Introduction to risk management and insurance dorfman pdf

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George E. Rejda

Michael J. McNamara

Principles of Risk ManageMent and Insurance

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Library of Congress Cataloging-in-Publication Data Names: Rejda, George E. | McNamara, Michael J. Title: Principles of risk management and insurance / George E. Rejda, Michael J. McNamara. Description: Thirteenth Edition. | Hoboken : Pearson Education, Inc., 2016. | Revised edition of the authors’ Principles of risk management and insurance, 2014. Identifiers: LCCN 2015040965 | ISBN 9780134082578 Subjects: LCSH: Insurance. | Risk (Insurance) | Risk management. Classification: LCC HG8051.R44 2016 | DDC 368--dc23 LC record available at http://lccn.loc.gov/2015040965

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v

contents

Preface xv

PaRT onE Basic concePts in risk ManageMent and insurance

chaPter 1 risk and its treatMent 1 Definitions of Risk 2 Chance of Loss 4 Peril and Hazard 4 Classification of Risk 5 Major Personal Risks and Commercial Risks 7 Burden of Risk on Society 13 Techniques for Managing Risk 13 Summary 17 ■ Key Concepts and Terms 18 ■ Review Questions 18 ■ Application Questions 18 ■ Internet Resources 19 ■ Selected References 20 ■ Notes 20

Case Application 16 Insight 1.1: What Are Your Chances of Not Being Able to Earn an Income? Calculate Your

personal Disability Quotient 10

chaPter 2 insurance and risk 21 Definition of Insurance 22 Basic Characteristics of Insurance 22 Characteristics of an Ideally Insurable Risk 24 Two Applications: The Risks of Fire and Unemployment 26 Adverse Selection and Insurance 28 Insurance and Gambling Compared 28 Insurance and Hedging Compared 28 Types of Insurance 29 Benefits of Insurance to Society 33 Costs of Insurance to Society 34 Summary 38 ■ Key Concepts and Terms 39 ■ Review Questions 39 ■ Application Questions 39 ■ Internet Resources 40 ■ Selected References 40 ■ Notes 41

Case Application 38 Insight 2.1: Insurance Fraud Hall of Shame—Shocking Examples of Insurance Fraud 35

Insight 2.2: Have You Ever Committed Insurance Fraud? Think Again 37

Appendix: Basic Statistics and the Law of Large Numbers 42

chaPter 3 introduction to risk ManageMent 46 Meaning of Risk Management 48 Objectives of Risk Management 48 Steps in the Risk Management Process 48

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Benefits of Risk Management 59 Personal Risk Management 59 Summary 62 ■ Key Concepts and Terms 63 ■ Review Questions 63 ■ Application Questions 63 ■ Internet Resources 64 ■ Selected References 65 ■ Notes 65

Case Application 61 Insight 3.1: vermont Leads U.S. Captive Domiciles 53

Insight 3.2: Advantages of Self-Insurance 54

chaPter 4 enterPrise risk ManageMent and related toPics 67 Enterprise Risk Management 68 Insurance Market Dynamics 74 Loss Forecasting 80 Financial Analysis in Risk Management Decision Making 82 Other Risk Management Tools 84 Summary 87 ■ Key Concepts and Terms 87 ■ Review Questions 88 ■ Application Questions 88 ■ Internet Resources 88 ■ Selected References 89 ■ Notes 89

Case Application 86 Insight 4.1: Weather Futures and Options: Financial Tools That provide a Means of

Transferring Risk Associated with Adverse Weather Events 79

PaRT Two the Private insurance industry

chaPter 5 tyPes of insurers and Marketing systeMs 91 Overview of Private Insurance in the Financial Services Industry 92 Types of Private Insurers 93 Agents and Brokers 98 Types of Marketing Systems 99 Group Insurance Marketing 102 Summary 103 ■ Key Concepts and Terms 103 ■ Review Questions 104 ■ Application Questions 104 ■ Internet Resources 105 ■ Selected References 106 ■ Notes 106

