Trieschmann, Hoyt & Sommer
Insurance as a Risk Management Technique
Chapter 6
©2005, Thomson/South-Western
Chapter Objectives
• Define insurance and explain how it differs from other
methods of risk transfer
• Identify situations that give rise to insurable interest and
explain how this principle supports the principle of
indemnity
• State how the subrogation process works and how it is
useful
• Determine what makes a risk insurable
• List the legal requirements of a contract and describe the
distinguishing legal characteristics of insurance contracts
• Differentiate between insurance agents and brokers and
describe the sources for their authority
• Define social insurance and explain the basic principles
that underline most social insurance programs
• Describe the central costs and values of insurance to
society
2
The Nature of Insurance
• Insurance involves not only risk transfer but also pooling
and risk reduction
– Pooling: The sharing of total losses among a group
– Risk reduction: A decrease in the total amount of uncertainty
present in a particular situation
• Insurers accomplish this by combining a group of objects situated
so that the aggregate losses become predictable within narrow
limits
• Overall risk for the group is reduced, and losses that
result are pooled
– Usually through the payment of an insurance premium
• Insureds transfer various risks to the group and
exchange a potentially large uncertain loss for a
relatively smaller certain payment (the premium)
3
The Nature of Insurance
• Gambling and insurance are exact opposites
– Gambling creates a new risk where none existed
before
– Insurance is a method of eliminating or greatly
reducing an already existing risk
• Insurance is usually implemented through legal
contracts, or policies
– Insurer promises to reimburse the insured for losses
suffered during the term of the agreement
– Implicit is the assumption that the insurer will be able
to pay whatever losses may occur
• Important to consider the financial condition of the insurer
4
Principle of Indemnity
• One of the most important precepts for many
types of insurance
– Particularly property insurance
• The insured may not collect more than the actual
loss in the event of damage caused by an
insured peril
– Serves to control moral hazards that might otherwise
exist
• Indemnify
– To restore insureds to the situations that existed prior
to a loss
• Likelihood of intentional loss is greatly reduced
5
Principle of Indemnity
• Typically contained within property insurance contracts
are clauses regarding the existence of other insurance
– Such causes provide that all policies covering the same loss will
share losses that occur
• Some exceptions to the application of the principle of
indemnity and property insurance
– Appropriate way to measure losses
• Replacement value or current value
– Valued policy laws
• An insurer must pay the entire face amount of the fire insurance
policy in the event of total loss
• Usually not applicable in the field of life insurance
– No attempt is made to measure the amount of the loss when the
insured dies
– The full amount of life insurance policy is paid
6
Principle of Insurable Interest
• Holds that an insured must demonstrate a
personal loss or else be unable to collect
amounts due when a loss caused by an insured
peril occurs
• If insureds could collect without having an
insurable interest a moral hazard would exist
• Necessary to prevent insurance from becoming
a gambling contract
– Necessary to remove a possible incentive for murder
7
What Constitutes Insurable Interest
• The legal owner of property having its
value diminished by loss
• Other rights exist that are sufficient to
establish an insurable interest in addition
to ownership
– The holder of a contract to receive royalties
– Legal liability resulting from contracts
– Secured creditors
– Building contractors, etc.
