applying the planning process Chapter 9 Property and Liability Insurance Planning Where Does This Fit in Your Comprehensive Financial Plan Protection Plan for death and incapacity Chapters 16 17 Build wealth Save and invest to meet short term and long term goals Chapters 11 15 Secure basic needs Liquidity consumer purchases and credit decisions insurance employee benefits Chapters 5 10 What is risk Uncertainty Some risks are within your control getting cancer from smoking Some are not getting hit by lightening Some expose you to risks of loss only pure risks Some give you a risk of loss or gain speculative risks Establish a firm foundation Evaluate your finances acquire tools and skills set goals develop a budget Chapters 1 4 The Risk Management Process 1 Identify your risk exposures 2 Evaluate your potential losses 3 Choose the most appropriate risk management tool 4 Implement your risk management plan 5 Periodically re evaluate your plan Identifying Risk Exposures Auto Theft Injury to person or property in an accident Medical expenses Home Theft Natural peril hurricane flood fire hail Liability for injury to people or property 1 Choose the Risk Management Tool Choose the Risk Management Tool Avoid the risk Do not expose yourself it Transfer the risk Contractually pass the risk to another Example Do not drive Example Do not have a swimming pool Reduce the risk Take action to reduce frequency or severity of risk Example Clear your sidewalks of snow frequency Example Wear a seatbelt severity How Insurance Works The law of large numbers As the size of a pool of identical risks gets larger the expected loss gets more predictable Insurers create risk pools of many individuals Everyone in pool has similar expected loss Insurer charges premium close to expected loss Some individuals will have no loss but will have paid the premium If losses exceed total premiums collected the insurer still has to pay Insurance Pools Problems with small pools Chance of exceeding the dollars in the pool Hard to get pool members to pay extra later Pools likely to have correlated risks Insurers have much larger pools and can raise capital to cover unusually high losses Example Insurance Example Hold harmless agreement Retain the risk Plan to pay the cost if the loss occurs Example Health insurance deductible Example Any time you fail to recognize the existence of a risk Example of Risk Pooling Group of 1 000 geographically diversified homeowners with homes worth 100 000 All homes have 1 1000 chance of being destroyed in a fire in the next year The homeowners get together and each puts 100 in a pool When a home gets destroyed by fire that year the pool gives the unlucky homeowner 100 000 What happens if two homes have a fire Fair Premiums Premiums include Share of expected loss for the pool Risk charge to cover risk that actual losses deviate from expected losses Expenses commissions office Profit to insurer s shareholders 2 Risk Classification Necessary to ensure that pool members have similar expected losses Should a homeowner in a rural mountain area pay the same premium as those living near a fire station Should good drivers pay the same premium as bad drivers Without appropriate risk classification a pool would be left with only the bad risks Insurance Policy Basics Insurance Policy Contract between policyholder and insurer Policyholder promises to pay premium Insurer promises to pay for certain losses if they occur during the policy period Supposed to be written to be understandable by an average person Ambiguities are construed against the insurer Evaluating Homeowner Risk 1 Risk of damage to the structure Fire rain wind hail or other natural occurrence 2 Risk that property will be stolen or damaged by others 3 Risk of liability being sued for another person s losses due to your negligence Pooling Doesn t Work If We Have Correlated risks Affect many policyholders at the same time Natural disasters war terrorism Nonrandom risks Intentional acts Unpredictable risks Some areas of liability risk such as environmental damage and medical malpractice Insurance Policy Terminology Principle of Indemnity You cannot recover more from insurance than you lost Example If you insure your jewelry for 10 000 but it is only worth 5 000 Terms to increase predictability of the loss and to reduce premium costs Exclusions Deductibles Limits Coinsurance You are negligent if You had a duty to another person You failed in your duty The failure caused that person or their property to have a loss You have no legal defenses 3 Strict Liability Possible Defenses to Negligence Contributory negligence The injured person was partly responsible for his or her own injury Example You rear ended another s vehicle because they stopped short at a green light Assumption of the risk The injured person knew about the risk and voluntarily did something that resulted in injury Example Person slipped on a visibly wet floor Homeowners Coverage Section I Property Buildings and structures Personal property Living expenses Section II Liability 100 000 standard coverage is too little Recommend umbrella policy supplement Liability without any proof of negligence Injuries to children Attractive Nuisance swimming pool Dog bites Injuries from known dangerous animals 4 7 million dog bites each year cost 1 billion Certain breeds excluded from homeowners insurance policies Automobile Insurance 30 million auto accidents every year with damages in excess of 30 billion Most states compulsory auto insurance 20 000 25 000 per person 40 000 50 000 for all people in accident and 10 000 15 000 for all property damage Some have financial responsibility laws allow you to meet the insurance requirement by showing you have sufficient assets Factors Affecting Auto Premiums How much you drive Young men drive more How well you drive Past driving record Your risk attitudes and responsibility Credit reports Where you drive Congested areas compared to rural Type of vehicle you drive Sports cars SUVs and trucks safety features Insurer Wide differences in price 4