurer
• Premium for everyone 750
• Does Equal Treatment cover its costs?
• _____, the YUMs pay less than their expected
  cost, but the MAPs pay more

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Implications of Heterogeneous Buyers

• New Scenario allow competition
• Competition from Selective Insurance Company
• If Selective assumes Equal Treatment will
  continue to charge 750, how does Selective set
  price to maximize profits,
• Premium to MAPs 600
• Premium to YUMs 1100
• Profit per policyholder 100

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Implications of Heterogeneous Buyers

• What happens to Equal Treatment?
• It would experience adverse selection
• I.e., it would obtain an adverse selection of
  policyholders -- only the YUMs will purchase from
  Equal Treatment
• Thus, Equal Treatment will have to classify or
  lose money

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Implications of Heterogeneous Buyers

• Key Points
• Profit Maximization
• Risk Classification
• Competition
• Lack of Classification
• Adverse Selection
• Competition

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Deductibles and Adverse Selection

• Insurer offers multiple policies with different
  deductibles and different prices per dollar of
  coverage
• Lower deductible (higher coverage) policies have
  a higher price per dollar of coverage
• Higher risk people might choose the lower
  deductible (higher priced) policies
• Lower risk people might choose the higher
  deductible (lower priced) policies

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Deductibles and Adverse Selection

• Result applicants separate themselves into
  different policy groups
• Thereby, permitting the insurance company to
  classify and underwrite risks in a low-cost way

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Similar Purpose of Policy Limits

• People have limited amount of wealth they want to
  protect
• Reduce classification costs when consumers have
  information that is costly for insurers to obtain
• Example
• Homeowners policy might limit coverage for
  jewelry losses to 1,500
• Those with more expensive jewelry buy special
  coverage
• Insurer does not have to investigate the value of
  each policyholders jewelry

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Fundamental Legal Principles Underlying Insurance
Contracts

• Principal of Indemnity
• Insurable Interest
• Subrogation
• Principle of Utmost Good Faith

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Principle of Indemnity

• States the purpose of insurance is to restore
  the insured to approximately the same financial
  position that existed prior to the loss.
• In other words, the insured should not profit
  from the loss

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Principle of Indemnity

• Two fundamental purposes
• To prevent the insured from profiting from
  insurance
• To reduce moral hazard

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Actual Cash Value

• Underlies the principle of indemnity
• The standard method for indemnifying in a
  property loss
• ACV Replacement cost less depreciation
• Example of Sarahs couch

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Exceptions to the Principle of Indemnity

• Valued policy
• Antiques
• Fine arts
• Rare paintings
• Family heirlooms

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Exceptions to the Principle of Indemnity

• Valued policy laws
• Original purpose to protect insured from
  over-insurance
• Less important now

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Exceptions to the Principle of Indemnity (cont.)

• Replacement Cost Insurance
• No deduction taken for depreciation in
  determining the amount paid for a loss
• Recognizes that few people budget for
  depreciation.
• Under ACV, Insured could be required to come up
  with a substantial cash to restore the property
  to its original condition.

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Exceptions to the Principle of Indemnity (cont.)

• Life Insurance
• Not a contract of indemnity
• Valued policy that pays a stated sum at the
  Insureds death

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Indemnity versus Valued Contracts

• Indemnity contract - insurer pays based on the
  amount of loss that occurred
• Example auto physical damage
• Valued contract - insurer pays a pre-determined
  amount
• Example life insurance

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Indemnity versus Valued Contracts

• Indemnity contract - insurer pays based on the
  amount of loss that occurred
• Example auto physical damage
• Valued contract - insurer pays a pre-determined
  amount
• Example life insurance

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Type of contract explained by two factors

• The costs of assessing value
• Moral hazard

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Indemnity versus Valued Contracts?

• When the amount of loss can be assessed at low
  cost following the loss, more likely to have
  indemnity contracts
• When moral hazard is less likely to be a problem,
  fixing the insurance payment before a loss can
  avoid costly haggling following a loss
• (e.g., life insurance, valuable personal articles)

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Insurable Interest

• Insured must lose financially if a loss occurs,
  or must incur some other kind of loss from the
  harm.
• To be legally enforceable, all insurance
  contracts must be supported by insurable
  interest.
• A policy can be voided if insurable interest is
  found to be non-existent.

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When Must Insurable Interest Exist?

• In property and liability insurance, the
  insurable interest must at exist at the time of
  loss.
• In life insurance, the insurable interest must be
  met only at the inception of the policy, not at
  the time of death.

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Examples of Insurable Interest

• Ownership of property
• Homeowner
• Potential Legal Liability
• Dry Cleaner
• Secured Creditors
• Bank granting a mortgage
• Contractual Right
• Business contracting to purchase goods from abroad

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Principle of Subrogation

• Supports the principle of Indemnity
• Substitutes the Insurer in place of the Insured
  for the purpose of claiming indemnity from a
  third party for a loss covered by insurance

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Subrogation Example

• Assume a negligent motorist
• Fails to stop at a red light
• Smashes into the Insureds car
• Causing damages to the Insureds car of 5,000.
• Insured has purchased collision insurance for her
  car.
• The Insureds Insurance Company will
• Pay the physical damage loss (less any
  deductible)
• Then attempt to collect from the negligent
  motorist

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Subrogation Example (cont.)