Case Application 103 Insight 5.1: Show Me the Money—How Much Can I Earn as an Insurance Sales Agent? 99

chaPter 6 insurance coMPany oPerations 107 Insurance Company Operations 108 Rating and Rate Making 108 Underwriting 109 Production 112 Claims Settlement 113 Reinsurance 115 Investments 120 Other Insurance Company Functions 122 Summary 124 ■ Key Concepts and Terms 124 ■ Review Questions 125 ■ Application Questions 125 ■ Internet Resources 126 ■ Selected References 126 ■ Notes 127

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Case Application 123 Insight 6.1: Home Owner’s Failure to Cooperate Yields Denied Claim 115

Insight 6.2: Be a Smart Consumer—Check the Claims Record of Insurers before You Buy 116

chaPter 7 financial oPerations of insurers 128 Property and Casualty Insurers 129 Life Insurance Companies 134 Rate Making in Property and Casualty Insurance 136 Rate Making in Life Insurance 140 Summary 141 ■ Key Concepts and Terms 142 ■ Review Questions 142 ■ Application Questions 143 ■ Internet Resources 144 ■ Selected References 144 ■ Notes 144

Case Application 141 Insight 7.1: How profitable Is the property and Casualty Insurance Industry? 135

chaPter 8 governMent regulation of insurance 146 Reasons for Insurance Regulation 147 Historical Development of Insurance Regulation 148 Methods for Regulating Insurers 150 What Areas Are Regulated? 150 State versus Federal Regulation 156 Current Issues in Insurance Regulation 159 Modernizing Insurance Regulation 159 Insolvency of Insurers 162 Market Conduct Regulation 163 Summary 166 ■ Key Concepts and Terms 167 ■ Review Questions 167 ■ Application Questions 167 ■ Internet Resources 168 ■ Selected References 168 ■ Notes 169

Case Application 165 Insight 8.1: The pros and Cons of Credit-Based Insurance Scores 164

PaRT ThREE legal PrinciPles in risk and insurance

chaPter 9 fundaMental legal PrinciPles 170 Principle of Indemnity 171 Principle of Insurable Interest 174 Principle of Subrogation 175 Principle of Utmost Good Faith 176 Requirements of an Insurance Contract 179 Distinct Legal Characteristics of Insurance Contracts 180 Law and the Insurance Agent 181 Summary 184 ■ Key Concepts and Terms 185 ■ Review Questions 185 ■ Application Questions 185 ■ Internet Resources 186 ■ Selected References 186 ■ Notes 186

Case Application 183 Insight 9.1: Corporation Lacking Insurable Interest at Time of Death Can Receive Life

Insurance proceeds 176

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Insight 9.2: Auto Insurer Denies Coverage Because of Material Misrepresentation 177

Insight 9.3: Insurer voids Coverage Because of Misrepresentations in proof of Loss 178

chaPter 10 analysis of insurance contracts 188 Basic Parts of an Insurance Contract 189 Definition of “Insured” 191 Endorsements and Riders 193 Deductibles 193 Coinsurance 195 Coinsurance in Health Insurance 196 Other-Insurance Provisions 196 Summary 199 ■ Key Concepts and Terms 199 ■ Review Questions 200 ■ Application Questions 200 ■ Internet Resources 201 ■ Selected References 201 ■ Notes 201

Case Application 198 Insight 10.1: When You Drive Your Roommate’s Car, Are You Covered Under Your

policy? 192

PaRT FouR life and health risks

chaPter 11 life Insurance 202 Premature Death 203 Financial Impact of Premature Death on Different Types of Families 204 Amount of Life Insurance to Own 205 Types of Life Insurance 210 Variations of Whole Life Insurance 216 Other Types of Life Insurance 224 Summary 228 ■ Key Concepts and Terms 229 ■ Review Questions 230 ■ Application Questions 230 ■ Internet Resources 232 ■ Selected References 233 ■ Notes 233

Case Application 227 Insight 11.1: Cash-value Life Insurance as an Investment—Don’t Ignore Two points 215

