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Fundamentals of Risk and Insurance EmmEtt J. Vaughan • thErEsE m. Vaughan

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FUNDAMENTALS OF RISK AND INSURANCE

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FUNDAMENTALS OF RISK AND INSURANCE

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ELEVENTH EDITION

EMMETT J. VAUGHAN THERESE M. VAUGHAN

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Library of Congress Cataloging-in-Publication Data

Vaughan, Emmett J. Fundamentals of risk and insurance / Emmett J. Vaughan, Therese M. Vaughan. —

Eleventh edition. pages cm

Includes bibliographical references and index. ISBN 978-1-118-53400-7 (pbk.) 1. Insurance. 2. Risk (Insurance) I. Vaughan, Therese M. II. Title. HG8051.V35 2014 368—dc23

2013033075

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

http://www.copyright.com
http://www.wiley.com/go/permissions
To Bob, Kevin, and Tommy

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ABOUT THE AUTHORS ■

Emmett J. Vaughan was a Professor of Insurance at the University of Iowa for over 40 years, where he held the Partington Professorship in Insurance until his death in 2004. Professor Vaughan earned his un- dergraduate degree in economics from Creighton University and his M.A. and Ph.D. in economics and insurance from the University of Nebraska. He was an enthusiastic teacher, prolific scholar, and beloved by his students. He inspired hundreds of students to choose careers in insurance.

Therese M. Vaughan has spent her career in academia and insurance regulation. She was the Robb B. Kelley Distinguished Professor of Insurance and Actuarial Science at Drake University. Prior to joining Drake, she served as Iowa Insurance Com- missioner for over 10 years, and most recently, she was the CEO of the National Association of Insur- ance Commissioners. Vaughan earned her under- graduate degree in economics and insurance from the University of Iowa and her Ph.D. in risk and in- surance from the University of Pennsylvania.

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PREFACE ■

This eleventh edition of Fundamentals of Risk and Insurance marks the 41st anniversary of the first edi- tion, published in 1972. Over the years, the book has undergone major changes as the field of risk management and insurance has changed. Emmett J. Vaughan, the original author and architect of the text, guided the revisions over the years to main- tain the text’s primary focus, that of a consumer- oriented text. He was passionate about the field of risk and insurance, and his passion was reflected in the book through the decades. Professor Vaughan saw risk and insurance implications everywhere, from personal life events to the changing world around him to the fairy tales he read to his chil- dren (with commentary). His enthusiasm for the field was infectious and influenced many students to pursue careers in risk and insurance. I was fortu- nate to have him as a teacher, advisor, role model, and father.

Professor Vaughan died in October 2004, just as we were beginning to discuss the tenth edition of the book. This text had been a proud accomplishment of his for over 30 years., and, in nearly all respects, this is still his book. Though I have updated it to reflect recent developments and tried to shorten it in parts, the bulk of the text reflects his thoughts over his forty-plus year career. I hope I have been able to capture some of the enthusiasm with which he approached the field.

At the time the first edition was published, the field of insurance differed from what it is today. Many of the current forms of insurance coverage did not exist; the world seemed a simpler place. Medicare was not yet ten years old, and had no Parts C and D. Richard Nixon was president of the United States. Automobile no-fault insurance was an experiment that had been adopted by a single state (Massachusetts), and only three states had com- pulsory automobile insurance (New York, North Carolina, and Massachusetts). The 1943 Standard Fire Policy was the standard form of coverage for

most commercial entities, and the Family Auto Policy was the standard for personal automobile insurance. Universal life insurance was not yet on the drawing board and endowment policies were a staple for the life insurance agent. There was no such thing as long-term care insurance, no indi- vidual retirement accounts, and Employee Retire- ment Income Security Act of 1974 (ERISA) was not yet a gleam in a Congressperson’s eye. The Social Security tax base was $9000, the Medicare Part B premium was $5.60, and there was no such thing as Obamacare.

Although the book has changed over the years, its purpose, organization, and approach remain essentially the same. The original goal was to create a consumer-oriented text, and this orientation is continued in the present edition. The first edition of this book was written in response to a perceived need for an insurance textbook that addressed the principles of risk management without abandoning the discussion of insurance. The reception to the book over the past three and a half decades has been gratifying. At least a part of the book’s success is due to the fascinating subject matter with which it deals. Experience shows that insurance can be an exciting subject. This comes as no surprise to those of us who find this field an exciting one. It is satis- fying, however, to find that our excitement can be shared by our students.

SCOPE OF THE SUBJECT

As the title indicates, Fundamentals of Risk and Insur- ance is about risk and about insurance. Its objective is to summarize the pervasive nature of pure risk on the individual and on society, and to illustrate the way in which insurance can be used to deal with the problems posed by such risk. It is a book on insurance theory as well as on how students can use insurance personally.

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The main emphasis is on the insurance product and the use of insurance within the risk manage- ment framework. The traditional fields of life insur- ance, health insurance, property and liability insur- ance, and social insurance are treated in terms of their relationship to the wide range of insurance risks to which the individual and the business firm are exposed.

The text is designed for use in a college-level sur- vey of the area of risk and insurance. As an intro- duction to the subject, it is intended for students who have had little or no prior education in insur- ance. It may serve as the basis for more advanced texts for those students who intend to specialize in the field of insurance, and at the same time, it constitutes a compendium of what an informed citizen and consumer should know about the subject.

WHY STUDY INSURANCE?

The reasons for studying insurance are varied. For some, the study is undertaken in preparation for a ca- reer in the field. Others study to improve their knowl- edge of the subject to become more knowledgeable consumers. The average individual will spend a sig- nificant percentage of his or her disposable income on insurance over a lifetime, and one of the logi- cal reasons for studying insurance is to learn how it can be used in personal financial planning. Still others study insurance as a part of the discipline of risk management, the managerial function that aims at preserving the operating effectiveness of the organization.

Although each of these reasons is adequate jus- tification for the study of insurance, whether that study should be considered essential for business students depends on the approach and the specifics of what is studied. Some have argued that the study of insurance per se is a narrow specialty, yet the broader discipline of risk management, of which in- surance buying is a part, is a function that all future managers should understand. A proper understand- ing of the methods of dealing with exposures to loss is essential for organizational leaders. Although in- surance is only one of the techniques that can be used to deal with pure risks, risk management deci- sions presuppose a thorough understanding of the nature and functions of insurance.

