Chapter One - American Education Systems LC
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Chapter One
Ethics, Professionalism, and the Insurance Industry
Risk is a small word, but one that can make the stomach tighten and shoulders rise. It holds a powerful influence over us because human nature is fascinated with uncertainty. Despite its fascination, however, it is difficult for most persons to think clearly about risk. Naturally, we feel uncomfortable contemplating the loss of a loved one, or the unintentional injuring of a stranger, or the loss of a home. On the other hand, some persons are fascinated with risks that present the possibility of gain. The “professional” gambler, the day-trader, and the land speculator are examples of those who thrive on risk.
The consequences of any significant risk can be so devastating that we are compelled to face the fact that risk is a force in our lives that must be reckoned with. As we examine the risk in our lives, we find that it possesses distinct properties, and these can be analyzed and classified. From our analysis, we find that risk also follows some general laws, and that knowing these laws, risk can be managed, and our lives can be lived with a little less anxiety.
Risk can be defined as an uncertainty of loss. Typically, the loss is of a financial nature. It can also be termed a danger that one insures against. The questions that arise as we analyze risk and how it operates are the following: What categories of risk exist? What rules or principles can risk follow? What kinds of risk can be avoided, what kinds can be managed?
One type of risk affects everyone. This is fundamental risk. For example, every area can experience severe or damaging weather. A severe dislocation in the economy is a fundamental risk, as is the threat of war. These types of risk are usually met with social insurance and government involvement.
Fundamental risks are very different from particular risks. Particular risk is specific to an individual, and subject to choices. For example, if Joe Client chooses to skydive as a hobby, only he bears the risk of this activity.
Risk can also be classified as static and dynamic. A static risk has to do with human error, wrongdoing, and acts of nature. A dynamic risk is connected with the volatile nature of the economy. Most dynamic risks are also speculative risks. This means that both loss and gain are possible. Investing in a limited partnership is an exposure to a dynamic, speculative risk.
Static risks are pure risks, and can be further subdivided. For example, there are personal risks affecting individuals through the loss of their property, their income, and their health. One way a family experiences pure risks is through the premature death of one of its members. Being held legally liable for a person’s loss is another form of pure risk. This variation of risk touches professionals through accusations of malpractice, business persons through accusations of product defects, and anyone who operates an automobile through accusations of negligence. Of course, this list could go on and on.
A final classification can be used when considering risk. The world of risk includes both objective and subjective risks. Subjective risk is uncertainty based on an individual’s emotional reasoning and state of mind. Objective risk, on the other hand, is the relative difference between the actual loss and the expected loss.
Objective risk follows a very specific mathematical principle---it is inversely proportional to the square root of the number of items observed. In practical terms, this means that the more exposures, the less the objective risk. This is very important because it means that objective risk can be measured.
Risk is also subject to the law of large numbers. This is another mathematical principle. It states that the greater the number of exposures, the more certain one can be in predicting the outcome. When speaking in terms of losses, we can state that actual losses will be less than expected losses as the number of exposures increases.
While most people are not aware of the mathematical principles that are used to analyze and measure risk, all people—and all businesses—practice some form of risk management. For example, risk can be avoided. Any non-swimmer will probably take pains to avoid the water. Choosing not to participate in high-risk hobbies like sky-diving is another example of avoiding risk.
Typically, most people passively retain a wide variety of risks. A risk is passively retained when it is not recognized or understood, when the cost of treating it is prohibitive, or when the severity of the loss is deemed inconsequential.
For example, many consumers do not believe that they need disability insurance, and are satisfied with the level of their life insurance. Most studies, however, statistically demonstrate that most people are more likely to face disability than they believe. In addition, it can be shown that the face value of the life insurance in force is in many cases inadequate.
The reasons for these example of passive retention are various and complex, and are as different as the individuals at risk. In some cases, consumers understand the threat presented by disability, but mistakenly believe that their health insurance provides extensive disability income benefits. In other cases, the consumer may believe that the cost of purchasing a disability policy would be more that he could afford.
Risk can also be handled by a non-insurance transfer. This strategy can shift risk from one party to another by contractual agreement. For example, a company may lease photocopiers. The lease agreement can stipulate that maintenance, repairs, and physical losses to the equipment are the responsibility of the company leasing out the photocopiers. Another example of non-insurance transfer is using a hold harmless agreement.
Loss control is another form of risk management. Loss control attempts to lower the frequency and severity of a loss. Loss control is an active retention of risk.
Examples of loss control could be safety training, posting of safety regulations, and an active policy of enforcing safety regulations. These practices would all fall under the category of controlling the frequency of the loss. An example of controlling the severity of a loss would be installing a perimeter alarm system.
The purchase of an insurance coverage (or coverages) is what most people consider as risk management. For a company or organization, a commercial insurance package will be employed. This insurance will cover the essential insurance that is mandated by law. It may also include desirable insurance that covers losses that would threaten the company’s survival, and available insurance that covers losses that are not serious, but would present major inconvenience.
REVIEW QUESTIONS
NOTES
REVIEW QUESTIONS
1. Objective risk is the relative difference between actual loss and expected loss.
a. true
b. false
2. Fundamental risks are the same as particular risks.
a. true
b. false
3. Fundamental risks affect everyone, while particular risks are specific to individuals.
a. true
b. false
4. The possibility of a fire in one's home is an example of:
a. fundamental risk.
b. speculative risk.
c. dynamic risk.
d. none of the above.
5. Most dynamic risks are also speculative risks.
a. true
b. false
6. A hold harmless agreement is an example of a non-insurance transfer.
a. true
b. false
7. Not going into the water because one cannot swim is an example of avoiding risk.
a. true
b. false
8. Loss control is a risk management strategy that ignores lowering the frequency of losses and concentrates solely on minimizing the severity of losses.
a. true
b. false
9. Following a loss control program in one’s risk management strategy is an example of active retention of risk.
a. true
b. false
10. When people do not apply for disability insurance because they falsely believe that such coverage is already provided by the state, we can say that they have passively retained some level of risk.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. true
2. false
3. true
4. fundamental risk
5. true
6. true
7. true
8. false
9. true
10. true
Licensing and Appointing Relationships
The needs insurance meets are tremendous. Without insurance, the burden to society would be enormous. Individuals and societies are confronted daily by forces largely beyond anyone’s control. A look at the evening’s news broadcast provides clear examples of the varieties of fortuitous losses that occur regularly. Although the insurance agent may not see it on a daily basis, his or her work is absolutely vital.
In order to effectively classify risks, design appropriate insurance coverages, and distribute the product, the insurance industry is a massive enterprise. Some of its constituent elements are briefly outlined in the following.
TYPES OF INSURANCE COMPANIES
Stock insurance companies are corporations with stockholders. The type of insurance that the stock company writes is spelled out in the corporation’s charter. The stock insurance company has a board of directors, and the clear purpose of earning a profit for the stockholders.
Mutual insurers are corporate entities owned by the policy owners. The board of directors of a mutual insurer operates the corporation –at least in theory-- for the benefit of the policy owners. There are a wide variety of mutual companies. These forms can include factory mutuals (which insure only certain properties), farm mutuals (which insure farm property in a relatively limited geographic area), as well as assessment mutuals and advance premium mutuals.
Assessment mutuals have the right to assess policy owners for losses and expenses. In this type of insurance company, no premium is paid in advance, and each policy owner is assessed a portion of the actual losses and expenses. An advance premium mutual, on the other hand, charges its policy owners a premium at the beginning of the policy period. If the initial, collected policy premiums exceed losses and expenses, the surplus is returned to the policy owners in the form of dividends. On the other hand, should the amount of collected premiums fall short of the amount needed to cover losses and expenses, additional assessments can be levied on the members.
Reciprocal insurers are unincorporated mutuals. Reciprocals are owned by their policyholders, and the policyholders insure the risks of the other policyholders. The reciprocal is managed by an attorney-in-fact that is usually a corporation.
Reinsurers are the big “behind the scenes” players in the insurance industry. The reinsurance company insures the insurance company that deals directly with the public. Through a reinsurer, an insurance company is able to spread its risks and limit the loss it would face should it have to pay a claim.
A major reinsurer can be found in the Lloyd’s Association, the most famous of which is Lloyd’s of London. Lloyd’s Associations are technically not insurance companies, but an association of individuals and companies. Besides reinsurance, underwriters who are members of Lloyd’s will provide coverages to specialized, “exotic” risks.
Fraternal insurers are the insurance arms of fraternal benefit societies. To be a fraternal benefit society, an organization must be non-profit, have a lodge system, and a representative form of government with elected officials. Typically, the fraternal organization is organized around ethnic or religious lines. Fraternals usually sell only to members.
TYPES OF INSURANCE SALESPERSONS
Insurance is sold primarily through professional salespersons. Mass marketing without the use of human representatives is another marketing system employed by insurance companies. Mass marketing may employ direct mail, radio, television, or opt-in e-mail. Nevertheless, despite the growth of new media technologies, the field force remains the backbone for the majority of insurance sales.
The majority of insurance salespersons are agents. Agents can be referred to as field agents, field representative, field underwriters, insurance representatives, and insurance salespersons. Whatever the title, agents are salespersons that possess some form of agent authority. The three forms of agent authority are express, implied, and apparent.
Express authority is the authority an agent receives from the insurer in the form of a contract. For example, an agent’s contract will give the express authority to solicit and sell the company’s product. Implied authority is not contractually outlined, but assumed to exist. For example, the contract may not say that the agent can use company letterhead, but it is assumed that this is acceptable. Apparent authority is authority created by the actions of the insurer. For example, if the insurer supplies an agent with forms and software to generate premium quotes, it is apparent that an agency relationship exists between the agent and the insurer.
• Property and Casualty
The property and casualty field employs three varieties of salesperson: the independent agent, the exclusive (or captive) agent, and salespersons for direct writers. The independent agent is an independent businessperson who represents several companies. The independent agent is compensated by commissions, and owns the expirations or renewal rights to the business.
The exclusive agent represents only one company (or company group). Generally, exclusive agents do not own the expirations or renewal rights to the policies. On the other hand, exclusive agents do receive strong supportive services from their companies.
Salespersons for direct writers are employees of the insurer. Salespersons for direct writers usually receive the majority of their compensation in the form of a salary. Like the exclusive agent, direct writer salespersons represent only one company.
• Life, Accident and Health
The life and health field uses primarily two forms of agent sales systems: the branch office system and the personal producing general agency system (PPGA). The branch office system makes use of career agents who are contracted to represent one insurer in a specific area. Career agents are recruited, trained, and supervised by a general agent (GA) or a manager who is an employee of the company.
PPGAs, on the other hand, typically do not recruit, train, or manage career agents. They may recruit a sales force, but these agents are employees of the PPGA, not the insurance company.
INSURANCE SPECIALISTS
Actuaries provide the statistical modeling and mathematical computations necessary for determining the correct premiums for policies. Closely connected to the actuary is the underwriter. The underwriter analyzes data from actuaries and field agents to decide whether the risk involved in writing a policy is desirable.
Should a loss occur, a insurance claims adjuster will be brought into play. Claims adjusters determine if losses are covered by policies. If the policies do cover the loss, the claims adjuster needs to estimate the cost of the repair or replacement.
Whatever the role one plays in the insurance industry, all participants are ultimately involved in a complex process of determining if a risk is insurable, transferring all or a portion of the risk, and pooling the losses. When the stipulations of the contract are met, insurance ultimately leads to the payment for a loss, either in the form of an indemnification or a benefit from a valued contract. An indemnification is a payment that seeks to restore an insured to their approximate financial condition before a loss occurred. A benefit from a valued contract, such as a life insurance policy, pays a predetermined amount.
In determining if a risk is insurable, it should ideally have the following characteristics:
• The risk should be a part of a large number of similar risks (or homogeneous exposures)
In order for the insurer to make use of the law of large numbers, there must be a sufficient body of exposure units to allow for an accurate prediction. The group or exposure units do not have to have exactly the same characteristics, but they should be roughly similar.
• The loss must be fortuitous
Insurance cannot indemnify a loss that an insured purposely caused. For a loss to be insurable, it must ideally be largely beyond the insured’s control, and/or accidental.
• The loss should not be catastrophic
Ideally, an overwhelmingly large number of losses should not occur at the same time.
• The loss should be determinable
A loss should be definable; one should be able to point to a specific time and place when the loss occurred, pinpoint the cause, and determine the amount of the loss.
• The possibility of loss should be calculable
In situations where the loss is very difficult to predict, and the severity of loss is extreme, insurance is often (though not always) unavailable through private insurers. When it is, the insurance is usually backed by federal assistance.
• The premium should make sense economically
For example, a term life policy on a 96-year-old male smoker would be enormously—or prohibitively—expensive. Theoretically, a policy could be written, but it would typically not make sense to do so. The same situation would apply to an insurance policy on the normal wear and tear of property.
REVIEW QUESTIONS
1. An assessment mutual charges premiums in advance. If losses and expenses are lower than expected, it returns surplus to the policyholders; if losses and expenses are higher, it charges an additional assessment.
a. true
b. false
2. Reciprocal insurers are a form of stock company.
a. true
b. false
3. Lloyd’s of London is a large stock insurance company that specializes exclusively in reinsurance.
a. true
b. false
4. Personal producing general agents, or PPGAs, staff and run their own offices. Agents and support staff are usually employees of the PPGA, and not an insurance company.
a. true
b. false
5. Ideally, an insurable loss should have six characteristics.
a. true
b. false
6. An indemnification is a form of restoration.
a. true
b. false
7. For a risk to be insurable, it must be a part of a large number of homogeneous exposures, the loss should not be catastrophic, the chance of the loss should be calculable, the nature of the loss should be measurable, the loss must fortuitous, and the premium must make economic sense.
a. true
b. false
8. A group of homogeneous exposure units is a group of people or items with the exact same characteristics exposed to the same risks.
a. true
b. false
9. The express authority of an agent is stated specifically in the contract provided by the insurance company.
a. true
b. false
10. Independent agents own the expirations or renewal rights to their business.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. false
2. false
3. false
4. true
5. true
6. true
7. true
8. false
9. true
10. true
NOTES
A profession is defined as an occupation that requires specialized study, training, and knowledge. In addition, professions are regulated by a governmental or non-governmental body that grants licenses to practice in the field. The license not only indicates a level of competence, but an expectation of ethical behavior.
In most states, the Insurance Commissioner is responsible for the licensure of insurance agents and solicitors. In order to earn an insurance license, the applicant must show completion of state mandated education requirements.
In addition to mandated CE, many agents choose to advance their insurance credentials by earning professional designations. These designations require coursework that is usually at the college level of difficulty, and often require the passing of a series of exams. Typically, designations are sponsored by professional industry associations such as the American Institute for Chartered Property Casualty Underwriters or the Society of Certified Insurance Counselors. Most professional associations also have their own specific Code of Ethics that all members and designation holders are required to uphold.
While licensing, CE requirements, and designations are all important, they are all only a part of the insurance professional’s equation. The license, the CE certificate of completion, and the letters that correspond to an agent’s earned designation all are symbolic representations of the specialized knowledge that the agent possesses and which is necessary for meeting consumer needs. Despite the hype in the popular media touting “do-it-yourself” planning for everything from estates to stock-picking, most people have neither the time nor the inclination to be their own insurance advisor. Furthermore, even if the “average person” were to dedicate a significant block of time to analyzing his or her insurance needs, chances are the main result would be frustration. Insurance is a difficult, confusing topic. Like it or not, the public needs qualified, professional agents to help analyze their insurance needs and provide them with viable options for their individual needs.
In order for the agent’s knowledge to be used effectively, he or she needs to become an outstanding communicator and educator. Many insurance concepts are difficult, and the dynamics of the insurance industry can seem counter-intuitive to the consumer. For example, unless told, the average consumer might well believe that damage caused by flooding and sewage back-up is a part of their basic homeowners coverage (after all, why did the buy the protection?)
In recent years, the insurance industry has moved to make insurance policies more “user friendly” and has limited much of the legalese of the past. Nevertheless, the typical consumer will be hard pressed when reading through any insurance policy. The agent is the only expert on hand that can effectively answer the consumer’s questions.
To be an effective communicator, the agent needs to be more than a salesperson. While explaining a coverage (or a need for coverage) to a consumer, the agent must always be completely candid and open. To understand something as difficult as insurance, the consumer needs to be given accurate and complete information.
The agent must also be willing to answer questions as fully and respectfully as possible. The old adage that there is no such thing as a stupid question was never more apparent than when dealing with insurance. Finally, to be an effective communicator, the agent must be responsive. Consumers are owed as quick a reply to questions as is practically feasible.
Another aspect of professionalism that is important for the insurance agent is an open and tolerant attitude toward competition. The agent should treat other agents as professional colleagues, and refrain from negative comments about other agents, agencies, companies, or products. Another old adage is applicable here: if you do not have anything good to say about someone, do not say anything at all.
By respecting one’s competitors and taking the high-road, one simply comes across in a more professional light. Furthermore, stressing the negative in others creates a negative atmosphere that ultimately taints the entire industry. As an insurance professional, it is always best to only speak about companies and industry associations in a positive light.
Occasionally, an agent may be approached by a consumer concerning a company’s financial strength, reserves, and general outlook. Even if one is quite knowledgeable about industry trends and a company’s current financial status, it is always best to refer the questioner to a professional rating company such as A.M. Best or Standard & Poor’s. Not only will their reports give a more complete and accurate picture, it will help keep one free of any appearance of wrongdoing.
In the final analysis, being a professional is ultimately dependent upon one taking their business and their industry seriously as a professional endeavor. No amount of licensing, CE courses, designations, or positive communication skills can outweigh a negative attitude. Only a positive attitude toward--and a sincere belief in--the professionalism of one’s occupation will result in others perceiving one in a professional light.
Agents can take many practical steps to enhancing their professionalism. At the basis of their efforts, they must meet all minimum standards of licensing and abide by all applicable laws in their state. But in addition, an agent can be constantly involved in the process of self-improvement. Whether in the form of additional, specific insurance education as is found in a designation track, or in general skill improvement, such as involvement in Toastmasters, the agent possesses a myriad of possibilities to improve their professional skills.
Finally, a true professional should act as an ambassador for their industry. At a minimum, this means striving to never embarrass or “drag down” the industry by negative comments. On the positive, active side, being an industry ambassador can include association involvement, charity work, and political activism on behalf of the industry.
Ethics is a frustrating topic for many people. A standard dictionary definition will state that an “ethic” is a principle, or body of principles, for good behavior. The word stems from the Greek ethos, meaning customary conduct. While this definition is very precise, it causes one to inquire about which principle or principles. It also assumes an understanding of “right or good conduct.” Furthermore, supposing that a body of principles for good conduct has been established, one still needs to know how these principles can be lived.
Ethics is a highly complex subject. Issues of right and wrong, when considered in terms of basic principles, force us to consider fundamental questions of truth and justice. These questions, when seriously considered, push us to think beyond our own limited personal experiences and subjective values and come to terms with general experiences and universal values.
The study of ethics is usually divided into two major fields. The first is the more purely philosophical, and is called meta-ethics. This is the study of terms as they relate to moral philosophy. This area of ethics finds its home on college campuses and university symposiums.
The second field of ethics is what concerns most people. This is called normative ethics. As the name would indicate, this is a study of what is the norm for right and wrong action.
Normative ethics is further broken into two branches. The first branch is the theory of value. The theory of value seeks to determine the nature of “the good.” As noted above, to state that an action is ethical because it is “good” or upholds “the good” opens the question of what “the good” actually is and how it can be known. A theory of value may be monistic, and define “the good” as a single principle, such as Aristotle’s “happiness,” Epicurus’s “pleasure,” and Cicero’s “virtue.” It is also possible for a theory of value to be pluralistic, and find a number of principles possessing intrinsic value.
The theory of obligation is the second branch of normative ethics. The theory of obligation is divided into two opposite groups. The first is the teleological viewpoint, which points to the consequences of actions as the measure for determining their morality. The second viewpoint of the theory of obligation is the deontological viewpoint. It focuses on motives, and sees morality and immorality as ultimately outside the realm of action.
Despite which approach one takes while thinking about ethics, any serious examination requires patience and honesty. A 17th century ethicist determined that ethical action was the pursuit of one’s self-interest “rightly understood.” To “rightly understand” one’s true self-interest, however, is not an easy task. Without careful thought and rigorous self-honesty, the rule of enlightened self-interest is no more than a charade.
Business and professional ethics follow the same lines as general ethics, and are really just extensions of moral philosophy. Business and professional ethics are the standards, or norms, by which their industries are regulated.
In the insurance field, ethical action rests largely upon “The Golden Mean”—Do unto others as you would have done unto you. This means being open and sensitive to the needs of the client, and not placing one’s own needs before those of the client. Within this basic tenet, one can also incorporate the “First, do no harm” maxim of the medical profession.
Examples of the ethical dilemmas that arise in insurance exist in many forms. They can come in the form of selling the wrong coverage. For example, selling an expensive whole life policy to a man of middling income with three dependents is arguably the wrong coverage; a more modestly priced term policy with a higher face value would probably be a more appropriate policy.
Another area of ethical dilemma for the agent can take the form of selling insufficient coverage. For example, selling an auto policy to a client with minimum liability coverage can present the insured with risk exposures that he or she does not fully understand or appreciate.
Failing to recognize a need and not offering any choices of coverage can also be a source of ethical concern for the agent. For example, not asking a client with a homeowners policy about the size and extent of their home-based, side-line business may create a belief that the business is adequately insured.
Each of the above examples is fraught with ethical tensions. These tensions can range from the serious argument to the self-serving rationalization. Are any of our examples as clearly unethical as churning? No. Do any of them pose potential ethical issues? Yes.
Because the agent has the specialized knowledge of the product, he or she has the clear advantage in any transaction with the overwhelming majority of consumers. If the agent is to act ethically, this advantage cannot be exploited. Obviously, the agent must offer insurance products on the basis of the client’s needs rather than his or her commission. But the agent must do more than that. He or she is responsible for offering an analysis of the client’s insurance needs and explaining them in a matter that can be understood.
Most insurance industry associations have a code of ethics that is meant to serve not only as a guideline for ethical action, but also as a roadmap for professional excellence and success. Some of the exhortations common to most of the ethical codes include the following:
• Treat all associates—prospects, clients, managers, employers, and companies—fairly by submitting applications which give all appropriate and pertinent underwriting information
• Exercise due diligence in securing and submitting the necessary information for the issuance of insurance
• Present all policies fairly and accurately
• Keep informed of and abide by applicable laws and regulations that pertain to insurance
• Hold one’s profession in high esteem and work to enhance its prestige
• Cooperate with other professionals providing constructive, complementary services to one’s clients
• Meet client needs to the best one’s ability
• Keep all private information personal and confidential; never do anything that would betray a client or employer’s trust and confidence
• Constantly improve one’s skills and knowledge through lifetime learning and continuing professional education
REVIEW QUESTIONS
1. An example of an ethical guideline is “The Golden Mean” of “Do unto others as you would have them do unto you.”
a. true
b. false
2. Most insurance industry organizations produce their own codes of ethics that serve as professional guidelines for their members.
a. true
b. false
3. Normative ethics is a branch of ethics and concerns right and wrong action.
a. true
b. false
4. Ethical action only demands “book-work” and a lot of reading. It is not necessary to approach ethics on a personal level, nor are self-honesty and introspection much needed in this pursuit.
a. true
b. false
5. The deontological position is a branch of normative ethics that views morality and immorality as existing primarily outside of, and prior to, action.
a. true
b. false
6. It is important to always bear in mind that a legal action is not necessarily a moral action.
a. true
b. false
7. Business ethics is simply the application of ethics to the field of business; it is bringing ethics out of the ivory tower and square into the middle of the "real world."
a. true
b. false
8. Failing to recognize a need and not offering insurance is a potential area of ethical concern for the agent.
a. true
b. false
9. Exercising due diligence is acquiring submitting all pertinent information for the issuance of insurance is an important example of an agent acting in an ethical manner.
a. true
b. false
10. As long as an agent has provided all the sales literature recommended by his or her company to a client, one can say that they have met their ethical obligation to inform the prospect. Clear verbal explanations and the answering of questions are polite, and serve as good sales techniques, but are not required from an ethical standpoint.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. true
4. false
5. true
6. true
7. true
8. true
9. true
10. false
NOTES
One of the great strengths of the American economy is that it allows for competition. There is no central government telling consumers that "You must buy this form of insurance," or "Only this company can make cars." Instead, many companies may offer the same service or product, seeking always to do the job better than the other person. This is the basis of the free market system.
The idea is that the cream rises to the top. The consumers -- those who buy the service or product -- see to it that the strong survive. The companies that best serve the public gain the upper-hand and thrive, while those offering shoddy products or poor service are driven out of business. Theoretically, competition will maintain (and even improve) quality.
In many situations, competition has a positive effect on the economy. In many cases, however, pure competition can have negative effects on the public welfare. For example, if one company drives out all of its competitors and establishes a monopoly, it is usually agreed that the majority of consumers will suffer. The monopoly, unconstrained by competition, will not be inclined to provide quality service, fair pricing, or product innovation.
Because a true free-market tends to produce economic winners in the form of monopolies, modern economies typically rely on state involvement to keep a level playing field and avoid monopolistic practices. For this reason, competition cannot be left alone as the sole mechanism guaranteeing the efficient running of the insurance industry.
Another reason that competition is problematic in the insurance field is that the product possesses a long-term nature that is often hard to assess and compare. The old adage "Let the buyer beware" hardly holds true when dealing with insurance, for the quality of what the consumer buys is only apparent many years down the road. Obviously, it is a very different transaction from a "normal" state of business affairs when one buys insurance. For example, when one purchases shares in a mutual fund, the results and performance of that fund are accessible daily. Buying insurance is very different from hiring contractors to put in a sprinkler system, or having a dentist fill a cavity, or leasing a car. In all of these cases, the results are readily and immediately observable. The performance of an insurance policy, on the other hand, is observable only after the passage of time. More than almost any product, insurance is bought on faith.
Because the performance of the insurance product is rarely immediately apparent, it would be potentially possible for a company to gain an unfair competitive advantage by offering products with premiums so low that they could never cover a reasonable number of losses. In a pure free-market, with a pure “buyer beware” culture, one could expect the result to be a great number of companies failing, and a great number of insureds facing hardship or economic ruin. If an insurance company does not accumulate adequate capital to meet its obligations, all of which are temptingly distant in the future, it will be insolvent when claims finally come due -- as they ultimately will. True, these failed companies would by driven from the market—but at what cost? Unlike most products, where low prices are thought of as a benefit to the consumer, insurance is in greater danger of being under-priced than over-priced.
Any financial mistakes the insurance company makes, from charging insufficiently low premiums to paying too lucrative a commission to its agents, will ultimately be carried by the consumer. The great competition among the multitude of active insurance companies creates tremendous pressure to offer the lowest rate to attract customers, pay the best commission to motivate agents, etc. In other words, competition can create pressure to do what is best in the short run for a minority of people, but is potentially ruinous in the long run for the majority.
REVIEW QUESTIONS
1. In free-market theory, competition helps maintain quality by driving the weak and unscrupulous from business.
a. true
b. false
2. One problem with pure, unregulated free market competition is that it tends to produce monopolistic situations.
a. true
b. false
3. Competition is a necessary but insufficient mechanism for the efficient running of the insurance industry; it is needed, but its very nature is potentially ruinous for insurance.
a. true
b. false
4. One of the limiting factors of free-market competition in the insurance industry is the long-term nature of the product.
a. true
b. false
5. The insurance industry today is one characterized by ever-increasing competition.
a. true
b. false
6. Since policy forms are clear and easy to read, the consumer does not have to study a policy in-depth in order to understand it, and can act as an informed economic agent with confidence and ease.
a. true
b. false
7. Human nature demonstrates that most consumers will actively study the available insurance products on the market and seek out all the information about those products.
a. true
b. false
8. As the performance of insurance is not readily apparent, there is a great deal of room in which the unscrupulous may operate.
a. true
b. false
9. If insurance premiums are too high, both the insurer and consumer will ultimately suffer, as the insurance company will likely become insolvent.
a. true
b. false
10. Insurance companies must charge just the right amount for premiums and pay just the right amount of commission for competition to work in the insurance industry.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. true
4. true
5. true
6. false
7. false
8. true
9. false
10. true
By regulation, we mean a set of laws that a governing body can employ to set a standard of service and competence for the industry it monitors. Its intent is to preserve the public interest, protect the consumer, and promote the general welfare of the industry. It prohibits abusive acts, establishes guidelines for practice, set minimum standards, and provides a mechanism for the enforcement of those standards. Effective insurance regulation will insure the financial solvency of private insurance providers, and create a business environment that is fair for all consumers.
Insurance entities are regulated through four vehicles. First, legislation in all states sets the boundaries of acceptable insurance practices. These laws determine the requirements and procedures for the formation of insurance companies, the licensing of insurance practitioners, the financial practices of insurers and their taxation, the rates charged by insurers and their general sales and marketing practices, and the liquidation of insurers.
Also, the federal government can play a role in the regulation of insurance company practices. For example, the sale of annuities is regulated by the Securities and Exchange Commission. The private pension plans of insurers come under the scope of the Employee Retirement Income Security Act of 1974, and Social Security has insurance programs that affect every American.
The insurance industry is also occasionally subject to the power of judicial review. Both state and federal courts can determine the constitutionality of any insurance practice, and the decision handed down by the court must be respected as the law of the land.
Third and finally, state insurance departments regulate insurance companies' business practices. In many states, an elected or appointed official known as the insurance commissioner administers the state's insurance laws.
The state insurance commissioners belong to the National Association of Insurance Commissioners (NAIC). Although this body bears no legal authority to enforce decisions, it can make recommendations. Indeed, it is largely through the NAIC that state regulations possess a workable level of uniformity. When the NAIC creates model laws, state legislatures and insurance departments often move swiftly to adopt these recommendations.
The states regulate five principle areas of insurance practice. The first, contract provisions, clearly show the influence of the NAIC’s work. One of the reasons for the regulation of contracts is the complexity of the language. The NAIC has helped mitigate this problem. Indeed, it has led the way to high level of uniformity by getting the states to employ standardized policies and provisions.[1]
The state keeps close scrutiny over any insurance policy contract because the language is technical, and can contain so may complex clauses that there is too much room for the unscrupulous to operate within. Therefore, the state insurance commissioner has the authority to approve or reject any policy form before it is sold to the public.
Regulation serves to address the shortcomings of competition. As insurance is a knowledge product, any consumer would have to possess a broad, general understanding of the insurance he or she desires in order to make an intelligent decision regarding its quality. Unfortunately, consumers simply lack the necessary information to adequately compare and determine the relative merits of different contracts. As consumers lack the knowledge needed to select the best product, the competitive incentive for the insurers to constantly improve their product is lessened. Regulation steps in to produce a market effect that imitates what would ideally occur naturally if consumers were informed, rational, economic actors.
Another area of state regulation is that of rates. This is largely an attempt at managed competition. It must be noted, however, that rate regulation is not uniform. Despite the lack of uniformity, the regulatory goal is to see that rates are adequate, meaning they are not too low. The insurer has the responsibility of meeting significant financial claims in the future.
At the same time, rates cannot be excessively expensive. The industry operates with a notion of the fair and correct range of prices for insurance. Rates cannot be discriminatory in any way. Thus, while not everyone pays the same amount for insurance, the insured at a higher premium cannot unfairly subsidize the other insureds at a lower premium when virtually the same risk.
Rating laws are diverse and multitudinous. There are state-made rates, prior approval laws, mandatory bureau rates, file-and-use laws, open competition laws, and flex rating laws.
State-made rates are those set by the state agency. All licensed insurance practitioners must follow these rates.
The majority of states employ some form of prior approval law for the regulation of rates. This simply means that rates must be filed and approved by the state before they can be offered to the public.
Mandatory bureau rates are those rates determined by a rating bureau. A small number of states employ this system.
Open competition laws are sometimes referred to as no-filing laws, and are at the opposite end of the spectrum of the above three varieties of rate regulation. Under this scheme, insurers do not have to file their rates, based upon the premise that competition in the market will ensure reasonable rates. This does not mean, however, that the rates are made without any oversight. The regulatory body maintains the right to require the insurance companies to provide a schedule of rates if there is a perceived problem or abuse, but this is a very liberal scheme that leans upon a trust of the market's efficacy.
Flex rating law is another liberal rating law. This situation requires that rates be submitted to the state for prior approval only when the rate increase or decrease exceeds a predetermined range.
The states also seek to maintain insurer solvency. Insurance, as we have discussed, is a product bought upon faith as a hedge against potentially serious occurrences. The insurance bureau seeks to allay any fears about insurance companies not being able to meet their obligations.
To this effect, the state regulatory commission seeks to guarantee that the insurance companies can demonstrate their solidity, or fiscal health. Even before an insurance company can form, it must meet minimum capital and surplus requirements. The insurer's balance sheet must reflect a certain level of admitted assets. These can consist of cash, bonds, stocks, real estate, and various other legal investments. Only those assets classified as admitted assets can be used to show the company's financial situation.
Opposite admitted assets on the company's balance sheet are reserves. These are liability items, and represent the company's financial obligations.
The difference between the insurance company's assets and its liabilities is called the policy owner's surplus. This figure is very significant, as it is the basis for how much insurance the company can safely offer. Even more important, the policy owners' surplus is the fund used to offset any potential underwriting or investment loss.
The state also regulates the securities that insurance companies hold. The state discourages high-risk investments, as these run contrary to the insurance mission.
The financial condition of an insurance company is an ongoing affair of the state. It is strictly and consistently monitored. Insurance companies must file an annual statement with the Insurance Commissioner. This statement is also called the Annual Convention Blank, and shows the current status of reserves, assets, total liabilities, and investment portfolio. In addition to this, an insurer is normally audited at least every three to five years.
If a company becomes insolvent, the state is obligated to act. The company becomes managed by the state. If the company cannot be fiscally restructured into solidity, it is liquidated.
The states also provide the licensing for the insurance industry. In many ways, this is the "big stick" for the regulating body. For example, a new insurer is normally formed in incorporation. It can only receive its charter or certificate of incorporation from the state, and it is only through the state office that its legal existence can be formed. After being formed, the company must then get licensed to be able to conduct business.
In addition, all states demand that agents and brokers be licensed. A written examination generally has to be passed, and many states are requiring continuing education requirements to maintain a licensed status.
Simply put, a license is a badge that indicates a base level of trustworthiness and competence to operate in a profession. Secondarily, it is a badge that can and will be taken away if both or either the base level of trustworthiness and competence are found wanting.
The major area that most people think of in regards to insurance regulation is centered on trade practices. Trade practices have to do with the interactions of the public and the representatives of insurance entities. The state insurance bureau will seek to stop all trade practices it deems to be unfair. Most states have adopted the NAIC model Unfair Trade Practices Act. Some examples of prohibited trade practices include:
• Misrepresentation
• Failure to remit insurance funds
• Falsifying financial statements and records
• Unfair discrimination
Misrepresentation can occur willfully or by accident. Misrepresentation occurs when untrue statements of material facts are made, or failing to state a material fact that would prevent other statements from being misleading. Misrepresentation also occurs when an insurance representative fails to make all the disclosures required by law. An example of misrepresentation is an agent telling a prospect that he represents many companies, when in fact he represents only one. Another example of misrepresentation would be telling a prospect that the premiums of a life insurance policy are payable for only a limited period of time when they are actually payable for life.
Another form of misrepresentation is twisting. Twisting happens when an agent convinces a policyholder to surrender an in force life policy and purchase a new policy that is not in the policyholder’s best interests. Twisting is also called external replacement.
Failure to remit insurance funds is a major trade practice violation. Obviously, agents must turn in any premiums collected in order for the insurance policy to be in force. This is of major significance for the first premium submitted with an insurance application.
Whether communicating with a state government official or a consumer, it is illegal to alter records or make statements that falsify the financial condition of an insurer. Willfully omitting pertinent financial information is also considered an effort to deceive, and is prohibited.
Another major area of concern for insurance regulation is unfair discrimination. Redlining is an example of an unfair underwriting practice that is discriminatory and illegal.
Originally, redlining was said to have occurred when an insurer refused to underwrite (or continue to underwrite) risks in a specific geographic area. The phrase “redlining” came from the drawing of red lines around areas on a map. Today, redlining can refer to a variety of discriminatory practices. For example, refusal to underwrite based on marital status or prior terminations can be called redlining.
REVIEW QUESTIONS
1. Four influences on insurance regulation are: legislation, the federal government, judicial review, and the state insurance bureau.
a. true
b. false
2. The aim of state regulation is solely to preserve the financial strength of insurance companies; issues of fairness and consumer rights are only handled by the local courts.
a. true
b. false
3. Regulation is necessary, because human nature, the dynamics of the insurance product, and the limits of competition as a regulatory mechanism create an environment in which consumers can be mistreated.
a. true
b. false
4. Redlining is an example of unfair discrimination.
a. true
b. false
5. One area that the federal government plays a role in regulating insurers is through the ____________. This organization regulates the sales of annuities.
6. State insurance commissioners belong to an advisory body called the ___________________. This organization work toward providing functional uniformity in state regulation.
7. Failing to state a material fact necessary to keep other statements from being misleading is an example of misrepresentation.
a. true
b. false
8. The state regulation of insurance rates is an effort at managed competition, and seeks to provide that rates are not too high.
a. true
b. false
9. Rating laws are uniform and mandated solely by the state.
a. true
b. false
10. Failure to remit insurance funds collected for an insurance premium is an example of a prohibited trade practice.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. false
3. true
4. true
5. Securities and Exchange Commission (SEC)
6. National Association of Insurance Commissioners (NAIC)
7. true
8. false
9. false
10. true
NOTES
Chapter Two
Law and Insurance Contracts
THE LEGAL CONTRACT
In using an insurance policy, the insured has transferred the risk of some peril to an insurer. This is done through a contract. For the contract to be binding, it must possess five basic elements. Without these elements being present, the contract is without legal power, and is considered void
CONSIDERATION
For a contract to be binding, it must carry a consideration, or something of value that is exchanged for the promise to perform some service or meet some obligation. In insurance, a consideration is the insured’s promise to pay the premiums specified in the contract, while the insurer promises to meet all the obligations that the contract outlines in event of a loss.
COMPETENT PARTIES
A contract can only be considered valid if both parties are deemed competent. The general test of competence is whether the parties are able to understand the terms and obligations present in the contract. Generally, adults are competent to enter an insurance contract. The mentally ill and minors are usually excluded from entering contracts.
LEGAL PURPOSE
For a contract to be valid, it must not involve an illegal activity. Any act that is deemed contrary to the general welfare is outside the boundaries of legal protection, and no court will uphold contractual claims that concern such an activity.
