FINC 475: EXAM 1
165 Cards in this Set
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Definition of Risk
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Uncertainty concerning the occurrence of a loss. Uncertainty about the outcomes that can be either positive or negative.
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Objective Risk
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The relative variation of actual loss from expected loss. (Can be calculated using a measure of dispersion—standard deviation, coefficient of variation, etc. Obeys "Law of Large Numbers.")
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Subjective Risk
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Uncertainty based on a persons' mental condition or state of mind ("Deterrence effect" of risk)
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Chance of Loss
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The probability that an event will occur.
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Objective Probability
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The long-run relative frequency of an event based on the assumptions of an infinite number of observations and of no change in the underlying conditions.
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Subjective Probability
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Individual's personal estimate of chance of loss.
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Loss Exposure
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Any situation or circumstance in which a loss is possible, regardless of whether a loss occurs.
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3 Elements of Loss Exposure
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1. An asset is exposed to loss
2. Cause of loss (a "peril")
3. Negative consequences
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Peril
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cause of loss
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Definition of Hazard
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A condition that creates or increases the frequency or severity of a loss.
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4 Major Types of Hazard
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1. Physical
2. Moral
3. Attitudinal (Morale)
4. Legal
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Direct Loss
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financial loss that results from the physical damage, destruction, or theft of the property.
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Indirect (consequential) Loss
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financial loss that results indirectly from the occurrence of a direct physical damage or theft loss
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Indemnification
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Compensation to the victim of a loss, in whole or in part, by payment, repair, or replacement.
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Risk Management
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A process that identifies loss exposures faced by an organization and selects the most appropriate techniques for treating such exposures.
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Enterprise Risk Management
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A comprehensive risk management program that addresses all aspects of an organization's risk
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How ERM differs from RM:
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It offsets one risk against another which reduces overall risk in the end
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Stages of Risk Management Process:
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1. Identify loss exposures
2. Measure and analyze losses
3. Select appropriate RM technique
4. Implement the Program and Monitor/Report (this can be considered one stage or two):
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Quadrants of Risk
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1. Pure (Hazard)
2. Operational
3. Financial
4. Strategic
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Frequency
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probable # of losses
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Severity
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probable size of losses
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Maximum Possible Loss
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worst loss that could happen
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Probable Maximum Loss
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worst loss that is likely to happen
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Risk Control
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techniques that reduce the frequency or severity of losses
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Risk Control Techniques: (Avoidance)
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certain loss exposure is never acquired or an existing loss exposure is abandoned
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Risk Control Techniques: (Loss Prevention)
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measures that reduce the frequency of a particular loss
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Risk Control Techniques: (Loss Reduction)
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measures that reduce the severity of a loss after it occurs
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Risk Financing
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techniques that provide for the funding of losses
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Risk Financing Techniques: (Retention)
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firm retains part or all of the losses that can result from a given loss.
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Risk Financing Techniques: (Non-Insurance Transfers)
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methods other than insurance by which a pure risk and its potential financial consequences are transferred to another party
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Risk Financing Techniques (Insurance)
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appropriate for loss exposures that have a low probability of loss but the severity of loss is high
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Low Severity & Low Frequency = __________
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Retention
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Low Severity & High Frequency = ___________
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Retention with Loss Prevention and Reduction
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High Severity & Low Frequency = _________
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Transfer (Insurance)
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High Severity & High Frequency = ________
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Avoidance
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Underwriting Cycle
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Cyclical pattern in underwriting stringency, premium levels, and profitability
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Hard Market
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tight underwriting, high premiums
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Soft Market
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Looser underwriting, low premiums
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Chief Risk Officer (CRO)
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Person responsible for the treatment of pure and speculative risks faced by an organization
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Insurance
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the pooling of fortuitous losses by transfer of such risks to insurers, who agree to indemnify insureds for such losses, to provide other monetary benefits on their occurrence, or to render services connected with the risk
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Pooling Function of Insurance
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The spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss
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Fortuitous Losses
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One that is unforeseen and unexpected by the insured and occurs as a result of chance (from the perspective of the insured)
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Risk Transfer
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Risk is transferred to the insurance company, which is in a stronger financial position to pay the loss than the insured
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Indemnification (relating to insurance)