• Alternatively, the Insured could attempt to
  collect directly from the negligent motorist.
• Subrogation does not apply, if a loss payment is
  not made by the Insureds insurance company.
• To the extent that a loss payment is made, the
  Insurer receives the legal right to collect
  damages from the negligent third party.

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Subrogations Effects

• Prevents the Insured from collecting twice for
  the same loss.
• Holds the guilty party responsible
• Holds down insurance rates
• Generally, subrogation recoveries are factored
  into the rate-making process

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Subrogation Caveats

• The Insured cannot do anything after the loss
  that impairs the Insurers subrogation rights.
• Subrogation does not apply to life insurance and
  most health insurance contacts.
• Insurer cannot recover against its own Insureds.

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Principle of Utmost Good Faith

• Insurance contracts are contracts uberrimae
  fidei, or of the utmost good faith.
• Utmost Good Faith imposes a higher degree of
  honesty on both parties to an insurance contract,
  than is imposed on parties to other contracts.
• Neither party is to take advantage of the others
  lack of information.

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Historical Roots of Utmost Good Faith

• Legal foundation rests on principles established
  long ago for insurance on ocean vessels and
  cargoes
• Marine underwriter had to place great faith in
  the statements made by the applicant for
  insurance
• The cargo may not have been able to be visually
  inspected
• The contract may have been issued in a location
  far removed from the cargo or ship
• Thus, a high degree of honesty was imposed on the
  applicant for insurance

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Legal Doctrines Supporting Utmost Good Faith

• Representations Statements made by the applicant
  usually made in response to a question from the
  insurer
• Concealment Intentional failure of the applicant
  for insurance to reveal a material fact to the
  Insurer
• Warranty A statement achieves the status of a
  warranty if it becomes a condition of the
  insurers promise

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Representation (cont.)

• Material means that
• If the Insurer knew the true facts, the policy
  would not have been issued or would have been
  issued on different terms.
• False means that
• The statement is not true or is misleading.
• Reliance means that
• The Insurer relies on the misrepresentation in
  issuing the policy at a specified premium

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Concealment Legal Significance

• Concealment is the same as non-disclosure.
• The applicant for insurance deliberately
  withholds material information from the insurer
• Legal significance is the same as
  misrepresentation
• The contract is voidable at the Insurers option.

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Concealment generally has two elements

• The concealed fact was known by the Insured to be
  material
• The Insured intended to defraud the Insurer

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Harsher standard applies in marine insurance

• An ocean marine insurer is not required to prove
  that the concealment is intentional.
• An ocean marine insurer can successfully deny a
  claim if it can be shown that the concealed fact
  is material

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Two Types of Warranties

• Affirmative warranty states a condition that is
  supposed to exist on the date the statement is
  made
• Example Auto policy applicant states at time
  of application that no auto insurer has cancelled
  coverage in the last three years
• Promissory warranty states a condition that is
  to exist throughout part or all of the policy
  period
• Example Burglary policy applicant warrants
  that burglar alarm system described in the policy
  will be maintained in working order throughout
  the policy period

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Breach of Warranty

• If a statement is construed as a warranty, the
  court may allow the insurer to deny coverage, if
  there has not been literal compliance with the
  statement
• Effect can be very harsh.
• To deny coverage, all the insurer may need to
  show was that the warranty was breached, even if
  the breach were unintentional and not related to
  the loss.

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Doctrine of Reasonable Expectations

• Courts interpret contracts as would a reasonable
  person not trained in the law.
• If a reasonable person would expect a policy to
  cover a certain loss, the courts might require
  the insurer to pay the loss,
• Even if the contract specifically excludes the
  loss

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Doctrine of Reasonable Expectations Examples

• Tavern owner purchased standard business
  liability insurance policy
• Policy clearly excluded claims arising out of the
  sale of alcoholic beverages
• Claim was brought against tavern owner for
  negligently serving alcohol to a person who later
  caused an auto accident
• Insurance company claimed that the Insured
  knowingly purchased this policy to receive a
  lower premium
• Court ruled that the insurer had to pay because
  the tavern owner would reasonably expect the
  claim to be covered

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Doctrine of Reasonable Expectations Examples

• Environmental Liability
• In 1973, sudden and accidental clause was
  incorporated in the standard CGL policy.
• This specifically excluded coverage arising from
  pollution, except if the event causing the
  pollution was sudden and accidental.
• During the 1970s and 1980s, the courts
  increasingly found businesses liable for
  low-level, gradual releases of potentially toxic
  substances.
• Many of these firms took the claims to their
  liability insurance companies, who denied
  coverage.

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Environmental Liability Example (cont.)

• Some courts found that coverage existed for these
  claims, even though the policies had a specific
  exclusion for all but sudden and accidental
  pollution.
• Further complicating factor Since pollution
  occurs over many year, multiple policies can be
  potentially liable
• This has led to stacking of limits.
• The result has been enormous litigation between
  insurers and policyholders over whether the
  policies cover pollution losses.

