International Insurance

Introduction to Risk Management
and Insurance
Finance Department of Shanghai University
1. Fundamentals & Terminology
 Risks---Risk Management---Insurance
 Mathematical Foundation of Insurance---Law
of Large Numbers
 Definition of Insurance
Financial Definition---Redistribution
Legal Definition---Contracts
Others: the Insurer, the Insured, a Premium, a
Policy, the Insured’s Exposure to Loss, Right & Duty
Loss, Chance of Loss,
Peril & Hazard: Moral Hazard, Morale Hazard
Proximate Cause
Insurable Loss: Direct Losses & Indirect Losses
Pure Risk, Speculative Risk, Risk Management
Building Blocks of an Insurance Premium
A. The Actual Cost of the Losses
B. The Expenses of Operating and Maintaining the
Insurance Pool
C. An Allowance for Unexpected Losses, or the Risk
Factor for the Insurance Pool
D. Earnings on Investment
An Insurance Premium=A+B+C-D
Sometimes an insurance premium can be priced below
the level of expected losses.
2. Insurable Loss Exposures
Not all potential losses are a good subject for
I. Ideal insurable loss exposure
1. A large group of similar items exposed to the same
Accidental losses.
Definite losses capable of causing economic
Extremely low probability of a catastrophic loss to
the insurance pool.
II. Risk Classification
Adverse Selection
Principles of risk classification---fairness
Separation and class homogeneity
Incentive value
Social acceptability
3. Risk Management
The risk management is carried out by firms
before they go to buy insurance. The
purpose is to reduce the risks exposure.
Risk Management Staff
Head: a manager with overall responsibility
Insurance expert
Claims manager
Loss control engineer
Employee benefits specialist
Financial analyst
II. Statement of objectives and principles
1. Objectives: Survival, Growth, and
2. Principles: Efficiency and Compliance
3. Risk Management Manual
General Guidelines:
(1) Engage in loss prevention activities as if all chance of
loss remained with the company
(2) Assume all risks that are not significant in relation to
the company’s financial strength
(3) Insure all risks not assumed
Example: protecting the company’s property against fire
and associated perils: commitment to loss control, good
housekeeping, sprinklers, adequate water supply,
emergency organizations, regular inspections
There are three steps in risk management
III. Step One: Identification and
measurement of exposures
 Direct property losses
 Losses of income and extra expenses following
a property loss
 Losses arising from lawsuits called liability
Losses caused by the death, disability, or
unplanned retirement of key people
Estimation of maximum loss
Emergency planning—disaster recovery
IV. Step Two: loss control and risk
(1) Loss control
Risk avoidance
Loss prevention
Loss reduction
(2) Risk financing
Risk assumption
Self-insurance and financed risk retention
Risk transfer other than insurance
V. Step Three: regular review of the risk
management program
VI. Financial Risk Management
Interest rate risk (swap)
Credit risk (investigation)
Currency risk (option, futures, forward)
Liquidity risk (allowance)
Market risk (hedging)
4. Private Insurance Companies
I. Two different types of insurance
Mutual insurance company
Stock insurance company
1. Mutual insurance companies: non-profit
The owners are the policyholders insured by
the corporation
Advance premium mutual
Assessment mutual
Factory mutual
2. Stock insurance companies
3. Demutualization:
The conversion from mutual to stock
insurance companies.
II. Lloyd’s of London: one of the most
important insurance markets
 Established in 1688.
 In 1969 foreigners were allowed to become
names of Lloyd.
 In 1990s Lloyd’s membership was 18,000
individuals organized in about 170 syndicates.
 An individual needed a net worth of at least
250 thousand pounds, with at least 150
thousand pounds in liquid assets, to become a
III. Blue cross and Blue shield, HMOs and
5. Insurance Occupation
In recent years in the U.S., some 2.2
million people were employed in the
insurance industry, among whom 1.5
million work in home offices and
700,000 work as agents, brokers, or in
service organizations.
I. Insurance agents & brokers
Insurance agent---the link between the
insurance company and the insurance
Duties of the agent
Agency contracts: specify the authorities to
the agent.
Agent should act within the limit of the
Two other fundamental legal doctrines.
Insurance broker
1. A broker is the agent of the insurance
2. A broker is needed when the applicant wants
to tailor out specific insurance requirements
Licensing requirements
Direct writers---employed by insurers
Independent agents
II. Loss adjuster
 Employees, independent adjustment bureaus
 Public adjusters---an agent of the insured.
reservation of rights
waiver and estoppel
III. Underwriter
IV. Actuary
6.Insurance Regulation
Regulation represents the rules by which
the game is played.
The government as market regulator: to
protect the weak group.