We believe that insurance and risk management is a subject that needs to be taught in colleges and universities. Far from being the narrow specialty it is sometimes characterized as, the study of insur- ance has a breadth that few disciplines equal. As you progress through the book, you will encounter applications from economics, statistics, finance, accounting, law, decision theory, and ethics.

Because the study of risk management and insur- ance draws on these different disciplines, it is some- times considered a subset of one of them. Thus, in many colleges and universities, insurance and risk management are a part of the finance curriculum, reflecting the financial nature of the risk manage- ment function. In other schools, it is considered a part of economics; in still others, it is located in another department. This organizational ambiguity reflects the confusion concerning what the study of risk management and insurance entails.

In fact, risk management and insurance is a sep- arate and distinct discipline, which draws on and integrates the knowledge from other business fields. In a micro sense, it is a discipline in which various methodologies are brought to bear on a significant problem.

Viewed from a macro perspective, the study of insurance addresses important issues facing society today: the high cost of medical care, crime, the tort system, pollution and the environment, climate change, and the broad subject of ethics. Indeed, it is not an exaggeration to say that the debates in the insurance arena address questions of what kind of society we will have and who will pay for what. Debates over the cost of insurance and the way in which insurance prices should be deter- mined have intensified over the past two decades. Increasingly, the debates over insurance availability and affordability have come to center stage as the challenges of the cost of automobile insurance, access to health care, responsibility for pollution, damage from hurricanes, product liability, and med- ical malpractice have become crises. As consumers, we are all affected by the way in which insurance operates.

Finally, the study of risk management and insur- ance is a fertile field for considering the subject of ethics in business and in society. Indeed, the ubiq- uitous presence of ethical problems in the field of insurance transactions raises an important ques- tion: is ethics something to be studied and learned, or is it something innate in the individual?

PREFACE xi

ORGANIZATION OF THE BOOK

This book is divided into three major sections. The first section examines the concept of risk, the na- ture of the insurance device, and the principles of risk management. This section also provides an overview of the insurance industry and the manner in which it operates.

The second section examines the traditional fields of life and health insurance as solutions to the risks connected with the loss of income. The Social Security system, workers compensation, and other social insurance coverages are discussed in this section to permit students to integrate the cov- erage under these programs in planning income protection. The final section deals with the risks as- sociated with the ownership of property and legal liability. The coverages applicable to the individual or family are treated in chapters that are separate from those designed for the business firm, permit- ting those instructors who prefer to concentrate on insurance for the individual to give only slight treat- ment to commercial coverages.

The book is designed to fit a one-semester or two- quarter course, but it may be adapted to longer and shorter sequences. We have composed what we consider to be a logical sequence of subject mat- ter, but the book can be used flexibly. Sections Two and Three in particular may be taken in different order.

CHANGES IN THE TENTH EDITION

The forty-one years that have passed since the publication of the first edition of Fundamentals of Risk and Insurance have been marked by signif- icant change in the field of insurance. The sec- ond through tenth editions are a chronology of that change.

The insurance industry and its environment con- tinue to change, and the authors have attempted to capture the flavor of that change in each revi- sion. Changes in the legal environment, revisions in policy forms, the introduction of new types of in- surance, and a myriad of new problems continue to make insurance an exciting field of study but a challenge to the authors of textbooks.

This edition has been updated to reflect new policy forms (including ISO’s 2010 Commercial

Auto Policy, 2011 Homeowners Policy, 2012 Commer- cial Property Policy, and 2013 Commercial Liability Policy), cyber risk, recent laws affecting health insu- rance and Medicare, changes in regulation stem- ming from the financial crisis, and other changes in the market. Where possible, I have eliminated extensive discussion of old topics. Unfortunately, the text continues to be lengthy, reflecting the breadth of the subject matter with which it deals.

As in the last edition, there is a companion website for individuals using the text. In prior editions, sample policy forms were included as an appendix to the book (from the first through sixth editions), as a separate bound volume (the seventh and eighth edition), or on a CD-ROM that came with the book (the ninth edition). With this edition, as in the last, sample policy forms will be posted to the website, allowing more forms to be provided (www.wiley.com/college/vaughan). In ad- dition, Chapter 34, Insurance in the Future, which deals with current events and trends, will be pub- lished on the website.

ACKNOWLEDGMENTS

Many people have provided support and encour- agement as I have worked on this revision. First, of course, are the members of my family, including my husband, children, mother, and siblings. I am par- ticularly grateful for their patience.

As a book progresses through successive editions, the number of persons to whom an author is in- debted increases geometrically, since the efforts of so many people become a part of the work. Over the years, my father recognized many people for their efforts, and I continue that appreciation. Our teachers, reviewers, and users have helped shape our thoughts and the book. Although much has changed over the years, colleagues and students who provided comments on earlier editions con- tinue to influence it. As a result, there are many to whom special thanks are due. They include our for- mer colleague and my teacher, Professor Michael Murray, who shared his insights with us over the years and whose influence has been significant. They include my colleague, Professor Robert W. Cooper, who generously provided his support and guidance over the years. The reviewers of the earlier editions, whose contributions helped to shape this one as well, were Tom Auippa, Richard C. Allgood,

xii PREFACE

Garth H. Allen, Albert L. Auxier, W. Oscar Cooper, Robert W. Cooper, Richard Corbett, Darlene Dicco, Bill Feldhaus, Roger A. Formisano, John W. Hanye, Kenneth J. Krepas, E.J. Leverett, Aaron Lieberman, Jim Milanese, Joseph R. Morrin, Robert J. Myers, John J. O’Connell, Mike Thorne, S. Travis Pritchett, Dede Paul, Gary K. Stone, and Robert Witt.

A number of my father’s former graduate teach- ings assistants offered many suggestions over the years: Lois Anderson, Phillip Brooks, Robb Fick, Tim Hamann, Terry Leap, Lacy McNeill, Joseph Panici, Mark Power, Lori Rider, Roger Stech, Ellen Steele, Mike Steele, Patrick Steele, Art Cox, Robert Carney, and Changsu Ouh. Their suggestions contributed to the earlier editions, and their influence carries through to this edition.