ACCEPTABLE FORM
Binding contracts usually have to possess specific elements that are designated by state law. Furthermore, if the state government has issued a standard policy with standard provisions, any contract issued privately must contain the same substance as the standardized contract. In addition, if a state government requires filing and approval of a contract form, then any issued contract must be filed and accepted by the state following the appropriate legal procedures.
OFFER AND ACCEPTANCE
The final element that must be present in the formation of a contract is an offer and acceptance. It is important to understand that both the offer and the acceptance must be clear, definite, and without qualifications.
The formation of a contract for property insurance begins with an offer and acceptance. The insurance agent may play the role of solicitor. In this case, he or she invites a prospect to apply for insurance. The prospect fills out an application, and the information in the application is used as information by the insurance company for underwriting and identification. In applying, the prospect is making an offer that the insurance company will accept or reject. The offer and acceptance can be oral.
When dealing with property insurance, an accepted offer is usually handled through a binder. This is really a temporary contract that serves in lieu of the actual contract that will be ultimately issued with the policy.
Again, a binder does not necessarily have to be written. Still, it is generally in everyone’s best interest to obtain a written binder, as this provides more accurate documentation.
Binders are used as a matter of convenience. A policy can take time to prepare and issue, and a binder is a way for the insured to gain protection immediately. It is important for the consumer to make certain that the agent he is dealing with does indeed have the power to bind the company. Some policies must be approved by the company, and there always exists the potential of a confused (or unethical) consumer claiming coverage through a binder when, in fact, none exists.
A binder should contain some basic elements. The names of the insurer and the insurance should be present. The specific risk covered should be identified along with the amount of insurance for limiting loss. The timeframe of coverage needs to be stated, and it should also be stated that the binder coverage only applies until the policy goes into effect. All applicable clauses should be identifiable and apparent, and the binder must specify that the insurance provided is subject to the terms in the policy.
With life insurance, binders are not applicable. All life insurance applications must be in writing. Instead of a binder, life insurance makes use of a conditional receipt, which is roughly analogous to the binder in property and casualty insurance.
Like the binder, a conditional receipt is a temporary contract that obliges the insurance company to provide coverage while the application is being processed. A conditional receipt is issued with an application and an initial premium payment. It is not a guarantee that the insurer will accept the application.
THE LEGAL CONTRACT
REVIEW QUESTIONS
1. For a contract to be binding, there must be clear evidence of a (an) .
2. A (an) is something of value that is exchanged for the promise to perform some service or meet some obligation.
3. Whether the signee of a contract is capable of understanding the provisions of the agreement is a test of .
4. Generally, adults are competent to enter a legal agreement, but the presence of mental illness may invalidate that status.
a. true
b. false
5. In many circumstances, minors are not deemed competent to enter contracts.
a. true
b. false
6. A contract that insures against loss from an illegal activity is still a legally binding agreement if it is made between competent parties and follows an acceptable legal form.
a. true
b. false
7. For a contract to be valid, it must involve a legal activity, and it cannot provide coverage for actions that are deemed detrimental to the public interest.
a. true
b. false
8. For contracts to be enforceable, they usually must follow an acceptable form.
a. true
b. false
9. A (an) is a temporary contract, and provides the insured coverage while the policy contract is being drawn up. It is used as a matter of convenience.
10. In life insurance, binders are not used. The temporary contract that is analogous to the binder is the , which states that the insurance company will provide coverage while the actual contract is being processed.
ANSWERS TO THE REVIEW QUESTIONS
1. offer and acceptance
2. consideration
3. competence
4. true
5. true
6. false
7. true
8. true
9. binder
10. conditional receipt
CONTRACT LAW SPECIFIC TO INSURANCE CONTRACTS
INDEMNITY
Insurance contracts that handle property or liability risks are products designed for indemnification of the contract holder. Indemnity is simply the compensation of a loss. A contract of indemnity is an agreement on the part of the insurer to restore the insured to their financial position prior to the loss. It is vital to understand that one cannot profit from an indemnity contract. The principle of indemnification is one of restoration, not gain.
Unfortunately, human nature is such that the insurance company must actively guard the integrity of the indemnity principle. To achieve this aim, both legal devices and policy provisions are employed.
INSURABLE INTEREST
The principle of insurable interest is a legal doctrine that maintains a contract is only legally binding when an interest is insurable. For example, one could not insure the property of another, hope for (or cause) damage, and then subsequently collect on the contract. This would represent a gain for the insured that had suffered no actual loss.
For an interest to be insurable, the insured must have an aspect of ownership in that which is to be insured, because the insured must suffer harm should a loss occur. By protecting the principle of indemnity, the insurance industry is promoting the public welfare, and protecting society from gambling and moral hazard.
ACTUAL CASH VALUE
The way that a property loss is indemnified is to make use of the principle of actual cash value. Actual cash value can be arrived at by subtracting the depreciation level from the replacement value of the property in question. The actual cash value is what the insurance company will pay the insured for their loss, regardless of the amount of insurance that has been purchased.
The principle of cash value is so very important because, like the principle of insurance interest, it helps to protect the public. Without the application of actual cash value as the basis for indemnification, it would be possible for an insured to purchase a great deal of insurance protection and then destroy the property in order to realize a financial gain.
PRO RATA LIABILITY
Pro rata liability is a policy clause designed to protect the indemnity principle of the contract. This clause protects against an insured profiting from a loss by using several insurance companies to cover a single loss. Instead of receiving the actual cash value of the loss from all of the insurance companies for a total payment greater than the cash value, only the actual cash value is paid out. The various insurance companies only pay an appropriate percentage based upon the percentage of insurance that they have written on the policy.
SUBROGATION
Subrogation is an important policy provision to understand. It is a device that not only upholds the principle of indemnification, but advances the public welfare by holding the negligent part responsible for an incurred loss. In addition, it also helps in controlling the price of insurance.
Subrogation is a policy provision that is a surrender of rights against a third person by the insured. These rights are then transferred to the insurance company. In the event of a loss, it will be the insurance company that will take legal action. This prevents the insured from profiting from a loss by only allowing the insured to receive an indemnity payment; legal action cannot be taken to sue the injuring third party to gain still more money.
The insurer, however, can pursue the third party and see to it that the individual that caused the loss will be held accountable. The monies that are won from such cases then flow to into the insurance company’s account and help defray the cost of insurance for everyone.
CONTRACT LAW SPECIFIC TO INSURANCE CONTRACTS
REVIEW QUESTIONS
1. One term for the compensation for an insured’s loss is called .
2. An indemnification is a return of the insured to their approximate financial position before a loss occurred.
a. true
b. false
3. The principle of indemnification can present the insured with the possibility of a financial gain.
a. true
b. false
4. Because of the danger of dishonesty, the principle of indemnity must be guarded by the insurance company through specific policy provisions and legal devices.
a. true
b. false
5. The principle of maintains that a contract is only legally binding when an interest is actually insurable.
6. By protecting the principle of indemnity, the principle of insurable interest guards the public interest by helping limit moral hazard.
a. true
b. false
7. A property’s actual cash value is usually the same as its current retail market value.
a. true
b. false
8. The is the amount of money that the insurance company will pay the insured in the event of a loss.
a. true
b. false
9. Pro rata liability is a policy clause that protects against an insured profiting from a loss by obligating several insurance companies to cover a single loss. Instead of receiving payment of the actual cash value of the loss from ALL of the insurance companies for total that would be LARGER than the actual cash value, each company pays only a percentage of the losses’ actual cash value.
a. true
b. false
10. Subrogation is a policy provision that is a surrender of rights against a third person by the insured to the insurance company.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. indemnity
2. true
3. false
4. true
5. insurable interest
6. true
7. false
8. actual cash value
9. true
10. true
FURTHER CHARACTERISTICS OF INSURANCE CONTRACTS
PERSONAL NATURE OF THE CONTRACT
An insurance contract is a contract between an insured and an insurer. While one insures property against a loss, the contract does not adhere to the property itself, but to the individual and his or her relationship to the property. Thus, if one were to sell his or her condominium, the insurance coverage would not be included in the sale.
UNILATERAL CONTRACT
In most commercial contracts, both parties exchange something of value. Insurance contracts, on the other hand, are characterized by their unilateral nature. This means that only one of the two parties has promised to provide a service or pay a claim.
CONDITIONAL NATURE OF THE CONTRACT
A conditional contract is one in which the provisions of the agreement only have to be met within specified conditions. Typically, this means that the party that has promised to provide services is only obligated insofar as the beneficiary of the services meets stated conditions.
Conditions are really a set of duties. The policy contract with conditions does not legally force the insured to meet the stated conditions, but the insurer need not meet their obligations if the conditions of the contract have not been fulfilled.
ALEATORY CONTRACT
Insurance contracts are aleatory contracts. As such, they are different from commutative contracts that are typical with most commercial arrangements. A commutative contract specifies the conditions of what is to be an exchange of (presumably) equal value. The exchange can be in the form of goods or services. An aleatory contract, on the other hand, specifies the conditions of a transaction that is not necessarily an equal value exchange.
This “unequal” exchange occurs in insurance contracts when the policy provides more in benefits than the total of the premiums that were paid. This situation can certainly happen in life insurance. On the other hand, many property insurance contracts never pay a benefit, because a loss never occurs during the time of coverage. In this case, it is the insurance company that enjoys the “better deal” in the contract.
It is important for both parties to understand the nature of an aleatory contract. In our example of the insurance company “making out” in a property insurance contract that never pays out a benefit, one should keep in mind the benefits that the insured received while paying their premiums: confidence that their property was protected, meeting any mandated financial responsibility laws, and protection of their property’s value.
One might ask, if the insured and insurer know that the probability of a loss occurring is actually quite low, are they not simply employing a gambling strategy? Could not one call aleatory arrangements simply elaborate games of chance?
Certainly, chance is at the basis of all aleatory contracts. This is not surprising or unusual, however, for we have already defined insurance as a method of dealing with risk, and defined risk as uncertainty regarding the chance of loss. What is important to understand is that while all gambling arrangements must be aleatory, not all aleatory arrangements are gambling.
The difference between a pure gambling arrangement and an aleatory contract is the intent. Gambling is done to realize gain; an aleatory contract is made to guard against loss. An aleatory contract is an acknowledgment of the risk that is a part of normal life, not the deliberate seeking out of additional risk for the possibility of reaping a profit.
CONTRACT OF ADHESION
A contract of adhesion is one in which the provider of the service writes the contract, and the receiver accepts or rejects it. In the case of insurance, the insurer presents the contract to the prospect, and the prospect accepts the entire contract or refuses it.
Although the substantive nature of the contract cannot be changed, elements can be amended by the use of forms and endorsements. Even so, these amendments are still essentially controlled by the insurance company. Like the contract itself, the amendments are presented to the insured by the company to be accepted or rejected.
Because the insurer has the advantage in setting the groundwork of the insurance agreement, the insurance contract is treated as a contract of adhesion. This means that any area of ambiguity in the contract tends to be decided in favor of the insured.
It should be mentioned, however, that this propensity to favor the insured in court has limits. Only circumstances when the contract (or application) is unclear favor the insured. A lack of understanding, or improper interpretation of the meaning of the contract by the insured, do not obligate a court to favor the insured. The strict compliance nature of a contract of adhesion is meant to be a protection to the insured, but not a free ride or a door for abuse.
UBERRIMAE FIDEI (utmost good faith) CONTRACT
Insurance contracts are considered uberrimae fidei contracts, or contracts of utmost good faith. This means that the parties to the contract operate on a high level of trust and honesty, and that all relevant information has been disclosed in an appropriate and timely manner. It also means an honest intent to meet the obligations of the contract exists in both parties.
The purpose of defining an insurance contract as a contract of utmost good faith is to underline the necessity of trust that must be present in any insurance arrangement. Without complete and accurate information, the actuarial principles upon which insurance is based become little better than empty promises, and the industry cannot perform its function.
Because of the necessity of accurate information, any false statement made by an individual applying for an insurance contract can lead to the insurers canceling the contract. Information that is knowingly concealed is also grounds for voiding an insurance contract. Neither misrepresentation nor concealment can be tolerated by an insurance company, as their consequences are so damaging to every concerned party.
FURTHER CHARACTERISTICS OF INSURANCE CONTRACTS
REVIEW QUESTIONS
1. A property insurance contract is a personal contract, and as such cannot be assigned without the consent of the insured.
a. true
b. false
2. A property insurance contract cannot be assigned because the assignment could cause a substantially greater risk to the insurer.
a. true
b. false
3. While commercial contracts are generally bilateral agreements, insurance contracts are typically unilateral.
a. true
b. false
4. Insurance contracts generally carry a list of conditions that must be met in order for the insurer to provide the promised service.
a. true
b. false
5. The insured legally must meet the conditions specified in an insurance contract.
a. true
b. false
6. Insurance contracts are unilateral, which means that the conditions of the transaction are not necessarily characterized by an equal exchange of equal value.
a. true
b. false
7. An aleatory contract is not a gambling arrangement because it is not formed with the intent of realizing a gain, rather it seeks to guard against a loss.
a. true
b. false
8. In a contract of adhesion, the terms and language of the agreement are worked out through the negotiation of both parties.
a. true
b. false
9. In a contract of adhesion, any area of ambiguity is usually decided in favor of the insurance company.
a. true
b. false
10. An uberrimae fidei contract is a contract of “utmost good faith,” which means that both parties to the contract are expected to operate on a high level of trust and honesty.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. false
2. true
3. true
4. true
5. false
6. false
7. true
8. false
9. false
10. true
Chapter Three
Automobile Insurance and the Auto Policy
INTRODUCTION TO AUTOMOBILE INSURANCE
The automobile has been called "the machine that changed the world.” This is a very accurate description of the power that the motor vehicle provides. The personal passenger car gives one unprecedented freedom. With the modern automobile, one can make a journey in a matter of hours that would have taken the 19th century American pioneer weeks. On a whim, one can use the automobile to make a trip that would have required major planning and expense during the horse and buggy era.
Because the freedom that the automobile provides is so desirable, it has dramatically changed the economic landscape. Automobile production and its supporting industries led the growth of American industry for most of the twentieth century. The demand for automobiles has been so strong that today it is by far the most common form of transportation in the United States.
With this freedom, however, comes responsibility. There are very real risks associated with driving. Furthermore, the rapid growth of the total number of vehicles on America’s roads has increased the dangers that the American motorist faces.
It is shocking to note that any given year will produce nearly as many American fatalities from automobile accidents as occurred during the entire course of the Vietnam War. This loss of life is simply catastrophic. With the loss of life comes the accompanying pain and sorrow.
There is also a steep material cost to automobile accidents. The high rate of loss costs untold billions in property damage, loss of productivity, and legal expenses.
Yet, the lure of the automobile's freedom and mobility keep Americans tied to their automobiles. The power of the auto simply outweighs the potential dangers. The pace of life in America is such that we can expect to see more, rather than fewer, automobiles on the highways.
To meet the inherent risk of the motor vehicle, the insurance industry has developed the automobile policy. Today, the personal auto policy (PAP) is employed. This policy largely replaces the older family auto policy (FAP) and special auto policy (SAP). Naturally, it has gone through a number of revisions since its inception. These changes reflect the fluid legal and sociological environment of the automobile. The present form is the most readable and "user friendly" auto policy to date.
Still, the auto policy is a complex and difficult document, combining three forms of insurance-accident, property, and liability-into a single policy. In fact, most states require their drivers to have some type of auto insurance. Mandatory auto insurance is result of a state’s financial responsibility laws. By requiring motorists to demonstrate ability to pay for auto-related losses, the general welfare is protected. As one finds it hard to live without an automobile, it is hard to drive without auto insurance.
BASIC STRUCTURE OF THE AUTO POLICY
Today’s personal auto policy has a defined structure. It begins with a declarations page, which provides information about the property to be insured. This is usually followed by a definitions page.[2] Here, the important terms in the contract are listed and defined in an outline form. Often, these terms are then bolded or bracketed throughout the remainder of the policy in order to call one's attention to them. Typical examples of definitions in auto policy include the following:
• “named insured”—Means the individual name in the declarations and also includes the spouse, when the spouse is a resident in the same household
• “relative”---Means a person related to the named insured by blood, marriage or adoption who is a resident of the same household (provided that neither such relative owns a private passenger auto). The definition of relative can include minors while away from home or attending an educational institution
• “automobile”—Means a four wheel motor vehicle with a wheel base of 56 inches or more designed for use primarily on public roads
• “owned automobile”—Means a private passenger, farm, or utility automobile described in the policy; a trailer owned by the insured; a temporary substitute automobile
• “non-owned automobile”—Means an auto or trailer not owned by or furnished for the regular use of either the named insured or any relative, other than a temporary substitute auto
• “private passenger automobile”—Means a four-wheel private passenger, station wagon, or jeep-type automobile
• “farm automobile”—Means an automobile of the truck type with a load capacity of two thousand pounds or less and is not used for business or commercial purposes (except, of course, farming)
• “utility automobile”—Means an automobile, other than a farm automobile, with a load capacity of fifteen hundred pounds or less of the pick-up body, sedan delivery, or panel type truck not used for business or commercial purposes
• “use”—Means operation, loading, and unloading of the vehicle
In order to make the policy more readable and accessible to the policyholder, the auto policy uses fewer words and less complicated sentences than most contracts. In addition, the insured is referred to as "you" and "your.” The insurer is referred to as "we" and "us" and "our.” By eliminating much of the "legalese" of the contract, the insurance industry has made an important step in empowering the consumer. Better consumer understanding of the parameters of the insuring agreement is not only a benefit for the general public, but for the insurance industry as well.
The auto policy typically consists of six parts that form the content area of the contract. These six parts can be labeled I, II, III, etc. or A, B, C, etc. The first four parts concern the specific coverages. This is what the consumer buys while they form a totality within the policy. Each part is a separate coverage with individual provisions, exclusions, and premiums.
The final two parts of the auto policy apply to the contract as a whole. These parts discuss the duties of the insured and the general operational framework of the contract, such as what occurs if there is a change in the information used to create the policy, or how a policy may be terminated.
LIABILITY COVERAGE
Liability coverage is the first and most important part of the contract. It is the contract's most difficult and complicated section. It is also a coverage that is required by law. The liability portion of the auto policy possesses two components: bodily injury liability, and property damage liability. These parallel coverages perform the following: payment, on the behalf of insured, of all sums that the insured becomes legally obligated to pay as damages because of bodily injury or property damage arising out of the ownership, maintenance, or use of the owned automobile or any non-owned automobile.
This part of the auto policy will also a series of supplementary payments. Supplementary payments are a provision in a liability policy that pay for specific aspects of the insured’s expenses. Supplementary payments in the auto policy typically include the following:
• All expenses incurred by the insurance company, all costs taxed against the insured in a lawsuit; this includes interest that accrues after a judgement is entered.
• Premiums on appeal bonds and bonds to release attachments in any suit the insurance company defends (up to $250).
• Up to $200 for loss of earnings because of attendance at hearings or trials at the insurance company’s request.
• Expenses incurred by the insured for immediate medical and surgical relief to others that is imperative at the time of an occurrence involving an insured automobile
Of course, there are specific limitations to these benefits listed explicitly in the contract. Should damages exceed the policy limit, the insurer will not be held legally accountable for the excess amount. The insured benefits only along the lines of the contract's terms.
The consumer often has little or no understanding of this concept. Even though a liability limit has been stated and agreed upon, some consumers are under the mistaken impression that being insured—especially in the era of no-fault--means that they are "covered for everything.” It is vital that they understand that this is simply not so. Should damages resulting from an accident exceed the policy limit, the insured, and not the insurer, has the responsibility of paying for these damages.
It is also significant to note that the insurer will defend the insured only up to the limits of the policy's liability. The insurer also maintains the right to settle the suit in the manner it deems fair and correct. Such settlements are not always to the insured's satisfaction.
Most states demand a minimum amount of liability insurance, but these minimums have proven to be far too low to meet the costs of typical judgments. This is an unfortunate situation because higher liability limits need not grossly increase the cost of a consumer's premium. Unfortunately, the cost-averse natures of many persons leads them down a path of minimum liability limits in the auto policy, causing them to carry more risk than they should.
The liability coverage in an auto policy can be designed in one of two ways. The coverage can be written with a single limit. Under this variation, a single amount of coverage is available to apply as needed, and this can be used for bodily injury or property damage.
A second method for writing liability coverage is the split limits form. This method is both more flexible and more complicated. The insurance arrangements for property damage and for bodily injury are considered separately, handled separately, and stated separately. One of the major criticisms of the split limits arrangement is that the entire coverage cannot be used, and the minimum amounts are often insufficient.
For example, a state may set the liability limits of a split limits personal auto policy are 20/40/10, meaning that there is $20,000 of coverage available for each person, and $40,000 for each accident. There is also $10,000 for property damage in per accident. When one stops to consider the current costs of medical services or motor vehicles, it is easy to see why many insurers are critical of the split limits plan. It provides a false sense of security on the part of the consumer that is a benefit neither to the general public nor to the insurance industry.
PERSONS COVERED
The liability coverage of the auto policy provides strict limitations on who is covered. Obviously, the named insured is covered. This is the "you" referred to in the policy. But "you" here also includes one's spouse. In addition, family members are covered under this agreement. To be considered a family member, there must be relation by blood, marriage, or adoption. Residence in the same home is another way to convey a familial relationship, as in the case of a ward of the family.
Also, any person using the insured's auto is covered provided that there is reasonable belief that permission was given. This coverage also extends to any individual or organization that is legally responsible for the acts of an insured while using the insured's auto. An example of this type of situation refers to when an insured's automobile is used during working hours for errands, and an accident occurs. The insured and the employer are both covered.
VEHICLES ELIGIBLE FOR COVERAGE
With automobile coverage, one must be specific about the type of vehicle that is being covered. Most, but not all, varieties of four wheeled motor vehicles are eligible for this coverage.
First, the auto policy refers to motor vehicles with four wheels. The passenger car is the most typical and obvious vehicle in this group. But jeeps, pickup trucks and vans are also eligible, provided they meet some specific criteria. They cannot, for example, be used primarily as transport vehicles for a company's materials when those materials are primary to the business. The van or pickup also cannot have a gross weight of more than a figure specified in the policy and still be eligible for this coverage.
As for as what specific vehicles can be considered "covered vehicles,” four possibilities exist. First, any vehicle listed in the declarations page of the contract is covered. This is obvious, and does not have to be elaborated. But what happens if one buys a new vehicle that is eligible for coverage? If it is purchased while the auto policy is in effect, then it is considered an additional vehicle and is automatically covered. The coverage provider is the broadest coverage available, but certain stipulations exist for this arrangement to continue.
To begin with, the insured must tell the company that an additional auto has been purchased. Secondly, a premium must be paid to continue coverage. The insurance for the second vehicle will not come free of charge.
If the insured purchases a new auto that replaces an old auto that is already covered, then the coverage that already exists extends to the new vehicle. If the insured wants to add or maintain physical damage insurance, then the insurance company typically must be notified within 30 days.
Two other possibilities exist where a vehicle can be considered covered. A temporary substitute auto is a covered vehicle. This situation applies when one is using a company's auto because the owner's auto is being repaired, recovered after a theft, or replaced.
Lastly, a trailer, while not an auto in the strict sense of the word, can be considered a covered vehicle for insurance purposes. The type of trailer is one designed to be attached to a passenger auto, van, or pickup. Typically, a “heavy duty” truck trailer intended for commercial purposes is excluded.
EXCLUSIONS TO THE LIABILITY COVERAGE
Exclusions are the perils, losses, and properties listed in an insurance contract that will not be covered. Exclusions are necessary, because the actuarial principles used in assigning premium rates refer to specific information about calculated risk levels.
Also, not all risks are the same. The risk of the personal auto used for normal, day-to-day travel is much different than that of a taxi, and both the taxi and personal auto are exposed to different risks than a vehicle that is primarily an off-the-road, recreational vehicle.
To attempt to provide insurance coverage for three disparate risks would result in inadequate premiums for the insurer. Ultimately, this situation could lead to the insurer being unable to meet its financial obligations. Also at stake is fairness! For the three different risks to share the same premium level, the risk at the lowest end of the spectrum would be unfairly supplementing the risk that encounters a greater level of hazard.
Because of the complexity and variable nature of risks, exclusions in the auto policy are legion. It is important that the agent explains the concept of exclusions to the insured, and reviews the important exclusions that affect his or her policy coverage. Some typical exclusions in the liability portion of the auto policy include the following:
GEOGRAPHICAL BOUNDARIES OF LIABILITY COVERAGE
In addition to financial limits of liability, the personal auto includes some geographical limits. This is handled in the out-of-state coverage component of the auto policy. The auto policy allows for coverage in all fifty states, Puerto Rico, and Canada. The auto policy automatically covers the insured to the necessary state minimums if the insured's policy is below those minimums. This way, one need not purchase "extra insurance" every time he or she visits or travels through another state.
NOTES
REVIEW QUESTIONS
1. Most states demand a minimum amount of liability insurance. Unfortunately, these minimums have seldom proved to be adequate.
a. true
b. false
2. Liability coverage is that part of the auto policy that protects one against the negligent ownership and operation of an automobile.
a. true
b. false
3. In a personal auto policy, the “named insured” is typically defined as the individual named in the policy’s declarations, plus the spouse (if the spouse is a resident of the same household).
a. true
b. false
4. An auto policy with split limits liability of 200/400/100 would mean there is $200,000 of coverage for each ACCIDENT, $400,000 of coverage for each PERSON, and $100,000 of coverage for PROPERTY DAMAGE.
a. true
b. false
5. The supplementary payments applicable to a liability policy can include premiums on appeal bonds and interest that accrues after a judgment is entered in any suit that the insurance company defends.
a. true
b. false
6. The auto policy refers only to passenger vehicles such as automobiles. Jeeps and vans can be covered, but only under a special endorsement.
a. true
b. false
7. When a new auto is purchased, the coverage that was already in effect carries over to the new vehicle. If physical damage insurance is desired, one must notify the insurance company within 30 days.
a. true
b. false
8. Trailers, most utility vehicles, and all farm vehicles are excluded coverage under the typical personal auto policy.
a. true
b. false
9. The liability section of the personal auto policy is only in force in the continental United States. The coverage does not extend to Alaska, Hawaii, Canada, Puerto Rico, or Mexico.
a. true
b. false
10. If the insured is involved in an accident in a state with higher liability minimums than present in the insured’s auto policy, the insurance company automatically expands coverage to meet the minimum limits.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. true
4. false
5. true
6. false
7. true
8. false
9. false
10. true
The second portion of the auto policy, Part B, is the medical payments coverage. Some insureds will reduce the cost of their premium by coordinating this coverage with their health and disability coverage. In these cases, their insured’s medical insurance will pay up to a certain limit, and the auto policy covers the remaining amount. Typically this is done with coverages termed excess medical and excess wage loss.
The medical payments insurance section in an auto policy is an agreement on the part of the insurer to pay all reasonable expenses incurred for necessary medical services because of bodily injury suffered by an insured. The benefits extend to injuries sustained in any state. The company will pay for expenses incurred by an insured within three years of the date of the accident.
The medical payments coverage will pay regardless of which party is at fault in the accident. In this sense, it is a no-fault coverage. The benefit limits typically range no higher than $10,000, but cover a wide range of treatments, including surgery, X-rays, and dental work.
The medical payments coverage also pays for any funeral services that result from an accident. Again, the payments occur within the level of the named amount of benefit limits. This is an important element of the medical payments coverage, because most health policies do not cover funeral expenses.
There are two groups covered under the medical payments section. The first is the insured and any family member injured while in a motor vehicle. Also within this first class are persons other than family members who are injured while in a covered motor vehicle. If the insured drives any non-owned vehicle and suffers an accident, however, only the insured and his family members receive coverage through the auto policy. All other passengers are excluded from this coverage under the auto policy.
The second group of covered persons under the medical payments coverage includes the insured and his or her family members as pedestrians. They are covered if they suffer bodily injury from a road vehicle. A "road vehicle" here means autos, pickups, vans, and trucks. But, an off-road recreational vehicle could cause an injury to the insured's wife, but this would not be covered.
EXCLUSIONS TO THE MEDICAL PAYMENTS COVERAGE
As with liability coverage, there are many exclusions to the medical payments agreement in the auto policy.
There are several other limitations that apply to medical payments in the auto policy. We have mentioned the first two in passing, but it is significant enough to be brought up again: the amounts payable are listed in the insurance agreement and generally range up to $10,000. Also, this is an optional portion of coverage that must be selected by the insured in order to be in force.
When payments are made for medical expenses by more than one company, the payment is on a pro rata basis. Lastly, medical payment recoveries are subject to subrogation clauses in the policy.
REVIEW QUESTIONS
1. Since medical payments coverage under the auto policy is not required by law, many insureds choose not to carry this kind of coverage so they can reduce their premiums.
a. true
b. false
2. The medical payments coverage of the auto policy is designed to pay for medical expenses incurred for an auto accident within three years of the date of the injury.
a. true
b. false
3. Part B of the auto policy only pays for medical expenses; funeral costs are never covered.
a. true
b. false
4. Under Part B of the auto policy, the insured and his or her family members are covered for injuries suffered while driving a non-owned vehicle, but other passengers are not covered.
a. true
b. false
5. The medical sections part of the auto policy also covers the insured and his or her family if they are injured as pedestrians as long as the injury was incurred by a road vehicle.
a. true
b. false
6. An injury sustained while using the motor vehicle as a residence are excluded from the medical payments section of the auto policy.
a. true
b. false
7. In most cases, an injury caused by an auto accident while one is working their job is excluded from coverage under the personal auto policy, because _________________ takes precedence over the auto policy.
8. An injury suffered while driving a moped is covered under the auto policy, but an injury suffered while driving a motorcycle is excluded.
a. true
b. false
9. Since medical benefits are extended to anyone driving a covered auto, a car thief could theoretically claim benefits from an injury suffered while driving a stolen auto.
a. true
b. false
10. If an injury is suffered by an insured with more than one policy, the benefit is paid on a pro rata basis.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. false
2. true
3. false
4. true
5. true
6. true
7. workers compensation
8. false
9. false
10. true
When people act irresponsibly and drive motor vehicles without insurance, a major risk exposure is created. Few people have sufficient personal resources to pay for damages caused in auto accidents. Because the potential cost to society would be catastrophic if restitution for auto accidents was easily avoidable, each state has taken serious measures to try and control this situation. Typically, these actions are found in the passing of financial responsibility laws that demand some basic forms of insurance coverage.
Despite the best efforts of legislators and regulators, however, the problem continues. To protect one from an injury caused by an uninsured motorist, a hit-and-run driver, or a negligent driver insured by an insolvent company, the insurance industry offers (an optional) uninsured motorists coverage.
The purpose of this kind of coverage is to pay the amount the insured would have received if the situation had been "normal," and the uninsured driver was insured or the insuring company was not insolvent. This is the basis of settlement for this coverage, but there is often disagreement between the insurer and the insured on the amount paid out. Often, this is a situation that goes to arbitration. When this occurs, the insured and the company each choose an arbitrator. The two selected arbitrators choose a third, and the decision reached by two of the three is binding, providing the damage award does not exceed the state's minimum financial responsibility law limits.
The damages that the insurance company compensates the insured for can include medical bills, lost wages from time missed at work, and compensation for physical disfigurement. It is important to note that damages can be pursued only in those cases where the uninsured motorist can be demonstrated to be legally liable. Uninsured motorist coverage is firmly locked into the tort liability system.
Those covered under the uninsured motorists section of the auto policy are as follows: the named insured and family; any other person in the insured's auto; any person who is legally entitled to receive payment for damages. The last situation occurs when a family member is lost due to a car accident. The wife, husband, etc. can pursue damages even though they were not there when the accident occurred.
EXCLUSIONS TO THE UNINSURED MOTORISTS COVERAGE
The exclusions to the uninsured motorists coverage are divided into two groups. The first handle exclusions based upon the vehicle. The second concern exclusions based upon actions or situations.
UNDERINSURED MOTORISTS COVERAGE
If one has opted for uninsured motorists coverage, they can also add underinsured motorist coverage. This creates a very complete form of automobile coverage, without significantly increasing the premium.
This form of coverage is designed to provide insurance against accidents caused by a motorist who has liability coverage, but whose coverage will not be sufficient to meet the costs of the bodily injury incurred. This compensates for other motorists who may have elected liability minimums due to lack of personal resources or poor planning.
The underinsured motorist coverage is usually written for the same limit as the uninsured motorist coverage, and it usually pays the remaining difference left after the negligent driver has paid whatever portion of the damages they could. Uninsured and underinsured motorist coverage cannot overlap in any way; the insured can collect on one of the two coverages, but not both. Like uninsured motorists coverage, it is subject to arbitration. The arbitration process is the same as for an uninsured motorist coverage claim.
REVIEW QUESTIONS
1. Uninsured motorist coverage is a mandatory supplement to no-fault; its sole purpose is to cover hit-and-run situations.
a. true
b. false
2. The idea behind uninsured motorist coverage is to pay the amount of benefits the insured would have received if the uninsured driver had been insured.
a. true
b. false
3. A situation in which a motorist could receive payment for compensatory damages is when an injury accident occurs with a party whose insurance company is insolvent.
a. true
b. false
4. The damage award named through arbitration can be quite substantial, but it cannot exceed the state's minimum financial responsibility law limits.
a. true
b. false
5. Uninsured motorist coverage pays the insured for all medical bills, lost wages, and physical disfigurement caused by a automobile accident with an uninsured driver, but only when the other driver can be shown to be legally liable.
a. true
b. false
6. Unlike uninsured motorist coverage, underinsured motorist coverage is never subject to arbitration.
a. true
b. false
7. If one chooses uninsured motorist coverage, then underinsured motorist coverage can be purchased as well. This coverage is designed for situations when an accident occurs with a driver who has insufficient insurance coverage.
a. true
b. false
8. In certain instances, an insured can collect damages from both the uninsured and underinsured sections of the auto policy.
a. true
b. false
9. Underinsured motorist coverage is usually written for the same limit as uninsured motorist coverage and pays difference left from the underinsured driver's insurance.
a. true
b. false
10. Exclusions to the uninsured motorist section of the auto policy are never based upon the vehicle; rather, they concern exclusively the actions of the participants in the accident.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. false
2. true
3. true
4. true
5. true
6. false
7. true
8. false
9. true
10. false
Part D of the auto policy concerns coverage for physical damage to the insured's motor vehicle. It is broken into two parts, collision and other-than-collision (usually referred to as comprehensive). Both of these are separate coverages, written with separate deductibles. Neither needs to be included in the auto policy. Thus, an insured that has a motor vehicle that is quite old might opt for no collision insurance. Or, one might opt for collision insurance with a high deductible and pass on the other-than-collision insurance. It is entirely up to the consumer, but it is vitally important that the consumer understand that he or she will only receive collision insurance and other-than-collision insurance if these coverages have been chosen and appear in the contract. Many consumers erroneously believe that an auto policy automatically provides physical damage coverage.
• Collision Coverage
Collision coverage affords payment by the insurer for any loss to a covered auto, less the deductible. Collision loss is defined as the loss or damage of the policyowner's covered auto or nonowned auto. The damage or loss can occur through impact with another auto or an object. This impact could occur when the auto is running, as on the open highway, or it could occur while the auto is stationary in a parking lot.
Collision loss can be paid regardless of who is at fault; in this case, liability is not the issue. If, however, the insured is not liable for the accident and collects a collision benefit, he or she must give up subrogation rights to the insurer. In doing so, one secures the possibility of regaining part or all of their deductible, depending on whether the company wins the court decision. Also, the principle of indemnity is secured, as the insured will not collect from the insurer and the negligent party.
VARIETIES OF COLLISION COVERAGE
1) Limited Collision
Pays damages caused by collision (with another vehicle or a stationary object) IF the driver of the insured vehicle is NOT more than 50% (“substantially”) at fault. This coverage does not pay any damages should the insured be more than 50% at fault.
2) Standard (or Regular) Collision
Pays collision damages on the insured vehicle REGARDLESS of which party is at fault. However, the insured must pay the deductible.
3) Broad Form Collision
Pays for collision damages on the insured vehicle REGARDLESS of who caused the accident. IF the insured is NOT more than 50% at fault, the insured does not have to pay the deductible. However, if the insured must pay the deductible when more than 50% at fault.
• Other-Than-Collision Coverage
As the name implies, other-than-collision coverage handles physical damage not caused by collision. Again, this is optional coverage that is separate from collision coverage. The deductible is separate, and generally lower, than for collision coverage.
Other-than-collision coverage handles such a wide variety of situations it is usually called comprehensive coverage. Comprehensive possesses two parts: protection of the automobile and personal effects. Typically, comprehensive coverage pays for loss caused by the following:
• Missile objects
• Falling objects
• Fire
• Theft or larceny
• Explosions
• Earthquakes
• Windstorms
• Hail
• Water
• Flood
• Malicious mischief or vandalism
• Riot or civil commotion
• Collision with animals
HOW A LOSS IS PAID OUT
In paying an insured for a physical damage loss, it is important to remember that the insurer is providing an indemnification. Simply put, the insurer is restoring the insured to their approximate condition before the loss was incurred. The insurer is obligated to pay only the actual cash value of the damaged or stolen property, or the amount needed to restore or repair that property. The insurer also has the choice of the less costly of these two options.
Sometimes, a "stated amount endorsement" is added to the auto policy. This is generally done when one has an exceptionally valuable auto. In this case, a stated amount of value is declared. If a physical damage loss occurs, then the insurer refers to the stated amount in the policy endorsement. If the stated amount is less than the actual value of the auto, the stated amount is paid. If the stated amount is greater than the auto's actual cash value, the insurer pays the actual cash value.
PHYSICAL DAMAGE EXCLUSIONS
Physical damage exclusions are among the most extensive in the auto policy. The exclusions range from types of property not covered to situations in which the coverage is not applicable.
PHYSICAL DAMAGE COVERAGE AND THEFT
Automobile theft is a growing problem for our society. Daily we read about stolen-car rings and car-jackings. The news can be numbing to our senses, but it is a part of our world. Insureds can play a vital role in reducing theft and vandalism in conjunction with civil authorities and insurance companies. In order to facilitate this process, the agent needs to educate the insured on how insurance companies handle loss situations due to theft.
First, if a covered auto or non-owned auto is stolen, the insurer will help provide transportation to the insured in the form of a supplementary payment. After 48 hours from the point of notifying the police and the insurer that an auto has been stolen the insurer will pay for damages—typically to the tune of $15 daily, up to a maximum of $450, for the insured's transportation costs.
If the stolen car is non-owned and is a rental car, the insurance company will pay for the loss-of-use liability the insured has incurred. (Loss-of-use liability refers to the money the rental company would normally earn on the stolen vehicle.)
If the car is stolen and belongs to the insured, the insurance company will pay the expense of returning the stolen car to the insured, and repair any damages that occurred as a result of the theft, as well as the process of recovering the auto.
.