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The insured is restored to his or her approximate financial position prior to the occurrence of the loss
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Characteristics of an Ideally Insurable Risk
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1. Large Number of Exposure Units
2. Accidental and Unintentional Loss
3. Determinable and Measurable Loss
4. No Catastrophic Loss
5. Calculate Chance of Loss
6. Economically Feasible Premium
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Adverse Selection
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Tendency of persons with a higher-than-average chance of loss to seek insurance at standard (average) rates, which if not controlled by underwriting, results in higher-than-average loss levels
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Comparison Between Insurance and Gambling
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1. Gambling creates a new speculative risk, while insurance is a technique for handling an already existing pure risk
2. Gambling is socially unproductive because the winner's gain comes at the expense of the loser
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Underwriting
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The process of selecting and classifying applicants for insurance
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Personal Lines
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coverages that insure the real estate and personal property of individuals and families or provide them with protection against legal liability
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Commercial Lines
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property and casualty coverages for business firms, nonprofit organizations, and government agencies
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Stock Insurers
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corporation owned by stockholders (earn profit for stockholders)
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Mutual Insurers
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corporation owned by policyholders (no stockholders)
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Reciprocal Exchanges
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private insurer, unincorporated mutual
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Lloyd's Of London
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not an insurer, but it is the world's largest insurance market that provides services and physical facilities for its members to write specialized lines of insurance
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Blue Cross & Blue Shield
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nonprofit, community-oriented prepayment plans that provide coverage primarily for hospital services
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Captive Insurer
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Insurer owned by a parent firm for the purpose of insuring the parent firm's loss exposures
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Agent
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legally represents the principle and can act on the principal's behalf
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Broker
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Legally represents the insured
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Binders
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Temporary insurance until policy is actually written
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Admitted Carrier
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carrier licensed to do business in a state
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Non-Admitted Carrier
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insurer not licensed to do business in a state
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Surplus Lines Insurance
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any type of insurance for which there is available market within the state so the coverage must be placed with a non-admitted insurer
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Surplus Lines Broker
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broker who is licensed to place business with a non-admitted carrier
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Types of P&C Marketing Systems
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1. Independent agency system
2. Exclusive agency system (captive agents)
3. Direct writer
4. Direct response system
5. Multiple distribution channels
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Steps in Underwriting Process
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1. Agent as front-line underwriter
2. Sources of underwriting info (applications, agency reports—narrative, inspections--- from outside party like ISO, physical inspection--- from loss control, physical exam--- life/health)
3. Make an underwriting decision (accept the application, acce…
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Producers
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Agents who sell insurance, field underwriter, or marketing rep
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The Claims Process
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1. Notice of loss
2. Investigation of Claim (Reservation of Rights Letter, Declarative judgement)
3. File proof of loss
4. Pay claim or deny (arbitration provision, avoid "bad faith" claims)
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Claim Adjustor
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An agent, company adjustor, independent adjustor, or public adjustor who settles the claims
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Insurance Agent
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authority to settle small first-party claims up to some maximum limit
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Company Adjustor
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owner of a single company who settles the company's claim(s)
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Independent Adjustor
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organization or individual that adjust claims for a fee
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Public Adjustor
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represents the insured rather than the insurance company and is paid a fee based on the amount of the claim settlement
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Types of Claim Adjustors
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1. Insurance Agent
2. Company Adjustor
3. Independent Adjustor
4. Public Adjustor
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Reinsurance
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Arrangement by which the primary insurer that initially writes the insurance transfers to another insurer (called the reinsurer) part or all of the potential losses associated with such insurance
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2 Main Ways Insurance Companies Make Money:
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1. Underwriting profit
2. Investment income
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Surplus (context of an insurer's balance sheet)
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Balancing item on the balance sheet, difference between an insurance company's assets and liabilities
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3 Important Reserves on Balance Sheet
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1. Loss
2. Unearned Premium
3. Loss Adjustment Expense
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Loss Reserves
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estimated cost of settling claims for losses that have already occurred but that have not been paid as of the valuation date
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Unearned Premium Reserve
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liability item that represents the unearned portion of gross premiums on all outstanding policies at the time of valuation
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Earned Premium
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portion of the premiums for which insurance protection has been provided
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Written Premium
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the actual coverage that was placed on the books for a given year
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Loss Ratio
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(incurred losses + loss adjustment expenses / premiums earned)
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Expense Ratio
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(underwriting expenses / premiums written)
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Combined Ratio