I. The reasons for insurance regulation
 Widespread severe impact of insurer
 Unequal knowledge and bargaining
power of the buyer and seller
 Unique problem of insurance pricing
 Promotion of social goals
Promoting solvency: the most important
goal of insurance regulation
Unequal knowledge and bargaining power
1.lack of technical expertise on consumer’s side
2.deterioration of competition
3.complexity of insurance contract is an intangible good
Prices: insurers set prices before costs are
fully known
Promotion of social goals.
II. Regulated Activities
 Legal Reserve and Surplus
 Admitted Assets/Nonadmitted Assets
 Property Insurance Reserve Accounts:
unearned premium reserve/loss reserve
 Life Insurance Reserve Accounts:
increase with the passage of time
 Asset Valuation Reserve/Interest
Maintenance Reserve
Regular Audits and Solvency Testing
Audits by the state insurance department once
every three years
IRIS monitoring
Risk-based capital as against minimum capital
Guaranty Funds
Rate Regulations
Investment Activities
Policy Form Approval and Expense
 Qualifications or Licenses
7. Insurance Contracts
Contract: Valid, Voidable, Void
Binder: a temporary property insurance
contract before the issuance of the formal
insurance contract.
Conditional Receipt: a temporary life
insurance contract when the applicants
submit a premium payment.
Difference between a binder and a
conditional receipt: the payment of the
II. Elements of a valid contract
Offer, Counteroffer, Acceptance
Consideration: exchangeable value---premium
against contingent promises.
Capacity: minors, insane, intoxicated are
Legal Purpose.
III. Insurance Contracts
Principle of Indemnity
Three exceptions to the rule: life insurance,
replacement-cost insurance, valued insurance policies
Insurable Interest
The insured should have a financial interest in the loss
Property Insurance: measured at the time of loss.
More than one party: owner, co-owner, mortgage
Life Insurance: measured at the time of purchasing the
Close family relationships, creditor and debtor,
close employment relations
Actual Cash Value
Actual Cash Value=Replacement Cost-Depreciation
A is responsible for B’s loss. B can claim the loss from
the insurer, and the company has the subrogation right
to sue A.
If it collects from A more than it compensates B, the
balance belongs to B.
An insurer has no right to subrogate against its own
Contract of Adhesion
Any ambiguous language will be construed against the
drafter of the contract
Reasonable expectations: misleading locations,
unreasonable evidence
The Personal Feature
Property insurance: transfer of rights & duties with the
consent of the insurer
Life insurance: change of beneficiary
Assumption Reinsurance
Utmost Good Faith
Representations: answering questions
IV. Discharge of Insurance Contracts
8. Rate of Premium
Pure rate of premium
=premium÷insurance amount
Rate of premium=pure rate of
premiumX(1+extra charge)
II. Principle of the rate of premium
p: chance of loss,S:insurance amount
Solvency: avoid vicious competition
 Comparative stability
 Encouraging loss reduction
III. Setting of property premium
 Rate of loss=compensation÷insurance
 Deviation: usual 10 percent
This is also the adjustment rate
Rate of property premium:
Rate of lossX(1+10%)X(1+g) ÷(1+y)
g: extra rate, y: investment gain.
IV. Rate of life premium
n:number of payment years,
9.Basic Property and Liability
Insurance Contracts
Commercial and personal property
insurance policies have the following
common elements: declarations,
insuring agreements, deductibles,
definitions, exclusions, endorsements or
riders, and conditions
Checklist to determine whether an
insurer is obligated to pay a claim
Is the property covered?
Is the person covered?
Is the loss caused by a covered peril?
Do any deductibles or exclusions apply to the
5. Do policy conditions limit the amount of
6. Is the location of the loss covered?
7. Did the loss occur during a covered time
I. Standard Policy: for most widely used
property & liability insurance contracts
II. Basic parts of an insurance policy
Insuring Agreement
III. Conditions
Suspension of Coverage
Other Insurance
Duties after a Loss
Claims Payment
IV. Conclusion
10. The Personal Auto Policy
The Auto Policy is an independent
category of insurance
The Personal Auto Policy (PAP)
Named Insured
Vehicles Covered
Premium Charged
Insuring Agreements
describe the insurance in broad terms
II. Part A---Liability
Limit of Liability
Single Limit of Liability
Split Limits
III. Part B---Medical Payments
Reasonable expenses on a no-fault basis within 3
years from the date of the accident
IV. Part C---Uninsured Motorist Coverage
Purpose: protect people from the loss of accident
caused by another uninsured motorist
Uninsured motorist:
 Drivers without insurance
 Drivers with less insurance than the minimum required
by the state law
 Hit-and –run Drivers
 Drivers with coverage provided by insolvent insurers
Contact or no-contact rules
Underinsured motorists
V. Part D---Damage to Your Auto
Other-than-collision Coverage
Loss Settlement
Actual Cash Value (ACV)
VI. Part E---Duties after An Accident or
VII. Part F---General Provisions
Territory Covered
11. Commercial Property Insurance
I. Commercial Insurance
Business Firms Purchase Insurance
II. Commercial Package Policy
A package of policies providing insurance
coverage to a broad range of organizations
Components of CPP:
Common Declarations
Common Conditions
Commercial Property, Commercial General Liability,
Crime, Inland Marine, Commercial Auto, Boiler, Farm,
Insureds must purchase at least two of the package’s
components, and as many as they need.