This edition benefited from the insights of many people, and it would be impossible to thank them all. I owe special thanks to Dana Ramundt, who sup- plied many of the sample premiums used to illus- trate various points in the text. Many others con- tributed advice or insights. Todd Sells was particu- larly helpful. Others who in some way influenced the text include Elise Liebers, Poojah Rahman, Ethan Sonnichsen, Eric Thompson, Mark Sagat, David Vacca, Mary Sarrazin, Diane Munns, Ed Toy, Eric Nordman, Jane Koenigsman, Aaron Branden- burg, Josh Goldberg, Kris DeFrain, Larry Bruning, Kay Noonan, Rob Esson, Cathy Weatherford, Glenn

Pomeroy, Sandy Praeger, and Dean Brooks. While their assistance improved the final result, all errors are entirely mine.

Thank you to the folks at John Wiley and Sons, who were so helpful in completing this revision, especially Joel Balbin and Courtney Luzzi. Thanks also to Robert Saigh at Razorsharp Communica- tions, who was delightful to work with during the editing process.

Finally, thank you to all of the students we have had over the years. Their many comments and in- telligent questions contributed to the design of the book and to the examples and illustrations used. Thank you to all of the users of the first ten editions who took time to write with their suggestions and comments.

I would be grateful to receive advice from the teachers who will use this book, particularly con- cerning any errors that should be corrected and any materials should be added or omitted when it is again revised. To the students who will be com- pelled to read it, I extend the hope that the mate- rial will seem as exciting and interesting as it has seemed to both of its authors.

Therese M. Vaughan Des Moines, Iowa

September 2013

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BRIEF CONTENTS ■

Chapter 1 The problem of risk 1 Chapter 2 Introduction to Risk

Management 12 Chapter 3 The Insurance Device 34 Chapter 4 Risk Management

Applications 54 Chapter 5 The Private Insurance

Industry 71 Chapter 6 Regulation of the Insurance

Industry 95 Chapter 7 Functions of Insurers 128 Chapter 8 Financial Aspects of Insurer

Operations 144 Chapter 9 The Legal Framework 163 Chapter 10 Managing Personal

Risks 181 Chapter 11 Social Insurance

Programs 204 Chapter 12 Introduction to Life

Insurance 224 Chapter 13 The Actuarial Basis of Life

Insurance 240 Chapter 14 The Life Insurance

Contract—General Provisions 253 Chapter 15 The Life Insurance

Contract—Other Provisions 264 Chapter 16 Special Life Insurance

Forms 279 Chapter 17 Buying Life Insurance 289 Chapter 18 Annuities and Pension

Benefits 307 Chapter 19 Managing the Retirement

Risk 333

Chapter 20 Health Insurance: Disability Income Insurance 348

Chapter 21 Health Insurance: Coverage for Medical Expenses 365

Chapter 22 Health Insurance for the Elderly 388

Chapter 23 Employee Benefits and Other Business Uses of Life and Health Insurance 412

Chapter 24 The Homeowners Policy—General Provisions 432

Chapter 25 The Homeowners Policy Forms 448

Chapter 26 Other Personal Forms of Property Insurance 462

Chapter 27 Negligence and Legal Liability 480

Chapter 28 General Liability Insurance for the Individual 494

Chapter 29 The Automobile and its Legal Environment 512

Chapter 30 The Personal Auto Policy 529

Chapter 31 Commercial Property Insurance 552

Chapter 32 Commercial Liability Insurance 582

Chapter 33 Surety Bonds, Trade Credit, and Financial Guaranty Insurance 609

Chapter 34 Insurance in the Future (Online) 620

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CONTENTS ■

SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

Chapter 1 The Problem of Risk 1

The Concept of Risk 1 Current Definitions of Risk 2 Our Definition of Risk 2 Uncertainty and Its Relationship to Risk

3 The Degree of Risk 4 Risk Distinguished from Peril and Hazard

5 Classifications of Risk 5

The Burden of Risk 8 The Growing Number and Variety of Pure Risks 8 Increasing Severity of Losses 10 Managing Risk 10 Important Concepts to Remember 10

Chapter 2 Introduction to Risk Management 12

The History of Modern Risk Management 13 Enterprise Risk Management 15 Risk Management Defined 16 Risk Management Tools 17

Risk Control 18 Risk Financing 18

Risk Management as a Business Function 20 Risk Management’s Contribution to the

Organization 21 The Risk Manager’s Job 22

Misconceptions About Risk Management 23 Universal Applicability 23 Anti-Insurance Bias? 23

Risk Management and the Individual 24 The Risk Management Process 24

Determination of Objectives 24

Identifying Risk Exposures 25 Evaluating Risks 28 Consideration of Alternatives and Selection

of the Risk Treatment Device 29 Implementation of the Decision 30 Evaluation and Review 30

Chapter 3 The Insurance Device 34

The Nature and Functions of Insurance 34 Risk Sharing and Risk Transfer 34 Insurance Defined from the Viewpoint of

the Individual 35 Risk Reduction Through Pooling 35 Insurance Defined from the Viewpoint of

Society 40 Insurance: Transfer or Pooling? 41 Insurance and Gambling 41

The Economic Contribution of Insurance 41 Elements of An Insurable Risk 42

Randomness 42 Economic Feasibility 43

Self-Insurance 43 The Fields of Insurance 44

Private (Voluntary) Insurance 44 Social Insurance 47 Public Guarantee Insurance Programs 51 Similarities in the Various Fields of

Insurance 52

Chapter 4 Risk Management Applications 54

Risk Management Decisions 54 Utility Theory and Risk Management

Decisions 55 Decision Theory and Risk Management

Decisions 55 The Rules of Risk Management 57

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Risk Characteristics as Determinants of the Tool 58

The Special Case of Risk Reduction 59 Buying Insurance 59

Common Errors in Buying Insurance 59 Need for a Plan 60 Other Considerations in the Choice

Between Insurance and Retention 61 Selecting the Agent and the Company 62

Alternatives to Commercial Insurance 65 Self-Insurance 66 Captive Insurance Companies 67 Risk Retention Act of 1986 68

Chapter 5 The Private Insurance Industry 71

A Brief History of Private Insurance 72 Insurance in Antiquity 72 Origins of the Modern Insurance

Business 72 Insurance in the United States 73

Classification of Private Insurers 74 Classification by Type of Product 74 Classification by Place of Incorporation and