REVIEW QUESTIONS
1. Physical damage coverage can typically takes three forms: limited, regular (or standard), and broad form.
a. true
b. false
2. Collision and other-than-collision coverage often overlap one another, and are paid out on a pro to rata basis.
a. true
b. false
3. Physical damage is an optional form of insurance coverage, and can be added or deleted from the auto policy at the owner's discretion.
a. true
b. false
4. The deductible for other-than-collision coverage is connected to the collision coverage deductible, and is always the same figure.
a. true
b. false
5. A collision with an animal or a bird is an example of a collision accident that is not carried under the collision coverage.
a. true
b. false
6. An insured with broad form collision possesses coverage that never requires a deductible to be paid.
a. true
b. false
7. An insured with limited collision coverage will not receive any benefits if he or she is substantially at fault in a collision accident.
a. true
b. false
8. In cases of an exceptional auto, a stated amount endorsement is typically added to the auto policy. If physical damage occurs to the automobile, one of two possibilities occurs. If the stated amount is ___________ than the actual cash value of the automobile, then the stated amount is paid. If the stated amount is ________ than the automobile's actual cash value, then the insurer pays the actual cash value.
9. In cases when a covered auto is damaged by a “civil authority” (which usually means the police), the physical damage coverage is excluded.
a. true
b. false
10. If one's auto is stolen, the insurance company will pay for the cost of returning the auto to the insured, but any damages that occurred during the theft and repossession of the auto are excluded.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. false
3. true
4. false
5. true
6. false
7. true
8. less, greater
9. true
10. false
It is vitally important that the insured knows what to do at the scene of an accident. Personal responsibility obligates the insured to take steps to learn the proper duties, as both the law and the auto policy demand certain minimum actions. Without accepting this responsibility, the insured may create legal problems or have the claim refused. It is important that the agent educate the insured on the duties that follow an accident or loss.
After an accident, one should determine if anyone has been injured. If an injury occurred, proper steps should be taken such as calling 911. Obviously, the police must be notified. If the situation is a hit-and-run, this information needs to be immediately offered to the police. It is important to take steps to protect the auto from further damage; if possible, the area of the accident should be protected. This can be done by roping off the perimeter or igniting flares.
When dealing with the other party to the accident, one should never admit to responsibility. This prejudices the insurance company's right to recover payment. One should merely give the other driver one's name and address, and the name of one's insurer. It is appropriate to request the same information from the other driver. Finally, one needs to inform the insured about the accident as soon as possible.
Furthermore, one is expected to cooperate with the insurer during the investigation and settlement of the claim. All legal papers need to be copied and forwarded to the insurer. If the insurer so requests, one should take a physical examination, authorize the release of medical records, and submit proof of a loss. All of these activities are designed to help the consumer, and quickly and efficiently process a claim.
REVIEW QUESTIONS
1. After one has had an accident, he or she must attempt to protect the covered vehicle from any additional damage, and if possible, try to secure the place where the accident occurred.
a. true
b. false
2. It is vitally important that one not admit responsibility for an accident to the other party, because this prejudice's the insurance company's right to recover payment
a. true
b. false
3. After an accident, one is responsible for seeing whether any of the parties has been injured and calling the police and an ambulance if an injury has taken place. If no one has been injured, the police do not need to be notified.
a. true
b. false
4. To be certain that one's claim can be processed, one should inform their insurance agent and company as soon as possible when an accident has occurred.
a. true
b. false
5. It is appropriate to request the name, address, and insurance company of the other party to an accident, and give that same information concerning oneself if asked.
a. true
b. false
6. To process a claim, one might be asked to release medical records, take a physical exam, and submit some proof of a loss.
a. true
b. false
7. One is expected to cooperate with the insurance company during the handling of a claim, but they need not forward legal papers or notices. This only needs to occur when there is a court order to do so.
a. true
b. false
8. Most people know what to do at the scene of an accident, so it is a rare occasion when a policy claim is denied because of action one failed to take after an accident.
a. true
b. false
9. The police must only be notified about an accident if criminal behavior was involved, such as a hit-and-run accident.
a. true
b. false
10. A hit-and-run accident does not result in a serious injury, the police do not have to be notified.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. false
4. true
5. true
6. true
7. false
8. false
9. false
10. false
POLICY TERRITORY AND PERIOD
This section refers to the geographical limitations of the policy. It is important to note the auto policy will be honored in all fifty states, Puerto Rico, and Canada. It does not apply in Mexico, however, and one driving in Mexico needs to purchase special insurance just for that event. Also, it states the policy only applies for the period assigned in the declarations.
CHANGES
The auto policy cannot change unless an endorsement is added. Any change in information given to the insurance company regarding the number of insured vehicles, the operators using the vehicles, the place of garaging the vehicles, etc., may result in a change in premium.
BANKRUPTCY
If the insured goes bankrupt, the insurer is not freed from its obligations. The policy is in force regardless of the insured’s solvency or insolvency.
FRAUD
Coverage is not provided if any statements made by the insured in connection with any accident or loss for which coverage is sought are found to be untrue. Coverage is not provided if any actions taken by the insured in connection with any accident or loss for which coverage is sought are fraudulent.
LEGAL ACTION
The insurer cannot take any legal action against the insured until there has been full compliance with all the terms and provisions in the policy. No right exists for any person or organization to bring the insurer into action in order to determine the insured's liability.
TRANSFER OF INTEREST
This provision simply states that the policy cannot be assigned without the written consent of the insurer. But if the insured dies, the insurer agrees to provide automatic coverage to the insured's spouse.
RIGHT TO RECOVER PAYMENT
Under this provision, the insured agrees to assign any right to recovery against a third party to the insurer, to the extent that payment is made to the insured. In other words, it requires the insured do whatever is necessary to enable the insurer to exercise its right to recover payment, and to do nothing that would prejudice this right.
TERMINATION
The termination provision applies to the ending of the insurance agreement by the insurer or the insured. The insured may cancel the policy at any time. All that needs be done is to return the policy, or send written notice of cancellation.
The insurer is more restricted when pursuing a policy cancellation. Unless the policy was obtained through misrepresentation, the insurer must follow certain steps for cancellation. If the policy was in effect for less than sixty days, then a ten-day notice must be issued. If the policy has been in effect for more than sixty days, the insurer can only cancel the policy if the insured's driver’s license was revoked during the policy period, or if the insured has failed to make premium payments. Even so, a ten-day notice must be issued in both instances.
An insurer can, however, decide to not renew a policy. If the insurer chooses to do this, a 20-day written notice must be given to the insured. And, if the policy is less than a full year period, it can only be refused for renewal on the anniversary of the policy's original date. A policy is automatically terminated if a company offers to renew a policy and the insured does not accept the company's offer.
REVIEW QUESTIONS
1. The duration of policy coverage is stated in the declarations, and the general provisions section states that the policy only applies for the specific period assigned.
a. true
b. false
2. Normally, the personal auto policy cannot change without the addition of an endorsement.
a. true
b. false
3. If the insured goes bankrupt, the insurer is freed of its obligations to perform services.
a. true
b. false
4. If an insured lies or makes false statements concerning material facts, or intentionally does not offer material facts to the insurance company while making a claim, the insurance company usually need not provide any coverage.
a. true
b. false
5. In most cases, an insured can take legal action against his or her insurer only after there has been full compliance with the terms written in the policy.
a. true
b. false
6. The general provisions of the auto policy state the agreement is a personal contract, and as such cannot be assigned without the explicit written consent of the insurer.
a. true
b. false
7. The auto policy requires that the insured cooperate with the insurer in every way possible in order for the insurer to exercise its _____ __ _______ _______.
8. An auto policy can be canceled either by the insured or the insurer at any time. The only stipulation is that a 60- day notice must be given by the insurer.
a. true
b. false
9. If an auto policy has been in effect for under 30-days and an insured's driver's license is revoked, the insurer can cancel the policy. However, the insurer must give the insured a ten-day notice of its intention to do so. If the insured’s license is revoked after the initial 30-day period, the insurer cannot cancel the policy.
a. true
b. false
10. A policy can be automatically cancelled if a company offers to renew the agreement and the insured does not accept.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. false
4. true
5. true
6. true
7. right to recover payment
8. false
9. false
10. true
Insurance is generally considered to be a necessary evil. As such, complaints about its structure and operation are commonplace amongst its users. The people who have suffered losses in automobile accidents are certain that their settlements are inadequate. Young drivers feel the strain of finding an insurer who will cover them at an affordable rate. All purchasers of auto insurance insist their rates are too high, and any consumer that has had a claim is certain that the insurance company could have produced a check a little bit faster, or paid out a little bit more.
The method for handling auto insurance is aimed at compensation in the form of indemnification. It had traditionally been a multi-stepped process within the tort liability system. In many respects, it was very cumbersome In order to begin action, the injured driver had to make a claim against the other driver's insurer. The victim then needed to demonstrate that the other driver had been negligent.
This system led to over-crowded courts and lengthy delays before any compensation was realized. All too often, it depended more on the skill of an attorney than the relevant facts of the case -- many of which had grown less clear in the mind's of the participants due to the long duration of the process. Such entanglements also produced high expenses, both to pay the attorneys and sustain the system.
There are other flaws with the tort liability system. The difficulty in proving negligence left many under-compensated or even uncompensated for their losses. The traditional auto insurance process made no room for the self-negligent. Nor could it handle the unknown party in a hit-and-run situation. A guilty party who was insolvent was also not adequately compensated for under the tort liability system.
Such weaknesses seemed glaring to many. Critics also pointed to the inequity within the system. Small claims were often overpaid in order to avoid litigation. The large claim for the seriously injured, on the other hand, were resisted wholeheartedly. This made them rather rare and, when payment came, it was only after substantial delay.
The traditional system of auto insurance ultimately became so fragmented with confusion and distrust, the insurance industry actively sought out alternatives. One was found—and, in many states, implemented--with no-fault insurance.
No-fault is contrasted to the tort system in a number of ways. In the tort system, only the driver at fault in the accident is eligible for compensation. If an injury occurs through one's own negligence, the situation is one's own individual responsibility. Under no-fault, on the other hand, there is no blame and no burden. Each party collects under its own insurance company. Fault is not the issue for coverage. Given the imperfect nature of humans and the hazards of driving, many find this very equitable.
The typical benefits for no-fault insurance are manifold. All medical payments up to a maximum amount are paid. Loss of earnings can be paid out for a specified duration and to a specified level. And essential services, such as housework, yard-work, etc., are broken down and expensed out. Funeral expenses can also paid up to a maximum limit.
There are, however, multiple variations in no-fault insurance. For example, a pure no-fault law essentially abolishes the tort system for the purpose of auto insurance. Under a pure no-fault system, an injured party cannot sue, no matter how grievous the injury. All benefits to the injured party come from the insurance company.
Other types of no-fault insurance maintain a tort liability window. These are known as modified no-fault laws. They normally make no payments for pain and suffering per se, but allow the injured party to sue under two conditions.
These conditions are listed as "thresholds.” A dollar threshold in a modified no-fault insurance arrangement means that the injured party can only sue if their claim is above a stated dollar amount. A modified no-fault insurance with a verbal threshold allows the injured party to sue for damages when specified, serious injuries have been sustained.
A third possibility of insurance that mirrors no-fault is an add-on plan. This system has the insurance company pay-out regardless of who is at fault in an accident, but keeps open the right to sue for pain and suffering. As this plan does not restrict the right to sue, it is not a true no-fault insurance system.
NOTES
Chapter Four
Introduction to Homeowners Insurance
For most people, a home represents many things. A goal to be realized, a place of security and nurturing, or fond memories of time spent with loved ones. On a practical level, it is also the major form of wealth that most people will acquire in their lifetimes. Homeownership is not, however, only a source of tax deductions and equity; it is an investment that must be maintained and protected. As such, it is a source of risk exposures, some based on physical damage to the structure itself, others that have to do with personal liability.
At present, homeowner’s policies are standardized and preprinted. They are an outgrowth of the movement toward multi-line package policies. Today, the homeowner's policies available are the product of the ISO's work, and combine the old, mono-line policies of property insurance, theft insurance, and liability insurance into a single policy.
There are at present six homeowners forms, and three types of coverage. The forms relate to the types of structures and property covered. The coverages relate to particular perils. The basic form, for example, covers 10 named perils listed in the property coverage section of the policy. The broad form insures against the above 10 named perils plus six more perils. The special form is an inclusive form. It covers any peril not specifically excluded in the policy contract.
Homeowners insurance is so broad that we will restrict our discussion of the topic to the most popular homeowner’s policy, the Homeowners 3 Special Form. This form provides the fullest coverage for property available today. It is an open perils policy, meaning that it covers all perils except for those specifically excluded.
BASIC STRUCTURE OF THE HOMEOWNERS 3 SPECIAL FORM
In structure, it is the same as all the homeowner's forms, possessing two distinct parts. The first part is the declarations page, which includes definitions. The second part is the policy forms.
The declarations page is what sets the boundaries of the policy in regards to who is covered, and during what time-frame. Section I of the policy covers three groups. Obviously, the named insured is covered. His or her spouse is also covered, but only if the spouse is currently living at the residence. (Residence is a significant factor in this form or coverage, and extends protection to relatives as well.) In addition, minors are covered when they are the insured's legal responsibility. The number and types of persons covered is stable throughout the life of the contract.
The life of the contract is determined by the named policy period. This is the time frame in which the policy is in force. It is typical for the policy to be written for a one-year period, although it is possible to write a three-year period.
When a loss occurs, and the insurance company deems that it is insurable under the terms of the policy, a deductible generally will be paid. The typical deductible is $250.00. This amount is changeable, however, and can be written for higher or lower amounts.
The declarations page also names the location of the covered property. Obviously, this named location is generally the insured's dwelling place. There are other possibilities, however, such as other structures used as a residence that are not actually the insured's house. The insured location is also called the described location. This suggests its broadness, and really describes the residence in whatever form it takes.
Finally, the perils and situations that are covered are named by stating the specific forms and endorsements used to provide coverage. This section will state the premium and the amounts of available insurance.
The policy form is issued by the insurer, and consists of two sections. The first section, Section I, describes property coverages. This section lists what property is covered, and for what perils. It lists the conditions under which the policy is honored, and details the responsibilities of the insured and the insurer.
The second section of the policy form, Section II, concerns liability coverage. Liability situations that are covered are named, as are those which are excluded. The conditions under which the policy is honored are again listed, as are the responsibilities of the insured and the insurer. The responsibilities of any injured person are listed. And, finally, any additional related expenses are clearly spelled-out.
THE FIVE BASIC COVERAGES-SECTION I
Following the declarations and definitions, the specific coverages are described. The Homeowners 3 Special form lists five basic coverages. The first four are named, specific coverages, and the fifth is a bundle of additional coverages.
The first basic coverage is termed "Coverage A", and handles the insurance for the actual dwelling. It is also covers structures that are attached to the dwelling, the most common being the garage. This coverage also extends to any material on the residence premises that is ultimately intended to become a part of the dwelling or its attached structures. The minimum amount of this coverage varies by company.
"Coverage B" is the second of the five basic coverages. This coverage concerns structures other that the dwelling and its attached structures. This means that any building that is on the residence premises gains coverage as long as a clear space separates it from the dwelling (although a fence is not considered an attachment). The amount of coverage for these additional structures is determined by a simple formula. The insurer takes 10 percent of the insurance amount for the dwelling and applies that to any loss to additional structures on the residence premises.
The third area of coverage, personal property, is extremely broad, and includes numerous exclusions that will be discussed in detail later. It is important to note that "Coverage C" in Section I of the Homeowners 3 Special policy covers the insured's personal property anywhere in the world. The amount of insurance on personal property is equal to 50 percent of insurance on the dwelling. This full amount is available for personal property on the residence premise, and for property being moved into the residence premise. Thus, the property is insured during the process of moving.
Property that is borrowed, rented, or in the insured's care is also covered. This includes when the property is in the dwelling or with the insured anywhere in the world.
"Coverage C" will also specify an extensive list of property that is subject to special limits of liability. Most of these can be increased by an endorsement or scheduling, but whether higher limits are pursued or not, it is vital that the insured by aware of those items which have specific limits. We will list some of the most common, and briefly discuss their implications.
Loss of use is the fourth area of coverage. "Coverage D" provides the insured with options should the insured's dwelling suffer a loss that makes living in it impossible. The options available are described as benefits, and are threefold.
First, the fair rental value of the residence premise can be paid to the insured. This is the equivalent of the rental value of the dwelling that has been made unlivable. This applies when the insured rents a portion of the dwelling to others.
The second benefit available is an additional living expense. This is simply the amount of money needed by the insured to maintain an expected and reasonable standard of living. Thus, the cost of finding a temporary apartment and the rent for that apartment would be covered as an additional living expense.
The insured has the choice of benefits after a loss has made the dwelling unlivable. The payment is made for the shortest time to repair or replace the damage, or to relocate.
A third benefit is available under "Coverage D" when a government official prohibits the insured from occupying his or her dwelling. (This occurs most typically because of gas leakage.) Should the government order an insured to temporarily move, then the insurance company will pay additional living expenses or fair rental value, but only for two weeks.
The Additional Coverages section supplements Coverages "A" through "D". This section names ten additional coverages that the insurance company is obligated to meet.
Ten Additional Coverages
REVIEW QUESTIONS
1. Coverage A only covers the basic structure where people actually live in the home. Materials and supplies located on or next to the residence premises used to construct, alter, or repair the dwelling are never covered.
a. true
b. false
2. Coverage B covers the attached structures to the principal residence. The level of coverage is 25% that of the residence premise.
a. true
b. false
3. Coverage C covers the insured's personal property anywhere in the continental United States, but not in other countries such as Canada and Mexico.
a. true
b. false
4. Coverage C can only cover personal property; rental property is never afforded coverage.
a. true
b. false
5. Coverage C provides $1000 for loss of jewelry, watches, and precious stones. The loss must occur through a forced-entry theft, and the insured must file a police report during the claims process.
a. true
b. false
6. The section of coverages that supplements Coverages A-D is called:
a. supplemental coverage.
b. umbrella coverage.
c. additional coverages.
d. All of the above
7. Trees and plants are covered up to $5000 per plant.
a. true
b. false
8. Stolen credit cards are covered up to $500, and this coverage comes without a deductible.
a. true
b. false
9. Coverage D will provide an additional living expense benefit if a loss has made the dwelling unlivable.
a. true
b. false
10. Should a civil authority force an insured to move temporarily because of a perceived hazard, the policy will pay living expenses up to one month.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. false
2. false
3. false
4. false
5. true
6. additional coverages
7. false
8. true
9. true
10. false
The Homeowners 3 Policy form insures against all losses except those that are specifically excluded in the policy. In one sense, it is easier to see what the policy excludes from coverage than what it specifically covers.
Despite the open perils nature of the policy, there are specific named perils that the policy explicitly protects against. These are perils concerning personal property.
The homeowner's policy covers property damaged by fire. This includes damage not only caused directly by the fire's flame, but by the heat generated, the smoke caused, and all efforts made to stop the blaze.
Lightning is also covered under the homeowner's policy, as is wind and hail. Even the insides of a building can receive coverage if reasonable steps were taken to avoid damage (like closing and bolting windows) and the storm caused the opening to the inside of the building.
Property damage caused by explosions is covered in very broad terms. Most explosions, whether from gas lines or faulty furnaces, are usually covered.
Riots are insured against as well, but the definition of a riot is fluid, and dependent upon the state in which coverage is sought.
Vandalism is another area that is covered, along with theft. Both theft and vandalism are increasing problems in today's world, and insurance is one of the most common methods of handling this risk.
Physical damage caused by aircraft is covered. The definition of aircraft is quite broad, extending from private airplanes to commercial jets to missiles and spacecraft. Thus, in the unlikely event that another space shuttle accident should occur and damage an insured's property, the loss would be covered.
Damage to personal property by a motor vehicle is covered. This damage could happen to one's house, for example, if a vehicle actually struck the building. But the coverage also applies to one's personal property inside of an automobile. Hence, if one's skis were destroyed in an auto-accident, the homeowner's policy, not the PAP, would cover the loss.
Falling objects that damage personal property are also insured against. This damage can be to the outside of a building, for example, when a tree falls and damages a section of the roof and awnings. The damage can also be to the inside of the building, such as when the impact of the falling tree on the roof causes a hanging lamp to come crashing down. The key for damage to the inside of the building is that this damage must somehow be related to damage initiated by a falling object outside the house.
Property damage that results from the accidental discharge or overflow of water is covered by the policy, but the cost of repairing the system or device from which the water emerged is not covered. Water damage here can be from water in the form of liquid or steam.
Water damage is also covered against when water takes the form of snow, ice and sleet. The damage protected against here is usually caused by excessive weight. Any collapse or changing of a structure caused by ice, snow, or sleet receives protection under this coverage.
When steam or hot water cause bulging, tearing apart, or cracking, the property damage is covered. This kind of damage usually comes from water heaters, fire sprinklers, or air conditioners.
Freezing is covered when proper steps have been taken to prevent damage. Thus, if pipes freeze and cause damage to the building's plumbing system, the loss is covered provided the water was not shut off, and the building's heat was set on some minimum level.
Accidental damage that occurs from artificially generated electrical currents are covered. This generally occurs through power surges and shorts.
Finally, losses that are caused by volcanic eruptions, however unlikely this might seem in comparison to our other named perils, are covered. This damage could occur through the actual explosion, lava flow, or ash.
REVIEW QUESTIONS
1. The Homeowners 3 Special policy insures against all losses except those that are specifically listed in the exclusions portion of the policy.
a. true
b. false
2. Usually, for the Homeowners 3 Special policy to cover a loss caused by a fire, two conditions must be present: the fire must be hostile and there must be evidence of combustion or rapid oxidation.
a. true
b. false
3. Damage that occurs to the interior of an insured’s dwelling during a storm is not covered by the Homeowners 3 Special policy; only damage that occurs to the exterior receives covers.
a. true
b. false
4. While property damage resulting from a riot is covered under the Homeowners 3 Special policy, it is important to note that the definition of a riot is flexible, and depends on the state in which the coverage is pursued.
a. true
b. false
5. Vandalism is not covered under the homeowner’s form, unless it occurs in conjunction with a theft.
a. true
b. false
6. If a tree were to fall and strike a covered dwelling, thus causing damage to the roof and glass breakage to mirrors in the home’s interior, only the property damage occurring outside would be covered.
a. true
b. false
7. Water damage is covered, but only in the form of a fluid. Thus, damage due to sudden overflow or discharge is covered, but damage from steam is not.
a. true
b. false
8. Freezing that causes damage is covered by the policy provided that the proper and reasonable steps to avoid this damage have been taken.
a. true
b. false
9. Losses caused by volcanic eruptions are not covered, but can be covered through an endorsement.
a. true
b. false
10. Damage that occurs through electrical shorts or power surges is covered.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. false
4. true
5. false
6. false
7. false
8. true
9. false
10. true
The part of the policy that lists the general rules and regulations for the insurance coverage described throughout is called the conditions section. There are conditions in the homeowners policy forms that apply solely to Section I and Section II, and there are conditions that are applicable to both sections.
CONDITIONS APPLICABLE TO SECTION I AND II
• Policy period
Losses are only covered when they occur during the active policy period. The beginning and ending of the policy period is explicitly stated in the policy's declarations. It is put in terms of standard time for the insured location.
• Fraud
The insurer will not make payments on claims that are shown to be fraudulent. Any concealment of material facts, any intentional misrepresentation, or any false statement made by the insured in connection with making a claim gives the insurer license to challenge payment or services.
• Waiver of Change of Provisions
Changes or waivers of any item or provision in the policy must be done in writing. The written request for change or waiver must then be approved in writing by the insurer. Oral agreements that change or waive provisions on the homeowner’s policy are not held to be valid.
• Liberalization clause
The liberalization clause does just what its name implies: it "liberalizes" coverage by broadening it. This is accomplished when a revised policy has been accepted by an insurer without an additional premium either within 60 days before the activation of a policy, or during the active policy period. This expanded coverage then applies automatically to the policy.
• Assignment
The homeowner’s policy is a personal contract, an agreement between the insured and the insurer. As such, the policy cannot be assigned to another party without the expressed, written consent of the insurer. On the other hand, the payment of a loss can be assigned to whomever the named insured desires, as this represents no change in the risk situation for the insurer.
• Death of the insured or the insured's spouse
An exception to the above condition is an assignment htat has been made due to the death of the insured and/or his or her spouse. In such a situation, coverage automatically continues, causing a de facto assignment. In cases where a person has taken temporary custody of the deceased insured's property while a legal representative is being appointed, the custodian is covered as an insured.
• Subrogation
You will remember that the principle of subrogation is brought to bear when the insured surrender's his or her rights to seek reimbursement for an injury from another party to the insurance company. The insurance company pays the loss and then seeks to recover the cost of its benefit payment from the injuring party. This principle is incorporated into all insurance policies, but the homeowner's policy presents an exception to this rule. The insured may waive rights of recovery against another if the waiver is made in writing before a loss occurs.
• Nonrenewal
A policy need not be renewed by the insurer, provided the insured is given written notice or nonrenewal. The notice period is 30 days before the expiration date.
• Cancellation
The homeowner's policy can be canceled. Should the insured wish to cancel, he or she need only notify the insurer or return the policy. The insurer must follow certain guidelines, however, in order to cancel a homeowner's policy. The possibilities are as follows:
CONDITIONS SPECIFIC TO SECTION I
• Insurable interest and limit of liability
This condition applies to situations where more than one person has an ownership interest in an insured dwelling. How does the insurance company determine the liability for any one loss? It is limited to whatever the insured's insurable interest in the property at the time of loss is, within the maximum amount of insurance stated in the policy.
• The insured’s duties after a loss
The insured is expected to perform certain duties in the event of a loss. Failure to perform these duties can lead to a claim being denied. The first two sets of duties are performed more or less at the time of loss; the second two sets of duties are carried-out after a loss while a claim is being processed.
• Loss settlement
Covered losses are settled on the basis of either the actual cash value or the replacement cost of the property. Generally speaking, personal property items are paid-out at the actual cash value of the item at the time of loss. The actual cash value is determined by subtracting the depreciated value from the replacement cost. This protects the principle of indemnification, for to replace the lost or damaged property at its current new market value would result in a net gain for the insured. (It is, however, possible to add an endorsement to cover personal property on the basis of replacement cost.)
More and more situations where property losses have occurred have had the losses considered under the broad evidence rule. A result of case and state law decisions, the broad evidence rule expands the possibility of true indemnification by compelling the insurer to consider everything relevant to the specific situation when determining actual cash value. The idea is that replacement cost and depreciation alone are insufficient for returning the insured to the same economic position that existed prior to a loss.
In most cases, covered losses to the insured's dwelling and other structures on the residence premises are paid on the basis of replacement cost. Moreover, replacement cost is paid with no deduction for depreciation.
Two possibilities occur with replacement cost insurance on a dwelling. The first is in effect when the amount of insurance is equal to 80 percent of the replacement cost of the structure at the time of loss. When this situation applies, the full cost of repair or replacement is paid with no deduction for depreciation, up to the limits stated in the policy.
If, on the other hand, the insurance carried is less than 80 percent of the replacement cost, then the insured receives either the actual cash value of the section of the building damaged, or a payment based upon this formula:
insurance carried ÷ insurance required x amount of loss
• Loss to a pair or set
When a pair or a set of personal property has been lost, the insurer can select to replace a part of the pair or set, repair the damaged part of a pair or set, or pay the difference between the actual cash value of the property before and after the loss.
• Glass replacement
In most cases, an additional cost that is the result of a law or ordinance is not covered under the homeowner's policy. The exception to this rule concerns glass replacement. In this case, any damage to glass from an insured peril will be replaced with the safety glazing material if required to do so by law or ordinance.
• Appraisal clause
Occasionally, the insured and the insurer will disagree on the amount of a loss. In order to reduce legal costs and delays, and to allow for a fair procedure for resolving disagreement regarding the amount of a loss, the homeowner's policy contains an appraisal clause.
When a loss is disputed, either party can demand to resolve the dispute by appraisal. Each party selects an appraiser, and the two appraisers select an umpire. If they cannot agree on an umpire within 15 days, a judge will name one. The decision, made in writing by two of the three is binding on the amount of the loss to be paid.
• Other insurance
If an insured has insurance in addition to their homeowner's policy that covers the same property, then only a proportion of the loss will be paid by the homeowner's policy, with the other insurer paying the remaining amount. This is a payment on the basis of pro rata liability.
• Legal action against the insurer
Until all policy provisions have been complied with, an insured cannot bring suit against the insuring company. Furthermore, legal action must be started within one year after a loss occurs.
• Option to repair or replace
The insurer has the option of repairing or replacing any part of the damaged property with like property. Written notice must be given to the insured by the company if this option is exercised. Also, while exercising the replacement option allows the insurer to meet its contractual obligation to pay a covered loss, this loss settlement cost may be lowered.
• Loss payment
This condition simply states that it is the insured that receives loss payment unless another person has been named in the policy.
• Abandonment of property
This provision frees the insurer from having to accept an insured's abandoned property after the occurrence of a loss. The insurer may take the damaged property and repair it, or it may pay the actual cash value of the damaged property and take the property itself as salvage.
• Mortgage clause
The mortgage company has an insurable interest in the insured property. The mortgagee protects its insurable interest through the mortgage clause in the homeowner's policy. Put simply, the mortgage clause can name the mortgagee as entitled to receive loss payments from the insurer to the level of its interest in the property regardless of any policy violation by the insured.
The obligations of the mortgagee under this arrangement are fourfold. The insurer must be immediately notified of any change in ownership, or any change in risk regarding the insured property. Secondly, the mortgagee is required to pay the premium if the insured fails to do so. Next, the mortgagee must submit proof of loss when the insured fails to do so. Finally, the mortgagee must give subrogation rights to the insurer.
REVIEW QUESTIONS
1. While the homeowners policy is a personal contract, and cannot be assigned, the payment of a loss can be assigned to whomever the insured desires.
a. true
b. false
2. Oral agreements that change or waive provisions on the homeowners policy are to be just as valid as written changes.
a. true
b. false
3. A policy does not have to be renewed by the insurer, as long as the insured is given written notice of nonrenewal thirty days before the expiration date.
a. true
b. false
4. An exception to the rule of nonassignment of the homeowner's policy occurs when an insured's spouse dies. In this case, coverage automatically continues, and creates a de facto assignment.
a. true
b. false
5. The insurer, like the insured, can cancel the policy any time at will.
a. true
b. false
6. The insured is expected to do the following when reporting a loss:
a. notify the insurer as soon as possible.
b. notify the police if a theft occurred.
c. notify the credit card company if a credit card is stolen.
d. all of the above.
7. In most situations, the insured can expect a covered loss to be paid on the basis of replacement cost.
a. true
b. false
8. Payment in terms of replacement cost for a loss is done without making a deduction for depreciation.
a. true
b. false
9. While in most cases, a loss resulting from a low or ordinance is not covered, an exception is made for glass replacement. In this instance, damage to glass from an insured peril will be replaced with safety glazing if the local law or ordinance demands this.
a. true
b. false
10. Until the full frame of policy provisions have been complied with, an insured cannot bring suit against the insurance company, not can legal action be started any earlier than one year after a loss has occurred.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. false
3. true
4. true
5. false
6. all of the above
7. true
8. true
9. true
10. false
Exclusions to the coverages in the homeowner's policy can be divided into several groups. The first set of exclusions is built into the named perils and specific coverages.
PROPERTY NOT COVERED UNDER COVERAGE C
EXCLUSIONS TO THE ADDITIONAL COVERAGES
EXCLUSIONS BUILT INTO THE NAMED PERILS
EXCLUSIONS FOR NON-FORTUITOUS EVENTS, PREVENTABLE LOSSES, AND EXTRAHAZARDOUS RISKS
The next set of exclusions is twofold. It includes exclusions shared by all of the homeowners forms, and exclusions specific to Homeowners 3 Special form.
EXCLUSIONS COMMON TO ALL FORMS
CONCURRENT CAUSATION EXCLUSIONS
Concurrent causation is a doctrine that states when a property loss can be shown to have been caused by two agents -- one that is covered and one that is not -- then the policy will provide coverage. The next three exclusions are particular to the Homeowners 3 Special form and are specifically designed to eliminate coverage for losses that previously would have received coverage under the doctrine of concurrent causation. The three exclusions possible here are as follows:
REVIEW QUESTIONS
1. Trees and shrubs damaged by wind are not covered by the policy.
a. true
b. false
2. Freezing that causes damage to specified outdoor property is always covered.
a. true
b. false
3. Theft is excluded coverage under the following circumstances:
a. theft by an insured is not covered.
b. theft at a dwelling under construction is not covered.
c. theft that occurs in part of a dwelling that is rented to someone not insured is not covered.
d. all of the above
4. The property of tenants NOT related to the insured is excluded unless specifically covered by the insured.
a. true
b. false
5. Separately described and specifically insured items cannot be covered, as this would provide duplicate coverage.
a. true
b. false
6. Normal wear and tear, such as marring, chipping and peeling does not receive coverage.
a. true
b. false
7. Losses incurred by a law or ordinance, such as specific named improvements to the structure of the building, are not covered by the policy.
a. true
b. false
8. Damaged caused by earth movement, ranging from earthquakes to mudslides, is not covered.
a. true
b. false
9. As war is considered a catastrophic event, damage caused by war is excluded coverage.
a. true
b. false
10. The unauthorized use of a credit card by resident of the named insured’s household is not covered.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. false
3. all of the above
4. true
5. true
6. true
7. true
8. true
9. true
10. true
NOTES
Section II of the homeowner's policy, a brief review of law is necessary. General law is divided into two categories: criminal law and civil law.
Criminal law involves a legal wrong committed against an individual or society. It can involve the various levels of government, from the local all the way up to the federal. Criminal law handles wrongdoings that are punishable by fines, imprisonment, or execution.
Civil law, on the other hand, concerns legal wrong doings that are not typically violations of criminal laws. In addition, civil wrongs are generally settled by an award of money damages. Breach of contract and torts are the two classes of legal wrongs that are covered by civil law. Torts are the most common form of legal wrongdoing in the insurance field. There are four areas of torts: negligence, intentional interference, absolute liability, and strict liability.
NEGLIGENCE
Negligence is also referred to as unintentional tort. It is defined as the failure to use the care necessary and required by law to protect others from harm. In this situation, a hypothetical "reasonable" person is conjured up who provides the standard of prudent, responsible action by which others are measured.
This hypothetical, reasonable person is not the product of any one mind. Rather, it is a personified standard that has been slowly constructed out of the subjects involved in the particular suit, the degree and seriousness of the injury, the skill and imagination of the litigants, and, most important of all, legal precedent, which is an amalgamation of interpretations and decisions.
For a negligent act to have occurred, four elements must be present and apparent. No damages can be collected until a court is convinced that all four elements are involved. Foremost, a legal responsibility to protect others from injury or harm must exist. Also, it must be shown that one has failed to carry out this responsibility. This failure could be active (or "positive"), meaning one has done something that our hypothetical reasonable person would avoid. Or, the failure could be passive (or "negative"), meaning no reasonable action was taken.
Third, someone must have suffered damages, injuries, or both for an act to be negligent. These damages are determined along varying levels of severity, and carry varying dollar amounts.
Finally, a causal relationship must be present for an act to be negligent. This is specifically called a proximate cause, and means that the connecting sequence of events that begins with the alleged negligent act and the occurrence of damages must be clear and unbroken.
When people incur legal liability through being deemed negligent by court decision, they must pay a named amount to the wronged party. These costs can be devastating, and most people seek protection from them through insurance. Sometime this insurance is found in a separate, self-standing policy. For the homeowner, it can function through Section II of the homeowners policy.
Section II provides liability coverage for protection against lawsuits that concern the bodily injury or property damage of another. This coverage pays the cost of defending the insured as well as any damages decided on upon the court, up to the party limit.
WHO IS COVERED?
Section II coverage of personal liability is extremely broad, and extends the range of benefits in a wide circle. Of course, the named insured and his or her spouse are covered. (It should be noted, however, that the spouse must be a resident of the household in order to enjoy coverage.)
Those family members who reside in the household are covered. This residence is a significant factor, for whereas a son or daughter of the insured is covered while away at college, the cousin who visits for the holidays is not.
Minors who are the legal responsibility of the named insured are also given coverage. Again, they must be residents of the household, not just guests or visitors.
THE TYPES OF COVERAGE
• PERSONAL LIABILITY
Coverage E in Section II of the homeowners policy is for protection against torts of negligence. In other words, if someone sues the insured for property damage or personal injury, this is the part of the homeowner's policy that "goes to bat" for the insured.
Coverage E also pays for the costs of defending the insured, and prejudgment interest. Prejudgment interest is a sum that the injured party requests on top of the actual judgment. The idea is that the process of coming to a legal decision takes time, and deprives the injured party use of the money that ultimately will come from the damage award. To make up for this loss of use, the injured party is awarded interest for that period when he or she could not use the claim money.
The minimum of liability is $100,000. This amount applies to legal costs, the damage claim for property damage and personal injury, and prejudgment interest. Naturally, with a higher premium, the minimum level can be increased.
A number of items are important to keep in mind when considering Coverage E. First of all, since this coverage is based upon legal liability and the law of negligence, the insured must be shown to be legally liable. This is not accident insurance, and the company will not pay for damages without the appropriate legal conditions of liability present and apparent.
Sometimes, the legal action brought against the insured is utterly groundless. One can rest assured that all claims will be vigorously investigated by the insurance company for fraud. Many such claims are defused early on.
Even when it is apparent that liability on the part of the insured does indeed exist, the claim need not go to court. The conditions of liability need to be present and apparent, but it does not always take a court to resolve the situation. As a matter of fact, it should be noted that a high percentage of personal liability suits are settled out of court.
The homeowners policy will provide the insured personal liability coverage anywhere in the world. This is an impressive range of protection, and extends an element of "home's security" wherever the insured goes.
Lastly, the insurance company will pay up to the liability limit for each separate occurrence. This is significant to note because of the definition of occurrence in this context. Simply put, an occurrence means that some damaging action has occurred. It might have occurred all at once, as when a satellite dish one has set up falls over into the neighbor’s yard and destroys a section of their fence. Or, more subtly, an occurrence can be a damaging action that has slowly built up over time. Think of a series of actions that are damaging, but damaging on such a small scale that they are initially not noticed. If the ultimate result of their repetition is a sizable accident, the policy will count this as an occurrence that is insured up to the liability minimum of the coverage.
• MEDICAL PAYMENTS TO OTHERS
Coverage F of the homeowners policy is different from Coverage E in a number of ways. It is not based on negligence and the tort liability system, and is effectively an accident policy. Certainly, a lawsuit might arise from an injury, but often suits have a time delay effect. In other words, an injury occurs, and the injured party only sues after "thinking about it." In such a situation, the policy would pay medical expenses for the injured party (up to the policy limit) under Coverage F immediately after the accident occurred. If the insured were subsequently sued, Coverage E would take over.