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Requirements of a Legal Contract

• Four Requirements Apply to All Contracts
  Generally
• Insurance is no Exception
• Offer and Acceptance
• In Insurance, offer made by the applicant
• Insurer may accept or make counteroffer
• Consideration
• Payment of premium
• Promise to pay premium

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Requirements of a Legal Contract (cont.)

• Legal Capacity
• Insane or intoxicated not competent
• Minors may void contract before attaining
  majority (some exceptions)
• Insurer presumed to be competent if meets
  statutory requirements to be licensed

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Requirements of a Legal Contract (cont.)

• Purpose Not Contrary to Public Interest
• All Contracts agreement to commit criminal act
  is not a legal contract
• Insurance Must be an Insurable Interest
• Life insurance when the contract is written
• Property insurance at the time of the loss

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Insurance Contracts Distinctive Features

• Personal Contract
• Unilateral Contract
• Conditional Contract
• Aleatory Contract
• Contract of Adhesion

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Personal Contract

• Insurance contract insures the legal interest of
  a person or entity in the valued object
• If the owner at time insurance contract is issued
  sells the property, the new owner is not insured,
  unless the insurer agrees to an assignment of the
  insureds rights to the new owner

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Unilateral Contract

• Most contracts are bilateral
• This means the courts may be used to enforce the
  contract
• They can require the performance of either party
• In contrast, most insurance contracts are
  unilateral.

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Unilateral Contract (cont.)

• The courts will enforce the contract against only
  one party the insurer
• Exception If the insureds promise to pay in the
  future induced the insurer to issue coverage, the
  insurer could use the courts to force payment.
• Example of Unilateral Contract Typical Life
  Insurance Policy

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Conditional Contract

• Insurance contract is an conditional Contract
• Insurer can refuse to perform if insured does not
  satisfy certain conditions in the contract
• Examples of conditions
• If the insured increased the chance of loss in a
  manner prohibited in the contract
• The insured failed to submit a proof of loss as
  required by the contract

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Examples of Conditions (cont.)

• Conditions found in a liability policy
• Failure to provide assistance to insurer in
  investigating circumstances giving rise to the
  claim
• Refusal to testify in court if requested

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Aleatory Contract

• Characterized by two design elements
• Chance element
• Uneven exchange
• Performance of at least one of the parties is
  dependent on chance.
• And, one party promises to do much more than the
  other party.

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Aleatory Contract (cont.)

• Most non-insurance contracts are commutative
  the exchange is of equal values.
• Many people mistakenly employ this concept when
  thinking about insurance.
• An insurance contract will only result in an
  equal exchange by coincidence or over a very long
  period of time.

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Aleatory Contract (cont.)

• The uneven exchange is not a flaw in the
  contract.
• Rather it is a fundamental feature of a contract
  that is both conditional and aleatory.

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Contracts of Adhesion

• A contract drafted by one party to which the
  other party must adhere.
• In most insurance transactions, the Insured is
  not allowed to participate in the drafting of the
  contract.
• Since contract is presented as take it or leave
  it the company is held responsible for unclear
  or ambiguous provisions.

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Contracts of Adhesion (cont.)

• This is often referred to as the ambiguity rule
• Ambiguities are interpreted in favor of
  policyholder
• Ambiguity rule applied less often to commercial
  insurance.
• Bargaining over wording results in a manuscript
  policy

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Summary Characteristics of the Insurance
Contract

• Aleatory values exchanged are not equal
• Unilateral only the insurer makes a legally
  enforceable promise
• Conditional policyowner must comply with all
  policy provisions to collect for a covered loss
• Personal property insurance policy cannot be
  validly assigned to another party without the
  insurer's consent
• Contract of adhesion since the insured must
  accept the entire contract as it is written, any
  ambiguities are construed against the insurer

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Law and the Insurance Agent

• General Rules of Agency
• There is no presumption of an agency
  relationship.
• Agents may bind the principal by
• express authority
• implied authority
• apparent authority

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Law and the Insurance Agent

• Principal is
• Responsible for an agents torts, and
• Charged with agents knowledge of notice.

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Doctrines of Waiver and Estoppel

• Waivervoluntary relinquishment of a known legal
  right
• Estoppelrepresentation of fact made by one
  person to another person that is reasonably
  relied on by that person to such an extent that
  it would be inequitable to allow the first person
  to deny the truth of the representation

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Waiver Example

• Application received by insurer with missing
  information
• Insurer does not contact applicant for missing
  information
• Insurer cannot deny claim later on basis of
  incomplete application
• By issuing the contract, the insurer has waived
  its right to a complete application

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Estoppel Example

• Insureds auto premium is due.
• Calls asks agent for an extension of time
• Agent indicates there is a 10-day grace period
  for overdue premiums
• If insured has accident during so-called grace
  period, Insurer cannot deny claim
• Insurer is estopped or precluded from denying
  coverage due to non-payment, because the Insured
  relied on the agents statement

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Waiver and EstoppelSignificance

• Insurer legally may be required to pay a claim
  that it ordinarily would not have