Licensing 74 Insurers Classification by Legal Form of

Ownership 75 Marketing Systems 80

The Agent 80 Life Insurance Distribution System 81 Property and Liability Distribution

Systems 82 Insurance Marketing and the Internet 83 Corporate Combinations 83 Nuclear Energy Pools 83 Other Voluntary Syndicates 83 Banks and Insurance 84

Cooperation In the Insurance Industry 85 Rating Organizations 85 Distressed and Residual-Risk Pools 86 Educational Organizations 87 Insurance Trade Associations 87

Competition In the Insurance Industry 88 Price Competition 88 Quality Competition 89 Is the Insurance Industry Really

Competitive? 89

Chapter 6 Regulation of the Insurance Industry 95

The Why of Government Regulation of Insurance 95 The Why of Regulation Generally 95 Approaches to Government Control of

Business 96 Rationale for Regulation of the Insurance

Industry 97 Goals of Insurance Regulation 99 A Brief History of Insurance

Regulation 99

Regulation Today 101 The Current Regulatory Structure 101 National Association of Insurance

Commissioners 102

Areas Regulated 102 Solvency Regulation 102 Market Regulation 107 Regulation of Rates 109 Risk-Retention Groups 112

State Versus Federal Regulation 113 Pressure for Repeal of the

McCarran-Ferguson Act 113 Arguments Favoring Federal

Regulation 113 Arguments Favoring State Regulation 114 Consequences of the Repeal of the

McCarran-Ferguson Act 114 Repeal of the McCarran-Ferguson Act as a

States-Rights Issue 115 The NAIC’s Efforts to Modernize State

Insurance Regulation 115 State versus Federal Regulation and Public

Choice 116

Global Influences On Insurance Regulation 117

Appendix: The Availability/Affordability Debate 118 Existing Subsidies in the Insurance

Market 118 Income Redistribution Effects of Subsidies

in Insurance 122 Causes of Availability Problems 122 Causes of Affordability Problems 123 Availability and Affordability and Public

Choice 125

CONTENTS xvii

Chapter 7 FUNCTIONS OF INSURERS 128

Functions of Insurers 128 Ratemaking 128

Some Basic Concepts 129 Types of Rates 130

Production 133 Underwriting 133

The Agent’s Role in Underwriting 134

Underwriting Policy 134 Process of Underwriting 134 Postselection Underwriting 135 Credit Scoring 136 Predictive Analytics 137

Loss Adjustment 137 Adjusters 138 Courses of Action in Claim

Settlement 138 Adjustment Process 138 Difficulties in Loss Settlement 139

The Investment Function 139 Miscellaneous Functions 140

Legal 140 Accounting 140 Engineering 140

Appendix: Retrospective Rating Plans 141 The Retrospective Formula 141

Chapter 8 Financial Aspects of Insurer Operations 144

Statutory Accounting Requirements 144 Differences Between Statutory Accounting

and GAAP 145 Terminology 146

Property and Liability Insurers 147 Concept of Earned Premiums 147 Incurred Losses 147 Expenses Incurred 148 Summary of Operations 148

Life Insurance Companies 150 Life Insurer Assets 150 Life Insurer Liabilities 150 Life Insurers’ Policyholders’ Surplus 151 Life Insurer Summary of Operations 151 Surplus Drain in Life Insurance 152

Reinsurance 152 Nature of Reinsurance 152 Types of Reinsurance Treaties 153 Reinsurance in Property and Liability

Insurance 153 Reinsurance in Life Insurance 154 Functions of Reinsurance 154 Risk-Financing Alternatives to

Reinsurance 155 Taxation of Insurance Companies 158

State Premium Tax 158 Federal Income Taxes 159

Important Terms and Concepts 160

Chapter 9 The Legal Framework 163

Insurance and the Law of Contracts 163 General Requirements of an Enforceable

Contract 164 Void and Voidable 166

Special Legal Characteristics of Insurance Contracts 166 Insurance Is a Contract of Indemnity 166 Insurance Is a Personal Contract 172 Insurance Is a Unilateral Contract 172 Insurance Is a Conditional Contract 173 Insurance Is a Contract of Adhesion 173 Insurance Is an Aleatory Contract 173 Insurance Is a Contract of Utmost Good

Faith 173 The Insurance Contract as a

Contract 177 Policy Construction 178

SECTION TWO LIFE AND HEALTH INSURANCE

Chapter 10 Managing Personal Risks 181

Objectives In Managing Personal Risks 182 Other Steps In Managing Personal Risks 183 Managing Risks Associated With Premature

Death 183 Identifying Risks Associated with

Premature Death 183 Measuring Risks Associated with

Premature Death 183

xviii CONTENTS

The Estate Liquidity Need 193 Estate Planning 193 Trusts 195

Longevity Risk 196 The Risk of Outliving the Retirement

Accumulation 197 Estimating the Accumulation Need 197

The Risks Associated With Disability 198 Needs Analysis for the Disability

Risk 198 Resources Available to Meet the Disability

Risk 199 Addressing Unmet Disability Income

Needs 199 Evaluating the Medical Expense Exposure 199 Managing the Risk of Unemployment 200

State Unemployment Insurance Programs 200

Retention and Risk Reduction 201

Chapter 11 Social Insurance Programs 204

Old-Age, Survivors, Disability, and Health Insurance 204 Eligibility and Qualification

Requirements 205 Financing 206 Amount of Benefits 207 Classes of Benefits 207 Summary of Qualification

Requirements 209 Loss of Benefits—the OASDHI

Program 209 Soundness of the Program 212

Workers Compensation 216 Historical Background 216 Rationale of Workers Compensation

Laws 217 Principles of Workers Compensation 217 An Overview of State Workers

Compensation Laws 218

Chapter 12 Introduction to Life Insurance 224

Some Unique Characteristics of Life Insurance 224 Life Insurance Is Not a Contract of

Indemnity 225

Types of Life Insurance Contracts 225 Reasons for Difference in Term and Cash

Value Insurance 226 The Level Premium Concept 227

Tax Treatment of Life Insurance 228 Code Definition of Life Insurance 229

Current Life Insurance Products 230 Term Insurance 230 Whole-Life Insurance 231 Universal Life Insurance 232 Variable Life Insurance 232 Adjustable Life Insurance 233 Endowment Life Insurance 233 Participating and Nonparticipating Life