8
What Constitutes Insurable Interest
• Always presumed to exist in life insurance for
persons who voluntarily insure their own lives
• However someone who purchases life insurance
on another’s life must have an insurable interest
in that person’s life
– For instance, a business firm may insure the life of a
key employee
– A husband may insure the life of his wife
• There are practical limits as to the amount of life
insurance an individual may obtain
9
When the Insurable Interest Must
Exist
• In property and liability insurance it is possible to
effect coverage on property in which the insured
does not have an insurable interest at the time
the policy is written
– However such an interest is expected in the future
• Courts generally hold that in property insurance,
insurable interest need exist only at the time of
the loss and not at the inception of the policy
– However, if at the time of the loss the insured no
longer has an interest in the property
• There is no liability under the policy
10
When the Insurable Interest Must
Exist
• In life insurance, the general rule is that
insurable interest must exist at the
inception of the policy
– It is not necessary at the time of the loss
• Courts view life insurance as an
investment contract
11
Principle of Subrogation
• Grows out of the principle of indemnity
• One who has indemnified another’s loss is entitled to
recovery from reliable third parties who are responsible
• Reasons for subrogation
– To reinforce the principle of indemnity
• To prevent the insured from collecting more than the actual amount
of the loss
– Keeps insurance premiums below what they would otherwise be
– The burden of loss is more nearly placed on the shoulders of
those responsible
• The party that caused the loss is held financially accountable for its
actions
12
Exceptions to the Principle of
Subrogation
• Subrogation normally does not exist in such
lines as life insurance and most types of health
insurance
• Subrogation does not give the insurer the right
to collect against the insured
– Even if the insured is negligent
• It is not uncommon for an insurer to waive rights
of subrogation under certain circumstances
– Where, by doing so, there is no violation of the
principle of indemnity
13
Exceptions to the Principle of
Subrogation
• A waiver can be performed by inserting a waiver-ofsubrogation clause
– Such clauses are common
• An insured who acts in such a way as to destroy or
reduce the value of the insurer’s right of subrogation
violates the provisions of most subrogation clauses
– Forfeits all rights under the policy
• Insurer’s subrogation rights also cannot be avoided by a
settlement between the primary parties after the insurer
has paid under the policy
• The insurer is entitled to subrogation only after the
insured has been fully indemnified
– If the insured has borne part of the loss, the insurer may claim
recovery only after these costs have been repaid
• Exception: The insurer is entitled to legal expenses incurred in
pursuing the subrogation process against a negligent third party
14
Principle of Utmost Good Faith
• A higher standard of honesty is imposed
on parties to an insurance agreement than
is imposed through ordinary commercial
contracts
• Casts a very different light on the
interpretation of insurance agreements
than many persons often suppose
15
Representations
• Statements made by an applicant for insurance before
the policy is issued
– Usually embodied in a written application
• If the representation is relied on by the insurer in
entering into the contract and if it proves to have been
false at the time it was made or becomes false before
the contract is signed
– There exists legal grounds for the insurer to avoid the contract
• Avoiding the contract does not follow unless the
misrepresentation is material to the risk
– If the truth had been known, the contract either would not have
been issued or would have been issued on different terms
– If the misrepresentation is inconsequential, its falsity will not
affect the contract
• Generally, even an innocent misrepresentation of a
material fact is no defense for the insured if the insurer
elects to avoid the contract
16
Warranties
• A clause in an insurance contract stating
that before the insurer is liable
– A certain fact, condition, or circumstance
affecting the risk must exist
• Creates a condition of the contract, and
any breach of warranty, even if immaterial,
will void the contract
– This is the central distinction between a
warranty and a representation
17
Warranties
• Express warranties
– Stated in the contract
• Implied warranties
– Not found in the contract but are assumed by the
parties to the contract
• Promissory warranty
– Describes a condition, fact, or circumstance to which
the insured agrees to be held during the life of the
contract
• Affirmative warranty
– One that must exist only at the time the contract is
first put into effect
18
Concealments
• Silence when obligated to speak
• Has approximately the same legal effect
as the misrepresentation of a material fact
• The applicant must volunteer material
facts
– Even if disclosure of facts might result in
rejection of the application or the payment of
a higher premium
19
Concealments
• The important question about concealment lies in
whether the applicant knew the fact withheld to be
material
• The tests of the concealment are
–
–
–
–
Did the insured know of a certain fact?
Was this fact material?
Was the insurer ignorant of the fact?
Did the insured know the insurer was ignorant of the fact?
• The test of materiality is especially difficult because often
the applicant is not an insurance expert
– Is not expected to know the full significance of every fact that
might be of vital concern to the insurer
• Final determination of materiality
– Would the contract be issued on the same terms if the concealed
fact had been known?