III. Building and Personal Property Form
 Property Covered:
Building, Business Personal Property, Personal Property
 Property excluded from Coverage
 Perils Covered:
The Basic Form, The Broad Form, The Special Form
 Definition of Fire
Hostile Fire, Friendly Fire
 Reporting Forms
Business Income Coverage
Indirect Losses
Business Income from Dependent Properties
 Additional Forms
 Property Insurance
Rating: Class Rating, Schedule Rating
IV. Transportation Insurance
 Ocean Marine Insurance: the origin of any
Ocean Marine Coverages
The Hull Exposure
The Cargo Exposure: Particular Average, General Average
The Loss of Freight
The Liability Loss Exposure
The list of perils is very broad.
 Ocean Marine Insurance Rating
Based on the judgment of the underwriters, includes:
The seaworthiness of the ship
The experience and ability of captain and crew
The potential for loss of the cargo
The route and the season
The coverage provided by the policy
V. Aviation Insurance
Purchased by the owners and operators of
aircraft, airport operators, and by companies
building and supplying parts for aircraft, but
not passengers.
Including planes, helicopters, hot air balloons,
hang gliders and space satellites.
Aircraft owners purchase:
property insurance:aircraft hull
liability insurance
The core problem facing aviation insurers is the
weakening of law of large numbers
Aircraft insurance premium: a function of the
perils covered.
VI. Automobile Property Insurance
Commercial Auto Component provides both
liability and property coverage.
The commercial auto policy covers:
Medical Expenses: drivers A and B and passengers
Lost income and services: drivers A, B and passengers
Damage to automobiles: A and B
Additional property
Ambulance expense
Funeral expense
Investigation expense
Legal expense
The cause of the loss: Collision or not collision
Collision Coverage
Comprehensive Coverage
VII. Automobile Liability Insurance
A. Liability Insurance: The third-party insurance
(The passengers in the auto are not the thirdparty)
If A’s loss was caused by the negligence of B, A
could sue B in a tort case. B’s insurer should
compensate A according to the judgment, or
settle with A without litigation.
B. No-Fault Automobile Insurance
All parties receive compensation from their
own insurer, regardless of who caused the
No-fault insurance is to speed the
compensation in less serious traffic accidents.
After some threshold of damage has been
reached, the injured party may revert to the
liability system to seek compensation.
C. No-Fault Vs. Tort Liability
The shortcomings of tort liability:
Too small proportion of money used for compensation
Unfair indemnity
Slow recovery
Difficult to prove negligence
The supporting points to tort liability.
The no-fault insurance provides one more option
to the insureds so that it is more flexible.
D. Commercial Automobile Insurance
Business Auto Coverage Form
Garage Coverage Form
12. Reinsurance
One insurance company purchases insurance
from other insurance companies.
Primary insurer/ceding insurer
Facultative reinsurance
Treaty reinsurance/Automatic reinsurance
I. Reinsurance Coverage
Pro rata reinsurance
Excess-of-loss reinsurance
The insured will most likely be unaware of any
reinsurance coverage agreement. It receives one
check in the event of a loss.