Insurance 234 General Classifications of Life Insurance 234

Individual Life Insurance 234 Group Life Insurance 235 Credit Life Insurance 236 Total Life Insurance in Force in the United

States 237 Other Types of Life Insurance 238

Chapter 13 The Actuarial Basis of Life Insurance 240

Life Insurance Premium Computation 240 Mortality 241 Interest 241 The Net Single Premium 244 The Net Level Premium 246

Reserves On Life Insurance Policies 247 Benefit-Certain and Benefit-Uncertain

Contracts 249

Chapter 14 The Life Insurance Contract—General Provisions 253

Inception of the Life Insurance Contract 254 General Provisions of Life Insurance

Contracts 254 Entire Contract Clause 254 Ownership Clause 255 Beneficiary Clause 255 Incontestable Clause 256 Misstatement of Age Clause 256 Grace Period 257 Reinstatement 257 Suicide Clause 258

CONTENTS xix

Aviation Exclusions 258 War Clause 258

Settlement Options 258 Interest Option 259 Installments for a Fixed Period 259 Installments of a Fixed Amount 260 Life Income Options 260 Taxation of Policy Proceeds under Various

Settlement Options 262

Chapter 15 The Life Insurance Contract—Other Provisions 264

Nonforfeiture Values 264 Cash Option 265 Paid-Up Reduced Amount 266 Extended Term Insurance 266 Policy Loan Provisions 267 Automatic Premium Loan 267

Dividend Provisions 268 Important Optional Provisions 270

Disability Waiver of Premium Provision 270

Accidental Death Benefit 271 Guaranteed Insurability Option 272 Common Disaster Clause 273 Spendthrift Clause 273 Rights of Creditors to Life Insurance

Proceeds 274 Cost-of-Living Riders 274

Universal Life Policy Provisions 274 Premium and Cost of Insurance

Provision 274 Changes in the Amount of Insurance 275 Death Benefit Provision 275 Universal Life Insurance with Secondary

Guarantees 276 Index Universal Life Insurance 277

Chapter 16 Special Life Insurance Forms 279

Specialized Life Contracts 279 Mortgage Redemption Policy 280 Joint Mortgage Protection Policy 280 Survivorship Whole Life 280 Family Income Policy 281 Family Income Rider 281 Family Protection Policy 281

Return-of-Premium and Return-of-Cash-Value Policy 282

Modified Whole Life 283 Graded-Premium Whole Life 283 Single-Premium Life 283 Juvenile Insurance 284 Indeterminate Premium Policies 285 Low-Load and No-Load Life

Insurance 286 Advantages and Disadvantages of Special

Forms 286

Chapter 17 Buying Life Insurance 289

Decisions In Buying Life Insurance 289 Buy Term and Invest the Difference? 290 Life Insurance as an Investment 292 Choosing the Company 293 Comparing Differences in Cost 295 The NAIC Life Insurance Illustrations

Model Regulation 298 NAIC Model Replacement

Regulation 299 Investor-Owned Life Insurance 299 Industry Reform Initiatives 300 Shopping for Universal and Variable

Life 301 Some Additional Tax Considerations 302

Section 1035 Exchanges (“Rollovers”) 303

Life Insurance and Divorce Agreements 304

Chapter 18 Annuities and Pension Benefits 307

Annuities 307 Classification of Annuities 309 Income Tax Treatment of Annuities 310 Annuities and the Federal Estate

Tax 311 Specialized Annuities 311 Annuities as Investments for

Retirement 315 Regulation of Annuity Sales 316

Qualified Retirement Plans 317 A General Overview of Qualified

Plans 317 Basic Types of Qualified Plans 318

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Significance of the Nature of the Employer’s Promise 319

Other Types of Qualified Plans 320 Other Requirements for Qualified

Retirement Plans 323 Other Benefits 325 Required Joint-and-Survivor Option 326 Period-Certain Payments 326 Distribution Requirements 326 Taxation of Distributions 327

Individual Retirement Accounts 328 Traditional IRAs 329 The Roth IRA 330

A Concluding Note 331

Chapter 19 Managing the Retirement Risk 333

An Overview of the Retirement Risk 333 Causes of the Retirement Risk 334 Two Risks Associated with

Retirement 334 Retirement Risk Alternatives 334 An Overview of the Retirement Planning

Process 334 Countering the Urgency Deficit 337

Constructing a Retirement Plan 337 Estimating Retirement Needs 338 Planning the Retirement

Accumulation 341 Planning the Retirement

Distribution 343

Chapter 20 Health Insurance: Disability Income Insurance 348

General Nature of Disability Income Insurance 349 Types of Insurers 349 Methods of Marketing 349 Need for Disability Income

Insurance 349 Short-Term versus Long-Term Disability

Coverage 350 Disability Income Underwriting and

Pricing 350 Disability Income Contracts 351

Perils Covered 351 Elimination Periods 352 Limitations on Amount of Coverage 353

Definitions of Disability Income Policies 353

Exclusions in Disability Income Contracts 354

Payments for Other Than Total Disability 355

Optional Benefit Provisions 356 Individual Health Insurance Policy

Provisions 357 Individual Health Insurance Continuance

Provisions 357 Uniform Provisions 358 Optional Uniform Provisions 360

Programming and Buying Disability Income Insurance 360 Determining Disability Income Coverage

Needs 361 Evaluating Existing Sources of

Protection 361 Taxation of Disability Income 362 Cost of Disability Income Insurance 362

Chapter 21 Health Insurance: Coverage for Medical Expenses 365

Background On the Current Health Insurance Market 366 Historical Development of Health

Insurance in the United States 366 The Attack on Managed Care 368 Consumer-Directed Health Care 369

The Health Insurance Market 370 Employer-Provided Health

Insurance 370 The Public Sector 371

The Insurance Product 373 HMO Contracts 374 Exclusions under Health Insurance

Policies 374 Coordination of Benefit 375

Other Medical Expense Coverages 375 Limited Health Insurance Policies 375 Dental Expense Insurance 375 Limited Policies—Prescription

Drugs 376 Health Insurance 376

First-Dollar Coverages 376 Taxes and Health Care Costs 377

Deficiencies In the System and Prior Reform Efforts 377

CONTENTS xxi

The Patient Protection and Affordable Care Act of 2010 (The Aca) 380 The Future 385