Insight 11.2: Be a Savvy Consumer—Four Life Insurance policies to Avoid 226

chaPter 12 life insurance contractual Provisions 234 Life Insurance Contractual Provisions 235 Dividend Options 241 Nonforfeiture Options 243 Settlement Options 245 Additional Life Insurance Benefits 249 Summary 254 ■ Key Concepts and Terms 255 ■ Review Questions 256 ■ Application Questions 256 ■ Internet Resources 257 ■ Selected References 258 ■ Notes 258

Case Application 254 Insight 12.1: Is This Death A Suicide? 237

Insight 12.2: Selection of the Best Dividend Option in a participating Whole Life policy 242

Insight 12.3: Accelerated Death Benefits—A Real-Life Example 252

Insight 12.4: What Is a Life Settlement? Examples of Actual Cases 253

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chaPter 13 Buying life insurance 259 Determining the Cost of Life Insurance 260 Rate of Return on Saving Component 263 Taxation of Life Insurance 265 Shopping for Life Insurance 267 Summary 270 ■ Key Concepts and Terms 270 ■ Review Questions 270 ■ Application Questions 271 ■ Internet Resources 271 ■ Selected References 272 ■ Notes 272

Case Application 269 Insight 13.1: Be Careful in Replacing an Existing Life Insurance policy 263

Appendix: Calculation of Life Insurance Premiums 273

chaPter 14 annuities and individual retireMent accounts 278 Individual Annuities 279 Types of Annuities 280 Taxation of Individual Annuities 287 Individual Retirement Accounts 288 Adequacy of IRA Funds 291 Summary 294 ■ Key Concepts and Terms 295 ■ Review Questions 295 ■ Application Questions 296 ■ Internet Resources 296 ■ Selected References 297 ■ Notes 297

Case Application 1 293

Case Application 2 294 Insight 14.1: Advantages of an Immediate Annuity to Retired Workers 281

Insight 14.2: Bells and Whistles of variable Annuities 284

Insight 14.3: Ten Questions to Answer Before You Buy a variable Annuity 288

Insight 14.4: Will You Have Enough Money at Retirement? Monte Carlo Simulations Can Be Helpful 292

chaPter 15 healthcare reforM: individual health insurance coverages 298 Defects in the Healthcare System in the United States 299 Basic Provisions of the Affordable Care Act 304 Individual Medical Expense Insurance 310 Individual Medical Expense Plans and Managed Care 312 Health Savings Accounts 313 Long-Term Care Insurance 314 Disability-Income Insurance 318 Individual Health Insurance Contractual Provisions 321 Summary 323 ■ Key Concepts and Terms 324 ■ Review Questions 324 ■ Application Questions 325 ■ Internet Resources 325 ■ Selected References 326 ■ Notes 327

Case Application 323 Insight 15.1: Health Insurance Options for College Students under the Affordable

Care Act 307

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chaPter 16 eMPloyee Benefits: grouP life and health insurance 328 Meaning of Employee Benefits 329 Fundamentals of Group Insurance 329 Group Life Insurance 331 Group Medical Expense Insurance 332 Managed Care Plans 334 Affordable Care Act and Group Medical Expense Insurance 336 Key Features of Group Medical Expense Insurance 338 Consumer-Directed Health Plans 339 Recent Developments in Employer-Sponsored Health Plans 340 Group Medical Expense Contractual Provisions 343 Group Dental Insurance 344 Group Disability-Income Insurance 345 Cafeteria Plans 346 Summary 348 ■ Key Concepts and Terms 349 ■ Review Questions 349 ■ Application Questions 350 ■ Internet Resources 351 ■ Selected References 351 ■ Notes 351

Case Application 347 Insight 16.1: Basic Characteristics of the Small Business Health Options (SHOp) Marketplace

program 338

chaPter 17 eMPloyee Benefits: retireMent Plans 353 Fundamentals of Private Retirement Plans 354 Types of Qualified Retirement Plans 357 Defined-Benefit Plans 357 Defined-Contribution Plans 360 Section 401(K) Plan 361 Section 403(B) Plan 363 Profit-Sharing Plans 364 Retirement Plans for the Self-Employed (Keogh Plans) 364 Simplified Employee Pension (SEP) 364 Simple IRA Plan 365 Saver’s Credit 365 Funding Agency and Funding Instruments 366 Problems and Issues in Tax-Deferred Retirement Plans 367 Summary 369 ■ Key Concepts and Terms 370 ■ Review Questions 370 ■ Application Questions 370 ■ Internet Resources 371 ■ Selected References 371 ■ Notes 372

