Insurance and annuities
1. Insurance is risk protection in economical terms. Purpose is to hedge risk by compensating in the event of financial loss, not to provide an opportunity for financial gain.
2. Risk is uncertainty about the future.
- Two types: speculative and pure
- Speculative involves three outcomes:
- No change
- Pure involves no possibility of gain.
- Either a loss or no loss.
- Possibility of economic loss without the possibility of gain is pure risk
- Only Pure risks can be insured.
- Speculative involves three outcomes:
3. Risk Management
- Involves identifying risk, assessing risk and dealing with risk
- In order to do eliminate or reduce expose to financial risk four things can be done:
- Avoiding risk
- Controlling risk – prevention or reduction of losses i.e. installing fire and smoke detectors
- Accepting risk
- Self-insurance – risk-management technique which accepts financial responsibility for loss
- Transferring risk – shifting risk to another party in exchange for fee such as insurance
- Insurance policy is document that contains terms of agreement between insurance company and owner of the policy
- Policy benefit or policy proceeds provide that insurer receives a specific amount of money called a premium for accepting transfer of risk.
4. Types of Risk Covered
- Property damage risk covers property damage due to such things as accident, theft, fire etc.
- Liability risk includes economic losses from being held responsible for harming others or their property.
- Personal risk includes risks of economic loss associated with death, poor health and outliving one’s savings.
Insurers for property and liability are called property-casualty or property-liability insurance companies. Property insurance covers insured property while liability insurance covers a party who is legally responsible for unintentionally harming others or their property.
Insurers for policies that provide financial security from personal risk are life and health insurance companies. These companies assume or accept the transferred risk from the insured.
Risk pooling – pools together individuals who may suffer a certain loss. The costs are then spread out among those individuals.
“If the economic losses that actually result from a given peril, such as disability, can be shared by large numbers of people who are all subject to such losses and the probability of loss is relatively small for each person, then the cost to each person will be relatively small.”
Insurability of Risks
- Applicant: applies for policy; either person(s) or business.
- Policyowner: owns the policy; typically applicant
- Insured: person whose life or health is insured
- Third-part policy: insurance policy that on person purchase on life of another
- Beneficiary: receives policy benefit if event insured against occurs
Insurable interest requirement: only pure risks are insurable. Insurance not intended for financial opportunity for gain. Must have an insurable interest in the likelihood that policyowner or beneficiary will suffer loss or detriment if event insured against occurs.
Insurable interest in health insurance – typically only for themselves and dependents.
Assessing Degree of Risk
- Antiselection: tendency of individuals who believe they have a greater-than average likelihood of loss to seek greater insurance than those who do not.
- Underwriting: process of identifying and assessing risks. Two stages:
- identifying risks that proposed insured represents
- classifying the degree of risk that a proposed insured represents
- Physical hazard is a characteristic (e.g. history of heart disease) that increase likelihood of loss.
- Moral hazard is chance that person involved in insurance transaction will act dishonestly.
Classifying risks enables insurers to categorize risks in order to determine equitable premium rate for coverage. Generally, four categories of proposed insureds:
- Standard risk: normal chance of risk
- Substandard risk: significantly greater risk. Has higher than standard premium.
- Declined risk: risk too great to insure.
- Preferred risk: significantly less risk. May have less than standard premium.
Characteristics of Insurable Risks
In order for a risk to be insurable it much have certain characteristics.
- The loss must occur by chance.
- The loss must be definite.
- Loss must be definite in terms of time and amount.
- Insurer must be able to determine when and how much.
- The loss must be significant
- The loss rate must be predictable.
- Must be able to predict probable rate of loss.
- Loss rate is prediction of number and timing of covered losses.
- This determines proper premium.
- Loss rates are based not upon individuals but a given large group.
- Probability and the law of large numbers
- In terms of death, probability and LLN is used to make mortality tables display the rates of mortality by age in a given group of people.
- Rates of morbidity (morbidity tables) are rates of sickness and accident by age in a given group of people.
- The loss must not be catastrophic to the insurer.
- Can not cause catastrophic financial damage to insurer.
- To prevent catastrophic financial damage, insurers spread risks
- Can also transfer risk to another insurer via reinsurance.