Chapter 22 Health Insurance for the Elderly 388

Medicare 389 Original Medicare 389 Traditional Program Medicare Supplement

Policies 393 Part C—Medicare Advantage 396 Part D—Prescription Drug

Coverage 397 The Financial Condition of

Medicare 399 Proposals for Reform 401

Long-Term Care Insurance 402 Nature of the Long-Term Care

Exposure 402 Inadequacy of Medicare for Long-Term

Care Needs 402 Development of LTC Insurance 403 Coverage of LTC Policies 404 Cost of LTC Insurance 406 The Life Insurance Accelerated Benefits

Alternative to LTC 407 Combination Policies 407

Medicaid Planning 408 Statutory Restrictions 408 Spousal Impoverishment

Provisions 408 Estate Recovery 409 Long-Term Care Partnership

Programs 409

Chapter 23 Employee Benefits and Other Business Uses of Life and Health Insurance 412

Employee Benefits Generally 413 Group Life and Health Insurance as Employee

Benefits 414 Group Term Life Insurance 414 Group Ordinary Life Insurance 414 Group Paid-Up Life Insurance 414 Group Universal Life 415 Survivor Income Benefit Insurance 415 Retired Lives Reserve 415

Funding Issues 415 Funding through a 501(c)(9) Trust 416

Pensions 417 Legislation Affecting Pension Plans 417 Qualification Requirements 418 Funding Pensions 420 Trusts and Insurance Companies 421

Erisa Pension Plan Termination Insurance 423 Accounting For Defined Benefit Plans 425 Plan De-Risking and Longevity Risk

Transfer 425 Cafeteria Employee Benefit Plans 426 Some Specialized Uses of Life Insurance in

Business 427 Business Continuation Insurance 427 Key-Person Insurance 428 Split-Dollar Plan 428 Deferred Compensation 429 Corporate-Owned Life Insurance 429

Summary 430

SECTION THREE PROPERTY AND LIABILITY INSURANCE

Chapter 24 The Homeowners Policy—General Provisions 432

The Homeowners Policy Program 432 Historical Development 432 General Nature of the Homeowners

Program 433 Homeowners Section I Coverage 433

Section I Coverages: An Overview 433 Perils Insured 434 Dwelling and Other Structures

Coverage 434 Personal Property Coverage 437 Loss of Use Coverage 440 Additional Coverages 440

Other Provisions 443 Section I Conditions 443 General Conditions Applicable to Sections

I and II 445

Chapter 25 The Homeowners Policy Forms 448

Differences Among Homeowners Forms 448 Homeowners 2 Broad Form 448

xxii CONTENTS

Homeowners 3 Special Form 449 Homeowners 4 Contents Broad

Form 454 Homeowners 5 Comprehensive

Form 455 Homeowners 6 Condominium

Unit–Owners Form 456 Homeowners 8 Modified Coverage

Form 457 Homeowners Section I Optional

Coverages 458 Optional Perils 458 Other Endorsements 459

Chapter 26 Other Personal Forms of Property Insurance 462

Monoline Fire Dwelling Program 463 Current Dwelling Program 463 Eligibility 463 Coverages under the Dwelling

Program 463 Endorsements to the Dwelling Program

Forms 464 Mobilehome Program 465

Eligibility 465 Coverage on the Mobilehome 465

Flood Insurance 466 General Nature of the Program 466 The Flood Insurance Policy 468

Inland Marine Coverage For the Individual 471 Personal Inland Marine Floaters 471 Scheduled Personal Property

Endorsement 471 Insurance on Watercraft 474

Buying Property Insurance For the Individual 475 Pricing and Cost Considerations 475 Choosing the Form 476 Tailoring the Coverage under the

Homeowners Policy 476 Flood Insurance 477

Title Insurance 477 Torrens System 478

Chapter 27 Negligence and Legal Liability 480

Criminal and Tortious Behavior 481 Negligence and Legal Liability 481

There Must Be Negligence 481 There Must Be Damage or Loss 484 Negligence Must Be the Proximate Cause

of the Damage 485 Defenses to Negligence 488

Possible Changes In the Tort System 490 Summary 492

Chapter 28 General Liability Insurance for the Individual 494

Liability Insurance In General 494 Types of Liability Insurance 495 Comprehensive Personal Liability

Coverage 495 General Nature of the Coverage 496 Personal Liability Coverage 496 Medical Payments to Others 503 Additional Coverages 504 Section II Conditions 505 Cost of Personal Liability

Insurance 506 Optional Personal Liability

Endorsements 506 Professional Liability Insurance 507

Malpractice Insurance 507 Errors and Omissions Insurance 508

Umbrella Liability Policy 508 Exclusions under the Umbrella Liability

Policy 509 Cost of the Umbrella 510

Chapter 29 The Automobile and its Legal Environment 512

A Brief Overview of Automobile Coverages 513 Automobile Liability Insurance 513 Medical Payments Coverage 513 Physical Damage Coverage 513 Uninsured Motorists Coverage 513

Legal Liability and the Automobile 513 Vicarious Liability and the

Automobile 513 Guest Hazard Statutes 514 Automobile Liability Insurance and the

Law 515 Insurance for High-Risk Drivers 517

The Automobile Insurance Problem and Changes in the Tort System 519

CONTENTS xxiii

Criticisms of the Traditional System 519 The No-Fault Concept 519

Automobile Insurance Rates 524 The Shifting View of Auto Insurance 526

Chapter 30 The Personal Auto Policy 529

General Nature of the Personal Auto Policy 529 Eligibility 530 Policy Format 530

Liability Coverage 531 Liability Insuring Agreement 531 Liability Exclusions 533 Other Liability Coverage

Provisions 535 Medical Payments Coverage 536

Medical Payments Insurance Agreement 536

Medical Payments Exclusions 536 Limitations Applicable to Medical

Payment Recoveries 537 Uninsured Motorist Coverage 537

Uninsured Motorist Insuring Agreement 537

Underinsured Motorist Coverage 539 Physical Damage Coverage 539

Physical Damage Insuring Agreement 539

Physical Damage Exclusions 541 Other Physical Damage

Provisions 542 Policy Conditions 543

Part E—Duties after an Accident or Loss 543

Part F—General Provisions 544 Endorsements to the Pap 545

Extended Nonowned Coverage 545 Named Non-Owner Policy 545 Miscellaneous Type Vehicle