Case Application 368 Insight 17.1: Six Common 401 (k) Mistakes 362

chaPter 18 social insurance 373 Social Insurance 374 Old-Age, Survivors, and Disability Insurance 376 Types of Benefits 377 Medicare 383 Problems and Issues 388 Unemployment Insurance 391 Workers Compensation 393

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Summary 398 ■ Key Concepts and Terms 398 ■ Review Questions 399 ■ Application Questions 399 ■ Internet Resources 400 ■ Selected References 401 ■ Notes 402

Case Application 397 Insight 18.1: Claiming Social Security Benefits — Strategies for Single persons 380

Insight 18.2: How Would You Reduce the Long-Range Social Security Deficit? 389

PaRT FIvE Personal ProPerty and liaBility risks

chaPter 19 the liaBility risk 403 Basis of Legal Liability 404 Law of Negligence 405 Imputed Negligence 407 Res Ipsa Loquitur 408 Specific Applications of the Law of Negligence 408 Current Tort Liability Problems 410 Summary 420 ■ Key Concepts and Terms 420 ■ Review Questions 421 ■ Application Questions 421 ■ Internet Resources 422 ■ Selected References 423 ■ Notes 423

Case Application 419 Insight 19.1: Judicial Hellholes 2014–2015 413

chaPter 20 auto insurance 425 Overview of Personal Auto Policy 426 Part A: Liability Coverage 427 Part B: Medical Payments Coverage 433 Part C: Uninsured Motorists Coverage 434 Part D: Coverage for Damage to Your Auto 438 Part E: Duties after an Accident or Loss 445 Part F: General Provisions 446 Insuring Motorcycles and Other Vehicles 447 Summary 448 ■ Key Concepts and Terms 448 ■ Review Questions 448 ■ Application Questions 449 ■ Internet Resources 451 ■ Selected References 451 ■ Notes 451

Case Application 447 Insight 20.1: What Do Ride Sharing and Car Sharing Mean for personal Auto

Insurance? 430

Insight 20.2: New Study Reveals a Declining Trend in the percentage of Uninsured Motorists 435

Insight 20.3: Using Electronic Devices while Driving Is a Serious problem 442

chaPter 21 auto insurance (Continued) 453 Approaches for Compensating Auto Accident Victims 454 Auto Insurance for High-Risk Drivers 464 Cost of Auto Insurance 465 Shopping for Auto Insurance 469 Summary 473 ■ Key Concepts and Terms 473 ■ Review Questions 474 ■ Application Questions 474 ■ Internet Resources 474 ■ Selected References 475 ■ Notes 475

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Case Application 472 Insight 21.1: Filing an Auto Claim with the Other party’s Insurance Company 458

Insight 21.2: protect Yourself: Insuring Your Teen Driver 468

Insight 21.3: More Folks Are Tweeting, Texting, and Taking pictures While Driving: AT&T Survey 471

chaPter 22 hoMeowners insurance, section i 477 Homeowners Insurance 478 Analysis of Homeowners 3 Policy (Special Form) 482 Section I Coverages 483 Section I Perils Insured Against 489 Section I Exclusions 492 Section I Conditions 493 Section I and II Conditions 498 Summary 500 ■ Key Concepts and Terms 500 ■ Review Questions 500 ■ Application Questions 501 ■ Internet Resources 502 ■ Selected References 503 ■ Notes 503

Case Application 499 Insight 22.1: Renters Insurance Checklist 481

Insight 22.2: How Do I Take a Home Inventory and Why? 494

Insight 22.3: The Big Gap between Replacement Cost and Actual Cash value Can Empty Your Wallet 495

chaPter 23 hoMeowners insurance, section ii 504 Personal Liability Insurance 505 Section II Exclusions 507 Section II Additional Coverages 511 Section II Conditions 512 Endorsements to a Homeowners Policy 513 Cost of Homeowners Insurance 516 Summary 520 ■ Key Concepts and Terms 521 ■ Review Questions 521 ■ Application Questions 522 ■ Internet Resources 523 ■ Selected References 523 ■ Notes 523