Coverage E is also different from the medical payments to others coverage in that payments are made on per person rather than per occurrence rates. In addition, the liability limit is significantly lower. The minimum liability level is $1000. This limit can naturally be increased with a higher premium, but generally $5000 is the maximum.
Coverage F is designed to pay the necessary and reasonable expenses of an injured party. The idea is that the expenses are paid directly after the injury, as the level of coverage is relatively low. Still, some injuries possess characteristics that require treatment over a period of time. Coverage F will pay its full liability limit up to three years after an accident.
The types of medical treatments available are quite broad. The possibilities include hospital services, surgery, X-rays, dental care, ambulance services, and prosthetics. Furthermore, the costs of funeral services are also covered up to the liability limit under the policy.
The individuals covered under this section of the policy are found in two groups. The first group consists of any persons injured while on the insured location with the insured's permission. This element of permission is significant, and disallows absurd situations as trespassers seeking coverage for injuries sustained while trying to rob an insured's home.
The second group that can potentially seek coverage is made up of persons who are injured off the insured location, but meet a number of conditions.
If another person is injured because of the actions of an insured, that person is covered. In this case, the insured carries his or her policy anywhere in the world.
Any animal owned by the insured also carries the policy with it off of the insured location. Thus, if an insured's dog wanders off the yard and bites a neighbor's child in the street, the child is covered.
And finally, any residence employee of the insured is protected by Coverage F of the homeowner's policy. This coverage applies to the residence employee whether the injury occurred on or off of the insured location.
• ADDITIONAL COVERAGES UNDER SECTION II
Section II of the homeowners policy also provides an Additional Coverages section. These benefits extend beyond Coverages E and F, and are common to all the homeowners policy forms.
The first of the Additional Coverages is the payment of claim expenses. This is the section of the policy that pays the expenses of the liability process. The most obvious of these expenses are found in court costs and attorney's fees. But there are other possible expenses that can be incurred, including premiums on appeal bonds when a decision is appealed to a higher court, the expenses the insured incurs at the insurer's request, and interest on a judgment that has been made, but has not begun payment. In addition to all of this, the company will compensate the insured for up to $50 per day for loss of earnings due to time off of work.
First aid expenses are also paid under the Additional Coverages section of the homeowners policy. First aid expenses are those immediate expenses incurred when helping someone that has been injured. The most common example of this is the cost of calling an ambulance.
There is an additional amount of insurance that can be applied to property damage of others that is caused by the insured. This is for situations where the law of negligence is not employed, and the intent is to avoid difficult and uncomfortable legal proceedings between friends and neighbors. The amount of coverage is no more than $500.
The fourth and final benefit found under the Additional Coverages section of the homeowners policy pertains to loss assessment.
• SECTION II EXCLUSIONS
The three various coverages in the Section II portion of the homeowners policy are not without exclusions. There are four sets of exclusions in the Section II portion, and they are divided as follows: personal liability exclusions; medical payments to others exclusions; personal liability and medical payments exclusions; and lastly, exclusions for the damage to property of others portion of the Additional Coverages.
• COVERAGE E EXCLUSIONS
Coverage E of Section II excludes coverage to the property damage of the insured's own personal property. The broad definition of the insured also catches the insured's spouse, children, and resident, dependent minors in its net. While at first this exclusion seems confusing, one need only bear in mind the principle that underlies it. The insured cannot be liable to itself. Property that the insured has temporarily "owned" through renting, borrowing, or occupying is also excluded from coverage.
If an insured receives a bodily injury, he or she is not covered. In other words, an insured that is negligently injured cannot collect damages under this coverage. The injured party would have to pursue action through the legal system in the form of a lawsuit.
In most cases, the policy will not cover the insured when liability arises out of the insured's own contractual liability. The only time when the liability under a contract or agreement is not excluded is when the contract relates in some direct way to the ownership or maintenance of an insured location. Another possibility where this exclusion will not apply is when the insured has willingly assumed the liability of others prior to an occurrence. An example of such an assumption of liability is providing coverage to renters under the written lease.
Another occasion for exclusion arises out of the insured's involvement in a legal association, such as an apartment cooperative or a lake owner's association. Any loss assessed and leined on the insured is not paid for under Coverage E of the policy.
Furthermore, as in the case of most forms of personal property insurance, the homeowner's policy can in no way pay out benefits when the injured person is eligible for workers compensation. It does not matter whether the workers compensation benefits are voluntary or mandatory; bodily injury liability is excluded whenever there is eligibility for benefits under workers compensation.
Also excluded are liability losses caused by nuclear energy accidents and radioactive contamination. Protection from liability that is caused by nuclear energy is best sought for under a nuclear energy liability policy. Such a policy is available through a nuclear energy pool, and offers broad coverage specifically for nuclear energy losses.
• COVERAGE F EXCLUSIONS
Two areas of exclusion are very similar to those discussed above for Coverage E. First, medical payments are not made whenever the injured person is eligible for benefits under workers compensation. It does not matter whether the workers compensation coverage is voluntary or mandatory.
Also, as in Coverage E, nuclear energy incidents that result in losses are excluded coverage. In this case, medical payments would not be paid for any bodily injury sustained from a nuclear accident or contamination.
Another exclusion for Coverage F occurs when a regular resident of the insured location is injured. In this case, unless that person is also employed by the insured, he or she will not receive medical payments.
Likewise, an employee of the insured who is injured off of the residence premises is not afforded coverage. Thus, the policy is not mobile for the insured's employees, and is bound to injuries occurring on the insured location.
EXCLUSIONS APPLICABLE FOR PERSONAL LIABILITY AND MEDICAL PAYMENTS
Foremost among the exclusions that are valid for both personal liability and medical payments to others is the intentional injury exclusion. Because intentional damage to property and intentional injuries are both actions contrary to the public interest, they are excluded coverage.
Business related losses are also not covered. This is applicable in situations where the home is also the office, or site of business activity. This exclusion extends from such "typical" home-business as daycare to the professional activities of lawyers and doctors.
Rentals are a form of business activity that are generally excluded, but may be covered under certain situations. They are generally excluded so as to prevent the large landlord from insuring at a rate identical to the individual homeowners. For the homeowner can rent a portion of the insured location and still retain coverage so long as the rental is to no more than two persons in a single family unit. Also, coverage is not excluded if the residence is only occasionally rented.
Liability occurring through an incident with a motor vehicle is generally excluded. The homeowner’s policy cannot overlap with the personal auto policy. The situations where motorized vehicles are not excluded are as follows: trailers not towed by a motor vehicle; off-road recreational vehicles owned by the insured and on the insured location; golf carts while in use on the golf course; motor vehicles not subject to registration that are used for the maintenance of the residence, or by the handicapped.
Watercraft are broadly excluded by the homeowners policy. This broad exclusion is followed by a series of exceptions, all of which are based upon factors having to do with the watercraft. For example, if the watercraft is a sailing vessel, it is covered when less than 26 feet in overall length and owned or rented by the insured.
When powered by a motor, horsepower becomes a crucial factor in determining whether or not the watercraft is excluded. Thus, watercraft with an inboard or inboard-out-drive engine of more than 50 horsepower are covered if not owned or rented by the insured. If the motor is an outboard and less than 25 horsepower, it can be covered even if it is owned or rented by the insured. On the other hand, if the watercraft is powered by more than one outboard motor of less than 25 horsepower, it generally cannot be covered if the insured owns or rents it. But if the insured purchased the watercraft before the policy period, or if a written intention to insure was made to the insurance company within 45 days from the point of purchasing the watercraft, it can be covered.
Any liability arising out of incidents with aircraft is also excluded. In this case, aircraft is the term that designates any vehicle that flies and is used for transportation.
Acts of war are not covered under the policy. Losses arising out of the (accidental or intentional) use of nuclear weapons are not covered.
The AIDS crisis has led to another exclusion; the liability originating from the transmission of disease is excluded for both personal liability and medical payments coverage. While AIDS is the most dramatic example, the exclusion applies to any transmittable disease.
• EXCLUSIONS UNDER THE ADDITIONAL COVERAGES
The section of Additional Coverages that requires a list of exclusions is the damage to property of others. The possibilities for exclusion here a fivefold:
Illegal activities, such as drug abuse, physical abuse, and sexual misconduct are also explicitly excluded under both personal liability and medical payments to others. Drug abuse in this context is a broad category, and refers to not only the use of illegal drugs, but to their manufacture, sales, and delivery as well. An illegal drug is any classified as such by the Food and Drug Law. (Obviously, the use of any drug prescribed by a licensed physician is not subject to this exclusion.)
REVIEW QUESTIONS
1. The minimum liability in Coverage E is $100,000, but this amount can be increased by paying a higher premium.
a. true
b. false
2. All family members who reside in the house are extended coverage under Section II of the Homeowners 3 Special Policy. This would include the minor at boarding school during the school year.
a. true
b. false
3. Coverage E is based upon the concept of legal liability. For it to pay a loss, the insured must be shown to have been negligent.
a. true
b. false
4. It is vital that a causal relationship exists in order for an act to be negligent. This is called a proximate cause, and means that an unbroken, connecting chain of events occurs that lead to damages.
a. true
b. false
5. The homeowners policy provides the insured personal liability insurance only in the United States.
a. true
b. false
6. Coverage F of the policy is for medical payments. Like coverage E, it will only provide coverage in cases of negligence.
a. true
b. false
7. Coverage F's minimum liability level is $100, but it can be increased all the way up to a maximum of $100,000 in almost all incidents.
a. true
b. false
8. Any animal owned by the insured "carries" Coverage F with it. Thus, if it bites the neighbor in the neighbor's own yard, the neighbor will be covered up to the limit of the policy.
a. true
b. false
9. Coverage F will pay up to its liability limit up to three years after the occurrence of an accident.
a. true
b. false
10. The payment of claim expenses, such as court costs, legal fees, and appeal bonds, are provided for under the Additional Coverages' portion of Section II.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. true
2. true
3. true
4. true
5. false
6. false
7. false
8. true
9. true
10. true
It is hardly a well-kept secret that we live in a litigious society. Each day, the newspapers are filled with stories about persons taking legal action, while the television blares-out the latest sensational lawsuit. Such catastrophic lawsuits have become a part of the cost of living.
The most obvious class of persons who are in danger of being slapped with a potentially ruinous suit would be the professionals. Doctors, surgeons, dental workers, attorneys, and a whole host of other workers who perform vital, specialized tasks are in constant danger of being sued. Yet, in today's world, they are hardly alone.
Another category of persons needing protection are not defined by occupation, but rather financial resources. Anyone with significant assets can find him or herself the target of an opportunistic lawsuit, often with ruinous results.
Our culture has become so prone to legal action, however, that it is now not only the wealthy that need to guard against being sued. Today, even "ordinary people" are finding themselves on the receiving end of lawsuits that exceed the liability limits of their basic insurance. The outcome is often financial difficulty, up to and including catastrophe.
One popular strategy to meet this challenge is to make use of the personal umbrella policy. A non-standard contract, the umbrella policy is a broad-based coverage that handles liability exposures connected with the home and automobile, as well as recreational vehicles and sports activities.
The personal umbrella policy is, in a nutshell, "extra" insurance; it is insurance that extends over and beyond what one's basic, underlying insurance contracts cover. Generally, it is written for $1 million to $10 million dollars. One of the elements that has made the umbrella policy popular is that it is not perceived to be overly expensive for the amount of protection it affords. Often, a premium of $250 can buy a $1 million policy that significantly expands one's coverage.
The most striking aspect of the umbrella policy is its underlying coverage requirements, and its self-insured retention component. The underlying coverage amounts vary from company to company. What is important to emphasize here is that an umbrella policy cannot be purchased instead of a homeowner’s policy or a personal auto policy. The umbrella policy will "kick in" and pay only after the base amount of the underlying contracts have paid-out to their full limits. If for some reason the underlying amounts are not maintained, the umbrella policy will not make-up the difference. Instead, what occurs is the umbrella policy acts as though the underlying amounts had been maintained, and only pays out the amount it would have been expected had the underlying amounts remained active and current.
When a loss occurs that is not covered by the underlying insurance, but is included in the umbrella policy, then the insured must pay a self-insured retention fee. This is roughly analogous to a deductible. Such losses generally occur from libel and slander cases, but many more possibilities exist, such as humiliation, defamation of character, false arrest and imprisonment, and invasion of privacy.
The coverage afforded through the umbrella policy is extremely broad. It includes property damage, personal injury, and liability property damage. The definition of personal injury is generously inclusive, and embraces bodily injury, disability, shock, mental anguish, and disease.
Still, the umbrella policy, like all insuring agreements, comes with exclusions. These can be far-reaching, and this course will cover just a few of the most common.
REVIEW QUESTIONS
1. The personal umbrella policy is a self-standing policy that effectively replaces other insurance with a comprehensive coverage.
a. true
b. false
2. Since we do not live in a legalistic society that provides many opportunities for exposure to lawsuits, the umbrella policy has become fairly superfluous.
a. true
b. false
3. One of the attractive features of the personal umbrella policy is that it can be had for a fairly low premium that greatly expands one's coverage.
a. true
b. false
4. If an insured has not kept the underlying insurance required by the umbrella insurer, then no amount of coverage is afforded at all.
a. true
b. false
5. Umbrella policies include slander and libel under their definition of personal injury, and extend coverage for losses resulting from such attacks.
a. true
b. false
6. When an insured incurs a loss covered by the umbrella policy, but excluded from the basic underlying insurance, he or she must pay a _____________________ fee.
7. The personal umbrella policy can supplement any payment for which the insured is legally liable for under workers compensation.
a. true
b. false
8. The personal umbrella policy coverage is extremely broad, and includes all forms of automobiles, recreation vehicles, and aircraft.
a. true
b. false
9. Generally, professional liability is excluded from the personal umbrella policy, but it may be purchased with an endorsement.
a. true
b. false
10. Most companies write personal umbrella policy coverages for $100,000 to $300,000.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. false
2. false
3. true
4. false
5. true
6. self-insurance retention
7. false
8. false
9. true
10. false
NOTES
Chapter Five
Fire Insurance
OVERVIEW AND BACKGROUND OF FIRE INSURANCE
Prior to analysis of the Standard Fire Policy, it is important to explore the beginnings of the fire insurance industry and the reasons underlying the standardization of the fire insurance form.
The fire insurance industry, like so many other branches of property insurance, grew out of immediate necessity. Businessmen and homeowners alike felt the need for protection of their properties from natural occurrences, like fire, that were largely beyond their control.
The first fire insurance policies were written by individual underwriters or small companies to insure those of whom they had personal knowledge. The policy was generally very short in form, consisting of a property description, an amount of insurance, the term of duration, and the premium. This early policy, as it was applied with varying terms, restrictions, and conditions created a great amount of litigation and very little satisfaction for both insurer and insured. The need for standardization quickly became apparent.
Another factor contributing to the need for standardization was the growth and expansion of the American economy in the nineteenth century. The rise of American business represented a greater financial stake in property and physical wealth. With more people having more goods to protect, the need for fire insurance increased drastically. Financially, the business of fire insurance grew beyond the means of individual and small insurers.
As corporations began to enter this arena, the need for standardization grew into a necessity. The result of increased underwriting over a larger area left many companies open to dishonest or ignorant agents, who contracted overinsurance or underinsurance. The resulting uncertainty led to large contracts filled with endless provisions and restrictions to protect the insurer. Some of these contracts were so large and detailed that it sometimes took multiple insurance professionals to decipher the actual coverage! This problem was multiplied by the tendency to use multiple terms.
These factors led to multiple legal actions that, more often than not, led to still more litigation. The logical answer to this problem was the creation of a standard form with standardized terms. The form would, in time, be tested by the courts to further define a standard terminology. The National Board of Underwriters is credited with the first attempt at adopting such a form in 1867. In 1880, the State of Massachusetts required the use of their standard form for all companies writing fire insurance in their state. By 1887, the legislature of New York adopted a standard form that soon became the model for many other states. The New York Standard Fire Policy of 1887 became the standard fire policy most of the United States. This contract has been modified many times since its inception, but continues to be the basis of today’s fire policies. The following sections of this chapter identify and explain the provisions of the New York Standard Fire Policy of 1943.
The New York Standard Policy is divided into two parts. The first is the agreement and the second consists of provisions and stipulations.
The agreement portion contains the actual agreement and can serve alone as a complete contract. The agreement contains the establishment of two principles of fire insurance. The fire insurance contract is personal, and it is a contract of indemnity. Because the agreement is a contract, it is necessary to establish the required provisions of a contract.
The policy limits rights of assignment, excludes consequential losses, and establishes the policy as an interest policy. The agreement also outlines the coverage, and states the available protection against direct loss by fire, lightning, and removal.
The second part of the Standard Policy explains stipulations and conditions. Specifically, this sections covers fraud, uninsurable property, perils not covered, and property not covered without special provision. Provisions are also make for the suspension or restriction of insurance, waiver of contract provision, policy cancellation, limiting other insurance, and addition of coverage for perils other than those outlined in the agreement.
Special provisions can also be added to contend with the interest and obligations of third parties such as mortgage holders. This section also contains the rights and obligations of all parties after a loss occurs, including the rights of the insurer to subrogation.
A key area of the Standard Fire Policy is the covered hazards. These are outlined in detail in the policy. The covered hazards are fire, lightning, and debris removal. The definitions of these hazards are not necessarily spelled out in the policy. “Fire” for the purpose of the Standard Fire Policy is an intense combustion that results in flame or a glow. Excessive heat, scorching, or blistering without a flame or a glow is not considered fire, nor is the damage resulting from this heat considered fire damage. Lightning is defined as the discharge of electrical energy from the atmosphere. Debris removal is defined as the removal of physical objects from the insured location.
An important stipulation of the Standard Fire Policy is that fire damage is only covered in the event of a hostile fire. A hostile fire is one that occurs outside of its normal environment. It is an unforeseen, fortuitous condition. A friendly fire, on the other hand, is a planned event that is confined to a specific area. For example, a fire in the fireplace, grill, or furnace are all varieties of friendly fire.
A fire becomes hostile at the moment that it escapes the intended confines. For example, flames escaping through a crack in a wood-burning furnace can cause a hostile fire. Damage from this fire would most likely be covered by the Standard Fire Policy. On the other hand, if the furnace grows excessively hot and singes a wall, the damage is not covered, because the friendly fire was still contained in its proper environment.
The Standard Fire Policy covers losses that are directly caused by one of the covered perils. The causal chain of events is therefore crucial for determining whether the policy will cover the loss. The fire must be the primary cause of damage, and the fire must be unfriendly.
An insurer may be liable for damage on an uninsured property if a hostile fire spreads from a location they have insured. In this case, damage that is direct or proximate may be the insurer’s responsibility. The following are two examples of such promixate damages.
1. A fire destroys the bottom level of a bi-level apartment complex. The damage to the beams supporting the top-level is sufficient to significantly weaken the building structure. The beams crumble, and the upper level crashes down upon the lower level two days after the initial fire.
2. A fire in an electrical plant causes the turbines to malfunction. During the malfunction, the turbines rotate too rapidly, and cause an overload. The overload subsequently destroys sensitive computer equipment in an adjacent building.
In the above examples, the fire was not the direct cause of damage to the upper level of the apartment complex or the computer equipment in the adjacent building. In both cases, however, the fire was the proximate cause of the damage, and may be covered by the Standard Fire Policy.
Elements of the Standard Fire Policy
• Right of Assignment
In many other types of insurance agreements, the insured is allowed to assign the interest to another party. This act is forbidden in the fire policy, and would invalidate the contract. The reason that assignment is not allowed is simple. The Standard Fire Policy is a personal contract, and assigning it to another would deny the insurer the opportunity to assess the new risk. Fire insurers must take significant measures to investigate the risks they will insure.
• Indemnity
A fire insurance policy is an indemnity contract. Following a loss, the insured will be indemnified by the insuring company, meaning that he will be restored to his financial standing prior to the loss. This compensation can take different forms.
One possibility is reimbursing the actual cash value of the loss. Actual cash value is usually interpreted as the cost to replace minus depreciation. Loss of merchandise for sale is replaced at market value plus cost of labor and administrative costs. The loss of physical property is more difficult to determine, and must go through an appraisal process.
The payment of cash value for a loss is only valid up to the limit of the policy. Under no circumstances is the insurer required to provide compensation beyond the limits spelled out in the contract.
The insuring company may also choose to repair or replace the damaged property. If the insuring company elects to repair damaged property, it must give notice of this intention to the insured within thirty days after receipt of the proof of loss.
• Pro Rata Liability
The insurer will limit its own losses when the insured has more than one policy. Each fire policy should possess a pro rata liability clause. This provision spreads the obligation to pay a claim to the various insurers covering the claim. The obligation to pay is spread in proportion to the insurance that each company has written. Therefore, if a property owner has four fire insurance policies from four different companies on one building, each policy is only liable to pay a maximum one quarter of the actual total damage to the property. This limit would hold true even if only one of the four companies financially capable of paying.
• Uninsurable Property, Perils Not Covered, and the Insured’s Obligations After a Loss
There are several hazards that are considered uninsurable and excluded coverage under the Standard Fire Policy. For example, the policy excludes losses caused by military attack. The policy also excludes loss by any nuclear hazards. Losses caused by the enforcement activities of a civil authority typically are not covered.
Two exclusions under the Standard Fire Policy deserve particular attention—losses due to neglect, and losses due to intentional damage. To receive protection under the Standard Fire Policy, the insured must protect the property by using all reasonable means during and after the time of loss. Failure to meet this obligation excludes the insured from indemnification.
The Standard Fire Policy also treats certain property as uninsurable. For example, personal records, currency, bank notes, deeds, evidence of debt, passports, securities and precious metals are not covered. Most policies also exclude motor vehicles and aircraft unless the vehicle is used to service the property or aid the handicapped.
The Standard Fire Policy also excludes loss of credit cards and data. The exclusion for loss of data holds regardless of the type of storage used by the insured. This exclusion pertains to account books, drawings, blueprints, computer disks, CDs, reel to reel and audio-cassettes, and other data processing material.
In order for a claim to be paid, the several conditions must be satisfied. First, the loss must occur during the policy period specified in the contract. Second, it is understood that the contract is void in the event of concealment or fraud. Thus, the policy is void if the insured made false statements regarding the policy, withheld or concealed important information, or intentionally engaged behavior with the intent to defraud the insurer.
Duties of the insured after a loss also must be met for a claim to be paid. The insured is required to contact the insuring company immediately after a loss occurs. The insured is also instructed to protect the property from further damage, to make reasonable repairs for the purpose of protecting the property from further damage, and to keep accurate records of all expenses related to this repair.
The insured is also required to prepare an accurate inventory of all personal property, whether it is undamaged, damaged, or destroyed. The inventory should show in detail the quantities, costs, and amount of loss claimed. The insured must also furnish proof of loss upon demand and submit to examination under legal oath.
Within sixty days of a loss the insured is required to submit legal documentation detailing the time and cause of loss, the interest of the insured and other parties in relation to the loss, the actual cash value of the loss, the amount of loss, other insurance covering the loss, any changes in the title of the property, specifications of the damaged building including repair estimates, the purpose of occupation, and whether the building stood on leased property.
Upon completion of the above requirements the subject of loss settlement may be approached. As a principle, the covered property losses are settled at actual cash value but not for more than the cost to repair or replace the loss. The settlement cannot exceed the policy limit.
In the event that the valuation of the loss is challenged, either party may request that the property be appraised. In event of a dispute, both parties must hire a competent appraiser within 20 days. Both sides appoint separate appraisers and one impartial umpire. If an umpire cannot be agreed upon within 15 days an umpire may be appointed by a judge of the court of record. The disputing parties pay for their appraisers individually and the judge jointly.
During the appraisal process, each appraiser submits an amount for the loss. If the appraisers reach an agreement on the amount, then the matter is settled. If the appraisers disagree on the amount, the differing figures are submitted to the umpire.
• Cancellation
The cancellation clause details the rights of parties to cancel the contract. At the insured’s request, a policy can be cancelled at any time. This can be done by returning the policy or providing written notification with the date of cancellation. When the policy is cancelled at the insured’s request the company can bill on a short rate basis. This allows the company to keep a greater than proportionate share of the premium as a penalty.
In the event the insuring company wishes to cancel the policy, the premium is returned on a pro rata basis. The insurer keeps a share of the premium proportionate with the expired period of the policy.
The insurer’s power to cancel fire policies is limited. The insurer may also cancel the policy for any reason, but the cancellation must be done within sixty days of the inception of the policy. This right of cancellation does not apply to a policy renewal. However, the insurer does have the option of not renewing an existing policy. An instance of non-renewal must be accompanied by timely written notice.
After the sixty-day trial period, the insurer can only cancel the policy if there is a material misrepresentation of fact that would have caused the insurer to not issue the policy. In this case, the insurer would only need to notify the policy holder thirty days prior to the cancellation.
Obviously, the insurer can cancel a policy if the premiums are not paid. However, even in this event the insurer is required to notify the insured at least ten days prior to cancellation.
• Endorsements to the Standard Fire Policy
The 165-line Standard Fire Policy is not complete for most insurance situations. For these reasons, it is typical to add multiple forms and endorsements. These additional endorsements cover additional risks and “round out” the policy.
There are three accepted methods of describing property for the purposes of the form. These methods are called specific, blanket, or reporting. Based upon the method, the form falls into one of five categories. These categories are called specific, blanket, floater, automatic, and schedule.
The specific coverage form insures one type of property in a single location for a defined amount of coverage. Blanket coverage, on the other hand, insures the same type of property at different locations. Blanket coverage can also insure different properties at one location. An example of this option would be a policy holder insuring multiple types of property within a warehouse or a particular type of merchandise within multiple warehouses. Obviously, this allows greater latitude for insurance coverage for merchandisers and wholesalers.
A floater policy covers property so long as it is located within a general geographic area. This type of policy protects the property as it moves or “floats” form location to location within prescribed limits. An example of this situation is an art exhibit traveling from museum to museum. In this example, the art exhibit may be protected under this type of coverage no matter the location of the loss as long as it is within the limits of the policy.
Automatic coverage is used when the value of insured property fluctuates. This type of form automatically adjusts the amount of coverage to the limit of inventory that is reported at specified, regular intervals. This coverage is used for an accurate accounting of the value of the protected property, and helps avoid over and underinsurance.
The schedule form provides blanket coverage for a specific amount to a large number of properties. This form allows organizations with multiple land holding to have specific amounts of insurance on each property, but within a single form. This limits the amount of work an organization must undertake in order to protect its holdings.
• Provisions commonly found in the various forms
The debris removal clause typically extends coverage to the costs of removing covered property when a named peril has caused a loss. The expense of removal is under the policy liability limit that applies to property loss. This means that while coverage is extended to debris removal, it cannot increase the amount of insurance.
The coinsurance clause allows the insured to risk partial damage for a lower premium. Under the coinsurance clause the insured agrees to carry insurance of not less than a certain percentage of the actual cash value of the property. At the time of loss, a formula is used to find the actual liability of the insurance company. An example of the coinsurance clause in action can look like the following:
A book store carries a $50,000 fire policy. The actual cash value of the covered merchandise is $100,000. Because the insured agreed to an 80% coinsurance clause, the amount of required insurance is $80,000. To find the liability of the insurer, we divide the amount of insurance carried by the amount of insurance required (expressed as IC/IR). We multiply this figure by the amount of actual loss to find the total of actual liability (expressed as IC/IR ( AD= AL). In our example, the result of $50,000 divided by $80,000 multiplied by $100,000 gives us a total liability of $62,500.
The coinsurance clause encourages the insured to carry the proper amount of coverage and maintain accurate records. If the proper percentage of insurance is carried, the insured is entitled to full coverage (up to the policy limit) in the event of a loss. Many states limit or prohibit a coinsurance clause on certain dwellings or risks.
The liberalization clause allows for the application of state statute, regulation, or ruling that would modify or broaden a fire policy or endorsement. This allows the policy to remain valid without rewriting the policy.
The pro rata distribution clause is common to blanket policies. When one wishes to cover multiple buildings, this clause allows each building to be covered with a specific maximum coverage. At the same time, the company’s liability is limited to the percentage value of the building in the overall policy. For example, the actual cash value of four properties are as follows:
Building A = $5,000
Building B = $5,000
Building C = $10,000
Building D = $20,000
Suppose a blanket policy for $25,000 covers all four of these properties. Following the pro rata distribution clause, the actual liability for this situation would be the value of the damaged location divided by the overall value of all covered locations multiplied by the value of the policy. For example, if building B is destroyed the equation would be $5,000 (the value of building B) divided by $40,000 (the total value of all the buildings), multiplied by $25,000 (the value of the policy). Following the figures in this formula, the insurer’s liability is $3,125.
The above equation would only be applied if the insured accepted a coinsurance clause. If the policy covered 100% of the actual cash value, the insurer’s liability would be for the entire amount of the cash value up to the limit of the policy.
In many areas it is possible to insure property on a replacement basis. In order to cover property for the actual cost of replacement, it is necessary to base the value of the coverage on the replacement value rather than the actual cash value. Normally this type of form requires a coinsurance clause with a non-increase in rate. This type of coverage also requires the insured to replace the property within a defined time frame.
The building and contents form is a special form designed for commercial properties. The form begins with providing coverage for machines used in the service of the building. These include wiring, plumbing, ventilation systems, lighting, boilers, doors, windows, and other associated items. The form also extends coverage to all personal property inside the building, including property that is entrusted to the owner of the policy.
The building and contents form naturally excludes some property from coverage. The type of excluded property varies from state to state, and tends to rely on the presence of a coinsurance clause. If the insured agrees to a coinsurance clause, he me also opt for a foundation exclusion. This clause generally excludes loss of sub-basement or foundation damage. If there is not a coinsurance clause, the foundation is considered a part of the building structure.
The building and contents form also outlines a number of special obligations that must be met by the insured. One such obligation is the work and materials clause. This clause allows the insured to use the property in any manner that is usual to the regular business described in the policy. Without this clause the introduction of new materials may be considered an increase in risk and would invalidate the coverage. What is important here is how the use is classified—usual, or incidental to the regular business. The insured can cover a wide range of risks as long as it can be classified as “usual.”
A vacancy and unoccupancy clause is also found in the dwelling and contents form. Under the Standard Fire Policy, a contract is suspended if the property is unoccupied or vacant for a period of sixty days. The vacancy and unoccupancy clause allows the insurer to grant an exclusion to this rule, usually for a specific time period. Each state regulates this type of clause separately with regard to time limits.
Because the forms attached to the policy broaden the coverage of the insured, they also make demands on the insured. These demands may require the insured to monitor the property at all times and/or maintain and monitor the sprinkler and fire alarm system. Some states require yearly inventory reports and a fire safe area for keeping records. Fairly to comply with demands can void the policy agreement.
The dwelling and contents form applies specifically to the protection of a home or an apartment and the contents within. The trend in insurance has been to create special multiple-peril policies for homeowners. While we recognize this trend in the evolution of insurance, it is important to note the principles within this fire insurance form, as it serves as the foundation for modern policy developments.
The dwelling and contents form extends coverage to all contents of the household except for motor vehicles. As long as the items remain within the policy’s jurisdiction, the form offers coverage even in the process of moving. Once the move is complete, the insurance coverage at the previous residence ends and is automatically extended to the new location. In addition to covering the internal contents of the household, this forms also covers non-commercial plants, trees, and shrubs outside the building structure.
The dwelling and contents form can also allow the insured to collect rent insurance on untenantable property. The general rule is up to 10% of the amount of insurance can be applied per calendar year to lost rent. This clause only pays the indemnity on a monthly basis, not does not allow the insured a lump sum payment. Therefore, the insured can only collect 1/12th of 10% of the amount of insurance per month.
The need for different types of coverage to handle special risks has given rise to a number of extended coverage contracts. These contracts provide protection for perils unnamed and not excluded in the standard fire policy. Extended coverage contracts can cover a wide range of risks, and some of the most common are business interruption coverage, natural disaster coverage, vandalism and theft coverage, and water damage coverage.
One of the legal principles required for a valid fire insurance policy is the clear presence of an insurable interest. It is not hard to imagine multiple parties with an insurable interest on a single property. One of the most common examples of this would be the relationship of the mortgagee and mortgagor in the context of fire coverage.
Both the mortgagor, as property owner, and mortgagee, as trustee, have an individual, definable interest in the same property. Insurance companies and courts have come to recognize this relationship and address it with a standard mortgage clause that can be written into the basic fire form.
This clause allows the mortgagor to take out a policy for his own benefit and also protect the interest of the mortgagee. The key provision of this clause protects the interest of the mortgagee regardless of the conduct of the mortgagor, so long as the mortgagee is unaware of any actions that would invalidate the policy. In other words, the agency holding the mortgage is fully insured even if the primary holder of the policy acts in a way that would void the coverage. This clause also directs the insurer on the subject of payment to the mortgagee, premium liability, and subrogation.
When there is a mortgagee, payment for a loss can be problematic. Many companies make settlement by draft, allowing both parties to submit inventories of their interest in the property. When the actual cash value of the loss is determined, a joint draft is issued to the mortgagor and mortgagee. At this point, both sides attempt to reach agreement as to the application of the indemnity.
The options in this situation are numerous. The owner may take the indemnity in full and continue to pay under the terms of the original mortgage, or the mortgagee may apply the entire amount of the principle. Another option is the right of the insurer to pay the mortgage in full and become subrogated to collect the balance from the mortgagor.
The mortgagee clause also makes the mortgagee liable for the premium if the policy holder neglects to make payment. The rationale for this clause is to link financial responsibility for maintaining the policy to the party that receives the most benefit from the coverage. This clause also requires the insurer to notify the mortgagee ten days prior to a cancellation. This allows the mortgagee to protect his interest in event of cancellation.
Rate-making for fire insurance can be regulated by statute, state regulation, or case law. Many companies rely on the services of professional rate-making organizations to inspect, analyze, and set rates for a risk. Some states require the rates to be set by state agencies, and some states maintain a board for insurance rate-making.
Regardless of the organizational vehicle used to set rates, the same factors are employed to determine insurance rates. The basic tactic is to classify the risk by possible hazard(s). An example of this would be to classify the fire hazard of a brick building versus the hazard of a wooden building.
A second tactic differentiates the hazard of like risks. An example of this would be making the differentiation between a wooden building with a sprinkler system versus a like building without a sprinkler system.
Other issues that factor into the rate equation include the hazards of occupancy, the hazards of exposure, and the element of time. Of these, the time element is the most difficult to calculate. For example, suppose a rate is based upon results of one, two, or three years. Experience shows that fire loss varies greatly from year to year. A company may only pay out a small number of minor claims over a period of years, but in any twelve month period it could conceivably experience an avalanche of claims. It is important as a rate-maker to account for these occurrences in order to protect the insuring company’s assets. The integrity of the industry rests upon the ability of the company to pay the promised indemnity. A run of claims following a period of low premiums can strain an insurance company’s reserves.
FIRE INSURANCE
REVIEW QUESTIONS
1. The growth of industry and personal business ownership in America had little to do with the development of the fire insurance industry.
a. true
b. false
2. New York was the first state to begin standardizing the fire insurance form.
a. true
b. false
3. The Standard Fire Policy stipulates payment for a loss from both friendly and hostile fire.
a. true
b. false
4. The agreement portion of the Standard Fire Policy can stand as a complete contract.
a. true
b. false
5. A wide range of uninsurable hazards can be found in the Standard Fire Policy.
a. true
b. false
6. It is possible to base the fire policy on the replacement value of a property rather than on the actual cash value.
a. true
b. false
7. Fire damage caused by electrical wiring would most likely be covered in a Building and Contents Form.
a. true
b. false
8. The Building and Contents Form is typically used in Homeowner’s Insurance.
a. true
b. false
9. The Dwelling and Contents Form provides coverage on losses due to explosions.
a. true
b. false
10. Fire insurance rates are determined in part by both hazards covered and time.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. false
2. false
3. false
4. true
5. true
6. true
7. true
8. false
9. true
10. true
Chapter Six
Surety Bonds
SURETY BONDS
A significant sector of the insurance industry is bonding. Bonding for insurance purposes is a form of suretyship. They provide a method of reimbursement for financial losses.
Surety bonds are a type of insurance, but they are different than insurance contracts. First, an insurance contract typically has two parties. The surety bond, on the other hand, is an agreement with three parties: the surety, the obligee, and the principal. Secondly, the insurance contract is designed with the expectation of a loss. The bonding contract, on the other hand, expects to not see a loss, and goes so far as to reserve the legal right to collect from the principal. Also, in insurance agreements, the insuring party generally does not have the right to recover losses from the insured. In the bonding contract, however, the situation is quite different. Should the principal default and the surety pay the obligee, the surety can legally “go after” the principal. Surety bonds are sometimes called financial guaranty bonds.
A key element in which surety bonds and insurance contracts differs rests in the measure of control that the interested parties possess in relation to the risk involved. For insurance contracts, insured losses have to do with fortuitous events. The bonding agreement, on the other hand, protects against losses that the covered individual possesses a great deal of control over.
In most cases that a surety bond is employed, the party with the primary responsibility for completing a task (the principal), does what has been agreed to. When this occurs, the bond becomes void. Should the party with the secondary responsibility (the surety) have to step in, another phase of the bonding agreement is activated. The surety, through its right of exoneration, will pursue the principal for reimbursement of the expenses incurred while performing the contracted obligation.
Obviously, the bonding business is one that is based upon large sums of capital. Without significant financial backing, the guarantees made by the bond agreement would be meaningless. Due to the capital-intensive nature of bonding, the surety will often demand collateral from the principal before issuing the bond. The surety is essentially transferring its own outstanding credit to the principal for a premium payment.
Surety bonds come in a variety of forms, and provide protection for a number of economic activities. Some examples of possible bonds include public official bonds, litigation bonds, judicial bonds, fiduciary bonds, auctioneer bonds, and lost instrument bonds.
A more common example of surety bonding occurs when a municipal government issues bonds for persons engaged in activities that could threaten the common welfare. Bonds of this nature are called license bonds. Such instruments guarantee that the bonded individual will obey all the laws and regulations applicable to the activity. An example of license bond is found in bar and liquor licenses.
Another common form of bond is the contract bond, of which there are several varieties. The most common is the bid bond, through which the obligee is guaranteed that the party awarded the bid will sign a contract and provide a performance bond. The performance bond guarantees the conditions and time under which the project will be completed.
The bail bond is perhaps the most widely recognized form of bond. The bail bond is a variety of court bond, and guarantees the appearance of the bonded person in court at a specific time under threat of forfeiting the entire bond penalty.
Bail bonds can be issued by a fidelity and surety insurance company or obtained through a property bondsman who operates through his or her own assets. While property bondsmen must obtain prior approval of their financial condition and ethical character by the jurisdiction in which they operate, they do not represent a fidelity and surety insurer and do not have to be licensed by the Insurance Bureau. A bondsman who does represent a fidelity and insurance company, however, must be licensed for this qualification by the Insurance Bureau.