Endorsement 546 Buying Automobile Insurance 548

Liability Coverage 548 Medical Payments Coverage 549 Physical Damage Coverage 549 Uninsured Motorist Coverage 550 Cost Differences among

Companies 550 Summary 550

Chapter 31 COMMERCIAL PROPERTY INSURANCE 552

Commercial Property Coverage 553

Commercial Property Direct Loss Coverages 554 Commercial Property Coverage

Policies 554 Building and Personal Property Coverage

Form 555 Blanket Insurance 561 Reporting Form Coverage 561 Builder’s Risk Coverage Form 562 Condominium Association Coverage

Form 562 Condominium Commercial Unit-Owner’s

Coverage Form 562 Standard Property Policy 562 Plate Glass Insurance 562

Commercial Property Coverage For Indirect Loss 562 Business Interruption Insurance 563 Extra Expense Insurance 563 Contingent Business Interruption and Extra

Expenses 564 Leasehold Interest Insurance 564 Rain Insurance 565

Boiler and Machinery Insurance 565 The ISO Breakdown Protection Coverage

Form 565 Direct Damage Equipment

Coverages 566 Indirect Loss Boiler and Machinery

Coverages 567 Deductibles 567 Suspension 567

Transportation Coverages 568 Ocean Marine Insurance 568 Inland Marine Insurance 569

The National Flood Insurance Program 572 The General Property Form Flood

Insurance Policy 573 Nonresidential Condominiums 573

Insurance Against Dishonesty 573 Dishonesty Insurance Coverage

Triggers 573 The ISO Crime Insurance Program 574 Employee Crime Coverages 574 Nonemployee Crime Coverages 576

Package Policies For Business Firms 578

xxiv CONTENTS

Commercial Package Policy 578 Businessowners Policy 578

Summary 579

Chapter 32 Commercial Liability Insurance 582

Employers Liability and Workers Compensation 583 Workers Compensation Policy 583

General Liability Insurance 585 General Liability Exposures 585 Commercial General Liability

Coverage 587 Occurrence-First-Reported Coverage

593 Other Portfolio Liability Coverages 594 Miscellaneous General Liability

Coverages 594 Cyber Liability Insurance 595 Commercial Automobile Insurance 596

Business Auto Coverage Form 597 Garage Coverage Form 599 Auto Dealers Coverage Form 600 Trucking 600

Insurance For Bailees 602 Bailee Liability 602 Bailee Liability Coverages 603

Aviation Insurance 604 Excess Liability and Umbrella Liability

Coverage 604 Excess Liability Distinguished from

Umbrella Liability Contracts 605 Umbrella Liability Policies 605

Chapter 33 Surety Bonds, Trade Credit, and Financial Guaranty Insurance 609

Surety Bonds 610 Suretyship Distinguished from

Insurance 610 Contract Bonds 611 Judicial Bonds 611 License and Permit Bonds 613 Public Official Bonds 613 Miscellaneous Bonds 613

Trade Credit Insurance 614 Specific-Account versus Whole-Turnover

Coverage 614 Proportional versus Excess-of-Loss

Coverage 615 Credit Insurance in Securitization of

Accounts Receivable 615 Collection Service 615

Financial Guaranty Insurance 616 Public Finance Insurance 616 Structured Finance Insurance 616 FGI and the Financial Crisis 617 Regulation 617

Mortgage Guaranty Insurance 617

Chapter 34 Insurance in the Future (Online) 620

Glossary G-1 Author Index I-1 Subject Index I-3

■

CHAPTER 1

THE PROBLEM OF RISK

■

CHAPTER OBJECTIVES

When you have finished this chapter, you should be able to do the following:

• Define and explain the meaning of the term risk • Distinguish among the terms risk, peril, and hazard • Identify and explain the classes of hazards • Differentiate between pure risk and speculative risk • Differentiate between fundamental and particular risk • Describe the categories into which pure risk may be subdivided • Identify and explain the principal methods of handling risk

You see the mangled metal of two cars that have collided on an interstate highway. A fire engine with its siren screaming roars down the street. A building in your neighborhood burns, or you see an ambulance racing to the hospital. Such tragic events arouse your interest and emotions. After the noise and excitement have died down, you are grateful that the loss did not happen to you and you may feel sorry for whoever suffered the loss. But you’re glad that it wasn’t you. Losses like these happen to some people, whereas others go along happily, free from misfortune. The fact that these losses or similar events could happen to you, and the fact that you can’t tell for sure whether or not they will, is a condition we call risk. Risk is a pervasive con- dition of human existence. Although our instinctive

understanding of the concept of risk is clear enough, terms that have a simple meaning in everyday usage sometimes have a specialized connotation when used in a particular field of study. In this chapter, we will examine the concept of risk as the fundamental problem with which insurance deals. In addition, we will examine several related concepts.

THE CONCEPT OF RISK

It would seem that the term risk is a simple enough notion. When someone states there is risk in a particular situation, the listener understands

1

2 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

what is meant: In the given situation, there is uncertainty about the outcome, and the possi- bility exists that the outcome will be unfavor- able. This loose, intuitive notion of risk, which implies a lack of knowledge about the future and the possibility of some adverse consequence, is satisfactory for conversational usage, but for our purpose, a somewhat more rigid definition is desirable.

Economists, statisticians, decision theorists, and insurance theorists have long discussed the con- cepts of risk and uncertainty in an attempt to con- struct a definition of risk that is useful for analysis in each field of investigation. So far, they have not been able to agree on a single definition that can be used in each field. A definition of risk that is suit- able for the economist or statistician may be worth- less as an analytic tool for the insurance theorist. Because each group treats a different body of sub- ject matter, each requires a different concept of risk. Although the statistician, the decision theorist, and the insurance theorist use the term risk, each may mean something different.

Insurance is in its infancy as a body of theory. As a result, we find contradictory definitions of risk throughout the literature dealing with this phenomenon from an insurance point of view. One reason for these contradictions is that insu- rance theorists have attempted to borrow the def- initions of risk used in other fields. Surprising as it may seem, insurance text writers have not been able to agree on a definition of this basic concept.

To compound the problem, the term risk is used by people in the insurance business to mean either a peril insured against (e.g., fire is a risk to which most property is exposed) or a person or property protected by insurance (e.g., many insurance com- panies believe young drivers are not good risks). In this text, however, we will use the term in its general meaning to indicate a situation in which an expo- sure to loss exists.