20
Mistakes
• When an honest mistake is made in a
written contract of insurance
– Steps can be taken to correct it after the
policy is issued
• Generally a policy can be reformed if there
is proof of a mutual mistake
– Or mistake on one side that is known to be a
mistake by the other party
• Where no mention was made of it at the time the
agreement was made
21
Requisites of Insurable Risks
• Not all risks are commercially insurable
• Requisites of insurable risks
– Characteristics of risks that make it feasible for private
insurers to offer insurance
• Should be viewed as guides or standards that
are not always completely attained in practice
• Even when their absence makes it impossible
for insurance to be offered by private insurers
– Government agencies may offer some protection
22
Large Number of Similar Objects
• Probable loss must be subject to advance
estimation
• Number of insured objects must be sufficiently
large
– The objects themselves must be similar enough to
allow the law of large numbers to operate
• Nature of the objects must be enough alike so
that reliable statistics on loss can be formulated
• Sometimes insurers act as risk transferees even
when it is impossible to obtain a sufficiently large
number of exposure units to allow the law of
large numbers to operate
23
Accidental and Unintentional Loss
• There must be some uncertainty surrounding the loss
• Insurers normally exclude in all policies any loss caused
intentionally by the insured
– If the insured knew that the insurer would pay for intentional losses
• A moral hazard would be introduced
– Causing losses and premiums to rise
• Adverse selection
– Tendency of insureds who know that they have a greater than average
chance of loss to seek to purchase more than an average amount of
insurance
– Asymmetric information
• When an insured possesses knowledge about likely losses that is
unavailable to insurers
• Its existence is one cause of adverse selection
• Underwriting
– Process of selecting and classifying insureds from among the many
applicants
24
Determinable and Measurable Loss
• The loss must be definite in time and place
• Even if it is clear that a loss has occurred it
may not be easy to measure it
– For example, what is the loss from “pain and
suffering” of an auto accident victim?
25
Loss Not Subject to Catastrophic
Hazard
• Conditions should not be such that all or most of the
objects in the insured group might suffer loss at the
same time and possibly from the same peril
– For instance, large fires, floods, earthquakes, hurricanes in
particular major geographical areas
• Most insurers reduce this possibility by dispersion of
insured objects
• Insurers themselves may purchase insurance against
the possibilities of excessive losses
– Called reinsurance
• Following the 9/11 terrorist attacks many firms had difficulty
obtaining insurance for trophy properties
– Due to the recognition by insurers of the catastrophic loss potential
associated with these buildings
• Effectively eliminates many speculative risks from the
possibility of being insured
26
Large Loss
• The maximum possible loss must be
relatively large
– A requisite from the standpoint of the insured
• States that businesses and individuals
should ensure potentially serious losses
before relatively minor losses
– To do otherwise is uneconomical
• Small losses tend to occur frequently and are very
costly to recover through insurance
27
Probability of Loss must not be too
High
• Probability of loss must be reasonable
– Else the cost of risk transfer will be excessive
• Insureds are often willing to pay more to
avoid a loss than the true expected value
of that loss
– If it were not for this phenomenon, insurance
could not exist
– Insurers must always charge more for their
service than the expected value of a loss
28
Table 6-1: Examples of Requisites
of Insurable Risks
29
Requirements of all Valid Contracts
• Agreement must be for legal purpose
• Parties must have legal capacity to contract
• There must be a valid offer and acceptance
– In property and liability insurance, it is the custom to give local
agents authority to accept offers of many lines of insurance on
the spot
• The agent will bind the insurer
– A legal offer by an applicant for life insurance must be supported
by a tender of the first premium
• Usually the agent gives the insured a conditional receipt
– Provides that acceptance takes place when the insurability of the
applicant has been determined
• Promises must be supported by the exchange of
consideration
– The value given to each contracting party
30
Distinguishing Characteristics of
Insurance Contracts
• Aleatory contract
– Values exchanged by the contracting parties are not necessarily
equal
• Due to the fact that the outcome of the contract depends on the risk