Bondsmen cannot delegate their signature authority, nor can they employ non-licensed persons to solicit bonds or take application. Bondsmen can, however, employ solicitors licensed by the Insurance Bureau. Licensed solicitors in the bond arena may perform all the actions of the licensed bondsman except binding the surety company.
SURETY BONDS
REVIEW QUESTIONS
1. A surety bond is the same instrument as an insurance contract. The only difference is an insurance contract is issued by an insurance agent and the surety bond is issued by a bondsman.
a. true
b. false
2. Persons issuing bail bonds NEVER have to be licensed by the Insurance Bureau.
a. true
b. false
3. Collateral is generally required by the surety before it issues a bond.
a. true
b. false
4. The three parties to a surety bond are: the principal, the surety, and the obligee.
a. true
b. false
5. A bondsman’s solicitor can perform ALL of the duties of the bondsman.
a. true
b. false
6. An example of a license bond is a liquor license, which allows an establishment to legally sell liquor within strict guidelines.
a. true
b. false
7. A performance bond does not have to be issued after a bid has been awarded.
a. true
b. false
8. Surety bonds are also referred to as financial guarantee bonds.
a. true
b. false
9. When the principal completes his or her contracted duty, the surety bond becomes void.
a. true
b. false
10. The party to whom compensation is owed in a surety arrangement is called the obligee.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. false
2. false
3. true
4. true
5. false
6. true
7. false
8. true
9. true
10. true
Contents – Principles of LH, Special
Chapter One
The Specter of Premature Death 239
Estate Planning 251
The Role of Life Insurance in the Financial
Planning Process 261
Chapter Two
Fundamental Elements of Life Insurance 267
The Concept of Cash Value 273
Cash Value Versus Term 280
Chapter Three
Term Insurance Fundamentals 285
Chapter Four
Whole Life Insurance Fundamentals 301
Traditional Whole Life Variations 307
Endowment Policies and MECs 315
Chapter Five
Universal Life 319
Adjustable Life 326
Current-Assumption Whole Life 329
Variable Life Insurance Products 332
Chapter Six
Basic Contract Elements for Life Insurance 347
Contract Provisions in Life Insurance 357
Other Features of the Life Contract 367
Loans and Options 373
The Cost of Living and Double
Indemnity Riders 382
[pic]
Chapter One
THE SPECTER OF PREMATURE DEATH
Two things in life, we are told, are certain and unavoidable: death and taxes. It is not surprising that people, being the stubborn creatures that they are, have developed a tool to help handle these unpleasant realities. That tool is life insurance.
Unfortunately life insurance, much like death and taxes, can be bewildering and difficult to explain. To begin with, it is a product that is euphemistically named. Certainly, "death insurance" is a more accurate term. What we would gain in precision, however, we would no doubt lose in the offense of our sensibilities.
A dictionary definition will describe life insurance as protection against the premature death of an individual.
"Protection" here refers not to stopping the death, but to a payment of a beneficiary. Again, the confusing nature of life insurance rears its ugly head: this is a product that one buys for the peace of mind it engenders while contemplating death. The inevitable has not been avoided, but one's loved dependents are at least provided for.
Another of life insurance's perplexing qualities arises out of how the government views the product. While the consumer, more often than not, sees this insurance purchase as a vehicle to save his or her dependents from financial need, Uncle Sam sees only death's ugly twin-- taxes.
Indeed, for the government, life insurance is defined through the manner in which it is taxed. This definition is found in the Internal Revenue Code Section 7702 of the Deficit Reduction Act of 1984, also known as DEFRA. It is important at this time to keep in mind that cash value insurance policies are best thought of as containing a dual nature regarding money. First, there is the money that belongs to the policy-owner _ the cash value. In addition to this, there is also money paid into the policy that goes to pay for the insurance costs. It is money from this account that is paid-out if the insured dies. This is the
insurance company's money.
Internal Revenue Code Section 7702 insists that life insurance contain a certain net amount of money at risk. Three tests exist to determine if the net amount at risk meets the government’s standards. (Should the government’s standards not be met, the insurance becomes endowment insurance, and loses its tax advantages.)
First, there is the so-called cash value accumulation test. This test states that the policy-owner's current cash value, or the "net cash surrender value," cannot be greater than the value of the net single premium that could Compound to the face amount of the policy at age 95 (with a net single premium discount factor of either 4% or the contract's minimum guaranteed rate).
A second test is the cash corridor test. The corridor test is simply relationship expressed as a percentage difference between the policy's cash value and the policy's face value. This ratio is found in the Internal Revenue Code Section 7702(d)(2).
Finally, there is the guideline premium test. This method can take the form of a guideline single premium or guideline level premium test. The guideline single premium test simply means that the policy-owner may not invest more into his or her policy than the current net value of the benefits to be paid out at age 95, less a discounted 6% rate that assumes the stated mortality charges and expenses of the contract. The guideline level premium, on the other hand, states the level annual amount necessary to fund future benefits to age 95, while assuming the contract's mortality and expense charges, plus 4% interest.
Even to the professional in the field, such aspects of life insurance as the government's income tax definitions can seem inarticulate, unwieldy, and simply unclear. To the consumer, such details about life insurance are more often than not cryptic, complicated, and simply confusing.
Nevertheless, the total amount of life insurance in force continues to grow. This should not be surprising, however, when we reflect upon the needs that life insurance seeks to address: premature death, payment of estate taxes, an income readjustment fund, emergency monies, college funding, and a mortgage fund, to name a few. Confusing or not, these concerns are real, apparent, and pressing to most people.
These needs can be broken into two categories, the first constant, and the second fluctuating. Constant needs include a death fund to handle premature death, emergency savings, and estate planning. Fluctuating needs are those that change as one ages, and include such financial planning issues as funding a college education, buying out a business partner, or handling a mortgage after the death of one's spouse.
While not all of these needs are created by death, death remains the dominant factor in the life insurance equation. While life expectancy has increased -- it is currently 73 for a male and 79 for a female in the United States, according to the U.S. Bureau of the Census -- no one seriously believes that they can avoid the inevitable. It is this inevitability that creates many (though not all) of the constant and fluctuating needs that life insurance is designed to meet.
Moreover, while actuaries can gain a surprisingly accurate picture of when one will die, death at an age earlier than expected is not so rare as to be overlooked. Indeed, premature death is a more likely event than most persons believe. Since the time of death is uncertain, it is a form of risk. It is the temporal uncertainty of this event that is covered by the life insurance's valued policy contract.
While we have named some of the concerns that life insurance attempts to address, the real-life consumer's needs are as unique as only individuals can be. One aspect of life insurance is, however, uniform: the underlying reason for its purchase, premature death, is a risk that touches everyone. Also, at least one cost of death is familiar to everyone: the loss of a loved one that can never be replaced. The emotional impact of death can be as heavy as the event is final.
In addition to the loss of another's love and companionship, there are also multiple, difficult hard realities that premature death can create. Foremost, of course, is the loss of financial support. Should the principal "breadwinner" die without a life insurance policy in place, it is quite possible that his or her dependents will face desperate financial straits.
It is vital to underscore his or her dependents here, as demographic and cultural changes in the United States have helped turn life insurance into more than a "man's product." Indeed, with the growth of female-headed households, life insurance is needed by a more diverse public than ever before.
In addition to the changes in heads of households, dependents are becoming more diverse as well. When the responsibility of an aged parent, for example, or the children of a divorced and remarried spouse are added to one's responsibilities, the need for coverage expands. The soaring divorce rates that this country has experienced in recent years, as well as our aging population, make both of these situations less than unusual, and can dramatically alter a family's financial planning.
Furthermore, premature death can have costs beyond emotional bereavement and financial ruin. For many two-income households, for example, the death of a spouse causes financial juggling and insecurity rather than complete destitution. Life insurance in this case plays the role of a readjustment fund.
The need for a readjustment is also not limited to a two-income household. Many "traditional" households that lose a spouse who is not the principal supporter of the family still face the loss of the skills and services which that person provided while living. A readjustment fund can play an invaluable in this situation as well.
Even the single person with no children often "needs" life insurance. This is because one may not carry any other insurance coverages that pay for funeral costs, which can run as high as $10,000. Furthermore, unforeseen and unpaid expenses can occur, such as bills relating to an extended final illness. In addition, unpaid bills may also be present at the time of death. Life insurance is also an acknowledgment and assumption of personal responsibility.
Lastly, life insurance is an acceptance of another unpleasant reality in addition to death and taxes: we generally do not save enough money. We generally think primarily about today, and depend upon our earning capacity to meet both our current and future obligations. Ultimately, though, that all-important earning power will end.
While pursuing a life insurance policy does not mean one no longer needs to save, it is an important tool with a vital roll. Along with savings, Social Security, and pension benefits, it helps provide peace of mind -- and financial security -- for the inevitability of tomorrow. Fortunately, unlike death and taxes, financial insecurity can be avoided through proper planning and the effective use of such instruments as life insurance.
• Why People Purchase Life Insurance
The primary purpose of life insurance is to provide a sum of money to a beneficiary at the death of an insured. The uses of this money, however, can be quite varied. Also, not all life insurance policies function equally well for all goals. The specific purpose of the policy will help determine the type of life insurance policy that one will purchase. The following is a list of the most common uses of life insurance for individuals.
1. Creation of an Estate
For the majority of persons purchasing life insurance, the life insurance policy is used to “create an estate.” The estate in this instance is the sum of money paid to the beneficiary at the death of the insured. Through life insurance, the insured determines the exact size of the estate by selecting the face amount of the policy.
2. Protection of an Estate
Some individuals already possess sizeable assets. These assets may be in a variety of forms, such as property, investments, collectibles, etc. Depending on the valuation of the estate, their heirs may face substantial costs at the time of death. Without proper planning, the estate’s heirs can be forced to sell assets in order to meet their tax obligations. Life insurance can be used to provide available cash to meet necessary estate costs.
3. Final Expense Fund
When a person dies, a number of expenses will invariably come due. These can include, but are not limited to, the following: state and federal death taxes, outstanding debts, funeral costs, unpaid hospital and medical bills, and potential host of legal fees (e.g. executor’s fees).
4. Mortgage or Rental Fund
In a household with only one wage-earner, the premature death of the wage-earner can force the sale of a home or a relocation from an apartment due to the loss of income. Even as the American economy has moved to a two-wage-earner model, the death of a spouse usually causes serious cash flow problems for the survivor. A life insurance policy can provide the liquidity necessary in order to give the survivor the flexibility to pay off the mortgage or continue mortgage or rent payments.
5. Monthly Income Supplementation
When a wage-earning spouse dies, his or her monthly income is subtracted from the family budget. However, the monthly income needs and expectations of the surviving family members remain. Generally, the most pressing need is maintaining an adequate income stream for housing (as discussed above). In addition to housing, the remaining income needs include all the items typical for a household budget: food and clothing, utilities, entertainment, etc.
The insurance industry classifies two specific “needs periods” that follow the death of a wage-earner: the dependency period and the blackout period.
The dependency period is that flexible time-frame when dependent children are still living at home. This time-frame is when a family’s income need is the usually the most significant.
The blackout period occurs when no Social Security benefits are available for the surviving spouse. If the family has no children, the blackout period begins immediately, and continues until age 60.[3]
6. Education Fund
Post-secondary education is important for enhancing economic opportunities. The costs of post-secondary education are significant, and their annual increases continue to outpace inflation. Life insurance can play an important role in guaranteeing the availability of education funds.
7. Emergency Fund
Because of its guaranteed nature, insurance is also valuable as an emergency fund for unforeseen expenses.
8. Retirement Income Supplement
Depending on the type of policy, life insurance can play a role in supplementing retirement income.
9. Business Uses
Life insurance is able to deliver a guaranteed amount at a specific time, and can enjoy a range of tax benefits. For these reasons, life insurance is often used for a variety of business purposes.
REVIEW QUESTIONS
1. Life insurance is needed by many people, in no small part because premature death is often more common than realized.
a. true
b. false
2. The life insurance product is very easily understood. One generally does not even need an agent to explain it.
a. true
b. false
3. A definition of life insurance for income tax purposes is found in the Internal Revenue Code Section 7702 of the Deficit Reduction Act of 1984.
a. true
b. false
4. In order to be classified as insurance and receive the tax benefits of the product, a certain net amount at risk must be present.
a. true
b. false
5. The cash value accumulation test for life insurance states that the policy-owner's current cash value cannot be greater than the value of the net single premium that would compound to the face value of the policy at age 95 (with a single premium discount factor of 4% or the contract's minimum rate).
a. true
b. false
6. The percentage ratio needed to determine the cash value corridor of a policy is found in the Internal Revenue Code Section 7702(d)(2).
a. true
b. false
7. Confusion over the product has resulted in a continual shrinkage of the total amount of life insurance in force over the years.
a. true
b. false
8. Life insurance can be used to meet both constant and fluctuating needs that are caused by premature death.
a. true
b. false
9. As opposed to a valued contract, life insurance is an indemnity contract.
a. true
b. false
10. As a result of the changing demographics and economy of the United States, life insurance has ceased to be an exclusively "male product.”
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. a
2. b
3. a
4. a
5. a
6. a
7. b
8. a
9. b
10. a
ESTATE PLANNING
• Determining How Much Life Insurance One Needs[4]
Life insurance needs fall into three broad categories: individual and family income needs, business needs and, estate preservation and liquidity needs. Especially in relation to estate planning, it is important that a sufficient sum is available, and that it is directed in the proper manner.
Today, a wide variety of resources are available to help one calculate the “correct” amount of life insurance, from computer software programs to Internet websites. However, relative ease of calculation is not sufficient for proper life insurance planning. One must also adopt an approach that supplies a rationale for the coverage proposed.
For example, a common “rule of thumb” for individual life insurance is the following: most people require at least 6 to 8 times their annual gross income for adequate coverage. Thus, a person earning $38,000 per year would require an approximate range of $225,000 to $300,000 of life insurance. Naturally, this model can break down fairly quickly. For example, what if the spouse also works, and makes $50,000? Is all of the income from the $38,000 per year earner vital to the family’s financial needs and objectives? Does the household carry significant debt? If so, what kind of debt (i.e., mortgage, student loan, consumer loan, etc.)? Obviously, this general rule of thumb is only a basic starting point for assessing life insurance needs.
Many life insurance companies employ one of two specific needs approaches for determining life insurance needs—the human life value approach and the human needs approach. Neither is demonstrably superior to the other, but the needs approach has gained ascendancy among the majority of today’s insurance practitioners.
Human Value Approach
The human value approach was developed by the late Dr. S.S. Huebner. This is an income replacement reproach. It offers a method for expressing the economic value a human life. The “economic value” that this approach uses is a dollar valuation.
In its most basic outline, the human life value approach makes use of several assumptions for its calculations: the current annual after-tax earnings, the number of working years prior to retirement, and a reasonable after-tax discount rate.
A weakness of the human life value approach is that it does not factor inflation and salary increases into its estimates. The human life value approach tends to produce a static analysis of insurance needs. As such, it can overstate or understate the amount of life insurance needed.
Needs Analysis Approach
The needs approach determines the appropriate level of life insurance coverage through analyzing specific needs. The second step in this approach is to measure the family’s ability to meet these needs in the event that a wage-earner should die.
Needs are categorized as immediate and multi-period. Immediate needs can include, but are not limited to, the following:
1. Final expenses
2. Estate settlement expenses
3. Tax liabilities
4. Debt liquidation
Multi-period needs include, but are not limited to, temporary adjustment income for the household, the children’s and spouse’s income needs, and the spouse’s retirement needs.
To meet the immediate and multi-period needs, this approach includes the family’s existing capital (i.e. savings, investments, pensions, etc.), Social Security, and the spouse’s income in its calculations. Usually, the total dollar amount for needs will exceed the total dollar amount available from existing capital. This difference will be addressed by the appropriate amount of insurance.
REVIEW QUESTIONS
1. The human value approach for determining life insurance needs is an income replacement strategy. This approach uses the estimated after-tax earnings plus the total number of years worked to find an appropriate amount of life insurance.
a) true
b) false
2. All of the following are usually classified as immediate needs under the needs analysis approach except:
a) final expenses
b) estate settlement expenses
c) spouse’s retirement needs
d) debt liquidation
ANSWERS TO THE REVIEW QUESTIONS
1. a
2. c
NOTES
• Life Insurance and Estate Planning
Estate planning is no more than a plan to accumulate and then distribute wealth to named heirs. At the death of the owner, a well-conceived estate plan will experience only the necessary minimum loss in taxes and expenses.
The legal nature of our society has turned estate planning into a science, and many professionals need to play a role in its development. In addition to a qualified life insurance agent, a lawyer, a banker, and an accountant may all serve in formulating an effective estate plan.
The life insurance product itself typically plays one of two parts in the estate "game." First of all, it can be used to create an estate. The money that the death benefit from a high value life insurance policy creates instantly upon the death of the insured would take many years of shrewd investing for the average consumer to amass. Moreover, the benefits from a life insurance policy are not subject to probate costs. You will remember of course that probate is nothing more than that legal process by which money and property is transferred to the deceased's heirs.
In cases where the proceeds of the policy's death benefit are not the sole estate, life insurance performs a different function. Here, the monies generated by life insurance serve the purpose of liquidity. Non-liquid assets are preserved that in other circumstances might have been sold for death taxes, funeral costs, and estate clearance costs.
When the named insured in the policy has any "incidents of ownership" at the time of death, the paid out death benefit can and will be taxed according to the federal estate tax. Furthermore, the monies paid out by the policy are attached to the insured's gross estate when their payment is directed to the estate.
"Incidents of ownership" are those powers that are typical to ownership of a policy. Such powers might include policy loans and partial surrenders, optional modes of settlement, and the right to change a beneficiary.
Should an absolute assignment be made, however, these incidents of ownership are waived, the death benefit's monies are potentially separated from the gross estate. We say potentially because the assignment must be made three years prior to the insured's death in order to avoid federal estate taxes.
At this point, the consumer will wonder what has happened to his or her tax benefits. We must emphasize that it is the federal income tax that is waived for the death benefit in a life insurance policy, not all taxes. The wishful thinking of consumers often lulls them into believing that every financial aspect of their life insurance contract is tax-sheltered.
Again, the lump sum payment of a life insurance death benefit is free of federal income tax. Alternative modes of settlement, however, may not escape federal income tax. For example, periodic distribution of an insurance policy's death benefit are subject to tax on the interest income (the principal remains tax free).
Lastly, life insurance is a way to provide an estate that is fair to all one's heirs. In cases where one's assets are tied up in property, a life insurance death benefit provides a method to keep ownership of property in the hands of one heir, with an equal value in cash proceeds from the policy going to other heirs.
REVIEW QUESTIONS
1. Estate planning is really no more than commonsense, and is a matter that one can easily take into their own hands without the counsel of professionals.
a. true
b. false
2. Life insurance proceeds avoid all taxes when disbursed to the beneficiary in a lump sum.
a. true
b. false
3. One benefit of life insurance is that it can help provide fair and equal transferring of an estate to one's heirs.
a. true
b. false
4. Life insurance is often used as a way of providing liquidity in estate planning, as it avoids probate and provides immediate cash.
a. true
b. false
5. Federal estate tax, death taxes, and funeral expenses are some of the expenses associated with estate planning.
a. true
b. false
6. Generally, when an insured has some form of incidents of ownership in a policy, he or she can expect that the death benefit will be attached to the gross estate.
a. true
b. false
7. One device to avoid attaching a life insurance's proceeds to the gross estate is to make an absolute assignment at least three years prior to an insured's death.
a. true
b. false
8. For the typical consumer, life insurance is often used to actually create an estate at death.
a. true
b. false
9. Incidents of ownership simply means that one has rights to make policy loans, partial surrenders, choose a beneficiary, and decide upon the mode of settlement.
a. true
b. false
10. Probate is nothing more than a legal process through which money and property is transferred to one's heirs.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. b
2. b
3. a
4. a
5. a
6. a
7. a
8. a
9. a
10. a
THE ROLE OF LIFE INSURANCE IN THE FINANCIAL PLANNING PROCESS
Obviously, a death fund which pays for final expenses is a part of one's financial planning. Providing for dependents is also within the domain of financial planning, whether in delivering a specific lump-sum that avoids federal income tax and "creates" an estate, or in efficiently disbursing an estate.
All of these elements of financial planning focus on life's end. As such, they are permanent needs. Life insurance can play an additional role in financial planning, however, and as such is indeed a tool for the living, and not just one's heirs.
Foremost, life insurance can form an effective savings vehicle that can either serve as an account geared to a specific goal, an emergency cash fund, or both. Life insurance is effective in such a capacity because of a unique tax advantage of this product. Like an IRA, or an annuity, its account can grow tax-deferred. Unlike the IRA or annuity, however, many cash value life insurance policies retain a level of penalty-free liquidity that make them the envy of these other investments. Even with the expense fees and loads of the insurance policy, the tax-deferred build-up of interest over time is a powerful tool for financial planning, and an effective method for many families searching for a tax-advantaged tool to meet changing goals.
In addition to providing an emergency savings account, life insurance can be used as a mortgage fund. In this capacity, life insurance is designed to protect a survivor from the burden of mortgage payments. This feature allows one to remain in a home that under other circumstances would have to be sold or rented out.
Life insurance can also be a means of saving for a college fund. The cash value universal variable insurance is perhaps the best vehicle for this task, as the flexibility of this product with its aggressive investment portfolio allows for an attractive build-up of tax-deferred, liquid funds.
Finally, life insurance can play a useful role for continuing business operations. For example, the policy can be used to hire a replacement for the owner in event of his or her death, it can repay business loan obligations, or buy-out a partner.
The Strengths of the Life Insurance Product
Life insurance is a form of valued property, and is in many ways unique. It offers numerous advantages over other types of property for meeting specific financial planning needs.
• Favorable Tax Treatment
Cash values in a whole life policy will grow tax-free. The proceeds from any life insurance policy, whether whole life or term, are exempt from federal income tax when paid in a lump sum.
• Guaranteed Values
The majority of life insurance policies will guarantee the face value of the death benefit. Depending on the type of policies, other guarantees may be available. These can include cash values, minimum interest rates, and premium rates. Guaranteed sums and expenses are very valuable for the financial planning process.
• Appreciation
The payment of a death claim represents a significant appreciation in value over the total of premiums paid into the policy.
• Direct Payment to Beneficiaries
The proceeds from a life policy are payable directly to the beneficiary. In most cases, an insurance company will issue payment for a death claim within 24 hours after the claim work has been completed.
• Flexible Income Options
Death benefits are available to the beneficiary in a variety of formats, called “settlement options.” Settlement options are the choices presented to a beneficiary for collecting the death benefit. These can include a lump sum payment, an interest option, a fixed amount option, a fixed period option, and a life income option.
With an interest option, the death benefit is left on deposit with the insurance company with earnings paid the beneficiary annually. A fixed amount option is a death benefit paid in a series of fixed installments until the proceeds are exhausted. A fixed period option occurs when the death benefit proceeds are left on deposit with the insurance company and paid out in equal payments for a specified period of time. A life income option is a life annuity; with this option, payments occur for the life of the insured.
If the insured possess a cash value life insurance policy, he or she will also have access to the policy’s cash value in the form of loans, surrender values, and, in some cases, partial surrenders.
• Protection from Creditors
A life insurance policy is valued property, however, unlike most forms of property, proceeds from a death benefit receive protection from creditors in the majority of instances.
REVIEW QUESTIONS
1. Clarence is single, but has a sizeable amount of debt. Some of these loans have been co-signed by his girlfriend. One definite use that Clarence could make of a life insurance policy is
a) an education fund
b) an estate conservation tool
c) a final expense fund
d) none of the above
2. Life insurance is often used to provide a monthly income stream to dependents when a wage-earning spouse dies. The insurance industry classifies two specific “needs periods” following the death of a household wage-earned. These two periods are:
a) the dependency period
b) the secondary period
c) the blackout period
d) the Social Security
e) a & e
f) a & c
3. The proceeds from a life insurance policy, when paid in a lump sum, are exempt from federal income taxes.
a) true
b) false
4. In most cases, the death benefit proceeds from a life insurance policy cannot be attached by creditors.
a) true
b) false
ANSWERS TO THE REVIEW QUESTIONS
1. c
2. f
3. a
4. a
Chapter Two
Traditional Life Insurance
FUNDAMENTAL ELEMENTS OF LIFE INSURANCE
All life insurance agreements have fundamental elements that make the policy workable. Simply put, in order to provide their service, which is essentially a disbursement of monies, they must first somehow accumulate money. The most obvious payment of money to the consumer by the insurance company comes through the death benefit, or face value of the policy. However, money can flow from the insurance company to the consumer in other ways. Two examples of payment to the insured are survivorship benefits, and the treatment of cash values.
The survivorship benefit is a feature of cash value insurance policies that allows insureds who do not die or surrender their policy to receive the face value of the policy. The accumulated cash value is not paid out to the insured, but remains with the company.
Another possibility of cash flow from the insurance company to the insured occurs in the case of dividends. In a participating policy, the insurance company will credit the insured with gains made from the company's investment accounts.
Money flows into the insurance company through a number of paths. These are various charges to the insured. First, there is the "cost of insurance" itself, the so-called mortality charge. This charge is based upon mathematical principles used by the company's actuary to calculate the probability of an insured's death. The actuary uses what are termed mortality tables that factor an insured's age, sex, state of health and habits in order to provide a statistical snapshot. The underwriter then classifies the applicant into risk categories based upon the actuarial information.
This information allows the insurance company to have a good sense of its expected losses. Knowing this allows the company to charge the insured proper rates so that each is bearing his or her proper amount of cost. The actual cost of the premium is derived by a use of a rate that assumes a cost per thousand dollars of insurance. That rate times one thousand dollars of coverage equals the premium that the insured will need to pay for coverage.
The insurance company carries still other costs for doing business which it will pass on to the insured. One such area of cost it that of general administration. The state premium tax and overhead office costs are both a part of this charge. The cost of managing the investments, distributing the dividends, and collecting premiums also play a large part in this expense.
Insurance also needs to pay for what is termed its acquisition expenses in order to function efficiently. This is the cost of getting the product out before the consumer and processing the applicant. General sales costs such as advertising, promotions, and the printing of sales literature all play a part in this expense. In addition, the payment of agent's commission comes under the acquisition expense heading, as does the printing of the policies and application forms. Lastly, the services which the insurance company uses to guard itself against adverse selection also fall under this rubric.
In short, it is not useful to think of the premium as the cost of insurance. The premium is more than this. It reflects the cost of pure insurance by covering the mortality costs of the insured, but it also pays for the insurance company's operations. In addition to this, a portion of the premium is credited to the general or separate accounts of the company. This portion of the premium generates the cash value of the insured.
Traditionally, premiums were paid annually, but the emergence of flexible premium policies such as universal and variable universal life have altered this situation. Even though the newer, flexible policies offer more choices on how the premium can be paid, the cost of insurance must still ultimately be paid. Should the premiums paid into the policy be insufficient for insurance coverage, the accumulated cash value will be tapped to meet the insurance company's costs.
REVIEW QUESTIONS
1. A survivorship benefit is a way in which the insured who has neither died nor surrendered his or her policy can receive the death benefit's face amount.
a. true
b. false
2. The insured can receive a credit from the insurance company if the company's investment account earned a profit. This credit can come in the form of a dividend.
a. true
b. false
3. The mortality charge is the actual cost of pure insurance protection.
a. true
b. false
4. The mortality cost is arrived at by the sales agent assessing the health, age, and habits of the insurance applicant.
a. true
b. false
5. The information provided by the applicant and used by the actuary and underwriter provide a statistical picture that allows the company to adequately classify the risk and charge an appropriate premium.
a. true
b. false
6. The cost of general business administration is another charge that the insured will assume in order to receive coverage.
a. true
b. false
7. Acquisition expenses pay for general overhead, the cost of managing investment accounts, collection of premiums, and the state premium tax.
a. true
b. false
8. Advertising, sales promotions, and the printing of sales literature are all elements of the insurance company's acquisition costs.
a. true
b. false
9. Premiums include more that the cost of pure insurance coverage.
a. true
b. false
10. Premiums must always be paid on an annual basis.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. a
2. a
3. a
4. b
5. a
6. a
7. b
8. a
9. a
10. b
THE CONCEPT OF CASH VALUE
Cash value is the concept that is often the most confusing concept of insurance to consumers, and the most decisive feature that distinguishes whole life and its various innovations from term insurance. While the cash value element of the whole life family has many qualities which make it potentially more attractive than term insurance, ironically the mysterious functioning of this policy feature sometimes drives customers away. Simply put, it is challenging to sell a product in which the most exciting benefit is not always readily comprehended.
While the mathematical computations and financial prognoses that support cash values accounts are rather mind-boggling, the basic concept is not. In his or her role as educator, the insurance agent needs to be able to explain effectively the cash value idea to the consumer.
Cash value in a whole life policy is the result of the overpayment of the premium. Initially, these premiums do no more than cover the insurance company's cost of doing business with the insured. Subsequently, the cash surrender value of the policy is little or nothing in the contract's early stages. The passage of time, however, has a powerful effect on the money wisely handled. In other words, the cash value in the policy grows.
This growth occurs because the vehicle in which it is invested grows. In the broadest terms, this investment vehicle will take the form of either a general account or a separate account.
A general account in life insurance is the investment account of the life insurance company. That it is not a single account should not be surprising, because an insurer bases its risk assessments upon calculations derived from the law of large numbers and the pooling of risks. Individual accounts in such a scheme are not useful.
The insurance company's general account, or investment account, is geared toward conservative vehicles. This is at least partially due to the fact that insurance companies face oversight and regulation from the Insurance Commissioner in their state (or states) of operation. The state regulator will usually set a ratio of what percentage of the insurance company's policy-owner's surplus, or admitted assets, can be in any one form of investment.
The investments that comprise the equity of the insurance company's general account may include stocks, bonds, mortgage accounts and speculative real estate. Typically, the State will limit an insurance company's holdings in preferred stocks to 20% of a single company, with not more than a 2% holding of a company's admitted assets, while common stock holdings cannot be larger than 1% of admitted assets. Bonds tend to be debentures rather than convertibles. Speculative real estate holdings are limited to 10% of the company's admitted assets.
Both traditional whole life and universal life insurance make use of the insuring company's general account for the investment purposes of the excess premium. While this can provide a safe rate of return (providing the insuring company is stable and well-funded), many consumers desire to forego a certain amount of safety in order to reap higher returns. To this end, variable and variable universal life insurance were formed.
Unlike traditional whole life and universal life insurance, variable and variable universal products make use of a separate account. The separate account for these products is an investment portfolio (or portfolios) maintained or attached to the insurance company. These portfolios are essentially mutual funds, and like mutual funds, they can follow a specified investment strategy.
As mutual fund vehicles, these portfolios are professionally managed, and can be matched in order to provide diversification. Also, the cash value can be moved through the various portfolio options in order to take advantage of market shifts. The policy owner can make these decisions, or control can be handed to an asset allocation service. The investment possibilities in this arrangement are numerous, and can include such strategies as listed below.
Income Funds
Income funds invest in dividend-paying stocks, bonds, and money-markets. Their goal is not growth of capital, but the payment of income through dividends and interest earnings.
Growth Funds
Growth funds are the opposite of income funds. They invest in common stocks with the goal of capital appreciation. The emphasis might be on sustained, stable growth, with investments geared toward established companies. Another approach would be to target emerging companies for a more volatile – and hopefully, more aggressive -- rate of return.
Money Market Funds
A money market fund is one that invests in short term securities characterized by a high level of liquidity and
security. These funds produce comparatively low rates of return because of the short duration of the investment vehicles, but are valued for their low degree of risk.
Bond Funds
Bond funds aiM to produce income. They invest in debt
securities, and possess long term rates. They are riskier than growth and stock funds, but the risk level can be raised or lowered in accordance with the type and grade of bonds in which the fund invests.
As the monies in separate accounts are securities, they must be handled and regulated as securities. In order to sell variable life insurance policies (or variable annuities), an agent needs to be licensed by the National Association of Securities Dealers. The NASD is a group of brokers and dealers that operates under the umbrella of the Securities and Exchange Commission. The exams to sell this product line are taken in addition to the Life and Health Examination.
REVIEW QUESTIONS
1. Along with the duration of the insuring agreement, the cash value accumulation in the policy is a decisive difference between whole life and term insurance.
a. true
b. false
2. The general account is the investment account of the life insurance company.
a. true
b. false
3. The investment account of the insurance company is subject to little or no regulation by the State Insurance Bureau.
a. true
b. false
4. While an insurance company's investment account may include speculative real estate in addition to bonds and long term mortgages, the real estate investments usually make up no more than 10% of the company's admitted assets.
a. true
b. false
5. "Admitted assets" is a term that describes the policy owners' surplus in the insurance company's account.
a. true
b. false
6. Traditional whole life invests policy owner surplus in the general account. Universal life and all the other variations of whole life invest in separate accounts.
a. true
b. false
7. A separate account operates like a mutual fund.
a. true
b. false
8. Variable and variable universal are insurance policies that make use of separate accounts to attain a higher rate of return.
a. true
b. false
9. Separate accounts, like pure mutual funds, are professionally managed and have a targeted investment strategy.
a. true
b. false
10. Separate accounts are essentially securities, and are regulated as such by the SEC.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. a
2. a
3. b
4. a
5. a
6. b
7. a
8. a
9. a
10. a
CASH VALUE VERSUS TERM
The title of this part is perhaps misnamed, as it generates a sense of controversy and antagonism by the use of "versus." That is not our intent, but we thought it appropriate to try and capture a feel for the content of the plethora of pop financial planning books and magazine articles current in the market.
To read some of today's popular financial planning literature targeted to the general consumer, one would think that the purchase of life insurance is best achieved by following some magic formula. Depending on the prejudice of the writer, this all-purpose template would lead the consumer to invariably buy either term or some form of whole life.
The problem with such an approach is obvious to the professional in the field. Appropriate insurance coverage is completely dependent upon the consumer's unique needs. Obviously, not all consumers have the same needs (or lifestyles, spending habits, expectations, etc.)
Indeed, we approach the problem entirely off-center when we think in terms of cash value "versus" term insurance. The comparison is without meaning when an understanding of the consumer's specific needs and desires is lacking.
Naturally, we can speak in some broad generalities. Term insurance, for example, does tend to be cheaper. Again, however, so much of this can change when we apply the generalities to a specific case. Furthermore, cheaper is not always better. While this may sound quaint in a cost conscious world, it is nevertheless a maxim which often holds true. In addition, "cheaper" may be a temporary condition, especially as the insured ages.
One of the recent rallying cries for term insurance is BTID -- "buy term, invest the difference". While this tragedy can have definite merits, it simply will not suffice as an axiom.
Especially in the case of a policy replacement, it is vital that the insurance agent be keenly aware of the consumer's needs, desires and expectations. To avoid a situation of twisting, it is imperative that the new policy will clearly present a gain for the insured. Typically, policy replacement can present a new two year contestable period and higher premium rates. The insured must know what he or she is getting into when replacing a policy, and should be pursuing some recognizable and coherent financial planning strategy rather than the cant of the pop financial media. Another general rule is that it seldom makes sense to replace a cash value policy that an insured has held for a long period.
Finally, cash value and term insurance are complementary products. Each can play a role in life insurance, and each can be appropriate or inappropriate based upon the specifics of the situation.
REVIEW QUESTIONS
1. Term insurance is always more appropriate than cash value whole life, and should always replace such outmoded contracts.
a. true
b. false
2. The concept "cash value versus term insurance" is really inappropriate. Instead of an antagonistic relationship, a complementary one exists, as each product serves specific needs.
a. true
b. false
3. While term insurance does tend to be less expensive than whole life and its Innovations, it is not necessarily the best choice for the consumer.
a. true
b. false
4. BTID, or "buy term and invest the difference" is a strategy that is never appropriate for life insurance consumers.
a. true
b. false
5. Policy replacement can present a number of risks for a consumer, such as a higher premium and new two year contestable period.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. b
2. a
3. a
4. b
5. a
Chapter Three
The Traditional Products --
Term Insurance
TERM INSURANCE FUNDAMENTALS
Term Life Insurance provides life insurance coverage for a specified period of time, or “term.” Term life is the most basic form of life insurance. Often, term life is thought of as “pure” insurance because it offers only a death benefit. Because term life is a temporary, “no-frills” policy, it is generally used for limited, time-sensitive periods—for example, a young couple may carry term insurance until their children can earn their own incomes. The duration of the policy depends on the design offered by the insuring company. Typical terms include 1, 5, 10, and 20 years.
Another method of specifying the policy’s time period is to define the age at which the policy will expire. Usually age-based expirations include 60, 65, or 70. Such policies are referred to as “term to age” plans, such as “term to age 65.”
The primary advantage of term life insurance is based on cost. One can usually acquire the largest death benefit through the smallest premium with this policy design. * This is an attractive feature for young people who have insurance needs but are just entering the workforce or have limited financial means. Because of its initial low cost, term life insurance coverage finds enthusiastic proponents among those who believe life insurance should be no more than pure insurance coverage.
The primary disadvantages of term life are fivefold: 1) the policy does not provide life insurance coverage for the insured’s entire life; 2) the policy does not provide tax-free accumulation of cash value; 3) since no cash value can accumulate, the policy cannot provide living benefits; 4) the policy’s premiums become progressively more expensive at later ages; 5) it is generally not available to persons in extremely poor health, while persons in moderately poor health (termed “substandard”) often can find ordinary whole life policies easier than term life policies.
Characteristics of Term Life
All term life insurance has these three characteristics:
• Death benefit[5]
• Protection for a specified time period
• Decreasing, level, or increasing face amount
Decreasing Term Insurance
Decreasing term life insurance provides death benefit protection in decreasing increments for a specified period of time. At the end of the specified time period, the death protection is $0.
TABLE 1-1
| |
|$100,000 |
| |
|$75,000 |
| |
|$50,000 |
| |
|$25,000 |
| |
|$5,000 |
| |
|$0 |
1 5 10
$100 $100 $100 $0
In Table 1-1, the decreasing term concept is visually described. In this example, a $100,000 decreasing term policy with a ten-year term period has been purchased. The features of the policy are the following:
• The duration of the policy is ten-years
• Available amount of insurance protection decreases yearly
• The amount and frequency of the premium remain the same, or level, throughout the ten-year life of the policy—thus, the same premium is buying increasingly smaller amounts of insurance protection
Uses of the product
Decreasing term is used when a need for life insurance decreases on a regular, predictable basis. A commonly shared decreasing need is a mortgage balance. Because it is used so frequently in this capacity, decreasing term is often called mortgage cancellation insurance. Although a mortgage is the most typical situation met with decreasing term, any large loan that is paid in installments could create a need for this type of term coverage.