Current Definitions of Risk

If we were to survey the best-known insurance text- books used in colleges and universities today, we would find a general lack of agreement concerning

the definition of risk.1 Although the insurance theo- rists have not agreed on a universal definition, there are common elements in all the definitions: indeter- minacy and loss.

• The notion of an indeterminate outcome is implicit in all definitions of risk: The outcome must be in question. For risk to exist, there must be at least two possible outcomes. If we know for cer- tain that a loss will occur, there is no risk. Invest- ment in a capital asset, for example, usually involves a realization that the asset is subject to physical depreciation and its value will decline. Here, the outcome is certain, so there is no risk.

• At least one of the possible outcomes is undesir- able. This may be a loss in the generally accepted sense in which something the individual possesses is lost, or it may be a gain smaller than the gain that was possible. For example, the investor who fails to take advantage of an opportunity “loses” the gain that might have been made. The investor faced with the choice between two stocks may be said to lose if he or she chooses the one that increases in value less than the alternative.

Our Definition of Risk

We define risk as a condition of the real world in which there is an exposure to adversity. More specifically,

Risk is a condition in which there is a possibility of an adverse deviation from a desired outcome that is expected or hoped for.

First, in this definition, risk is a condition of the real world; it is a combination of circumstances in the external environment. Second, in this combina- tion of circumstances, there is a possibility of loss. When we say that an event is possible, we mean that it has a probability between zero and one; it is neither impossible nor definite. Third, there is no requirement that the possibility be measurable but only that it must exist. We may or may not be able

1 The term risk is variously defined as (1) the chance of loss, (2) the possibility of loss, (3) uncertainty, (4) the dispersion of actual from expected results, or (5) the probability of any out- come different from the one expected.

CHAPTER 1 THE PROBLEM OF RISK 3

to measure the degree of risk, but the probability of the adverse outcome must be between zero and one.2

The undesirable event is described as “an adverse deviation from a desired outcome that is expected or hoped for.” The reference to a desired outcome that is either expected or hoped for contemplates individual and aggregate loss exposures. The indi- vidual hopes that adversity will not occur, and it is the possibility that this hope will not be met that constitutes risk. If you own a house, you hope that it will not catch fire. When you make a wager, you hope that the outcome will be favorable. That the outcome in either event may be something other than what you hope for constitutes the possibility of loss or risk.

In the case of an insurer, actuaries predict some specified number and amount of losses and charge a premium based on this expectation. The amount of predicted losses is the desired outcome that is expected by the insurer. For the insurer, risk is the possibility that losses will deviate adversely from what is expected.

Uncertainty and Its Relationship to Risk

Because the term uncertainty is often used in connection with the term risk (sometimes even interchangeably), it seems appropriate to explain the relationship between the two terms.

The most widely held meaning of uncertainty refers to a state of mind characterized by doubt, based on a lack of knowledge about what will or will not happen in the future. It is the opposite of

2 We measure probability on an imaginary ruler, marked at one end with a zero and unity at the other. The high end of the scale, marked unity, represents absolute certainty. Any proposi- tion about which there is no doubt whatsoever finds its place at this point on the scale. For example, the probability that the reader will eventually die is equal to 1 because we will all die. Using the letter p to stand for probability, we would write p = 1. The bottom end of the scale, marked zero, represents absolute impossibility. The probability that the reader could run a mile in 30 seconds is zero because failure would be absolutely certain. The statistician here would write p = 0. Events that are neither certain nor impossible lie between the two ends of our imagi- nary ruler and are assigned values that vary with the likelihood of their occurrence. Thus, the probability of drawing the ace of spades from a deck of cards is 1/52, or .019. The probability of drawing any ace is 1/13; the probability of drawing a black card is 1/2, or .5.

certainty, which is a conviction or certitude about a particular situation. A student says “I am certain I will get an A in this course,” which means the same as “I am positive I will get an A in this course.” Both statements reflect a conviction about the outcome. Uncertainty, on the other hand, is the opposite mental state. If one says “I am uncertain what grade I am going to get in this course,” the statement reflects a lack of knowledge about the outcome. Uncertainty, then, is simply a psychological reaction to the absence of knowledge about the future.3

The existence of risk—a condition or combination of circumstances in which there is a possibility of loss—creates uncertainty on the part of individuals when that risk is recognized.

The individual’s conviction or lack thereof (certainty or uncertainty) about a specific fact or situation may or may not coincide with the condi- tions of the real world. The student who says “I am certain I will get an A in this course” may actually get a B, a C, a D, or even an F. Uncertainty varies with the knowledge and attitudes of the person. Different attitudes are possible for different individuals under identical conditions of the real world. It is possible, for example, for a person to experience uncertainty in a situation in which he or she imagines there is a chance of loss but where no chance of loss exists. Similarly, an individual may feel no uncertainty regarding a particular risk when the exposure to loss is not recognized. Whether or not a risk is recog- nized, however, does not alter its existence. When there is a possibility of loss, risk exists whether or not the person exposed to loss is aware of the risk.4

3 In addition to its meaning as a psychological phenomenon, a second possible meaning of the term uncertainty relates to prob- ability and is contrasted with a second meaning of certainty: a situation in which the probability of an event is 100 percent. An event may be said to be impossible (probability = 0), certain (probability = 1), or uncertain. Used in reference to the like- lihood of an event, uncertain means that the probability is judged to be between 0 and 1. 4 Some authors equate our notion of uncertainty with subjective risk, which is a person’s perception of risk. An individual may perceive risk where it does not exist. (Navigators in Columbus’s day perceived a risk of falling off the edge of the world.) They may fail to perceive risk when it does exist. The distinction between objective risk and subjective risk (i.e., between risk and uncertainty) is important because subjective risk affects the decisions people make. Ideally, they should make decisions based on actual risk (i.e., objective risk). Better information reduces uncertainty (improves subjective risk estimates) and leads to better decisions.

4 SECTION ONE RISK, INSURANCE, AND RISK MANAGEMENT

The Degree of Risk

It is intuitively obvious that there are some situations in which the risk is greater than in other situations. Just as we should agree on what we mean when we use the term risk, we should agree on the way(s) in which risk can be measured. Precisely what is meant when we say that one alternative involves “more risk” or “less risk” than another?