Case Application 520 Insight 23.1: Dog Bites Hurt, So Do Lawsuits 506

Insight 23.2: Trying to Save Money? Avoid the Five Biggest Insurance Mistakes! 519

chaPter 24 other ProPerty and liaBility insurance coverages 525 ISO Dwelling Program 526 Mobile Home Insurance 528 Inland Marine Floaters 529 Watercraft Insurance 530 Government Property Insurance Programs 531 Title Insurance 536 Personal Umbrella Policy 539

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Summary 543 ■ Key Concepts and Terms 543 ■ Review Questions 544 ■ Application Questions 544 ■ Internet Resources 545 ■ Selected References 546 ■ Notes 546

Case Application 542 Insight 24.1: Dispelling Myths about Flood Insurance 535

Insight 24.2: Title Insurance: protecting Your Home Investment against Unknown Title Defects 537

Insight 24.3: Umbrella Insurance policies: Why You Might Want That Extra protection 540

PaRT SIx coMMercial ProPerty and liaBility risks

chaPter 25 coMMercial ProPerty insurance 548 Commercial Package Policy 549 Building and Personal Property Coverage Form 551 Causes-of-Loss Forms 554 Endorsements 554 Reporting Forms 556 Business Income Insurance 557 Other Commercial Property Coverages 560 Transportation Insurance 563 Businessowners Policy (BOP) 568 Summary 570 ■ Key Concepts and Terms 571 ■ Review Questions 571 ■ Application Questions 572 ■ Internet Resources 573 ■ Selected References 574 ■ Notes 574

Case Application 569 Insight 25.1: Three Commercial property Endorsements That Every Client Should Have 555

Insight 25.2: Examples of Equipment Breakdown Claims: Recent paid Claims 562

chaPter 26 coMMercial liaBility insurance 576 General Liability Loss Exposures 577 Commercial General Liability Policy 578 Employment-Related Practices Liability Insurance 586 Workers Compensation Insurance 587 Commercial Auto Insurance 589 Aircraft Insurance 591 Commercial Umbrella Policy 593 Cyber Liability Insurance 594 Businessowners Policy 595 Professional Liability Insurance 595 Directors and Officers Liability Insurance 597 Summary 599 ■ Key Concepts and Terms 600 ■ Review Questions 600 ■ Application Questions 601 ■ Internet Resources 602 ■ Selected References 602 ■ Notes 602

Case Application 598 Insight 26.1: Cyber Loss Exposure—No Longer Breaching the CGL 581

Insight 26.2: Basic Facts about Workers Compensation 588

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chaPter 27 criMe insurance and surety Bonds 605 The ISO Commercial Crime Insurance Program 606 Commercial Crime Coverage Form (Loss-Sustained Form) 607 Financial Institution Bonds 612 Surety Bonds 613 Summary 616 ■ Key Concepts and Terms 617 ■ Review Questions 617 ■ Application Questions 617 ■ Internet Resources 618 ■ Selected References 619 ■ Notes 619

Case Application 615 Insight 27.1: Crime prevention Tips for Small Businesses 609

appendix a: Personal auto Policy 620

appendix B: homeowners 3 (Special Form) 634

Glossary 659

Index 678

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This text deals with risk and its management. Since the last edition of the text appeared, several trage- dies have occurred that clearly demonstrate the deadly presence of risk in our society. A suicide bomber entered a market near Baghdad, detonated a bomb, and killed 11 people. Malaysia Flight 360 mysteri- ously disappeared with 239 passengers aboard, caus- ing an enormous amount of pain and suffering to the surviving families. A deadly earthquake struck Nepal, a low-income country in Asia, which killed more than 8,600 people and destroyed or damaged tens of thou- sands of houses. Meanwhile, in the United States, a gunman killed nine members of a Bible study group in an historical African American church in Charleston, South Carolina, and a student enrolled at Umpqua Community College in Oregon killed nine people and himself in a tragic and senseless shooting.