An example of decreasing term providing mortgage protection functions as follows: Kerry purchases a home with a $100,000 30-year fixed-rate mortgage. Kerry’s wife does not work, and he is concerned that she could not meet the house payments if he were to die. Kerry reviews the amortization schedule of his mortgage and purchases a decreasing term policy that keeps pace with the declining balance of the mortgage.
PRACTICE QUESTIONS
1. Morrie Monie and his wife, Penny, have just purchased a 20-year decreasing term policy to pay off their mortgage in case Moose passes away. Which of the following statement(s) is/are correct?
a) The Monie’s have purchased a mortgage cancellation policy.
b) The Monie’s premiums will decrease each year because the level of insurance protection will decrease.
c) While the premium will remain the same over the policy’s life, the Monie’s will annually be buying less insurance .
d) The Monie’s purchased their policy in 1980. Morrie passes away in 2002. Unfortunately, their policy will have expired and Penny will not receive any proceeds.
2. Which of these two cases is the better choice for a decreasing term policy?
a) Sammy has just taken out a 15-year mortgage. Because his wife’s job would not allow her to meet the house payments if he were to die, he wants to purchase a policy that will pay the mortgage for her.
b) Eddie wants to purchase a policy that will last his entire life and provide a supplement to his retirement fund.
ANSWERS TO THE REVIEW QUESTIONS
1. a, c, d
2. a
Level Term Insurance
Like all term policies, level term life provides pure insurance protection for a specified period of time. Level term also provides a level death benefit and a level premium for the duration of the policy.
TABLE 2-1
| |
| |
| |
|$100,000 |
| |
1 5 10
$100 … $100 … $100
In Table 2 – 1, the level term concept is visually described. In this example, a ten-year level term policy has been purchased. The death benefit remains $100,000 throughout the ten years that the policy is in effect. The premium of $100 also remains the same for each year of the policy. After the tenth year, the policy expires—no more premium is due, and no death benefit is forthcoming. If the insured were to reapply for a new policy, the premium would be more expensive, because the insured was now ten years older.
An example of a level policy in action is as follows: Gerry and his wife, Corrine, have two children, aged 8 and 6, plus a new mortgage. Gerry is an electrician and Corrine works part-time as a teacher’s aide. Gerry wants to make sure that the following needs would be met if he were to die: one, that enough income would be generated so that Corrine could continue to work part-time and still meet all the household bills, including the mortgage, and two, that enough money would be available to help fund the children’s college education. Gerry’s agent reviews Gerry’s household income, debt, and assets. The agent suggests a 20-year level term policy with a $300,000 face value as a low-cost, temporary insurance solution.
Uses of the Product
Level term insurance is called for when one has a specific, time-sensitive need for life insurance protection. Level term is popular among younger persons who can purchase a relatively large face amount for a specific premium. Often this type of policy is used to meet the life insurance needs of a family during the time when the children are dependent.
REVIEW QUESTIONS
1. Jose has a wife and one twelve-year old child. Even though his wife, Gertrude, has a good job, Jose is worried that she and their child, Marie, will be hard put to enjoy the lifestyle they are accustomed to should he die. Jose’s agent suggests he purchase insurance that will pay Marie $250,000 if Jose dies at anytime in the course of the next ten years. Jose is also told that the premium for this insurance will be the same each year for the ten years that the policy is in force. Which of the following most completely describes the kind of policy has Jose purchased?
a) term life insurance
b) decreasing life insurance
c) level term life insurance
d) ten-year level term life insurance
2. Steve believes he is a shrewd insurance buyer. Five years ago, he purchased a five-year level term policy because “the price was right.” The policy has just expired, and he wishes to purchase the same policy again. He is surprised to find that, even though the policy is for the same face value and same duration of time, the premium has gone up. This increase is because of:
a) inflation
b) unscrupulous agent practices
c) Steve is now five years older
d) none of the above
ANSWERS TO THE REVIEW QUESTIONS
1. d
2. c
Increasing Term Insurance
Increasing term life insurance is essentially the opposite of decreasing term insurance. Increasing term insurance provides an increase in the amount of death benefit on an annual basis. Unlike decreasing term, however, increasing term insurance is usually not sold as a self-standing policy. Instead, increasing term is usually a rider to an existing policy.[6] As a rider, increasing term acts as an additional benefit to the base policy. A common example of increasing term is a return of premium policy in which the sum paid at death is the face amount plus an amount that is equal to all or a portion of the premium paid.
• Major Features of Most Term Products
Option to Renew and Varieties of Renewable Term Life
In most cases, a term life insurance policy offers the policy owner the option to renew the contract without showing evidence of insurability. This means that, regardless of the physical health of the insured, the insured must be allowed to renew the contract and the premium cannot be increased in response to any physical condition. However, the renewed premium will be higher to reflect the insured’s new age.
To control its risk level, the insurance company will set parameters when a policy may be renewed. These parameters could be a set number of times, or specified ages. On a practical level, whatever the parameters of renewal, a term policy will only be renewed while it is cost effective to do so. Ultimately, the premium will become prohibited based on the insured’s attained age and life expectancy.
A policy that is renewable will cost more than a nonrenewable policy because the insurance company assumes more risk. A nonrenewable term policy is the most basic form of life insurance. It provides a level death benefit with a level premium. At the end of the term, the policy expires.
Renewable policies, however, give the policy owner choices based on the policy design. For example, annually renewable term, or ART, provides coverage for one year with the option to renew (without evidence of insurability) at the end of the policy.[7] Because the premium increases, or “steps up” each year, an ART’s premium is called a “step-rate.” Most designs of this product limit the number of times the policy can be renewed, and the final age at which can be insured under the policy.[8]
Another renewable term policy design is called re-entry term. A re-entry policy offers the insured the option to renew, without evidence of insurability and at a specified premium rate. Usually, the renewal occurs every five years. The insured agrees to submit evidence of insurability at specified periods. If the insured is in good health, the renewal premium rate will be lower than the guaranteed rate. If the insured’s health is not good, he or she may still renew, but at the contract’s guaranteed rate.
Option to Convert
It is not uncommon for a term insurance policy to be “convertible.” This means that an insured may convert their current term contract into a permanent, or whole life, insurance contract.[9] Usually, a time-limit is stated in the policy for converting.
The option to convert is a valuable privilege in the term contract because it allows the insured to replace a temporary insurance coverage with a permanent coverage without evidence of insurability. Thus, an insured who purchased a ten-year level policy could convert his policy into a permanent policy without having to provide any information about his health history and current physical condition, let alone undergo a physical. Even if one developed a physical condition that would create a greater risk for the insurance company, this information does not have to be revealed to the company, and the company cannot refuse coverage.
Naturally, this does not mean that the insured will pay the same premium for his new, converted policy that he paid for his original policy. When an insured converts a policy, the conversion will be based on either the attained age or original age of the insured.
An attained age is the insured’s age at a particular point in time. An original age is the insured’s age at the date that a term policy was issued. A conversion based on attained age raises a premium to reflect the insured’s current age and reduced life expectancy. A conversion based on original age is sometimes called a retroactive conversion. The premium in this type of conversion is lower, but the policy owner must pay an additional sum to make up for the difference between the term and whole life insurance from the date of the term policy’s original issue to the time of conversion.
REVIEW QUESTIONS I
1. Clara is 26, divorced, with two children. In talking with her agent, she believes a $500,000 face amount would be adequate. She would like to purchase a whole life policy, but is feeling strapped for cash while she finishes law school. The insurance strategy her agent could suggest that would make the most sense is:
a) A non-convertible ART policy with a face amount of $1,000,000.
b) A non-convertible ten-year level term policy with a face amount of $750,000.
c) A $500,000 decreasing term policy with a ten-year term period.
d) A ten-year convertible term policy with a face amount of $500,000.
2. Duke purchased a 20-year renewable term policy with an option to convert within five years of the policy’s expiration date. It is now ten years since the policy’s inception, and Duke has developed high blood pressure and diabetes. Will he be able to convert his policy to permanent insurance?
a) Yes, provided the conversion occurs within five years of the policy’s expiration.
b) Yes, provided he passes a physical examination.
c) No, because his health situation has changed dramatically.
3. Graham has an ART policy that is renewable to age 70. Graham is now 40, and has renewed for five years in a row. Which statement is true?
a) Graham’s premiums have increased with each renewal.
b) Graham’s premiums have stayed the same, because the policy has the option to renew until age 70.
4. Trent has a renewable term policy with a re-entry option. Trent’s policy requires that he take a physical at specific times. Trent is in excellent physical condition, and continues to be insurable. When he renews his policy, his rates are:
a) lower than the policy’s guaranteed rates
b) the rate guaranteed by the policy
c) higher than the policy’s guaranteed rate
d) none of the above
ANSWERS TO THE REVIEW QUESTIONS I
1. d
2. a
3. a
4. a
REVIEW QUESTIONS II
1. Term insurance has only a small slice of today's life insurance market.
a. true
b. false
2. Term insurance is pure insurance protection.
a. true
b. false
3. Because it does not possess a cash value component and exists for only a limited, time frame, term insurance tends to be relatively inexpensive.
a. true
b. false
4. While it may begin as a good buy, term insurance does become progressively more expensive as the insured grows older and becomes more of a risk.
a. true
b. false
5. Term insurance is best suited to meet specific, temporary needs.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS II
1. b
2. a
3. a
4. a
5. a
Chapter Four
The Traditional Products (B) -- Whole Life Insurance
WHOLE LIFE INSURANCE FUNDAMENTALS
Whole life insurance is the direct opposite of term insurance.[10] While term insurance is designed to expire after the end of a specified period, whole life insurance is designed to be “permanent.” Permanent in this context means for the whole life of the insured, or until the age of 100.[11]
Whole life insurance can be represented visually by the following chart:
TABLE 3 – 1
The Policy’s Duration
Issue Age Age 100
The Policy’s Premium
$1500 $1500 $1500 $1500 $1500
The Policy’s Face Amount
$100,000 $100,000
The Policy’s Cash Value
$100,000
$0
A whole life policy has premiums that are payable to age 100. The premiums are level, so unlike term insurance, a whole life policy does not become prohibitively expensive as the insured ages.
A whole life policy can offer level premiums because it initially overcharges the insured for the cost of the chosen face amount. The excess amount is invested by the insurance company, and credited to the cash value in the insured’s policy. This cash value accumulates tax-free, and earns interest. Cash value provides a savings element, and is a major source of the policy’s living benefits.[12]
The living benefits from a life insurance policy can include loans against the accumulated cash value. Typically, insurance companies will allow up to 98% of the cash value in form of a loan with simple interest. The loan does not have to be repaid, but an unpaid loan plus its accumulated interest will be subtracted from the face amount before it is paid as a death benefit or an endowment.
Typical uses for a whole life policy’s cash values are the following:
• Providing collateral for a loan
• Paying off a mortgage
• Supplementing retirement income
• Providing an emergency cash fund
• Establishing a college fund
A whole life policy provides insurance protection until age 100, when the policy reaches maturity. At maturity, the whole life policy endows. This means that the cash value in the policy has accumulated to equal the face amount of the policy. If the insured is still living, he or she will receive the face amount as an endowment. When a whole life policy reaches maturity and endows, the contract is completed and expires. The insured no longer owes premiums, and the company no longer provides insurance coverage.
Just like term insurance, whole life insurance possesses relative strengths and weaknesses. The primary advantages of whole life insurance are the following:
• A whole life policy provides guaranteed cash values.
• The cash values are not subject to the market risk associated with other conservative investments such as longer-term municipal bonds.
• Cash value interest accumulates tax-free or tax-deferred, depending on whether the gains are distributed during lifetime or at death.
• A whole life policy can be used as collateral for personal loans.
• A fixed and known premium for lifetime life insurance coverage.
The primary disadvantages of whole life insurance are the following:
• The premium may be too expensive for the level of coverage needed.
• The rate of return on the cash value may not be competitive with higher-risk investments.
• Cash values are subject to inflation.
• If the policy is surrendered within the early years of the contract (typically up to five to ten years from the policy’s inception), the insured can face a considerable loss.
Uses of the Product
For most consumers, the essential purpose of the whole life product is very similar to term life. Like term insurance, whole life can provide an immediate estate. Typically, this estate is used to provide income for dependents. Whole life can also be used for specific goals such as funding a college education, funding a charity, or providing cash for federal estate and state inheritance tax purposes. Other uses include providing cash for business debts, mortgages, and funeral expenses.
Like term insurance, whole life insurance helps preserve the confidentiality of one’s financial affairs. Proceeds from an insurance policy’s death benefit payable to someone other than the deceased’s estate avoid probate and are not part of the public record.
Term insurance focuses on providing an insurance solution for short term needs. Whole life, on the other hand, is best suited for long term needs. Because whole life provides a series of “knowns” (fixed premium, guaranteed ceiling on mortality and expense and guaranteed cash value), it meets the financial and psychological security needs inherent in long term planning.
Whole life, however, is a more complex product than term insurance, and is often more useful for meeting more diverse needs. Whole life tends to be an excellent product for meeting various business life insurance needs. Some examples include split dollar and nonqualified deferred compensation arrangements, funding buy-sell agreements, and key person insurance.
REVIEW QUESTIONS
1. Ira has a $100,000 level premium whole policy. Ira has a massive heart attack and unexpectedly dies at 57. Ira had recently borrowed $5000 from his policy’s cash value. How much will his beneficiary receive?
a) $100,000
b) $0
c) $95,000 plus the interest
d) $95,000 less any unpaid interest
2. Which of the following are not (a) feature(s) of whole life insurance?
a) temporary protection
b) cash values
c) maturity at age 100
e) initial low cost, with escalating
premiums as one grows older
3. Otto has a whole life policy with a $25,000 face value. Otto has just turned 100, and is as healthy as ever. He has never missed a premium payment, and has never borrowed from his policy. Based on this profile, Otto will soon receive a check from the insurance company to the amount of:
a) $25,000 plus interest
b) $25,000
4. Which of the following can be counted part of a whole life policy’s living benefits?
a) loans from the policy
b) the policy’s face amount
c) disability income
d) waiver of premium
f) a & b only
g) a, c, d
ANSWERS TO THE PRACTICE QUESTIONS
1. d
2. a
3. b
4. f
Traditional Whole Life Variations
In addition to traditional whole life with level premiums to age 100, the whole life product exists in a range of variations. These modifications have been introduced by the insurance industry over time in order to better meet the specific needs of consumers. Some of these product variations include limited pay whole life, modified whole life, indexed whole life, graded premium whole life, and indeterminate premium whole life.
Limited pay whole life is a whole life policy that provides the same benefits as a traditional whole life policy, but with pre-defined limit on the number of required premium payments. Typical limited pay whole life policy designs include 15, 20 and 30 pay plans. The number of “pays” equals the number of years that the insured must pay a premium. Thus, a 15-pay whole life policy requires premium payments for 15 years.[13]
Another variation on the limited pay policy design is to state an age, short of 100, to which an insured must pay premiums. A typical age-based limited pay life policy is “to age 65.” This type of policy is usually referred to as “life paid up at age 65 (LP65).”
Still another form of limited pay whole life is 1-pay whole life, which is also known as single premium whole life. Because a 1-pay policy funds the entire contract with one premium, the premium must be very large. However, the real cost of this premium is actually less than what the total of premiums spread over a 15, 20, 30, or 100 year period would be. This reduction in premium occurs because of the interest that the lump sum payment will accrue and the minimized expenses realized by the company.
Single premium whole life policies are rarely purchased in today’s environment. Current tax legislation defines single premium policies as modified endowment contracts, which are discussed in the following sections.[14]
Because the premium payment period is reduced in a limited pay policy, the required dollar amount is higher than in a comparable traditional whole life contract. Within this structure, a higher percentage of the limited pay premium dollar is credited to the policy’s cash value. The shorter the premium-paying period, the faster the growth in cash value. After the premium paying period, the cash value growth slows down, as it is driven solely by interest earnings. At this point, the policy functions like a traditional whole policy, in that the cash value increases until it matches the face amount and the policy matures.
TABLE 4 – 1
COMPARISON OF 20-PAY AND TRADITIONAL WHOLE LIFE POLICIES WITH $100,000 FACE AMOUNTS
GROWTH IN CASH VALUE
$ 0
$100,000
28 … 48 … 100
Premium payments end
Another example of a whole life variation is modified whole life. This product offers a low period at the start of the contract, and then increases once. The new premium rate remains level for the duration of the policy period (age 100). The initial low-premium period usually lasts from three to five years.
During the initial period, the premium is only slightly more than for a term policy. When the premium increases, it is higher than the whole life rate at the age of issue, but lower than the term rate for the insured’s attained age at the time of the transition.
TABLE 5 – 1
$50,000 MODIFIED WHOLE LIFE
Age 30 Age 35
Age 100
Initial low premium
Subsequent premium
Graded premium whole life is similar to modified whole life, but adds an additional “spin.” Like a modified whole life policy, a graded premium plan will offer an initial period of lower premiums that ultimately level off to a level rate for the remainder of the contract (age 100).
The difference between the graded and modified whole life is in the duration and format of the initial premium period. First, the lower premium period lasts longer – usually ten years. Second, the lower premium period has a step-rate design. This means that the premium gradually increases each year until the level premium period is reached.
Both the modified and graded whole life policy are designed for consumers who want to lock in the benefits of a whole life design, but are initially “cash challenged.” While their premium structure helps meet one of the primary disadvantages of whole life insurance – the cost of the policy – they can only function if the insured is in a position to eventually pay a higher premium. These policies are ultimately not more or less expensive than level premium whole life. Actuarially, the premium rates are equivalent to traditional whole life.
Indeterminate premium whole life is another whole life design that seeks to meet the premium price objection. This variety of whole life insurance has a premium rate that is adjustable based upon the company’s anticipated future experience. In this form of whole life, a maximum premium is stated, with an initial rate that is both lower and fixed for a guaranteed short-term (typically two to three years.)
When the guaranteed short-term expires, the premium rate is reviewed in light of the insurance company’s expected and realized earnings and expenses. If the situation is favorable, the premium may be adjusted down. If the situation is unchanged, the premium may remain level. If the company’s situation is worse, the premium may be increased. Some of the factors the company reviews are: mortality experience, administrative expense, and investment returns.
Whole life variations all possess a number of advantages for the consumer. First, limited pay plans help the consumer with financial planning by providing a known dollar amount for the premium outlay. By providing a limited time-frame during which premiums must be paid, a limited pay policy also reduces the chances that the policy might lapse. The major reason that the limited pay design is popular, however, is that the cash values build faster than a traditional whole life policy.
The main disadvantage of any limited pay whole life policy is that it will be even more expensive than traditional whole life coverage. By compressing the payment period, these types of policies are often unaffordable for consumers with limited means.[15]
Modified whole life plans make whole life insurance more affordable for consumers that are just beginning their careers or returning to the workforce and have yet to experience significant earning power. These policies seek to meet the major obstacle many consumers find when trying to purchase whole life coverage – the cost of the premium.
Using modified whole life policies requires good planning. If the insured does not manage their expenses properly, they will be in a difficult position when the premium increases.
Uses of the Product
Limited pay policies are effective instruments for a number of cases. These policies are often used to provide insurance protection after retirement without the need of paying premiums. Limited pay policies are also good choices for persons with a brief working lifetime, such as professional athletes.
Another use of limited pay policies funding insurance is for juveniles. Parents can purchase basic insurance protection for their children, and have the policy paid-up before they leave the household to begin their own lives.
Modified whole life policies, as we have already mentioned, are geared to consumers that recognize the value of whole life insurance, but lack the means to comfortably meet the premium required for adequate protection. These policy designs can be very valuable for persons in training programs or defined pay structures who are confident about future salary increases.
While the modified plan will ultimately provide the same coverage as a traditional whole life plan, the insured will be “stuck” with little to no cash value in the policy for a longer time than in a traditional whole life policy. Furthermore, the insured will have some period of higher premiums than would have been paid with a level premium policy.
NOTES
REVIEW QUESTIONS
1. Hank has a 20-pay limited life policy. His twin brother Skippy has a traditional whole life policy. Both policies were purchased at the same time and for the same face amount.
Which brother pays the higher premium?
Whose policy will earn cash value quickest?
2. Most single premium whole life policies are :
a) sold to low- to middle-income consumers
b) modified endowment contracts
c) slightly more expensive than whole life policies
d) all of the above
3. Which of the following are true for limited pay whole life policies?
a) they provide lifetime protection until age 100
b) they endow at age 100
c) their premiums are payable for limited, stated time period
d) all of the above
4. Cosmo has a LP65 policy. This means:
a) he will be finished with premiums at age 65
b) he has lifetime protection with a face amount of 65,000
5. Renaldo has just graduated from McDonald College and taken a position as management trainee. He has a wife and child, and would like to purchase life insurance. Renaldo wants a policy that, should he die, can help provide income to his wife and child plus pay all final expenses. Renaldo’s training period lasts two years, after which he will earn a sizable pay increase. Of the following options, Renaldo is a good candidate for:
a) Declining term life
b) Graded premium whole life
c) Single premium whole life
d) Re-entry term life
6. Louie has purchased an indeterminate premium whole life policy. Which of the following is probably true about his coverage:
a) his premium will be higher for the first years of the contract, and then decline to a constant lower level
b) his policy will state a maximum premium that can be charged
c) his premium will be fixed for the initial few years, and then raised, lowered, or kept the same, based upon the company’s expected mortality, expense, and investment projections
d) a & b
e) b & c
ANSWERS TO THE PRACTICE QUESTIONS
1. Hank; Hank
2. b
3. d
4. a
5. b
6. e
Endowment Policies and MECs
Endowment policies are yet another type of ordinary life insurance. Unlike a traditional whole life policy, however, an endowment policy does not mature at age 100; the endowment policy does not provide lifetime insurance protection.
An endowment policy offers life insurance for a specific period of time. Typical time periods include 10 years, 20 years, and “endowment at age 65.” The premium during the time that the policy is in force is level, just like a traditional whole life policy. Should the insured die at any point during the premium paying period, the endowment policy will pay the face of the policy as a death benefit to the beneficiary.[16]
At the maturity date, an endowment policy will pay the face amount as an endowment. Like a whole life policy, the endowment is paid to the policy owner.
Endowment policies increase their cash value extremely quickly. Because of their abbreviated accumulation period, endowment policies have very expensive premiums.
TABLE 6 - 1
Policy Comparison – Endowment and Traditional Whole Life
Policy Begins Endowment Matures WL Matures
Age 35 Age 65 Age 100
The modified endowment concept originated from changes in the tax code. The United States Congress enacted the Technical and Miscellaneous Revenue Act (TAMRA) in 1988. TAMRA determined that all life insurance policies issued on or after June 21, 1988 must meet the 7-pay test or be classified as modified endowment contracts (MECs).
As an MEC, any amount that is withdrawn in the form of a loan or partial surrender is taxed as ordinary income and return of premium (if there is any gain in the contract over premiums paid). In addition, there is a 10 percent penalty tax on withdrawals if they occur before the policy-owner reaches age 59 ½ .
MECs can potentially occur with single pay and limited pay policies. Avoiding an MEC situation is the responsibility of the insurance company home office, but the agent needs to be aware of the concept and how it can affect consumers.
REVIEW QUESTIONS
1. Endowment contracts are known as (circle one) expensive / inexpensive policies.
2. Endowment contracts share all of the following characteristics as traditional whole life polices except for:
a) level premium
b) level death benefit
c) matures at age 100
d) builds cash value
ANSWERS TO THE PRACTICE QUESTIONS
1. expensive
2. c
NOTES
Chapter Five
New Worlds of Life Insurance
• Whole Life Variations
A variety of forces emerged that challenged the life insurance industry to develop alternatives to product designs that had received little more than “fine tuning” for nearly 100 years. First, the consumer movement led to a greater demand from consumers for knowing how their premium dollars would be invested. Second, the weakening of the “endowment” ethos and the growth of the “lifestyle” ethos, coupled with the increase in life expectancies, has greatly altered the perceived need for--as well as the anticipated uses of—life insurance.[17]
Some of these forces have been driven by the post-World War II Baby Boomer generation that numbers more than 78 million. Because of the influence that their sizeable numbers and affluence command, their tastes and demands have forced the insurance industry to develop products to meet such needs as college planning, retirement income supplementation, and estate planning.[18]
In addition to demographics, the volatility of the economy has exerted a powerful influence upon life insurance innovation. Such factors as the experience of hyper-inflation in the 1970s, “stagflation,” the subsequent changes in the interest-rate environment, and the “irrational exuberance” of the Bull Markets of the late 1980s and 1990s all have affected the product designs offered by life insurance companies.
Universal Life
Universal life insurance emerged out of the hyper-inflation and high interest rates of the late 1970s. As consumers were able to earn 10% or more on cash in bank and money market accounts, the insurance industry witnessed a massive withdrawal of funds from traditional whole life policies. As these policies were built upon the assumption of low, stable interest rates, the 3 to 4% returns they were generating looked meager to many policy owners.
Universal life (UL) was created to meet this challenge. While UL operates like a whole life policy, and enjoys the same tax advantages as whole life, it is essentially a level or decreasing term life insurance policy with an investment account. Following this design, universal life is an unbundled policy. As an unbundled policy, the investment, mortality, and cost features are all separated and reported annually in a yearly statement.
The universal life policy is unique among life policies. This is because universal life is based upon current, available cash value rather than regularly scheduled premiums. In a term or traditional whole life policy, the insurance company determines a premium based upon a series of assumptions and underwriting information. The policy is dependent upon regular, scheduled premium payments by the policy owner.
With universal life, however, the policy owner possesses wide latitude as to the frequency and level of premiums. As long as the cash value within the investment account is sufficient to pay the monthly mortality expenses for the insurance coverage and the necessary policy expenses, the policy stays in force. The policy owner may occasionally skip premium payments, make partial payments, or increase premium payments. With universal life, the policy may be funded in pattern that can be continually revised. In this type of policy, the policy owner has significant control over the amount and frequency of the premium payments.[19]
In addition to being able to skip payments, the policy owner may also increase or decrease coverage. If the policy owner desires, the death benefit can be decreased to a level at which the existing cash value would carry the policy to maturity. In this type of policy, the policy owner has significant control over the level of death benefit.
The universal life policy also possesses a variety of other flexibility features that benefit the policy owner. For example, the policy owner may let the cash values accumulate, make partial surrenders, or surrender the policy for the entire cash value. In addition, various riders can be added to a policy to further shape it to the policy owner’s specific needs. Riders that are commonly added to a universal life policy include the following: cost-of-living, additional insureds, children’s, guaranteed insurability, and waiver of premium.
The reason that the universal life policy can offer these flexibility options is because the cash values in the investment account reflect “current interest rates.” For universal life policies, “current interest rates” are determined by the company’s own investment earnings return rate, the sale of 90-day U.S. Treasury bills, or a bond index. In a high-interest rate environment, the monies in the investment account can grow tax-deferred at a rate faster than many traditional whole life policies.
Because the performance of the universal life policy is tied to current interest rates, the policy owner is exposed to a measure of volatility.[20] When interest rates are high, the policy performs well and the flexibility options described above can be employed by the policy owner. When interest rates fall, however, the universal life design is presented with some challenges.
First of all, low interest rates can cause a funding problem for the universal life policy. Even though the policy design allows the policy owner to skip payments, make partial payments, etc., the assumption is always that the cash value in the investment account is sufficient to allow for a monthly withdrawal that will meet both the mortality charge (the cost of the insurance) and the policy’s operating expenses. A sustained period of lower-than-expected interest rates can destroy the policy’s flexibility, as the target premium specified by the company will have to be met on a monthly basis in order to keep the insurance protection in force.
Secondly, low and/or declining interest rates and the increasing age of the insured will increase the cost of pure death protection. The result is that the amount of cash value allocated to the mortality charge will increase and the amount entering the investment account will decrease.
On a more positive note, however, universal life policies use a back-end load rather than the front-end load typical of most traditional whole life policies.[21] Because of the back-end load structure of the universal life policy, a larger portion of the policy owner’s initial premiums go into the cash value account. This means that the cash values in the universal life’s investment account will grow quicker than a traditional whole life policy.
Universal Life Death Benefit Options
Option 1 (or A)
The Option 1 (or A) death benefit is similar to a traditional whole life policy. As the cash value in the investment account grows, the net amount at risk decreases. The total death benefit remains constant. Option 1 is thus a level death benefit policy.
However, if the cash value growth approaches the face amount before the policy matures, the universal policy automatically provides an increased death benefit. This additional insurance is called the “corridor.” It is maintained in addition to the cash values, and is done to avoid negative tax consequences.
Death Benefit
Age 40 Age 100
Cash Value
Option 2 ( or B)
The Option 2 (or B) death benefit equals the face amount plus the cash values in the investment account. This makes the Option 2 death benefit similar to that found in a traditional whole life policy with a term insurance rider that equals the current cash value. The result is that the death benefit grows along with the cash values.
Age 40 Age 100
The primary advantages of the universal life policy are the following:
• The policy owner has flexibility in premium payments
• The policy owner has flexibility in changing the death benefit, and may select from two design options
• Most universal life policies are back-end loaded, with the result that cash values tend to build faster than in traditional whole life policies
• The unbundled design provides the policy owner with a clear presentation of the policy’s performance on an annual basis
• Universal life policies offer the cash value advantages typical of traditional whole life: tax-deferred build-up of the cash value and low-interest policy loans
The primary disadvantages of the universal life policy are the following:
• The policy owner is exposed to a greater deal of risk than a traditional whole life policy, as sustained low interest rates can cancel the policy’s flexibility features
• The flexibility of the policy can create unforeseen circumstances. For example, the policy can inadvertently become a MEC through over-funding. The ability to skip premium payments takes away the “forced savings” element of traditional whole life and can encourage under-funding and/or policy lapses
Uses of the Product
The flexibility of universal life makes it suitable for many insurance needs. However, the cash value element of this policy design generally makes it more appropriate for long-term needs.
A universal life policy can be designed to change with a person’s developing needs. For example, the initial phase of the policy can emphasize insurance protection, with lower premiums and a high death benefit. As insurance needs change, the emphasis can switch to build-up of cash value with an increase in premiums.
REVIEW QUESTIONS
1. Theo would like a cash value policy that allows him to easily change the death benefit level because of life-events like the birth of a child. His best option is:
a) Increasing term life
b) Traditional whole life
c) Universal life
d) Industrial life
2. Melissa is 46, and has a universal life policy with a $100,000 face value. When she purchased the policy, current interest rates were 8%. Interest rates have been falling steadily since she purchased the policy. Which of the following statement(s) reflect Melissa’s situation:
a) The policy’s features—death benefit, rate of cash value accumulation, target premium—will be unaffected
b) The death benefit will most likely be unaffected, but the cash value will not grow as fast
c) The death benefit and cash values will most likely decrease
d) None of the above
3. Felipe quits his job to start up an internet-service company. As his income stream is temporarily interrupted and his business start-up costs are high, he would like to not make life insurance premium payments for a brief period -- without surrendering his policy. Is this possible with a universal life policy?
a) No
b) Yes, if the policy has sufficient
4. The universal life policy possesses different designs of death benefit options.
a) Two
b) Three
ANSWERS TO THE PRACTICE QUESTIONS
1. c
2. b
3. b; cash values
4. a
Adjustable Life
Adjustable life, or ALI, is a flexible premium policy with an adjustable death benefit. Adjustable life is a whole life variation that has features similar to universal life and traditional whole life. Adjustable life is an example of a hybrid policy. As such, the adjustable life policy allows the policy owner the following options:
• Increase or decrease the premium[22]
• Increase or decrease the premium payment period
• Increase or decrease the death benefit
• Increase or decrease the protection period
These features mirror the flexible nature of the universal life policy. However, unlike the universal life design, an adjustable life policy is bundled. This means that the death protection and cash value components are not segregated. Unlike a universal life policy, withdrawals from the cash values are not permitted without a partial surrender of the policy.
Other features of the adjustable life policy that are consistent with a traditional whole life design include the following:
• Guaranteed maximum mortality charges
• Cash values
• Guaranteed minimum interest
• Nonforfeiture options
• Settlement options
• Dividend options
• Policy loan provisions
In addition, a variety of riders typical for traditional whole life may be attached to the adjustable life policy. These commonly include waiver of premium, cost-of-living, and accidental death & dismemberment.
Another element that differentiates the adjustable life policy from a true universal life policy is how the death benefit and premium level may be adjusted. Unlike the universal life design, changes in death benefit and premium level can only occur at specific intervals. All changes must occur with advanced notice to the insurer. The schedule of cash values, which is based upon the current program of premiums, face value, and duration of coverage, is recomputed each time the death benefit or premium payment is adjusted. During the time period between changes, the adjustable life policy functions like a traditional whole life level death benefit and level premium policy.
Adjustable life is simply another policy design created by the insurance industry to meet the public’s demand for greater flexibility. It is appropriate for a wide range of life insurance needs. However, because of its cash value component, adjustable life is typically better for long-term insurance needs.
Adjustable life is often sold on a money purchase basis. This means that a specific premium dollar figure is selected, and this figure is matched with an appropriate whole life policy.
NOTES
Current-Assumption Whole Life
Current-assumption whole life (CAWL) is also known as interest-sensitive whole life or fixed premium universal life.[23] Current-assumption whole life is another hybrid of universal life and traditional whole life.
The current-assumption whole life policy is usually issued with a level (i.e. fixed) premium and death benefit. The premiums, however, will reflect changing conditions in two broad categories: the insurer’s assumptions and actual experience with mortality and/or expenses, and current interest rates.[24] The company will usually tie the policy’s performance to a specified index or yield.
The result is that premiums for a current-assumption policy can become higher or lower than those stated at the policy’s issue. High interest rates will tend to produce lower premiums, while lower interest rates will produce higher premiums. Typically, the current-assumption policy presents a guaranteed minimum interest rate as well as a maximum charge for mortality expenses.
The current-assumption policy is similar to traditional whole life in the following features. Most current-assumption policies possesses such elements as guaranteed maximum mortality charges, minimum guaranteed cash values, nonforfeiture options, settlement options, policy loan provisions, and a guaranteed minimum interest level. Between determination periods, the policy functions as a level premium, level death benefit policy.
Current-assumption whole life resembles universal life through the following two major features. First, the policy is unbundled. Second, the current-assumption policy is generally back-end loaded.
Like adjustable life, current-assumption whole life blends aspects of the traditional whole life and universal life designs. The strengths of the policy include the following:
• Cash values that grow tax deferred
• An interest rate that is often higher than traditional whole life
• Low-interest policy loans
• Annual reports on the policy’s performance
• Back-end loads
• Withdrawal of the excess cash value accumulations
The weaknesses of this policy design are in the following:
• The policy owner is exposed to a level of risk in the form of volatile interest rates that can create higher premiums
• The policy only guarantees maximum mortality and/or expense rates
• Unlike a universal policy, the current-assumption policy will ultimately lapse if the scheduled premium payments are not paid, regardless of the accumulated cash values
Because of its cash-value features, the current-assumption whole life policy is best for long-term life insurance needs. It is well suited for the client who wishes to make use of the “forced savings” aspect of traditional whole life policy, but still wants an annual report detailing the policy’s performance as well as the potential for higher interest rates on the cash values.
REVIEW QUESTIONS
1. Another term for current-assumption whole life is interest sensitive whole life.
a) true
b) false
2. Jack has a current-assumption whole life policy. Since he purchased the policy, interest rates have increased several times and are now 5% higher than when the policy originated. It is reasonable to believe that Jack’s premiums are than (as) before.
a) higher
b) lower
c) the same
Samson has an adjustable life policy. He has recently taken a new sales
job for a major wig manufacturer. With the costs of relocation and
establishing a new territory, he believes his cash flow will be strained
for a temporary period. Can he decrease his premiums with this type of
policy design?
a) yes
b) no
4. Adjustable life and current-assumption whole life are both unbundled policies.
a) true
b) false
ANSWERS TO THE PRACTICE QUESTIONS
1. a
2. b
3. a
4. b
VARIABLE LIFE INSURANCE PRODUCTS
Variable life (VL) and variable universal life (VUL) are policy designs derivative of traditional whole life that, like universal life, evolved out of the economic conditions of the late 1970s and early 1980s. December of 1976 the SEC issued Rule 6E-2, which provided a limited exception from sections of the Investment Company Act of 1940. This rule requires that insurance companies provide an accounting to contract holders, imposes limitations on sales charges, and requires that the insurers offer refunds or exchanges to variable life purchasers under certain circumstances, including an option of returning to a traditional whole life policy.[25] Rule 6E-2 defines variable life as a contract in which the life insurance element is predominant, the cash values are funded by separate accounts of a life insurance company, and death benefits and cash values vary in response to investment experience.
The first variable life policy was issued in the United States in 1976. The growth of the product was initially slow. In 1981, only ten companies sold the product. In 1992, variable products only accounted for nine percent of total life insurance market share. However, with the strong bull market of the nineties, variable and variable universal life have grown steadily in popularity. In 1998, the sale of variable life insurance products surpassed traditional whole life sales for the first time in history.
• Variable Life
Variable life is also referred to as scheduled premium variable life. It is characterized by three main features.
First, the policy owner’s cash values are placed in a separate account (or accounts) that is (or are) different from the company’s general account. These separate accounts are investment vehicles that mirror mutual funds.[26] The variety of separate accounts dependent upon the company’s choices and policies. They can essentially include any form and style of mutual fund, such as a stock fund and its relevant variations (e.g. growth stock, foreign stock, small cap stock, etc.).
Policy owners may choose the initial mix of funds, and can switch funding options one or more times per year. Other policies allow for a managed account, in which an investment manager is in charge of the asset allocation of the cash values. Today’s products offer not only the money markets and common stock accounts typical of the earliest variable policies, but also aggressive growth accounts, global and international equity accounts, and various bond accounts.
Like a traditional whole life policy, cash values grow tax deferred. However, the investments that are allowed in a variable life’s separate account can be much more aggressive than those that fund an insurance company’s general account. Thus, the opportunity for returns that are significantly better than a traditional whole life policy are possible.
In addition, since the policy owner may invest in a mix of separate accounts, a level of diversification can be achieved. Furthermore, since switching funding options is not considered a taxable event, the policy owner may periodically alter the mix in reaction to the changing economic climate.
The second defining feature of the variable life policy is its lack of guarantees. Unlike a traditional whole life policy, the variable life policy does not guarantee the cash value in the separate account. The policy owner, not the company, will bear the risk of the separate account’s performance.
The third defining feature of the variable life policy is the functioning of the death benefit. The variable life policy requires the payment of a level, scheduled premium, and this supports a guaranteed minimum death benefit. However, the realized face amount of the death benefit is flexible. If the investment performance of the separate account is positive, the death benefit can increase. Conversely, it can also decrease if the investment performance is negative (but the death benefit will never be lower than the stated guaranteed minimums).[27]
In most other respects, variable life is like a traditional whole life policy. It has fixed and guaranteed mortality charges, does not allow partial surrenders from the policy, and has a “forced savings” element in its scheduled level premium. In addition, the variable policy will allow for low interest policy loans, nonforfeiture and settlement options, and a reinstatement period.