of whether a loss will occur
– If a loss takes place during the policy period, the amount paid by the
insurer usually will exceed the premium paid by the insured
– If no loss occurs, the premium exceeds the amount paid by the insurer
• Conditional contract
– Insureds must perform certain acts if recovery is to be made
– If the insured does not adhere to the conditions of the contract,
payment is not made even though an insured peril causes a loss
• Typical conditions
– Payment of premium
– Providing adequate proof of loss
– Giving immediate notice to the insurer of loss
31
Distinguishing Characteristics of
Insurance Contracts
• Contract of adhesion
– Any ambiguities or uncertainties in the wording of the agreement will be
construed against the drafter—the insurer
– Insurer had the advantage of writing the terms of the contract to suit its
particular purposes
– Insured has no opportunity to bargain over conditions, stipulations,
exclusions
– Doctrine of reasonable expectations
• Coverage should be interpreted to be what the insured can reasonably
expect
• Limitations and exclusions must be clear and conspicuous
• Unilateral contract
– Only one of the parties makes promises that are legally enforceable
– Insureds cannot be forced to pay premiums or adhere to conditions
• If the insured does what has been promised, the insurer is legally obligated
to perform in the event of a covered loss
32
Role of Agents and Brokers
• An agent is a person given power to act for a principal,
who is legally bound by the acts of its agents
• General agent
– Person authorized to conduct all of the principal’s business of a
given kind in a particular place
• Special agent
– Authorized to perform only a specific act or function
• In a legal sense, insurance agents do not necessarily
have to serve in the channel of distribution for insurance
– Although that is the most common use of the term insurance
agent
33
Role of Agents and Brokers
• An insurance agent should be assumed to be the legal
agent of the insurer
– Unless information to the contrary is known
• An insurance broker is the legal agent of the prospective
insured
– Is engaged to arrange insurance coverage on the best possible
terms
– Free to deal with any insurer that will accept the business
– Cannot bind any insurer orally to a risk unless the broker has an
agency agreement with the insurer
– When dealing with a broker one should not assume coverage
the moment the insurance is ordered
• The distinction between an agent and a broker is not
always clear
– In some situations a person may simultaneously be both an
agent and a broker
34
Authority of Agents and Brokers
• Agency agreement
– Sets forth the specific duties, rights, and
obligations of both the insurer and the agent
• Ratification
– If an agent performs some act outside the
scope of the agency agreement to which the
insurer later assents
• The agent has achieved additional authority
through ratification
35
Authority of Agents and Brokers
• Waiver
– Intentional relinquishing of a known right
• Estoppel
– Operates when there has been no intentional relinquishing of a
known right
– Operates to defeat a “right” that a party technically possesses
• Waiver is based on consent
– Estoppel is an imposed liability
– Often these two doctrines are not clearly distinguished even in
court actions
• Sometimes they’re used interchangeably
• Waiver and estoppel situations often arise when the
insurance policy is first put into force
36
Principles of Social Insurance
• Social insurance is offered through some form of government
– Usually on a compulsory basis
• Designed to benefit persons whose incomes are interrupted by an
economic or social condition
– That society as a whole finds undesirable and for which a solution is
generally beyond the control of the individual
• Examples include crime, poverty, unemployment, mental disease, ill
health, dependency of children or aged persons, drug addictions,
industrial accidents, divorce, economic privation of a certain class
– Insurance is not an appropriate method of solution for many of these
problems because the peril is not accidental, fortuitous, or predictable
• Following the 9/11 attacks firms could not secure terrorism insurance in
the private insurance market
– Leading to calls for a government role in providing such coverage
37
Principles of Social Insurance
• Compulsion
– Necessary that everyone involved cooperate
• Set level of benefits
– Little if any choice is usually given as to what level of benefits is
provided
– All persons covered under the plan are subject to the same benefits
schedules
• Floor of protection
– Aims to provide a minimal level of economic security against perils that
may interrupt income
• Subsidy