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loss ratio + expense ratio
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Investment Income Ratio
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net investment income / earned premiums
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Operating Ratio
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combined ratio - investment income ratio
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Domestic Insurer
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within the state (Tennessee)
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Foreign Insurer
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within the country (New York--> Tennessee)
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Alien Insurer
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not within the country (Germany---> Tennessee)
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Unfair Trade Practices
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1. Twisting
2. Rebating
3. Redlining
4. False Advertising
5. "Bad Faith" in Claims Settlement
6. Bid Rigging
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Principle of Indemnity
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Insurer agrees to pay no more than the actual amount of the loss; i.e. the insured should not profit from a loss
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Principle of Insurable Interest
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The insured must be in a position to lose financially if a loss occurs
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Principle of Subrogation
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The insured's rights to recover from a third party for an insured loss are transferred to the insurance company
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Principle of Utmost Good Faith
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Higher degree of honesty is imposed on both parties to an insurance contract than to other contracts
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Actual Cash Value (ACV)
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Method of valuating damaged property (replacement cost - depreciation)
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Replacement Cost
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Current cost of restoring the damaged property with new materials of like kind and quality
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Valued Policy
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Policy that pays the face amount of insurance if a total loss occurs
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How Can an Insurable Interest Be Established in P&C Insurance?
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Must have insurable interest at the time of loss
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How Can an Insurable Interest Be Established in Life Insurance?
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Must have insurable interest at policy inception (not at the time of death)
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Subrogation
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Substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third party for a loss covered by insurance; the insurer is entitled to recover from a negligent third party any loss payments made to the insured.
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Representations
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Statements made by applicant for insurance (generally on the application)
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Misrepresentation
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Policies/contacts can be voided; unintentional if a representation is material, false, or relied on by the insurer
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Concealment
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Intentional failure of applicant to reveal a material fact to the insurer
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Warranty
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A statement that becomes part of the insurance contract and is guaranteed by the maker to be true in all aspects
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Essential Elements of a Contract
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1. Offer and Acceptance
2. Consideration
3. Legally Competent Parties
4. Legal Purposeonly one party (the insurer) makes a legally enforceable promise
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Distinct Legal Characteristics of Insurance Contracts
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1. Aleatory Contract
2. Unilateral Contract
3. Conditional Contract
4. Personal Contract
5. Contract of Adhesion
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Aleatory Contract
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exchange of unequal amounts but depend on uncertain event
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Unilateral Contract
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only one party (the insurer) makes a legally enforceable promise
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Conditional Contract
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insurer's obligation to pay depending on whether insured or beneficiary has compiled with policy conditions
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Personal Contract
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between insurer and insured (P&C policy cannot be assigned without permission, life insurance rights can be assigned)
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Contract of Adhesion
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insured must accept entire contract (which is drafted by the insurer)
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Legal Definition of an "Agent"
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Person/entity with authority to act on behalf of another (the principal)
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3 Sources of Agent Authority
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1. Express
2. Implied
3. Apparent
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Express Authority
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specifically conferred
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Implied Authority
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incidental acts to fulfill purposes
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Apparent Authority
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agent acts with an apparent authority
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Waiver
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voluntary relinquishment of a known legal right
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Estoppel
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Situation where : one party makes a representation of fact, another party relies on that fact, or it would be inequitable to allow the first party to then deny the truth of the fact
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Major Parts of an Insurance Contract
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1. Declarations
2. Definitions
3. Insuring Agreement
4. Exclusions
5. Conditions
6. Miscellaneous Provisions
7. Endorsements/Riders
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Declarations
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identification of insurer, name of insured, location of property, period of protection, amount of insurance, amount of premium, size of deductible, etc.
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Definitions
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key words or phrases in bold or in quotation marks
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Insuring Agreement
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what the insurer promises to do and pay, two basic types of property coverage forms (Named Perils and All Risks), and sublimits
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Exclusions
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detail what is not covered
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Conditions
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provisions that qualify or place limitations on the insurer's promise to perform
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Miscellaneous Provisions
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cancellations, grace period, other insurance
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Endorsements/Riders
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Endorsement--> P&C Rider-->L&H; they modify the standard policy language
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Distinction Between "Named Perils" and "All Risks" coverage... How does this relate to burden of proof in the event of a claim?