• Variable Universal Life
Variable universal life is also called universal variable life, flexible-premium variable life, and universal life II. The first variable universal life product was introduced in 1985.
This policy blends the features of universal life and variable life for a whole life hybrid that offers flexibility and the possibility for aggressive growth of cash value. The key concept of variable universal life is policy owner control. The policy owner selects, within the guidelines of the company, the face amount, the premium allocation, and the investment vehicle.
Variable universal is like regular variable life in that the policy owner’s premiums are invested in separate accounts that are (usually) registered as mutual funds. The policy owner will usually have a choice of separate accounts, each representing a different investment style or objective. As with a variable policy, these accounts can be equity or bond accounts with such objectives as aggressive growth, growth and income, international growth, etc. Furthermore, the policy owner will be periodically able to alter the mix of separate account monies. The benefit of the variable life features is that they offer the possibility of aggressive cash value growth.
Variable universal life is like regular universal life in the following:
• Premium payments are flexible within limits specified by the company
• The policy owner can choose from two death benefit options: Option 1 (or A) with a level death benefit and Option 2 (or B) with a death benefit that is equal to a specified level of pure insurance and the current cash value in the separate account(s)
• The face amount of the death benefit is adjustable by the policy owner (within limits specified by the company and statutory law)
• The policy owner may make partial withdrawals of the cash value without a policy loan
• The policy is unbundled, and provides an annual report on performance and expenses
Because of the blending of variable and universal life, the variable universal life product is considered a “second generation” product. As a relatively new product, it is often poorly understood. In addition, by combining the best features of two products, it is subject to a variety of expenses that have received a great deal of attention in the financial and consumer-oriented press. It is vital to understand what these expenses are to properly explain this type of product.
Expenses in Variable Universal Life Insurance
Variable universal life expenses are found at two levels: the policy level and the investment account level. At the policy level, expenses have to do with the policy owner’s premium dollar before it reaches the sub-account(s) or separate account(s). Expenses at the policy level are what the company charges in order to cover its costs of doing business. Expenses at the investment account level include the cost of life insurance and the management of the underlying funds.
• Expenses at the Policy Level
Front-End Sales Load
This expense is charged against the policy owner’s going into the policy. Some companies charge a front-end sales load, others do not. The legal limit for a front-end sales load is 8.5 percent.
Back-End Sales Loads
The back-end sales load is the amount the policy owner forfeits when he or she surrenders the policy. A back-end load can be in force for the life of the contract, or it may have an expiration period. When a back-end load phases out after a period of time, it is referred to as a contingent deferred sales charge.
State Premium Taxes
State premium taxes are mandatory expenses levied by the state government. In most cases, when there is a front-end sales load, the state premium tax is taken from there.
Administration Fees
Administration fees can take two forms—first year and ongoing. First year administration fees cover the costs of setting up the policy and any costs incurred in underwriting. The ongoing administration fees go to company services such as mailing confirmation notices, periodic reports, and production of such materials as the prospectus and annual report.
Other service fees can also exist with this type of policy. For example, even though a policy owner may move his or her funds between accounts without incurring a taxable event, the company may or may not allow such changes to be made free of charge. Typically, companies allow a certain number of fund shifts per year free of charge; any number above this amount requires a fee.
• Expenses at the Investment Account Level
Cost of Insurance
The cost of insurance is referred to as the mortality cost. This cost is a monthly expense, and is based upon age, sex, health, use or non-use of smoking products, occupation, and avocation. Once the applicant’s mortality status is determined, it usually remains constant for the life of the policy. Future changes in health cannot increase the insured’s rates. However, the costs for insurance increase naturally during the life of the policy as the insured ages.
Mortality and Expense Charges
The insurance company will provide a number of guarantees within the policy; the cost of these guarantees are reflected in the mortality and expense (M&E) charges. Typical guarantees include maximum monthly administrative charges, maximum monthly cost of life insurance charges, guaranteed annuity factors within the contract, and continuing lifetime service.
Investment Management and Fee Advisory
This is the fee that is charged for the overall management of the underlying mutual funds. This fee is derived daily from the funds’ daily net assets. It varies from fund to fund, and can decline as the size of funds under management grows.
Policy Loans and Withdrawals in Variable Universal Life Insurance
In most cases, policy owners are permitted to borrow up to ninety percent of the cash surrender value of the policy (the cash surrender value is the gross value of money in the policy less the surrender charge.) Loans are typically available for a stated percentage of interest. While the policy owner is not forced to pay the accumulated interest (or the loan principle) back within a certain time, if the sum owed is not repaid during the policy owner’s life, it will ultimately be taken from the death benefit.
Partial withdrawals are also possible with the variable universal policy. Depending on the company’s operating guidelines and policy design, there may be a minimum and maximum on the amounts that can be withdrawn. In addition, withdrawals normally carry a service fee to complete the transaction. Even though partial withdrawals are usually contractually possible in variable universal policies, current tax legislation has made partial withdrawals less attractive than loans in many cases.
Death Benefit Options in Variable Universal Life Insurance
The variable universal life death benefit is a combination of the policy’s cash value and some portion of pure insurance coverage. The pure insurance coverage represents the company’s amount at risk.
Like universal life, the variable universal has two death benefit options, usually termed option one and option two (or “A” and “B”). The choice of death benefit is not irrevocable; the policy owner may switch death benefit option as life circumstances change.
Option One – Level Death Benefit
Under the level death benefit option, the insured selects a total death benefit amount. This face amount will remain level until one of two events: the policy owner decides to alter it, or the growth of cash value forces the death benefit to increase to maintain the legally required ration of cash value to death benefit.
Option Two – Variable Death Benefit
With the variable death benefit option, the policy owner selects the amount of pure insurance coverage desired rather than the total death benefit. The amount of pure insurance remains constant; as the cash value of the policy increases or decreases, the total death benefit varies. This option most closely represents the increasing death benefit option in universal life.
LEVEL DEATH BENEFIT OPTION
$
Age 30 35 40 45 50
VARIABLE DEATH BENEFIT OPTION
$
Age 30 35 40 45 50
Sales and Regulatory Aspects of Variable Insurance Products
Because of the nature of their separate accounts, variable life and variable universal life are classified as securities as well as insurance products. As such, they are regulated by both the state insurance department and state securities commissions.
Securities products are also subject to federal regulation. The federal agency charged with regulating all securities offered to the public is the Securities and Exchange Commission (SEC). This five-member commission was created by the Securities Exchange Act of 1934 for the purpose of enforcing the Securities Act of 1933. The SEC also sets disclosure and accounting rules for most issuers of corporate securities, and oversees the actions of securities firms, investment companies, and investment advisers. The SEC has authority to issue its own rules and regulations.
Along with state and federal regulation, securities products are self-regulated by the securities industry. This self-regulation is managed by the National Association of Securities Dealers (NASD), which is a not-for-profit membership organization of securities firm authorized by Congress in 1939. Membership in the NASD entitles firms to participate in the investment banking and over-the-counter securities business for distributing new issues underwritten by NASD members and to distribute shares of investment companies sponsored by NASD members.
The NASD was created to promote the investment banking and securities industry, standardize its principles and practices, promote high ethical standards, and help its members achieve maximum compliance with applicable state and federal securities laws and regulations. The NASD can issue rulings that are binding on its members.
In order to sell variable insurance products, an agent must be a registered representative for a broker/dealer. The broker/dealer is a firm (or individual) registered with the SEC to buy and sell securities. Generally, insurance companies that sell variable life products establish a broker/dealership for distribution of their product.[28]
In order to become a registered representative, an agent must maintain an active life insurance license and pass either the NASD Series 6 or NASD Series 7 exam and the NASD Series 63 exam. All applicants for these NASD tests must be thoroughly investigated to determine that he or she has not violated any federal or state law or any NASD exchange rule that would prohibit him or her from entering the securities business. As part of the background check, the applicant is finger-printed by the local police department.
The NASD Series 6 exam is titled the Investment Company Products/Variable Contracts Representative Examination. This is the exam most insurance agents selling variable life products opt to take. Unlike the life insurance license, there is no mandatory education component required to sit for the exam. However, as the exam is very rigorous, most agents choose to take an exam preparation course before sitting for the test. This exam only qualifies the individual for sales of mutual funds and variable products. The exam consists of 100 questions with a 2 hour and 15 minute testing time.
The NASD Series 7 exam, titled the General Securities Representative Examination, is an even more extensive exam. In addition to qualifying the applicant to sell mutual funds and variable products, successful completion also allows one to sell stocks, municipals, options, and direct purchase programs. This exam consists of 250 questions, administered in two equal parts of 125 questions each. The allowed testing time is 3 hours for each part.
The NASD Series 63 exam is titled the Uniform Securities Agent State Law Examination. It is also referred to as the “Blue Sky Laws Exam.” This exam consists of 50 questions with a one hour testing time.
It is vital to understand that until one has passed the appropriate exams and been appointed as a registered representative of a broker/dealer, one cannot even approach prospects about variable life insurance products
Just as the sale of life insurance is subject to specific trade practice regulation, the sale of securities must meet certain regulatory requirements. Two of the most important regulatory requirements for the sale of any securities product are the prospectus and suitability.
A prospectus is a document summarizing the information contained in a security’s SEC registration statement. It is important to understand that, with the exception of certain, limited advertisements and direct mail pieces that meet NASD and SEC requirements, contact with a prospect regarding variable life insurance products must be accompanied with a prospectus. This means that sales literature, illustrations, mailers, and face-to-face meetings must include a prospectus.
Suitability means that when an agent recommends a variable insurance product to a prospect, it must be suitable for the prospect’s specific financial needs, circumstances, and objectives. Suitability for a variable life policy includes, but is not necessarily limited to, such elements as a need for permanent life insurance protection, the willingness to be exposed to a risk level greater than traditional whole life, the financial capacity to assume this risk, and the ability to afford the required premium.
Uses of the Product
Variable life products are best suited to persons with a long-term life insurance need and an understanding of basic investments. Since variable products present an element of risk, and it is possible for the death benefit and cash values to decline, it is imperative that the prospect understand the volatility that these products possess. Because of the element of risk inherent in variable life products, these policy designs are often used as supplements to existing life insurance policies that provide the minimum base level of coverage that prudent planning would recommend.
NOTES
REVIEW QUESTIONS
1. Amory has a sound basic life insurance package from his employer. He is currently enjoying high earnings at work would like to boost his insurance coverage AND see his cash value account grow as aggressively as possible. Amory is a good candidate for:
a) traditional whole life
b) current-assumption whole life
c) interest sensitive whole life
d) variable life
2. The variable life policy presents no guarantees: mortality expenses, cash values, and death benefit are all variable.
a) true
b) false
3. Earl would like to start selling variable life products. Which of the following must Earl secure before he can sell these products?
a) Life insurance license
b) NASD Series 6 license
c) Variable contracts license
d) NASD Series 63 license
e) All of the above
f) a, b, and d
4. A life insurance agent without the appropriate NASD license can still solicit clients for variable life products as long as he or she provides a prospectus.
a) true
b) false
5. Variable universal life possesses all of the following features except:
a) two benefit options
b) guaranteed cash values
c) flexible premium
d) partial surrenders
ANSWERS TO THE REVIEW QUESTIONS
1. d
2. b
3. e
4. b
5. b
Chapter Six
The Life Insurance Contract
BASIC CONTRACT ELEMENTS FOR LIFE INSURANCE
For a life insurance contract to be valid, five conditions must be present. The contract must possess an offer and acceptance, a consideration, competent parties, and a legally acceptable form. The power of the contract to be binding is conditional upon the existence of these elements. The absence of even one eliminates the contract's power to bind the parties to the agreement. When a contract is without legal power, it is termed void, and is essentially a worthless piece of paper.
Legal Capacity to Enter a Contract
The first element that must be present for a contract to be valid is the existence of legally competent parties. The law attempts to protect the vulnerable from the actions of the unscrupulous by this provision. Generally, in the area of contract law, the term "competent parties" refers to adults who have the mental capacity to understand the terms and conditions of a legal agreement. Thus, the mentally infirm, retarded, and insane are not generally deemed competent parties. Furthermore, minors typically are not held competent to engage in a legal contract. We have hedged our statements with such words as "typically" and "generally" because the world of law is so complex and fraught with exceptions. As always, we are best advised to leave law to the lawyers, and keep to the plain of generalities rather than risk getting mired in the swamp of
exceptions.
Consideration
The consideration is the second element that is vital to the legal power of a contract. A consideration should be thought of that which make the whole agreement worthwhile. A consideration is simply something with real value that the two parties exchange. What is exchanged could be a service, an amount of money, or the promise to meet a specified obligation. For example, an insured agrees to pay a certain premium in exchange for the insurer's agreement to perform all the duties outlined in the contract should a loss occur. Thus, in a life insurance contract, an insured's premiums lead to the beneficiary's receiving a named death benefit following a premature death -- the paid premium, or consideration, secures the valued contract.
Offer and Acceptance
If legally competent parties and a consideration are present, the third essential element of the legal contract can be approached -- an offer and acceptance. The offer and acceptance is, remarkably for the world of law, just what it sounds to be, one party making an offer and the other party accepting it. The reason it is stated is that the offer must be clear, definite, and free of qualifications. Again, the intent of this condition is to protect honest business persons and the consumer from those who are less than honest and attempt to do business by "scams." Also, it is important to note that in life insurance, an offer and acceptance cannot be oral.
Legal Purpose
Another layer of protection to the consumer supplied by contract law is that an activity must be legal in order to be insurable. In this case, a contract's power is irrevocably bound to the legality of the goods, services, or obligations stipulated in the agreement. The general welfare is obviously protected by this legal provision, and absurd situations avoided.
Insurable Interest
An insurable interest exists when there is the expectation of a monetary loss that can be covered by insurance. For life insurance, an insurable interest must exist at the outset of the contract. Individuals are considered to automatically have an insurable interest in their own lives. An insurable interest also exists between a parent and his or her child, and between spouses.
Other forms of insurable interest can include the relationship between a creditor and a debtor, and an employer and a key employee.
Acceptable Form
Another element of a contract's power has to do with its legally acceptable form. Both the format and language of life insurance contracts must meet specific parameters outlined by the State Insurance Bureau. Furthermore, if a state government requires filing and approval of a contract form, then any issued contract must be filed and accepted by the state following the appropriate legal procedures.
Often in life insurance, a contract is not immediately signed. Rather, a conditional receipt is used instead. This conditional receipt is analogous to a binder in the Property and Casualty line of insurance. Like a binder, the conditional receipt is a temporary contract that makes the insurance company provide some agreed-upon coverage while the application is processed. A conditional receipt is issued with an application and initial premium payment, but it is not a guarantee of acceptance. Still, it must follow acceptable legal form, just like a contract, and temporarily obligates the insurer, just like a contract.
Beyond these basics, the life insurance contract possesses some additional fundamental features that make it different from contracts particular to their types of business. For example, most commercial contracts are commutative contracts. A commutative contract simply means that an agreement has been made that follows acceptable legal format, and specifies conditions for an exchange of more-or-less equal value.
An insurance contract, on the other hand, is an aleatory contract. Here, "aleatory" is really no more than a fifty-cent adjective meaning that the result of a contractual agreement is dependent upon an uncertain outcome or event. Also, in an aleatory contract, the conditions of the transaction may or may not be an equal exchange of value.
The "uncertain event" of a life insurance contract concerns the specific age at which the insured dies. The potentially unequal exchange pertains to the level of benefits paid out in relation to the total value of premiums paid in to the policy.
It is worthwhile to point out that an aleatory contract is not just an elaborate game of chance. First of all, as we have previously mentioned, a contract's legal validity rests in no small part upon it handling a legal activity. In addition, we should not focus overly much on the element of chance alone. Certainly, chance is at the basis of the aleatory contract, but this is not surprising or unusual when we think about the situation. Insurance as we have defined it is a method of handling risk, and risk is no more than uncertainty regarding a loss. What we should realize is that while all gambling arrangements must be aleatory, not all aleatory arrangements are gambling.
The difference here has to do with intent. Pure gambling is done to realize a gain, and has nothing to do with the general welfare. An aleatory contract for insurance purposes, on the other hand, is designed to guard against loss. It is a frank and rational acknowledgment of the risk that is a part of normal life, not the willful seeking-out of additional risk for the possibility of profit.
A further feature of life insurance contracts is that they are characterized by the principle of adhesion. This concept is significant, as it is yet another facet of the insuring contract that make it different from other legal agreements.
All that is meant by a contract of adhesion is that the legal agreement is not built from scratch in equal give-and-take between parties. Instead, in a contract of adhesion, the party which makes the offer to deliver services or meet obligations accepts the entire contract, or refuses it.
Obviously, the offering party in the contract of adhesion has a great deal of power in this arrangement. Everything seems to be formed according to the offerer's terms. In reality, however, the situation is not necessarily so one-sided. For example, areas of ambiguity in the contract that are contested tend to be decided in favor of the party accepting services, in our case, the insured. (Of course, this favoritism has its limits: a failure to understand or properly interpret the contract on the part of the insured does not necessitate that the court rule in the insured's favor.)
Furthermore, as a general rule, all arrangements are subject to compromise. The same is true of the contract of adhesion. Thus, while the substantive elements and overall nature of the contract in life insurance cannot be altered, a wide range of features can be amended by the use of riders. Even though the language and terms of these riders are controlled by the insuring party, the contract is not without flexibility.
Along with being an aleatory contract characterized by the principle of adhesion, the life insurance contract is a unilateral contract. This is yet another feature which separates the life insurance contract from most commercial business contracts. Typically, business contracts are bilateral, meaning that both parties to the contract exchange something of value along specific terms. In the unilateral life insurance contract, on the other hand, only the insurer promises to provide a service. The insured's premium payment is not seen in this case as a service or payment of a claim, but only as part of the consideration of the contract.
The life insurance contract, is also characterized by a conditional nature. This means that it is a contract in which the provisions of the agreement need only be fulfilled if the insured has met certain, specific conditions. In this sense, conditions may be seen as a set of duties. The insured is not legally bound to meet the agreed upon conditions, but the insurer need not meet its obligations if the contract's conditions have not been realized.
Finally, it should be stated that unlike property insurance contracts, life insurance contracts are not characterized by the principle of indemnity. Simply put, a property insurance contract attempts to return an insured to his or her approximate position before a loss. With property loss, a dollar figure can be arrived at to determine how much was at risk. Human life, on the other hand, is not so easily measured.
Life insurance contracts do not attempt to put a dollar value on human life. While various methods do exist to determine the "right" amount of life insurance, these methods are not in any way a form of indemnification. Rather, the life insurance contract is a valued contract. This means that a stated amount of money is paid contingent upon the death of the insured.
It is also worthwhile to note that since the life insurance contract is not an indemnity contract, the principle of subrogation does not apply. You will remember that subrogation is a legal principle by which the insuring party attains rights to pursue damage losses from the negligent party.
REVIEW QUESTIONS
1. Life insurance contracts, like all insurance contracts, are characterized by the principle of indemnity.
a. true
b. false
2. In life insurance, the temporary contract tool that is analogous to the binder in property insurance is called the______________.
a. conditional contract
b. conditional receipt
c. temporary receipt
d. life binder
3. Since the insurance contract is an aleatory contract, it is essentially a sophisticated and legal form of gambling.
a. true
b. false
4. Life insurance contracts are termed valued contracts, meaning that the insuring party will pay a stated amount of money if an agreed upon event -- in this case, premature death -- occurs.
a. true
b. false
5. For any contract in the insurance field to be legally valid, it is vital that it follows a form acceptable to the State Insurance Bureau.
a. true
b. false
6. If it can be demonstrated that one of the parties to a contract was not mentally competent when he or she entered the agreement, it is held that the contract is void due to the lack of legal capacity.
a. true
b. false
7. Since life insurance contracts are contracts of adhesion, entirely new contracts are not crafted out of equal give-and-take between the two signing parties. Rather, a contract is offered by the insurer, and it is accepted or rejected by the customer.
a. true
b. false
8. The conditions in a life insurance contract legally bind the insured to a specific set of duties. The insurer can not only withhold payment of obligations and services, but can even bring suit against the insured if the contract's conditions have been violated.
a. true
b. false
9. For a life insurance contract to be valid, there must be some consideration, meaning a monetary amount exchanged for a promised value to be paid out at the event of an agreed upon contingency.
a. true
b. false
10. Life insurance contract, like most business contracts, are bilateral, because both parties agree to perform a certain set of duties.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. b
2. b
3. b
4. a
5. a
6. a
7. a
8. b
9. a
10. b
CONTRACT PROVISIONS IN LIFE INSURANCE
The insured's rights, as well as the duties of the insurer, are outlined in the life insurance contract. These rights and duties are termed the policy's contract provisions. These provisions operate in conjunction with contract law, and provide the operative parameters of the insuring agreement.
It is important to note that life insurance policy's contract provisions are not universal. Varying from state to state, they are subject to the jurisdiction of the state legislature and the State Insurance Bureau. Nevertheless, there are standard elements to the common contract provisions in the life insurance contract, and this makes a general discussion of them possible.
As the life insurance contract's provisions serve such functions as demonstrating ownership of the contract, availability of policy loans, entitlement of the death benefit, etc., it obviously benefits one to possess a thorough understanding of them. Now, as the typical consumer of life insurance products has rarely distinguished him or herself by making a strong effort to read and master these provisions, it is vital that the insurance professional be able to succinctly explain them to his or her clients.
For life insurance, there are seven provisions that are absolutely vital for the operation of the contract. We will briefly go over each in turn.
Entire-Contract Clause
The entire-contract clause is essentially a device to protect the consumer. The way that the entire-contract clause protects the consumer is to block any incorporation by reference.
The incorporation by reference concept is actually a device to make contractual agreements less cumbersome by including other stipulations and agreements that are based upon the language of other legal documents. This is accomplished simply by reference to those documents.
The potential problem with the incorporation by reference device is that limitations which negatively affect the insured can be effectively hidden. Thus, the entire-contract clause guarantees that the policy is the entire contract between the insurer and the insured. Any changes and attachments made to the policy are considered modifications.
We should note here that the entire-contract clause pertains to the actual policy application as well as the contract. Therefore, all of the pertinent underwriting and medical information supplied by the insured is included. Generally speaking, the information in the application is treated as representation rather than warranty, and most states do not allow the insurer to contest the contract on the basis of statements in the application which are not attached to the actual policy. This helps protect the insurance consumer, as the insurer cannot deny a claim to a beneficiary based upon information in the application (unless, of course, the statement is a material misrepresentation).
Ownership Clause
The clause in the life insurance policy that states who owns the contract is the ownership clause. But this clause does still more than list the name of the owner. The ownership clause is in many ways the most significant clause in the contract as it details the owners rights in the insuring agreement. Such rights include the naming of the beneficiary, the changing of the named beneficiary, accessing the policy's accumulated cash value, and selection of an optional mode of payment. In addition, the policy-owner can transfer ownership of the policy, which can be done by simply filing a form with the insurer that creates an "absolute assignment," or a change of policy ownership free of conditions. The owner of the policy is free to exercise any of these powers unless he or she is constricted by the right of irrevocable beneficiary.
Incontestable Clause
Although life insurance contracts are supposedly contracts of utmost good faith, fraud and dishonesty do occur. In order to protect themselves from unscrupulous consumers, insurers employ an incontestable clause. Simply put, the incontestable clause gives the insurance company a two year time-frame in which to discover fraudulent activities or statements of an insured.
The intent of this clause is to provide a deterrent to fraud. It is reasoned that if a dishonest consumer knows that the insuring company is vigilantly searching for fraud for a full two years, the person will seek some other angle to earn a dishonest dollar.
But the incontestable clause also protects the consumer. Through this provision, the insuring company cannot challenge a contract after a reasonable period of time. The beneficiary is spared the corroding sense of insecurity and potential hardship that would occur if an insurer could contest and void a policy years after the underwriting information should have been made plain.
Lastly, the incontestable clause is designed to promote the general welfare. By providing a guard to the rights of the consumer and the insurer, both benefit. Also, actions that are grossly immoral, such as insurance contracts taken out for the intent of collecting a death benefit from the murder victim are of course not extended protection by the incontestable clause.
Grace Period
The grace period can literally by like an act of grace. This important provision is that stated period of time that the policy remains in force even though the premium has not been paid. This allows the insured to keep his or her insurance protection and avoids the complications of having to reapply for a policy. This device helps guard against tragedies that could occur out of mistakes, failures to communicate, or temporary financial short falls.
When a policy is operating during the grace period, all the rights and privileges contained in the contract are in effect. Should benefits need to be paid out, they would be paid less the amount of the "missing" premium. After the grace period has elapsed, the policy is no longer valid. The normal period for a grace period is 31 days, but because of the nature of such flexible policies as universal life, the grace period may well be longer.
Reinstatement Clause
The reinstatement clause allows for the return of a lapsed contact to its original terms within a specified period of time. This normally occurs after an insured has opted for a non-forfeiture option, such as paid-up conversion or an extended term conversion.
For an insured to be reinstated, evidence of insurability is generally expected. Also, the insured can expect to pay any overdue premiums from the previous due date with an additional interest charge.
Some states legally demand that insurance contracts carry a reinstatement clause. Whether required by law or not, however, most insurance companies carry a reinstatement clause in order to retain customers.
Misstatement-of-Age Clause
The most significant information used for life insurance underwriting is the age of the prospective insured. If an inaccurate age is used to compute the insured's premium, it stands to reason that the result will not be adequate for the risk-level of the prospect. Here, an inaccurate premium means potential danger for an insurer, as the actuarial basis for the company's financial decisions depends on statistical precision.
Lacking some means to guarantee that the correct age be stated in life insurance contracts, it is reasonable to assume that understatement of age would by quite common in the field. The result of lower than necessary premiums on a mass scale could prove ruinous to the industry when the belated claims started coming due.
What then occurs when an insured has misstated his or her age in the policy application? This depends primarily on the time when the error is discovered. For if the correct age is found before the incontestable clause comes into effect, the policy may simply be voided. The insurance company can correctly state that the prospect is not one with whom it cares to conduct business, and send him or her on their way.
The situation is somewhat different if the waiting period of the incontestable clause has elapsed. As mentioned above, the contract is now considered incontestable, and the insurance company cannot cancel it, even though it has discovered fraud.
Still, the company need not remain victimized simply because it was not able to discover the misstatement until some time after the waiting period expired. Rather, the policy remains in force, but the premiums are altered so that they reflect the correct and truthful age of the insured. If the insured has died, benefits are still paid out, but they are paid out at an adjusted level that reflects the correct amount of insurance.
Suicide Clause
The suicide clause mirrors the incontestable clause, in that a two-year window exists during which a claim can be legally denied by the insurer. However, after the two years has expired, the insurer must pay out benefits to the beneficiary even if the cause of death was suicide. (Even in the event of suicide, the named beneficiary does receive back the equivalent of the premiums paid into the policy, without interest.)
The suicide clause provides a dual purpose. Foremost, it is a shield for the insurer against adverse selection. Obviously, an insurer has no desire to sell life insurance coverage to a prospect who intends, for whatever reason, to commit suicide. Furthermore, it is certainly difficult to screen for potential suicides.
The suicide clause also protects the named beneficiary as well. By returning the paid premiums before the expiration of the waiting period and the full benefits afterwards, the best possible situation is made out of a tragedy.
REVIEW QUESTIONS
1. The purpose of the entire-contract clause is to protect the consumer from the potentially adverse elements of incorporation by reference.
a. true
b. false
2. The entire-contract clause only pertains to the contract, it does not encompass the actual policy application.
a. true
b. false
3. The ownership clause outlines the policy owner's rights and privileges in the contract.
a. true
b. false
4. A policy owner's powers are constricted if there is an irrevocable beneficiary.
a. true
b. false
5. The incontestable clause states that a policy cannot be dropped by the insurer after the expiration of a two year waiting period.
a. true
b. false
6. The incontestable clause protects the consumer by guaranteeing that the insurer cannot challenge a contract after a reasonable amount of time.
a. true
b. false
7. The grace period normally lasts for 31 days, and allows the policy to stay in force even if the last premium has not been paid.
a. true
b. false
8. Because of the flexible nature of universal life policies, the grace period is often shorter than 31 days.
a. true
b. false
9. The ____________ allows for the return of a lapsed contract to its original terms within a specified period of time.
a. replacement clause
b. reinstatement clause
c. reinforcement clause
d. retro clause
10. If a misstatement of age is found in an insured's policy after the waiting period has elapse, the policy stays active, but the premium is recalculated to reflect the accurate level.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. a
2. b
3. a
4. a
5. a
6. a
7. a
8. b
9. b
10. a
OTHER FEATURES OF THE LIFE CONTRACT
Beneficiary Status
A significant aspect of the life insurance contract concerns how the beneficiary is named. The beneficiary is that party who is named in the contract to receive the death benefit in event of the death of the insured. There are generally few limits on who or what can be named as the beneficiary to a life insurance contract. A pet, a charity, a partnership, or a trustee are just some of the more unusual potential beneficiaries of a life insurance contract. As would be expected, however, most often named beneficiary is a relative of the insured, usually a child or a spouse.
In regards to children, a couple of situations can occur. When the child is still that, a minor, then the death benefit cannot be received directly. In this case, a trustee or guardian should be named as the beneficiary.
When the insured has many children, another situation arises if no one specific is named as the beneficiary, but rather the "children" are to receive the policy's proceeds. In this case, the monies are divided equally among the multiple beneficiaries. This is termed the payment of a class beneficiary.
The class beneficiary is different from the two more typical varieties in life insurance: primary and contingent beneficiaries. The primary beneficiary is first in line for the death benefit. The contingent beneficiary is the secondary beneficiary. He or she is next in line, or is entitled to the death benefit proceeds should the primary beneficiary die before the insured.
Generally speaking, the named beneficiary can be changed. This is a policy with a revocable beneficiary status. The tricky (and dangerous) element here is that the beneficiary need not be informed that they have been dropped from the policy.
A life insurance policy with an irrevocable beneficiary, on the other hand, constricts the freedom of the insured to exercise his or her ownership. To begin with, the named beneficiary of this form of policy cannot be changed without his or her written consent. Secondly, when an irrevocable beneficiary is named, the policy is effectively placed outside the estate of the insured, who subsequently surrenders incidences of ownership as they relate to the federal estate tax.
Change Of Plan Provision
Another example of the life insurance contract's ability to change in order to adapt to new needs and conditions is the change of plan provision. Simply put, this provision is a feature that allows for the insured to change his or her contract. Should the exchange go for the policy with a lower premium than the policy it replaces, and if the insured has an amount of cash value built up in the former policy, he or she will have that amount refunded. Conversely, should a higher premium policy be desired, the difference in cash value would be corrected in favor of the insurance company.
Assignment
An insurance policy is also modified when it is assigned. Two varieties of assignment exist, absolute assignment and collateral assignment. This is a feature that is not available to the property insurance contract, and can have important business ramifications for the life insurance policy-owner.
When an absolute assignment is made, a situation is formed in which all ownership is transferred to the named party. A collateral assignment, on the other hand, is partial and temporary. In this situation, a part or all of a life insurance's death benefit is assigned to another party as collateral. An example of this is a bank making a loan to a policy-owner. This is a common enough practice that many banks possess assignment forms on file.
REVIEW QUESTIONS
1. Who can be named a beneficiary of a life insurance policy is limited to living persons. Pets, partnerships, and charities are excluded.
a. true
b. false
2. Generally, the named beneficiary in a life insurance policy is the insured's spouse or children.
a. true
b. false
3. Should the named beneficiary be a minor at the time of the insured's death, the proceeds from the policy are paid out in a lump sum and placed into a account. A trustee or guardian are useful, but not required.
a. true
b. false
4. A policy with an insured's children listed as the beneficiary has a class beneficiary. The proceeds in this case are split into equal portions and disbursed.
a. true
b. false
5. Should both the primary and contingent beneficiary be deceased before the death of the insured, the monies from the death benefit are attached to the insured's estate.
a. true
b. false
6. A life insurance policy with a revocable beneficiary provision allows for the insured to change his or her beneficiary without gaining their consent or informing them or the change in status.
a. true
b. false
7. The reason for the change of plan provision is to aid in the practice of twisting.
a. true
b. false
8. An absolute assignment is a fairly common practice in both life and property insurance.
a. true
b. false
9. A collateral assignment is a procedure by which the holder of a life insurance policy may obtain a loan from a bank by assigning all or part of the death benefit to the bank as collateral.
a. true
b. false
10. When a policy possesses an irrevocable beneficiary, the insured is said to have surrendered all incidences of ownership as they relate to the federal estate tax.
a. true
b.false
ANSWERS TO THE REVIEW QUESTIONS
1. b
2. a
3. b
4. a
5. a
6. a
7. b
8. b
9. a
10. a
LOANS AND OPTIONS
Policy Loans
One of the outstanding features of the cash value life insurance contract is that it builds monies that the contract holder can access. The methods of accessing these funds are diverse. One of the most popular is the policy loan.
The life insurance loan will be at interest rates that are much lower than those available from traditional lenders. The interest rate to be charged is stated in the policy loan provision section. It is possible that some contracts will have variable interest rates that are tied to a bond index. Most important, gaining a policy loan is much easier than loaning money from a banking institution. One is not subjected to the necessary but inconvenient hassle of a credit check. Also, the repayment schedule is set by the contract holder.
If the interest on a policy loan is not paid at the year's end, it is rolled into the outstanding loan. The loan amount should of course be paid in full before a death benefit is distributed. If it is not paid, then the death benefit is reduced by the amount necessary to pay the loan back in full.
Dividend Options
When we speak of a "participating policy" we are referring to a policy that pays dividends to its owner. A dividend is nothing more than a surplus that the insuring company receives when there is a positive difference between expected and actual expenses. This difference could arise from operating expenses, or mortality experience. As the consumer expects a dividend, even though it is not guaranteed, calculations of predicted losses and investment returns are made sufficiently low to make a dividend easy to generate. The money that arises in form of a dividend needs to take some form of pay-out. There are five methods of dividend pay-out.
One method of paying the dividend is to apply it to the next premium. Using this method, the contract holder receives a notice when there is a dividend stating the dividend's value. He or she then need only pay the difference between their premium and the dividend to continue coverage.
Also, a dividend can be paid out in cash. Naturally, this is a popular form of pay-out structure at first glance. Upon examination, however, cash payments tend not to be taken because the recipient must pay tax on these sums. The cash option is generally paid out on the anniversary date of the policy.
Dividends may also be used to buy increments of paid-up insurance. This can be used in a single premium whole life policy. Using a paid-up insurance dividend option circumvents the policy's load, effectively purchasing insurance at net rates.
Another option with dividends is to let them stay with the insuring company and accumulate at interest. These dividends may be withdrawn at any time by the insured, or they may be left in the account with the purpose of being ultimately added to the death benefit pay-out. It is interesting to note that the interest that accumulates under this system of dividend option is taxable, and must be reported.
Lastly, there is the so-called Fifth Dividend Option. This is a form of term insurance. The dividend in this option buys an annual, renewable term insurance, or a one year term contract that is equal to the cash value of the underlying policy. If a difference is left over under the second option, it is usually left in the insuring company's account to accumulate at interest.
While dividend options are generally the province of life insurance contracts, some health insurance contracts also present dividend options. All in all, a dividend option can be thought of as a refund of some portion of the contract's gross premium whenever the insurance company has had a favorable year.
Nonforfeiture Options
Nonforfeiture options are applicable to cash value life insurance policies. These options are a form of policy provision that protects the policy-owner from losing the cash value that has accumulated in the account. This option provides four methods of protecting the policy-owner's equity.
First, the policy can be surrendered for its cash value. This surrender will be for the full amount of the cash value account, less any outstanding loans and interest on the loans. It is technically feasible that an insurance company can reserve the right to withhold the cash value for up to six months. This is, however, a left-over from the Depression era, when devices were needed to slow the draw of cash from insurers. Today, this is rarely if ever used.
Another nonforfeiture option takes the form of extended term insurance. The cash value buys a paid-up term policy for a specified period of time under this strategy.
Also possible is a paid-up insurance option. This option uses the cash value to buy a reduced, paid-up policy with a net single premium. This creates a policy that is essentially the same as the policy that was replaced, but with a smaller death benefit -- and the absence of any future payments!
Lastly, there is the loan value option. This option allows the insured to borrow from the company, with the cash value used as collateral for the loan.
Settlement Options
Sometimes, an insured may not want to receive the life
insurance's proceeds in a single payment. When this occurs, we say that an optional mode of settlement has been decided upon. Optional modes of settlement have four main forms, with the fourth posing a number of variations within its own structure.
When a sizable amount of money is not needed immediately, the beneficiary may elect an interest option as the mode of settlement. This is a highly flexible form of pay-out. The benefit proceeds are left with the insurance company, and gain interest. The accumulated interest is paid-out to the beneficiary monthly, quarterly, or annually. Also, the principal can be accessed at any time. In addition, the beneficiary can alter this settlement to another form at any time. This option provides a small, regular cash flow.
Another type of flexible settlement option is the fixed amount option. As the name would indicate, the death benefit is paid out in installments until the monies are exhausted. This strategy allows the beneficiary considerable room to tailor the plan to his or her changing needs. For example, the fixed amount can be raised or lowered at any point. Withdrawals from the benefit proceeds above and beyond the fixed amount can be made, and this mode of settlement can be changed at any time.
A mode of settlement which is not flexible is the fixed period option, and is not to be confused with the fixed amount option. This strategy allows for the disbursement of the death benefit proceeds over a specific, fixed period of time. The structure is not adjustable, and withdrawals are rarely permitted.
Lastly, there are the life income options. Life income options are methods of disbursement through an annuity, and as such they mirror an annuity's structure.
Thus, a pure life income option is a pay-out format in which the proceeds are paid out only when the beneficiary is alive. When the beneficiary dies, proceeds cease and are kept by the insuring company.
On the other hand, a life income with period certain option allows for a secondary beneficiary to receive payments for some stated period after the death of the primary, named beneficiary. This provides a guarantee that someone will receive the benefit proceeds in the event of the primary name beneficiary's death, but the payments are smaller than under that of the life income option.
A married couple, however, would probably choose a joint-and-survivor option. This structure allows for the payment of the benefit to two persons, and payments continue when one of the two dies.
