Principles of Risk and Insurance. Introduction to the Principles of Risk and Insurance

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1 Principles of Risk and Insurance Introduction to the Principles of Risk and Insurance We are exposed to many situations that many cause a loss (perils). The primary purpose of insurance is to provide economic protection against losses that may be incurred due to a chance of an event happening such as death, illness, or accident. This type of protection is provide through an insurance policy, which is simply a device used by companies to accumulate funds to have enough reserves to meet these uncertain losses. DEFINITIONS Risk Risk can be defined as uncertainty regarding loss: the inability to work and earn an income due to disability is a risk the destruction of a home due to hurricane is a risk the loss of family income due to death is a risk the potential for an automobile accident is a risk the chance of someone slipping on your icy driveway is a risk

2 Insurable Risks Risks are generally divided into two classes: Pure risks and Speculative risks. Pure Risks- these risks involve only the chance of loss, there is never an opportunity for gain or profit. Examples: injury from an accident, loss of home from an earthquake. Only Pure Risks are Insurable Speculative Risks- These risks involve both the chance of gain or loss. Examples: Gambling at the race track, or investing in the real estate market. Speculative Risk is not Insurable Elements of an Insurable Risk Loss must not be Catastrophic Loss must be Unexpected or Accidental Loss produced by the risk must be Definite and Measurable Must be a significantly large number of homogeneous exposure units to make the losses reasonable predictable Risks can also be evaluated on an economic scale comparing static and dynamic risks: Static Risks are the losses that are caused by factors other than a change in the economy (for example- hurricanes, earthquakes, other natural disasters) Dynamic Risks are the result of the economy changing (examples- inflation, recession, and other business cycle changes). Dynamic risks are not insurable.

3 Self-Insurance - Self-insurance is the process of an individual or company acting like an insurance company to cover its own risks. This involves evaluating a large number of similar potential losses, the ability to predict the overall losses with some degree of accuracy, and the establishment of a formal fund for future losses and their possible fluctuations. Self-Insurance for both companies and individuals has its pros and cons: Advantages: Avoid the cost of premiums for commercial or personal insurance Reserves can be invested in short-term money market instruments and later used by the company or individual when the insurance is no longer needed Disadvantages: Company/individual is exposed to a catastrophic loss Services provided by the insurance company are assumed Income taxes may be due on the interest/profit from the reserve cash

4 RISK MANAGEMENT PROCESS The objective of risk management is to choose efficiently among methods to handle risk so as to avoid catastrophic losses. Risk management includes insurance management, but it should be used to measure both insurable and non-insurable risks. The process of risk management has six distinct steps: STEP 1- Identify risk management goals and objectives STEP 2- Gather pertinent data to determine the risk exposure STEP 3- Analyze and Evaluate the client's status STEP 4- Develop and Present risk management recommendations STEP 5- Implementation STEP 6- Ongoing Monitoring

5 RESPONSE TO RISK Risk Avoidance A risk may be avoided if the individual refuses to accept risk by not engaging in an action that creates a risk (removal of the peril). Consider the following risk avoidance instances: Taking the bus rather than buying a car Renting a home rather than buying it Not buying an office building without a sprinkler system Risk Diversification Risk diversification, also known as risk sharing, is a method of reducing your total exposure to risk by sharing the responsibility with another party. Consider the following risk diversification strategies: Forming a limited partnership for your business Hedging contracts Health insurance with deductibles and co-payments Risk Reduction Risk reduction is the process of diminishing risk through the implementation of loss prevention methods or implementing safety features or improvements. Consider the following risk reduction techniques: Mounting smoke detectors in your building Installing hurricane shutters on your home Put a burglary system on your vehicle

6 Risk Retention Risk retention is the act of accepting risk and confronting it if and when it occurs. In this process, no action is taken to avoid, transfer, or reduce risk. Consider the following risk retention actions: Self-insurance Coinsurance in various insurance policies Utilizing deductibles in insurance contracts Risk Transfer Risk transfer is the practice of shifting risk responsibility either through an individual or an insurance contract. The most effective way to handle risk is to transfer it so that the loss is consumed by another party. Consider the following risk transfer solutions: Purchasing an insurance policy Obtaining high protection limits on your auto policy Reassign the risk to another individual