II. Catastrophe Reinsurance
Example: total 100 million
 5 million: insured
 10 million: primary insurer
 25 million: first reinsurer
 60 million: catastrophe reinsurer
III. Reasons for Reinsurance
Stability in operating results (enlarges financial strength)
Reduction of size of the reserves
Services provided by the reinsurer
Improves relations between a company and its agents
by accepting the large-sized exposures
 Allowing an insurer to profit without marketing a
product to the public
IV. For and against
For: spread the losses abroad
Against: not subject to the same level of regulation
V. Providers of Reinsurance
 Professional reinsurance companies
 Primary insurance companies
 Self-insurance subsidiaries of noninsurance companies
 International insurance firms
A reinsurer can purchase reinsurance again:
13. Life Insurance policies
Broad meaning and narrow meaning
Three distinct types of life insurance:
 Life insurance
 Health insurance
 Annuities
Life insurance has a savings function
I. Three ways life insurance is distributed
A. Group life insurance
B. Industrial or debit life insurance
C. Individual life insurance
Group Life Insurance
Provided to a well-defined group of people who are
associated for some purpose other than purchasing
life insurance
Generally costs less than similar individually purchased
Industrial Life Insurance: small amounts
Individual Life Insurance: also called ordinary
life insurance
II. Term Insurance
Insurer is to pay the beneficiary if the insured
dies within a specified period
Term insurance does not build savings or cash
Types of term life insurance:
Single-year term policies
Five-year term policies
Longer-term policies
Term-to-a-specified age policies
Multiyear term policies may have benefits that
decrease, increase, or remain level
 Decreasing term policy: premiums remain the same
 Increasing term policy: premiums increase at each
Level term policies: pay the same amount of benefits
Renewable term policies: renew the policy at the end of
each term at a higher premium
Convertable term policies: convert the policy to a whole
life policy (from non-savings to savings) at a higher
Reentry term policies: insured to pass regular medical
examinations to qualify for low rates
Use of term life insurance
 The need for life insurance is temporary, or
 People need the maximum coverage with limited
financial resources
III. Whole Life Insurance
The policies promise to pay the beneficiary
whenever death occurs
Difference from both property insurance and
term life insurance: the insurer must
eventually pay a claim on every whole life
Cash Value:
Positive difference between level-premium and mortality
cost, plus its interest.
Contractual rights of cash value:
 Withdraw all cash value if policy owners want to end the
 Convert it to purchase an annuity
 Borrow all or a proportion of cash value
 Some terminally ill insureds can receive “accelerated
death benefit”---a percentage of a policy’s face
Types of whole life policies
 Single-premium whole life insurance: insureds pay a
large premium once and all
Continuous-premium whole life insurance: insureds pay
a level-premium until his death
Limited-payment whole life insurance: insureds pay a
level-premium for a limited number of years
Modified whole life insurance: level-premium rising in
stair steps
Combination whole life insurance: decrease term policy
combines with additions to the whole life policy
The Use of Whole Life Insurance
Whole life insurance policies meet people’s needs for
permanent protection combined with savings
Reasons for saving with life insurance
Example of a whole life ledger sheet
IV. Buy Term and Invest the Difference:
There is difference between a term insurance
premium and a whole life insurance premium.
People can buy term policy and invest the
difference to other products.
V. Universal Life Insurance
People buy a term policy and invest an additional
amount with the insurance company.
The minimum premium is to keep a term
insurance in force.
The insured is allowed to determine the amount
and frequency of the premium payments
within limits.
A guaranteed rate is specified in the contract,
while an excess interest rate is determined by
a formula or by company declaration.
Universal Life Insurance Death Benefits
Plan A: A death benefit remains unchanged at first, then,
after the cash value passes a threshold, the cash value is
added to the death benefit.
Plan B: A death benefit increases with the growth of the
cash value.
Advantages of Universal Life Insurance
 Flexibility of Premium Payments
 Ability to earn a great return when interest rates rise
 Flexibility of death benefits
Example of a Ledger Sheet for Universal Life
V. Variable Life Insurance
A modification of universal life insurance
One insured has two accounts: an insurance
account and a separate account
VI. Annuities
14. Medical Expense and Disability
Increasing Heath Care Costs
From 1970—1995 average U.S. consumption
prices increased 3.93 times (annual rate of
5.4%) while medical care price increased
6.49 times (annual rate of 7.5%)
In the developed countries, some European
countries has not enforced the commercial
medicare plans.
II. Common Contract Provisions
Entire contract
Grace period
Incontestable clause
Physical exam and autopsy
Legal action
Change of beneficiary
Optional contract provisions
Definitions and exclusions
III. Five Kinds of Health Insurance
A. Basic medical expense insurance
Covers the costs of both hospitalization and
Blue Cross and Blue Shield insurance policies pay
benefit directly to the service provider
Insurance companies other than Blue Cross typically
provide “reasonable and customary” payments
First dollar coverage: basic medical insurance policies
often have no-deductible provision
Surgical contracts
Specify a maximum amount of coverage. If one patient
needs more than one procedures, the most expensive
treatment determines the payment.
B. Major Medical Insurance
 Major medical policies have a substantial deductible
 Major medical policies have a participation provision
 Major medical policies have a high limit of liability
C. Disability Income Insurance
Replaces income not earned because of illness or accident.
Short-term: 30 weeks with an elimination period of 1 week.
Long-term: from the date of disability to retirement with
an elimination period of 6 months.
It is a logical complement to life insurance.
D. Medicare Supplement Insurance
Is to supplement benefits provided under the Medicare
IV. Long-Term Care Insurance
V. Health Insurance Providers
Life insurance companies, Blue Cross, Blue Shield,
In recent years,
HMOs: health maintenance organizations
PPOs: preferred provider organizations
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