– Losses of the unfortunate few are shared with the fortune many who
escape loss
– It is anticipated that an insured group may not pay its own way
• It will be subsidized either via other insured groups or by taxpayers
38
Principles of Social Insurance
• Unpredictability of loss
– Cost of benefits under social insurance
cannot usually be predicted with great
accuracy
– Therefore the cost of some types of social
insurance is unstable
• Conditional benefits
– For example, if one earns more than a
specified amount, various social insurance
benefits may be lost
39
Principles of Social Insurance
• Contributions required
– A public program should require a contribution,
directly or indirectly, from the persons covered, the
employer, or both
– Social insurance does not include public assistance
programs
• Wherein the needy person receives an outright gift and must
generally prove inability to pay for the costs involved
• Attachment to the labor force
– Most social Insurance plans cover only groups that
are or have been attached to the labor force
• Nearly all such plans are directed at those perils that interrupt
income
40
Principles of Social Insurance
• Minimal advance funding
– Social insurance usually does not provide
large accumulations for advance funding
• If, for example, a future retirement benefit is
promised, the full cost of paying for this benefit is
not set aside in the year which the promise is
made
– Instead, the benefit is paid from future revenues at the
time the benefits must be paid out to the retiring worker
• Social insurance programs and the revenues to
support them are expected to continue indefinitely
and require no advance funding
41
Social and Economic Values
• Reduced reserve requirements
– One of the chief economic burdens of risk is the necessity of
accumulating funds to meet possible losses
– One of the great advantages of insurance is that it greatly
reduces the total of such reserves necessary for a given
economy
• Because the insurer can predict the losses in advance
– Needs to keep readily available only enough funds to meet those
losses and to cover expenses
• If each insured had to set aside such funds, there would be need for
a far greater amount
• Capital freed for investment
– Cash reserves that insurers accumulate are made available for
investment
– Insurers as a group, and life insurance firms in particular, are
among the largest and most important institutions collecting and
distributing the nation’s savings
42
Social and Economic Values
• Reduced cost of capital
– Because the supply of investable funds is greater
than it would be without insurance
• Capital is available at a lower cost than would otherwise be
possible
• Brings about a higher standard of living because increased
investment will raise production and cause lower prices than
would otherwise be the case
• Reduced credit risk
– Insurance has been called the basis of the nation’s
credit system
– An entrepreneur is a better credit risk if adequate
insurance is carried
43
Social and Economic Values
• Loss control activities
– Although the main function of insurance is not to reduce loss but
to spread losses among members of the insured group
• Insurers are nevertheless vitally interested in keeping losses at a
minimum
• Otherwise losses and premiums would have a tendency to rise
– Illustrations of loss prevention and control in the field of property
and liability insurance
•
•
•
•
Investigation of fraudulent insurance claims
Research into the causes of susceptibility to loss on highways
Recovery of stolen vehicles and other auto theft prevention work
Development of fire safety standards and public educational
programs
• Provision of leadership in the field of general safety
• Provision of fire protection and engineering counsel for oil producers
• Investigation and testing of building materials to see that fire
prevention standards are being met
44
Social and Economic Values
• Business and social stability
– For example, if adequately protected, a
business need not face the prospect of
liquidation following a loss
– Similarly, a family may not break up following
the death or permanent disability of one or
more income producers
45
Social Costs of Insurance
• The costs for an insurance institution include
– Operation of the insurance business
• Mainly labor to operate the business
– Average annual overhead of property insurers accounts for
about 27% of their earned premiums but ranges widely
– Losses that are caused intentionally
• If it were not for insurance, certain losses would not occur
– Losses that are caused intentionally by people in order to
collect on their policies
– Losses that are exaggerated
• Tendency for some insureds to exaggerate the extent of
damage that results from purely unintentional losses
46