7 LEGAL ASPECTS OF INSURANCE Principle of Indemnity The indemnity principle applies to most insurance contracts whereby the insurer seeks to reimburse the insured for approximately the amount lost, no more and no less. The purpose of an indemnity contract is to return the insured back to his or her original financial position. Subrogation- In the event that a claim is paid, the insurer acquires the insured's right to action against any negligent third party that may have caused or contributed to the loss. Value Contract- A value contract differs from indemnity in that it pays a stated sum, regardless of the actual amount of the loss. An example of a value contract is a life insurance policy that pays a $50,000 death benefit. Insurable Interest An important element of a valid insurance contract is insurable interest. This is a relationship between the applicant and individual being insured whereas the person seeking the contract (applicant) must be subject to loss upon the destruction, damage, illness, disability, or death of the insured. Important: Insurable interest must exist at the inception of contracts; however, with life & health contracts it does not have to exist at the time of claim. Property and casualty insurance policies require that the insurable interest must exist at the time of the claim. Principles of Risk and Insurance - Contract Requirements An insurance policy is a contract. Contracts are agreements that are enforceable by law. We have contracts in insurance to allow two parties, typically an insurance company and an insured, to reach a mutual agreement to bind each other to certain promises- such as the insurer covering a particular risk of loss, and the insured agreeing to pay a premium (cost) for this protection. However, in order for a contract to be valid and enforceable, it must contain certain fundamentals.

8 To be Legally Binding an insurance contract must have the following five elements: 1) Offer and Acceptance To be legally enforceable, a contract must be made with a definite, unqualified offer by one party and the acceptance of its exact terms by the other party. The Offer- with many insurance contracts, the offer is made when the applicant submits the application with the initial premium. The Acceptance- the acceptance is confirmed when the insurance company accepts the offer and issues a policy. The company may counteroffer and then the applicant has the choice to accept or reject the new terms. No Initial Premium- When the applicant does not submit an initial premium with the application, the role of offer and acceptance is reversed. The insurer can respond by issuing a policy (the offer) that the applicant can accept by paying the planned premium when the policy is delivered. 2) Consideration In order for an insurance contract to be legally binding, there must be an exchange of value. Consideration is the value given in exchange for the services sought after. The submission of the completed application (offer) plus the payment of the initial premium (consideration) to the insurance company generally creates a binding contract provided that the application passes the underwriting process. 3) Legal Intent The subject of the insurance contract must be of legal purpose and/or a legal business entity in order for the contract to be enforceable. A contract whereas one party agrees to commit a crime for payment of services would not be enforceable in court because the subject matter is not of legal content.

9 4) Competent Parties To cement a valid contract, the parties involved (individuals, groups, or businesses) must be capable of entering into a contract per the law. For an insurance contract, the insurer (insurance company) is considered competent if it is licensed or approved by the state or states in which it conducts business. The applicant is presumed to be a competent party, unless one of these exceptions apply: Mentally Incompetent Minor Under the influence of alcohol or drugs If one of the parties is not competent, then the contract is voidable by the incompetent party. 5) Legal Form Contracts must also follow the laws and guidelines of state regulations. For example- not all contracts are required to be in written form, but state laws might mandate a written contract to make it binding. State Insurance Regulation attempts to accomplish the following (MAPS): Maintain competition Available coverage to all that want and need it Protect policy owners against insurer mistreatment Save the solvency of insurers If an insurance contract lacks one of the five characteristics of a valid contract above, the contract will not posses legal effect and cannot be enforced by either party.