- A ceding company is the original insurer
- To cede is to obtain reinsurance by transferring all or part of risk to reinsurer.
- Retention limit is maximum amount of insurance that insurer is willing to carry at own risk on any one life. Reinsuring distributes those risks among many insurance companies.
- Retrocession is reinsurer ceding risk to another reinsurer. Reinsurer of reinsurer is called retrocessionaire.
Side note: Every insurance policy either a contract of indemnity or a valued contract. Contract of indemnity: amount of the policy benefit payable for a covered loss is based on the actual amount of financial loss that results from loss. Insured receives either amount of financial loss or maximum state in policy, which ever is less. Valued contract: specifies the amount of the benefit that will be payable when a covered loss occurs regardless of actual loss. This is the death benefit or face amount/value.
Chapter 2 – The Life and Health Insurance Industry
Insurance companies must be corporations to provide stability and security. • Are either stock insurance companies or mutual insurance companies. • Mutual insurance companies are owned by policyowners and policy dividends may be distributed. • Stock insurance companies may convert to mutuals through mutualziation and mutual insurance company may convert to stocks insurance companies via demutualization.
Organizational operations • Home office is generally located in state of incorporation and houses executive officers • Regional office offers same functions and operations as home but is located geographically closer to market it serves. • Field office is local sales office and receives support from home and regional.
Insurance company as financial institution • Financial institutions accept savings and give loans • Financial services industry is made of financial institutions and help save, borrow, invest and manage money.
Individual vs. group insurance.
Term, permanent and endowment life insurance. Some have annuity options.
Health insurance – two types: 1. Medical expense coverage 2. Disability income coverage
Fraternal benefit societies provide social and insurance benefits to members. Often share common ethnic, religious or vocational background.
Chapter 3 – Meeting Needs for Life and Health Insurance
Reasons for individual life insurance • Final expenses and estate planning • Dependent support • Education costs • Retirement Income • Investment Income • Tax deductible benefits from charitable donations
Reasons for business owners to purchase life insurance and/or annuity products • Provides funds to ensure business continues in event of death of owner, partner or key person • Purchase for life insurance and annuity products for employees
Business continuation insurance Business continuation insurance plan (BCIP) allows businesses to continue operation following death of owner or key person. Important to closely held business such as sole proprietorship, partnership. Ways BCIPs can fund the purchase of a deceased owner’s or partner’s share in business: Buy-sell agreements provides that (1) first party agrees to purchase the financial interest in a second party following second parties death, and (2) second party agrees to direct estate to sell business interest to first party. Sole proprietorship buy-sell agreements generally sale to employee. However employee may not have assets to purchase. Life insurance policy on sole proprietor paid for by employee could provide assets. Partnership buy-sell agreements establishes terms on which a deceased partner’s share would be purchased by surviving partners. Two ways: Cross-purchase method provides that surviving partner(s) purchase predetermined proportionate shares of deceased partner’s interest. Could be funded by purchasing insurance on life of other partners. Entity method provides that the partnership purchases deceased partners shares and distributes shares among surviving partners. Again, life insurance purchased by partnership could be used to fund this. Closely held corporation buy-sell agreements often resemble partnership buy-sell agreements and utilize the cross-purchase or entity method of purchase. Key person (or employee) life insurance is insurance that business purchases on life of a person whose contributions are needed for business to continue.
Life insurance and annuity products as employee benefits come in both group and individual plans and are either whole paid for by the company or costs are split. Split-dollar life insurance plan are policies provided for select employees such as owners, officers etc. The employer and employee agree to share costs and is a form of permanent insurance. Employer receives what it paid in premiums and employee’s beneficiary will receive rest. Deferred compensation plans provide income benefits to an employee at a later date. Is funded by a portion of employees salary.
Health insurance includes both medical expense insurance and disability income insurance and can be purchased in both individual and group plans. Used as benefit for employee or to protect business from financial loss caused by employee’s illness injury or disability (typically sole proprietorship or partnership).
Chapter 4 – Regulation of the Insurance Industry
Primary goals of insurance industry regulation are ensure companies remain solvent and conduct business fairly and ethically.
In US, state governments have primary authority to regulate insurance industry.