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"Direct Physical Loss to Property"- to deny payment, the insurer must prove that the loss is excluded. In contrast, under a "named perils" contract, the burden of proof is on the insured to show that the loss was caused by a named peril.
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Sublimit
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Certain classes of property may have lower limits
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Reasons For Exclusions:
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1. Some perils considered undesirable
2. Presence of extraordinary hazards
3. Coverage provided by other contracts
4. Moral hazard problems
5. Attitudinal hazard problems
6. Coverage not needed by typical insureds
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Policy Condition***
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Standard policy language that can be attached to from part of the policy
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4 Types of Insureds
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1. Named
2. First Name
3. Other
4. Additional
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Named Insured
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party specifically named on the declarations pages
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First Name Insured
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first person or party named on the declarations page that has special privileges and responsibilities
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Other Insured
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parties insured under policy, even though not specifically named
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Additional Insured
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party added to the policy by endorsement
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Deductible
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A provision by which a specified amount is subtracted from the total loss payment that would otherwise be payable
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3 Types of P&C Deductibles
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1. Straight
2. Aggregate
3. Period of Restoration
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Straight Deductible
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insured pays the first X number of dollars of each loss
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Aggregate Deductible
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All losses during a certain period (usually the policy year) are accumulated to satisfy the deductible amount
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Period of Restoration
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For indirect losses (like loss of income), a "waiting period" before indemnification begins
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"Other Insurance Provision"
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Decides who pays what when two policies cover the same loss
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Primary Coverage
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pays before any excess insurance
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Excess Coverage
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Pays after underlying "primary" coverage is exhausted
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Pro-Rata Liability
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each insurer pays proportionally by their limits
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Contribution by Equal Shares
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insurers split equally until their respective limits are exhausted
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Broad Classes of Legal Wrongs
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1. Crimes
2. Breach of Contract
3. Torts
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Tort
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Civil wrong for which a remedy may be obtained, usually in the form of damages; a breach of duty that the law imposes on everyone in the same relation to one another as those involved in a given transaction
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Broad Classes of Torts
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1. Intentional
2. Strict (Absolute) Liability
3. Negligence
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Intentional Torts
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arise from an intentional act or omission that does harm or injures another person or their property
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Strict (Absolute) Liability Torts
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liability imposed without regard to fault
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Negligence Torts
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the failure to exercise the standard of care required by law to protect others from an unreasonable risk of harm
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Types of Damages
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1. Compensatory
2. Punitive
3. Special
4. General
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Elements of Negligence
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1. Existence of a legal duty
2. Failure to perform that duty
3. Damage or injury to claimant
4. Proximate cause relationship between the negligent act and the infliction of damages
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Defenses Against Negligence
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1. Contributory Negligence
2. Comparative Negligence
3. Last Clear Chance Rule
4. Assumption of Risk
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Contributory Negligence
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if the injured party was also negligent, no damages will be rewarded
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Comparative Negligence
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if both parties were negligent, the burden is shared according to fault (Pure rule, 50% rule, 51% rule)
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Last Clear Chance Rule
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plaintiff endangered by own negligence can still recover if defendant has a "last clear chance" to avoid the accident but failed to do so
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Assumption of Risk
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Recovery is barred if the defendant recognized and understood the danger inherent in an activity
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"Res Ipsa Loquitur" Doctrine
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"The thing speaks for itself." The occurrence of a certain event establishes the presumption of negligence.
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Trespasser
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enters or remains without owner's permission (minimal duty—cannot intentionally harm)
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Licensee
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enters or remains with the owner's express or implied permission (moderate duty---must warn of known hidden dangers)
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Invitee
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invited on the premises for benefit of owner (highest duty--- must inspect premises and ensure safety)
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Attractive Nuisance
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A condition that can attract and injure children (example: trampoline)
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Respondeat Superior" Doctrine
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Employers are general responsible for the work-related actions of their employees
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Joint & Several Liability
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If multiple defendants are held responsible, they share in the damages but if one party cannot pay (files bankruptcy) then the other party must pay the full amount; if only one responsible party is sued, that party may be responsible for the entire judgment, even if the another party had…
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FINC 475 EXAM ONE