10 Contract Characteristics Law of Agency- Insurance Brokers vs. Insurance Agents 1) Insurance Brokers- A broker is a representative of the policy owner that acts as a marketing mediator between the insurer and the policy owner. 2) Insurance Agent- An agent is a legal representative of the insurance company authorized to offer the sale of its goods and services. An agent's authority to legally bind the insurer stems from three sources- Express, Implied, or Apparent Authority. Agent's authority to Legally Bind a Principal: Express Authority Company\'s Appointment of Agent to act on its behalf i.e. agent is given the authority to solicit applications (agent agreement) Implied Authority Public is led to believe the individual has this authority i.e. agent runs TV ads noting themselves as a rep of the company Apparent Authority Company creates the impression that a relationship exists with the agent i.e. agent is supplied with applications, sales materials, etc... Aleatory Insurance contracts are considered to be aleatory because the outcome is affected by chance and may be unequal. a) There is an element of chance for both parties involved in the contract, and b) The dollar values exchanged may not be equal

11 Unilateral Insurance contracts are considered unilateral because only the insurance company (insurer) makes a promise under the contract. The insurer promises to pay a benefit upon the happening of a certain event, such as an auto accident, death, disability, etc... The applicant does not make any promise- they can even elect to stop paying premiums if they desire. The insurer will however have the right to cancel the policy if premiums are neglected to be paid. Conditional Insurance contracts are conditional contracts; whereas, the payment of benefits by the insurance company is conditioned upon the insured or owner paying the premium. Incontestable Clause An incontestable clause is an unusual feature sometimes found in life insurance contracts which makes the policy indisputable by the insurer after being enforce for a period of two years or more. Personal Contracts Most insurance contacts are personal contracts between the insurance company and the applicant/insured and they are non-transferable. Life insurance contracts are the exception, as they can transfer ownership by was of assignment. Adhesion An insurance contract is considered a contract of adhesion because the applicant adheres to the terms of the contract if they want the benefit to remain in effect. The contract is prepared by one party (insurance company) and accepted by the insured. These contracts are not negotiated between the two parties.

12 Insurance Ownership and Beneficiaries Policy Ownership Most insurance contracts are considered to be personal contracts, which means they are an agreement between the insurer and the individual that desires to cover a particular risk. They cannot be transferred to another party without the approval of the insurance company. In most cases the insurance company must do their own independent risk assessment of the situation in order to offer coverage- because of this policyholders cannot transfer their policy. However, life insurance is the exception to the personal contract rule. In this case, the insurer makes a promise to pay a benefit in the untimely death of the insured. The owner of the policy has no bearing on the amount of the risk that the insurer has assumed, so owners can transfer their ownership right as they desire. This transfer of ownership is known as assignment. Designation of Beneficiary The person that is listed to receive the benefits from a policy is known as the beneficiary. The beneficiary can be primary, contingent, revocable, or irrevocable. Primary- this is the main beneficiary of the contract. Contingent- this is the secondary beneficiary, if the primary beneficiary dies the contingent will receive the proceeds. Revocable- owner of the policy reserves the right to change the beneficiary at their own will. Irrevocable- owner of the policy has restrictions on changing beneficiaries. Beneficiaries should be clearly defined by including their full name, current residence, share of the proceeds to be received, and date of birth or social security number. They can be listed in various forms such as: individuals, trusts, estates, minors, and charitable organizations.

13 Analysis and Evaluation of Risk Exposure Introduction to the Evaluation of Risk Exposure When individuals consider risk management they must look at the risks associated with four crucial areas including: personal, property, liability, and business. Each of the four areas has special risks associated with it, and individuals should evaluate those risks and then determine a plan on how to cover, transfer, or eliminate those risks. PERSONAL Personal risks are those risks that we all face on a daily basis in the course of our everyday life- they include the perils of death, disability, bad health, unemployment, and Superannuation. Most personal risks center on the ability to earn an income and provide for your family. When we consider the consequences of uncovered personal risks, we think about protecting these areas of importance by entering into insurance contracts for life, health, disability, and income for life. Death None of us like to consider death, but as the old clique goes... "There are only two things guaranteed in life...that's death and taxes". So, in order to protect the ones we love, cover our debts, pay for funeral expenses, send your children to college, or whatever the reasonmany individuals need to protect their income stream in the event of their untimely death and life insurance is a way of doing that.

14 An individual faces three mutually exclusive risks centering around the uncertainty of death, they include: 1) Superannuation- outliving your income and assets, 2) Premature Death- dying when others remain dependent on your income, 3) Protecting your Estate- paying for taxes in the event of your death Source : http//: Vanitha Muguntharaj Assistant Manager- Health Team

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