REVIEW QUESTIONS
1. A loan from a cash value insurance policy really presents no advantage over a loan from a bank. One must still be approved, a credit check is run, etc.
a. true
b. false
2. Dividend options are a feature of insurance contracts in non-participating policies.
a. true
b. false
3. Essentially, a dividend payment is a type of refund that an insurance company offers to the policy holder because expenses or mortality were less than anticipated.
a. true
b. false
4. The Fifth Dividend Option is a method of purchasing annually renewable term insurance with the dividend.
a. true
b. false
5. Nonforfeiture options are policy provisions designed to protect the contract holder's equity in a cash value insurance policy.
a. true
b. false
6. Perhaps the most common nonforfeiture option is the surrender of the policy's cash value, less any outstanding loans or interest payments due the insuring company.
a. true
b. false
7. Settlement options are policy provisions that allowed for a mode of distributing a policy's proceeds in a manner other than a single, lump sum payment.
a. true
b. false
8. Interest option and fixed amount option are two types of settlement options that are characterized by a high degree of flexibility.
a. true
b. false
9. A life income option is a settlement option that turns the policy proceeds into a type of annuity.
a. true
b. false
10. The interest rate for a policy loan is stated in the contract's loan provision section. It is not uncommon for the rate to be tied to an index.
a. true
b. false
ANSWERS TO REVIEW QUESTIONS
1. b
2. b
3. a
4. a
5. a
6. a
7. a
8. a
9. a
10. a
THE COST-OF-LIVING AND DOUBLE INDEMNITY RIDERS
Cost-of Living Rider
The cost-of-living rider, or cost of living increase, is just that -- an increase in benefit level designed to ward off the corroding effects of inflation. This is a policy provision that is typically added to life insurance policies at the demand of an extremely inflation-conscious public.
In short, the cost-of-living rider allows the insured to buy a year's worth of term insurance that is equal to the percentage change in the Consumer Price Index (CPI). This additional insurance can be had without the insured's providing evidence of insurability.
The level of this additional term insurance is linked to the CPI, and will vary on a constant basis, just as does the CPI. Theoretically, this adjusted amount can go up or down. The rider is not designed to handle hyper-inflation, however, as the adjusted increase is generally capped to reflect some percentage of the policy's face amount.
Double Indemnity Rider
Double-indemnity is also known as the accidental death clause. It provides an additional (double) death benefit should the insured die from an accident. There is also a triple indemnity, in which case three times the face value of the contract is paid out in event of accidental death.
The double-indemnity rider can be had for a relatively small charge. Even though it is affordable, however, it is not usually as valuable as it is popular. Foremost, it provides an illusion of expanded coverage. The increase in benefits are accessible only after having met a number of exclusionary objections. Secondly, disease and not accidental injury is the killer of most insureds. Nonetheless, the double-indemnity rider remains in demand.
In order to be eligible for the added benefits of a double-indemnity claim, it must be demonstrated that the insured died as a direct result of an accidental injury. Next, the death has to occur soon after the accidental injury. Typically, the insured must die within 90 days of the injury. And finally, the rider will state the high-end age at which the benefit will be paid out.
As with so many insuring agreements, the double-indemnity rider outlines a list of exclusions to prevent abuses of this provision. For example, as the rider is limited to accidents, deaths from disease or insanity are not eligible for benefits. Suicide is also an excluded death, as is any death that occurs while committing a crime. Finally, death that arises out of the inhalation of poison fumes, flying in a non-commercial airplane, or during an act of war cannot receive benefits from this rider.
REVIEW QUESTIONS
1. The cost-of-living rider is a provision that will increase or decrease the face amount of a policy in conjunction with shifts in the Consumer Price Index.
a. true
b. false
2. The additional protection of the cost-of-living rider comes through the purchase of additional term insurance.
a. true
b. false
3. The primary goal of the cost-of-living rider to protect the insured from the negative effects of inflation by keeping his or her face value in tune with current prices.
a. true
b. false
4. The adjusted level of insurance in the cost-of-living rider is usually capped to reflect a stated percentage of the policy's face amount.
a. true
b. false
5. The double-indemnity rider is a valuable contract provision for most consumers, but is often not purchased because it is so expensive.
a. true
b. false
6. The double-indemnity rider is generally a good deal for most consumers because most people today die of accidents rather than disease.
a. true
b. false
7. In order for an insured to claim benefits through a double-indemnity rider, it must be shown that the death occurred as the direct result of an accidental injury.
a. true
b. false
8. The double-indemnity rider usually covers accidental death caused by inhalation of poisonous fumes.
a. true
b. false
9. If an insured with a double-indemnity rider dies exactly one year after an accidental injury, his or her policy will probably not pay double the face amount of the policy.
a. true
b. false
10. The double-indemnity rider is not subject to any exclusions.
a. true
b. false
ANSWERS TO THE REVIEW QUESTIONS
1. a
2. a
3. a
4. a
5. b
6. b
7. a
8. b
9. a
10. b
Ethics
Table of Contents
Part One. The Field of Insurance…………………389
Part Two. The Producer’s Role: Ethics and
Professionalism………………………..405
Part Three. Issues of Fairness in Insurance……….443
The Field of Insurance
Varieties of Risk: The Underlying Basis for Insurance
Risk. It is a small word, but one that draws attention. It has such a powerful influence because human nature dislikes uncertainty. Our risk-adverse natures can make it difficult to think willingly about risk. We feel uncomfortable contemplating the loss of a loved one, the unintentional injuring of a stranger, or a fire in our home. Yet, whether the threat of risk makes us feel uncomfortable or not, we must face up to it. Risk is pervasive.
The concept of risk also includes a sense that while a loss may occur, it is not likely to occur. Little security comes from knowing that losses seldom happen. After all, it is probable that some improbable events will occur. In addition, the loss could be minor (misplacing some costume jewelry) or devastating (wrecking one’s car).
Because of risk’s pervasiveness, it must be confronted and managed. As we examine risk, we quickly find that it possesses distinct properties, and these can be analyzed and classified. Risk possesses general laws, and knowing these laws, it can be managed. The better we can manage risk in our lives, the less anxiety we will experience, and we will be able to pursue our endeavors with greater confidence.
Risk can be defined as an uncertainty of loss. Typically, the loss is of a financial nature. It can also be termed a danger that one insures against. The questions that arise as we analyze risk and how it operates are the following: What categories of risk exist? What rules or principles can risk follow? What kinds of risk can be avoided? What kinds of risk can be managed?
One type of risk affects everyone. This is fundamental risk. For example, every area can experience damaging weather. A severe dislocation in the economy is a fundamental risk, as is the threat of war. These types of risks are usually met with social insurance and government involvement.
Fundamental risks are very different from particular risks. Particular risk is specific to an individual, and subject to choices. For example, if Joe Client chooses to skydive as a hobby, only he bears the risk of this activity.
Risk can also be classified as static and dynamic. A static risk has to do with human error, wrongdoing, and acts of nature. A dynamic risk is connected with the volatile nature of the economy. Most dynamic risks are also speculative risks. This means that both loss and gain are possible. Investing in a limited partnership is an exposure to a dynamic, speculative risk.
Static risks are pure risks, and can be further subdivided. For example, there are personal risks affecting individuals through the loss of their property, their income, and their health. One way a family experiences pure risks is through the premature death of one its members. Being held legally liable for a person’s loss is another form of pure risk. This variation of risk touches professionals through accusations of malpractice, business persons through accusations of product defects, and anyone who operates an automobile through accusations of negligence. Of course, our list could go on and on.
A final classification can be used when considering risk. The world of risk includes both objective and subjective risks. Subjective risk is uncertainty based on an individual’s emotional reasoning and state of mind. Objective risk, on the other hand, is the relative difference between the actual loss and the expected loss.
Objective risk follows a very specific mathematical principle—it is inversely proportional to the square root of the number of items observed. In practical terms, this means that the more exposures, the less the objective risk. This is very important because it means that objective risk can be measured.
Risk is also subject to the law of large numbers. This is also a mathematical principle. It states that the greater the number of exposures, the more certain one can be in predicting the outcome. When speaking in terms of losses, we can state that actual losses will be less than expected losses as the number of exposures increases.
Risk Management Strategies
While most people are not aware of the mathematical principles that can be used to analyze and measure risk, all people—and all businesses--practice some form of risk management.
For example, risk can be avoided. Any non-swimmer will probably take pains to avoid the water. Choosing not to participate in high-risk hobbies like sky-diving is another example of avoiding risk.
Typically, most people passively retain a wide variety of risks. A risk is passively retained when it is not recognized or understood, when the cost of treating it is prohibitive, or when the severity of the loss is deemed inconsequential.
For example, many consumers do not believe that they need disability insurance, and are satisfied with the level of their life insurance. It can be statistically demonstrated, however, that disability is a very real risk and occurs at a greater frequency than the “average consumer” believes. It is also statistically demonstrable that the face value of the life insurance in force is in many cases inadequate.
The reasons for these examples of passive retention are various and complex, and are as different and complex as the individuals at risk. In some cases, consumers understand the threat presented by disability, but mistakenly believe that their health insurance also provides extensive disability income benefits. In other cases, the consumer may believe that the cost of purchasing a disability policy would be more than he could afford.
A similar scenario can occur with life insurance. After a visit from an insurance representative, the breadwinner of a family may recognize the need for life insurance. They discuss options with the agent, and decide a whole life policy makes the most sense. A needs assessment shows that $100,000 of coverage would be ideal, but the cost is prohibitive. A policy with a $50,000 face value is purchased instead. In other cases, the agent may not be able to convince the prospect that life insurance is needed.
Risk can also be handled by a non-insurance transfer. This strategy can shift risk from one party to another by contractual agreement. For example, a company may lease photocopiers. The lease agreement can stipulate that maintenance, repairs, and physical losses to the equipment are the responsibility of the company leasing out the photocopiers. Another example of non-insurance transfer is using a hold harmless agreement.
Loss control is another form of risk management. Loss control attempts to lower the frequency and the severity of a loss. Loss control is an active retention of risk.
Examples of loss control could be safety training, posting of safety regulations, and an active policy of enforcing safety regulations. These practices would all fall under the category of controlling the frequency of the loss. An example of controlling the severity of a loss would be installing a perimeter alarm system.
The purchase of an insurance coverage (or coverages) is what most people consider as risk management. For a company or organization, a commercial insurance package will be employed. This insurance will cover the essential insurance that is mandated by law. It may also include desirable insurance that covers losses that would threaten the company’s survival, and available insurance that covers losses that are not serious, but would present major inconvenience.
A similar pattern exists for individuals and families. Some insurance will be purchased that is essential, such as PLPD coverage for automobiles and homeowners’ insurance when a house is purchased. Other insurance, such as health coverage, may be considered desirable. A life policy for a single person with no dependents could be considered available insurance.
Insurance is not always an option, however, when devising a risk management strategy. In order for a risk to be insurable, it must meet specific criteria. The requirements for a risk to be considered insurable are: a) the loss is definable; b) the loss is fortuitous; c) the loss can be insured for a premium that is reasonable; d) the loss is part of a large number of homogeneous exposures. Only when these requirements are met can we say that the loss can be underwritten.
Underwriting
Underwriting is the process of selecting, classifying, and rating risks. Underwriting occurs in the field by the agent and at the home office by a lay underwriter.
Field underwriting occurs when the agent collects information from the policy applicant. The agent as field underwriter helps protect the insurance company from adverse selection. Adverse selection occurs when a company insures someone who is a greater than average risk at a standard premium rate. In order to avoid this situation, the agent must ask the correct questions and supply the proper information so the policy can be denied (if uninsurable) or issued at the proper rate.
For insurance applications, the agent will typically ask for such information as the applicant’s name and address, and pursue relevant background information on the applicant. For life insurance, specific information on the applicant’s health will be asked, and a medical examination may be required. For health insurance, detailed information on the applicant’s medical history may or may not be required.
For property and casualty insurance, the agent will need to find out what kind of property (or hazard) is to be insured. The location of the property, as well as prior loss experience (if any), is vital information.
Throughout the field underwriting process, the agent should be on guard for evidence of moral hazard and morale hazard. Moral hazard refers to circumstances in which the probability of a loss is increased because of the applicant’s personal habits or morals. For example, an applicant who has shown an unwillingness to meet financial obligations and is excessively absent from work may present a greater chance of abusing disability leave.
A morale hazard is a situation in which the probability of loss is increased because of the applicant’s indifferent attitude. For example, an applicant that routinely leaves the keys in an unlocked car, or keeps the car running when filling the gas tank, creates a morale hazard.
When acting in the capacity of a field underwriter, it is the responsibility of the agent to be sure to ask clear questions in order to get accurate and precise answers. If potential problems arise, the agent should ask probing questions to ascertain the truth. If suspicions remain, these should be outlined for the home office underwriting department.
It is absolutely imperative that the agent keep in mind that the signed and witnessed application is a part of the legal contract between the insured and the insurer. Fraud can occur during the application process when the applicant withholds material facts.
The accuracy of information during the application process is important because the lay underwriters in the home office depend on these facts when determining the policy’s rates. The guidelines used for underwriting policies must have an accurate actuarial basis for the company to stay competitive.
The Ethical Tension in Insurance
Insurance is a product that consumers love to hate. At best, it is viewed as a necessary evil. At worst, it is considered a “scam.” The quick response the average consumer has toward insurance is that it cannot be issued for what he or she would like to cover (like stock market losses), and the company never wants to pay for losses that it has covered.
This dislike of insurance stems from multiple sources. First, the purchase of insurance requires an outlay of money that does not result in an immediate and readily perceived benefit. The consumer often feels that money is being spent for nothing. In cases where financial responsibility laws compel one to carry insurance coverage, as in the case of no-fault automobile insurance, the consumer chaffs at being forced to act—even if it is in his or her own best interests.
Second, when insurance pays out benefits, it does so only in the event of a loss. The situations in which consumers “enjoy” the benefits of adequate insurance coverage are never joyful ones.
Third, despite the growth of a vigorous consumer movement and an explosion of readily available information in the print media and the Internet, insurance remains a mystery to most consumers.
Compared to investments, real estate, and consumer goods like automobiles, insurance is a product that consumers often purchase without significant research. Whether because it is perceived as “boring” or just too complicated, the only thing many consumers know about their insurance is that they have to have it, and it is “too expensive.”
Along with the animosity many consumers feel toward insurance, it has been shown that even people that consider themselves trustworthy are more likely to defraud an insurance company than other institutions or industries. Why is this?
Besides resenting having to spend hard-earned dollars on what amounts to a promise, consumers also perceive insurance companies as being unimaginably (and unjustly?) rich. Because of this perception, consumers often adopt an entitlement attitude when filing for a claim. They may inflate the loss so that they can collect more than they know they should, but feel that they are entitled to. Often this behavior is rationalized with the argument that everyone inflates their claims, and the insurance companies know this and therefore inflate their premiums.
These attitudes help to create a vicious circle of mistrust. But it is more than mistrust that forms the foundation for this mistrust. Rather, the fundamental interests of the insured and the insurer are at odds. The insured wants to collect everything he or she can; the insurance company wants to pay only what it is legally obligated to, and wants to shape all of its procedures, from underwriting to marketing, so that it is in as strong a position as possible. A “strong position” in this case means pulling in premium dollars for insureds that do not suffer insurable losses. The tension is so palpably obvious that it even leads to jokes, such as the abbreviation “HMO” standing for “healthy members only”—implying that sick people need not apply for health coverage.
The idea that all insurance companies never will pay claims is obviously not true. But the notion that the insurance company wants to cover favorable risks is true. What arises is a struggle between actuarial needs, our social concepts of fairness, and the pursuit of individual interests.
This struggle is best seen in the underwriting issue known as redlining. Redlining is a term that refers to the process of denying coverage to areas deemed too risky to insure. During the 1970s, the NAIC amended its Unfair Trade Practices Act to prohibit unfair discrimination based on the geographic location (and age) of residential property. The concept of redlining now imbues a host of other potential risks.
The problem is obvious—not all risks are equal! In many instances, the increase in the level of risk is based on geographic area, and for the insurance company to remain viable, it must be able to charge premium that is correct for the increased level of risk. The insurance company must discriminate. The challenge is for its underwriters to discriminate fairly, based solely on sound actuarial information and staying completely within the letter and the spirit of the law.
Insurance can be defined as a mechanism whereby the burdens of a number of pure risks are shifted through legal contract by pooling them. This sterile definition, however, does not convey the intrinsic conflict that can exist in this arrangement: those who have employed the insurance vehicle are going to wish to collect, while those who have assumed the burden are hoping to avoid paying.
If everyone plays by the rules—meaning the spirit as well as the letter of the legal agreement—all would be in order. Unfortunately, money can all too often weaken the will to “play by the rules.”
Review Questions
1. Fundamental risks affect everyone, while particular risks are specific to individuals.
a) true
b) false
2. Adverse selection occurs when a company insures someone who is a lesser than average risk at a standard premium rate.
a) true
b) false
3. Moral hazard refers to circumstances in which the probability of loss is increased because of the applicant’s personal habits or morals.
a) true
b) false
4. The accuracy of information during the application process is important because underwriters in the home office depend on the facts for determining policy rates.
a) true
b) false
5. A morale hazard is a situation in which the probability of a loss is decreased because of an applicant's indifferent attitude.
a) true
b) false
Answers to Review Questions
1. true
2. false
3. true
4. true
5. false
The Agent’s Role: Ethics and Professionalism
Staying within Acceptable Guidelines
The inherent conflict of interest in insurance is well known to the agent. The agent is expected to adhere to the highest ethical standards, and put the interest of the consumer first. Unfortunately, the agent is paid by commission—he or she is expected to sell. In addition, the industry heaps its honors and rewards not on the most ethical, most educated, most diligent providers of policy service, but on its top producers, i.e. salespersons.
Because the agent is the key figure in the insurance transaction, the weight of insurance’s inherent ethical tension falls on his or her shoulders. The agent must sell enough to survive and, ultimately, prosper; at the same time, he or she must play by the rules, and obey both the letter and the spirit of the law. When staying within appropriate ethical guidelines, there are a number of areas that agents must pay special attention to.
Some of these areas are outlined under the Unfair Trade Practices Act, and can include issues in marketing and claims. Others are hot-button issues in insurance that have led to lawsuits and additional regulations.
Twisting, Churning and Replacement
Twisting occurs when an agent induces an insured to drop an existing policy in order to purchase similar coverage with a different company. This is typically done by giving incomplete—or inaccurate—comparisons of policies. Twisting can also be termed external replacement.
Churning occurs when a policy is replaced with a new policy from the same company. This typically happens to policies that have built up significant cash value. The cash value is used to pay all, or most, of the premiums in the new policy, often entirely depleting the entire cash value of the old policy. Churning is also called internal replacement.
Policy replacement is a very controversial issue for life insurance. The NAIC model act views replacement as any transaction that results in new life insurance or a new annuity, and a series of factors are involved. For example, if it is known to the agent or insurer that an in-force life insurance or annuity contract will be lapsed, forfeited, surrendered, or terminated, replacement has occurred. If an in-force policy is converted to reduced paid-up insurance that will continue as term coverage, replacement has occurred. If a policy is reduced in value through the use of non-forfeiture benefits or other policy values, replacement has occurred. If a policy is amended so benefits are reduced, replacement has occurred. Likewise, if a policy is amended so that benefits are reduced in the term that coverage would be in force, or that the benefits would be paid, it has been replaced. Finally, a policy is replaced if it is reissued with reduction in cash value.
Whenever replacement is involved, the agent needs to secure a signed statement form the applicant that insurance is to be replaced. The agent must give the applicant a Notice to Applicants Regarding Replacement of Life Insurance and Comparison Statement that has been completed and signed by the agent. The applicant should receive a copy of these two documents.
In addition, the agent must give the insurer a copy of all existing life insurance policies to be replaced, along with any proposals made. A copy of the Comparison Statement and the name of the insurer that is going to be replaced must also be submitted to the proposed insurer.
Most important of all, the agent needs to be careful not to mislead or misinform the applicant. This is a time when the agent wears the hat of educator, and must be sure that the applicant fully understands the ramifications of his or her decisions. Finally, the agent must be sure that the applicant does not purchase a policy that is not to his or her advantage.
Misrepresentations
It is against the law, and an ethical failure, to misrepresent oneself, one’s company, or one’s product. Misrepresentations can occur verbally, or they can be in the form of policy illustrations and sales materials. The areas that are typically misrepresented during the insurance sales transactions are the benefits and features of policies. Misrepresentations might include presenting an incomplete comparison, using misleading terms, or implying a feature or benefit exists when it does not.
False Advertising
False advertising is a form of deception. It occurs any time sales and advertising materials contain statements that are untrue, deceptive, or misleading. Because of recent concerns over false advertising, more and more insurers are allowing only the use of pre-approved sales materials and eliminating, or severely curtailing, individualized presentations.
Policy Illustrations
The 1980s saw significant changes in the economy, in interest rates, and in the development of new insurance products. Along with these changes came policy illustrations that are rife with problems. In many instances, these illustrations employed unrealistically optimistic interest rates, or highly favorable but non-guaranteed assumptions. These flaws created a potentially distorted picture, and when “vanishing premiums” failed to vanish, and cash values failed to accumulate at the implied rate, consumer groups went on the offensive.
While the agent understands that policy illustrations are just that—illustrations—the applicant is often unable to keep the proper perspective. The illustration tends to leave a stronger impression than the accompanying disclaimers. In addition, the applicant is much more likely to read and remember the policy illustration than the detailed sales literature (or, when applicable, the prospectus).
As a result of the concern surrounding policy illustrations and their use, the NAIC adopted new model regulation for illustrations in 1995. The goal of these illustrations is to make them easier to understand, less subject to misunderstandings, and help increase consumer confidence in the industry.
Illustrations following the new NAIC model must be “self-supporting,” and interest rates used for determining non-guaranteed elements may not be greater than the earned interest rate underlying a scale that is reasonable and based on actual recent historical experience. The illustrations are to have three clearly delineated columns that separately illustrate guaranteed values, current values, and the current return minus 1%.
Under the guidelines of the new NAIC model, agents cannot represent the policy as something other than a life insurance policy. The non-guaranteed elements must be clearly noted as non-guaranteed. Agents cannot present premium payments as not being required each year. The term “vanishing premium” may no longer be used.
Furthermore, the applicant who has been shown an illustration must sign a copy stating this. If no policy illustration was used, the applicant and agent must certify this in writing. The applicant must also be provided with an annual report on the policy’s status.
Defamation
Defamation is derogatory or malicious criticism about another individual or company. It is illegal, and can occur by written or oral statement. Most often it occurs when speaking about another company and its products. While some companies allow comparisons, it is best to limit comparisons to professional rating organizations like A.M. Best.
Disclosure
Another controversial issue for insurance has been “disclosure.” Disclosure is the “telling it like it is” portion of the insurance transaction, during which the benefits and the risks of the policy are to explained.
To help protect all parties, agents should ideally make use of disclosure forms and disclosure letters. The disclosure form outlines and explains the important elements of the policy, from information on the company to the policy’s features. It can also include any illustrations used, the prospectus (if applicable), and a life insurance buyer’s guide.
The disclosure letter recaps what occurred during the sales presentation. This is not only an excellent follow-up tool, but it also helps form a paper trail of what was discussed, what was recommended and why, and what decisions were made.
The life insurance industry has three hot points in the area of disclosure, all of which have to do with terminology. The first is the use of the word “agent.”
As the life insurance, banking, and securities industries both compete—and combine—with each other, agents begin to wear several hats. Nevertheless, when selling life insurance, the agent is a life insurance agent representing a life insurance company. They should not refer to themselves as financial planners, retirement planners, financial consultants, or any other of a host of titles. An agent may refer to the fact that he or she sells a variety of financial products to meet a variety of needs, but it is imperative to be explicit and clear about being a life insurance agent who represents a life insurance company.
A related area of concern in disclosure for life insurance is the distinction between investments and insurance. Even though cash value insurance has an investment element, it is an insurance product that is purchased primarily for protection. While cash value life insurance may be used for a wide variety of purposes, it should not be called an investment product.
Finally, cash value and premiums should only be referred to by their proper names. Thus, the agent should refrain from calling cash value equity, earnings, savings, or any related term. The premium is also not a deposit, payment, or contribution.
As the primary link between the consumer and the industry, the insurance agent is under constant pressure to both produce and stay within the rules. While the product that the agent sells is extremely important, it is also difficult to sell. The difficulty of building an adequate book of business, coupled with pressure from the home office, can make ethical sales challenging. How is the agent to make good decisions, to serve the customer, benefit the company, and write enough business to survive?
The formula for writing insurance business is the Holy Grail of the industry. While sales techniques come and go, ethical standards are constant. While maintaining high ethical standards may not lead directly to sales success in the short run, they can lead to sales success in the long run, and can help maintain success.
The Ethical Vision
Ethics is difficult word for many people. A standard dictionary definition will state that an “ethic” is a principle, or body of principles, for right or good behavior. The word stems from the Greek ethos, meaning customary conduct. While this definition is very precise, it causes one to inquire about which principle or principles. It also assumes an understanding of “right or good conduct.” Furthermore, supposing that a body of principles for good conduct has been established, one still needs to know how these principles can be lived.
Perhaps one reason whey ethics is deemed a difficult subject is that it is highly complex. Issues of right and wrong, when considered in terms of basic principles, force us to consider fundamental questions of truth and justice. These questions, when seriously considered, push us to think beyond our own limited experiences and personal values and come to terms with general experiences and universal values.
Properly speaking, ethics is moral philosophy. Moral philosophy examines the foundation of moral action. Ethics is the lens through which moral action is determined, and the template through which it operates.
Most often, when people are asked to consider ethics, they focus on specific actions, and give their opinion as to whether they believe them to be ethical. Also, people’s response to ethical questions tends to be highly personal and emotional. While the response may be justified by a connection to some guiding principle (such as the “Golden Rule”) or a set of principles (such as the Ten Commandments), more often than not the response is primarily heartfelt and subject to the specifics of a situation.
When ethical issues are examined solely in terms of specific actions, ethical standards are approached indirectly. This means that ethical questions are pursued indirectly, solely through personal experience. Unfortunately, ethical questions always involve the wider world, transcending the personal experience.
It is important for all people, but especially for professionals, to seriously approach ethical questions. While initially difficult, the study of ethics is like any other field—it can be broken into categories and analyzed. To better understand the realm of ethics, it is helpful to have an understanding of how philosophers and ethicists have studied ethics in the past.
The study of ethics is divided into two major fields. This first is the more purely philosophical, and is called meta-ethics. This is really the study of terms as it relates to moral philosophy. This area of ethics finds its home on college campuses and university symposiums.
The second field of ethics is what concerns most people. This is called normative ethics. As the name would indicate, this is a study of what is the norm for right and wrong action.
Normative ethics is further broken into two branches. The first branch is the theory of value. The theory of value seeks to determine the nature of the “good.” As we mentioned above, to state that an action is ethical because it is “good” opens the question of what the “good” actually is, and how can it be known? A theory of value may be monistic, and define the “good” as a single principle, such as Aristotle’s “happiness,” Epicurus’s “pleasure,” and Cicero’s “virtue.” It is also possible for a theory of value to be pluralistic, and find a number of principles possessing intrinsic value.
The theory of obligation is the second branch of normative ethics. The theory of obligation is divided into two opposite groups. The first is the teleological viewpoint, which points to the consequences of actions as the measure for determining their morality. The second viewpoint rejects this position, and insists that morality and immorality occur outside of action, and concentrate on such aspects as motives. This is called the deontological position.
We have not presented this section on ethics to merely provide a list of fifty-cent words. This brief overview of moral philosophy is meant to demonstrate that the question of ethical value is one that possesses many sides.
Despite which approach one may take while thinking about ethics, any serious examination of ethics and ethical behavior requires patience and honesty. A 17th century ethical philosophy determined that ethical action was the pursuit of one’s self interest “rightly understood.” To “rightly understand” one’s true self-interest, however, is not an easy task. Without careful thought and rigorous self-honesty, the rule of enlightened self-interest is no more than a charade.
Business and professional ethics follow the same lines as general ethics, and are really just extensions of moral philosophy. Business and professional ethics are the standards, or norms, by which their industries are regulated. The existence of a professional standard leads to a stronger, more stable industry, and benefits the society as a whole by helping guarantee the highest level of service possible for the public.
Being a Professional
A profession is defined as an occupation that requires specialized study, training, and knowledge. In addition, professions are regulated by a governmental or non-governmental body which grant a license to practice in the field. The license not only indicates a level of competence, but an expectation of ethical behavior.
In most states, a commissioner of insurance is responsible for the licensure of insurance agents/producers and solicitors. The licensing process typically consists of two parts. The first part is licensing examination, and second part is the qualification review.
In order to earn an insurance license, some states will demand the completion of state mandated education requirements.
Sometimes, the pre-licensing education requirement can be waived. This usually can occur when a professional designation has been earned, or when a concentration of credits in insurance have been taken at an accredited college.
A waiver may also be granted to an applicant who is currently licensed in another state or jurisdiction, or who was previously licensed within the previous 24 months, and who is moving to a new state.
When an applicant has successfully completed the license qualification exam, he or she is reviewed by the state’s Department of Insurance. The Department of Insurance may require reasonable questions to assist in the approval decision. The information provided by the applicant on the license application and the responses to any interrogatories is used to determine whether a license will be granted. (If an application is denied, the applicant may seek review of the decision.)
Most states have adopted mandatory insurance continuing education (CE) laws. For an insurance agent/producer or solicitor to maintain his/her license in good standing, these educational requirements must be met in a timely fashion.
In addition to mandated CE, many agents choose to advance their professional credentials by earning professional designations. These designations require coursework that is at the college level for difficulty, and may require specified CE courses in order to maintain.
The premier designation for the Property & Casualty agent is the Chartered Property Casualty Underwriter (CPCU). The CPCU curriculum is determined by the American Institute for Property and Casualty Underwriters/Insurance Institute of America. The program includes a study of property and liability loss exposures and coverages, principles of risk management, accounting, finance, economics, and law. The curriculum requirements for CPCU designation include five Foundation Courses and three courses in either Commercial or Personal Concentrations. To earn the designation, the candidate must pass a total of eight courses and eight examinations, adhere to the CPCU Code of Ethics, and meet an experience requirement.
Agents can also pursue the Certified Insurance Counselor (CIC) designation. The CIC is primarily geared to the Property & Casualty agent, although it can have a Life & Health component. It is awarded by the Society of Certified Insurance Counselors.
The CIC designation requires applicants to attend five two-and-one-half-day seminars. These seminars cover property insurance, workers compensation, commercial and general liability, auto coverages, homeowners coverages, management issues, life insurance, and health insurance. In addition, the applicant must pass five examinations. To be eligible to earn a CIC designation, the applicant must: be a licensed agent or solicitor, and/or have two year experience in the insurance industry, and/or have served for two years on an insurance faculty at an accredited college.
For Life and Health agents, there are several choices for additional credentials. A fraternal agent, for example, may pursue the Fraternal Insurance Counselor (FIC) designation.
Many life agents pursue the Life Underwriter Training Council Fellow (LUTCF) designation. The LUTCF designation is sponsored jointly by The American College and the National Association of Insurance Financial Advisors (NAIFA). The LUTC curriculum forms a foundational program for insurance professionals, agents and managers. To earn the LUTCF designation, one must do the following:
• Earn 300 Designation Credits (DCs) by successfully completing courses within the LUTC program.[29]
• Complete and pass the examination for one of the LUTC Program ethic’s courses: “Piecing Together the Ethical Puzzle,” “Charting an Ethical Course,” or “Charting an Ethical Course for the Multiline Agent.”
• Be a member in good standing of a local association of NAIFA in the year of conferment.
Another prestigious designation for the Life agent is the Chartered Life Underwriter (CLU). The CLU is awarded by the American College at Bryn Mawr. Its curriculum is designed to teach advanced knowledge about life insurance and financial planning for individuals, business owners, and professionals. The content area of the CLU program covers individual life insurance, family financial management, tax and estate planning, insurance law, and accounting. The CLU designation is maintained by periodic completion of PACE courses. The CLU designation requires successful completion of eight classes and eight examinations.
Many Life agents are also involved in financial planning and securities. These agents may choose to pursue a designation pertinent to their financial planning. Two popular choices are the Chartered Financial Consultant (ChFC) and Certified Financial Planner (CFP(). The ChFC is awarded by the American College, and the CFP( is sponsored by the Certified Financial Board of Standards, Inc.
The ChFC curriculum concentrates on the entire financial planning process. It is earned by successfully completing eight courses and eight examinations. The CFP® is earned by completing a 180-hour financial planning course of study with an institution that is registered with the CFP® board. The course of study covers financial planning, estate planning, employee benefits, retirement, and insurance. In addition, the candidate for the CFP® must successfully complete an examination and meet an experience requirement.
Agents who are very involved in Health insurance can pursue the Registered Health Underwriter (RHU), which is sponsored by the American College at Bryn Mawr. To earn the RHU, a candidate must pass three independent study courses and pass three examinations. The course curriculum includes individual health insurance, group health insurance, and a course in selected health insurance topics. To maintain the RHU, one must meet a continuing education requirement every three years.
Professional designations are not limited to the above, nor are they restricted to sales agents, producers, and managers. Designations also exist for the following:
• Accredited Advisor in Insurance (AAI)
Sponsoring Organization: Insurance Institute of America
• Associate in Life Underwriting (AALU)
Sponsoring Organization: Academy of Life Underwriting
• Associate in Automation Management (AAM)
Sponsoring Organization: Insurance Institute of America
• Associate, Casualty Actuarial Society (ACAS)
Sponsoring Organization: Casualty Actuarial Society
• Associate Customer Service (ACS)
Sponsoring Organization: Associate Customer Service
• Accredited Customer Service Representative (ACSR)
Sponsoring Organization: Independent Insurance Agents of America
• Associate in Fidelity and Surety Bonding (AFSB)
Sponsoring Organization: Insurance Institute of America
• Associate, Insurance Agency Administration (AIAA)
Sponsoring Organization: Life Office Management Association
• Associate in Insurance Accounting and Finance (AIAF)
Sponsoring Organization: Jointly sponsored--Insurance Institute of America and the Life Office Management Association
• Associate in Claims (AIC)
Sponsoring Organization: Insurance Institute of America
• Associate Insurance Data Manager (AIDM)
Sponsoring Organization: Insurance Data Management Association
• Associate in Management (AIM)
Sponsoring Organization: Insurance Institute of America
• Associate in Insurance Services (AIS)
Sponsoring Organization: Insurance Institute of America
• Associate in Loss Control Management (ALCM)
Sponsoring Organization: Insurance Institute of America
• Associate, Life and Health Claims (ALHC)
Sponsoring Organization: Life Office Management Association
• Associate in Marine Insurance Management (AMIM)
Sponsoring Organization: Insurance Institute of America
• Associate in Premium Auditing (APA)
Sponsoring Organization: Insurance Institute of America
• Associate in Reinsurance (ARe)
Sponsoring Organization: Insurance Institute of America
• Associate in Risk Management (ARM)
Sponsoring Organization: Insurance Institute of America
• Associate in Research and Planning (ARP)
Sponsoring Organization: Life Office Management Association
• Associate of the Society of Actuaries (ASA)
Sponsoring Organization: Society of Actuaries
• Associate in State Filings (ASF)
Sponsoring Organization: Society of State Filers
• Associate in Underwriting (AU)
Sponsoring Organization: Insurance Institute of America
• Casualty Claim Law Associate (CCLA)
Sponsoring Organization: American Educational Institute
• Casualty Claim Law Specialist (CCLS)
Sponsoring Organization: American Educational Institute
• Certified Employee Benefit Specialist (CEBS)
Sponsoring Organization: International Foundation of Employee Benefit Plans
• Chartered Financial Analyst (CFA)
Sponsoring Organization: Association for Investment Management and Research
• Certified Fraud Examiner (CFE)
Sponsoring Organization: Association of Certified Fraud Examiners
• Certified Insurance Data Manager (CIDM)
Sponsoring Organization: Insurance Data Management Association
• Certified Insurance Service Representative (CISR)
Sponsoring Organization: Society of Certified Insurance Counselors
• Certified Pension Consultant (CPC)
Sponsoring Organization: American Society of Pension Actuaries
• Certified Professional Insurance Agent (CPIA)
Sponsoring Organization: Certified Professional Insurance Agents Society
• Certified Professional Insurance Woman/Man (CPIW/M)
Sponsoring Organization: National Association of Insurance Women (International)
• Fellow of the Academy of Life Underwriting (FALU)
Sponsoring Organization: Academy of Life Underwriting
• Fellow, Casualty Actuarial Society (FCAS)
Sponsoring Organization: Casualty Actuarial Society
• Fraud Claim Law Specialist (FCLS)
Sponsoring Organization: American Educational Institute
• Fellow, Life Management Institute (FLMI)
Sponsoring Organization: Life Office Management Associate
• Fellow, Society of Pension Actuaries (FSPA)
Sponsoring Organization: American Society of Pension Actuaries
• Health Insurance Associate (HIA)
Sponsoring Organization: Health Insurance Association of America
• Legal Principles Claim Specialist (LPCS)
Sponsoring Organization: American Educational Institute
• Managed Healthcare Professional (MHP)
Sponsoring Organization: Health Insurance Association of America
• Member, Society of Pension Actuaries (MSPA)
Sponsoring Organization: American Society of Pension Actuaries
• Property Claim Law Associate (PCLA)
Sponsoring Organization: American Educational Institute
• Property Claim Law Specialist (PCLS)
Sponsoring Organization: American Educational Institute
• Qualified Pension Administrator (QPA)
Sponsoring Organization: American Society of Pension Actuaries
• Registered Professional Liability Underwriter (RPLU)
Sponsoring Organization: Professional Liability Underwriting Society
• Senior Claim Law Associate (SCLA)
Sponsoring Organization: American Educational Institute
• Society of Insurance Licensing Administrators Associate (SILAA)
Sponsoring Organization: Society of Insurance Licensing Administrators
• Society of Insurance Licensing Administrators Fellow (SILAF)
Sponsoring Organization: Society of Insurance Licensing Administrators
• Workers Compensation Claim Law Associate (WCLA)
Sponsoring Organization: American Educational Institute
• Workers Compensation Claim Law Specialist (WCLS)
Sponsoring Organization: American Educational Institute
While designations are very worthwhile pursuits, the most important aspect of professionalism is putting the client’s interests first. Only when the agent is actively striving to benefit the client to the absolute best of his or her ability can the agent be considered a professional.
In some ways, high volume sales and professional designations are easy to attain, because they are actively awarded and recognized. On the other had, an action’s virtue is often known only to the person who made the ethical choice. As Cicero tells us, “Virtue is its own reward.” To be a professional, one must have a strong internal desire to do the right thing, and to be the best that one can be.
Ethical, professional action never possesses glamour. It is conservative and staid. It cannot guarantee success in terms of gaudy sales. But without high ethical standards that inform consistently professional behavior, success is always at risk. Professional ethics form the foundation upon which all lasting and fulfilling success must be built.
Competition in the Insurance Industry
One of the great strengths of the free-market economy is that it allows for competition. There is no central government telling consumers that "You must buy this form of insurance" or "Only this company can make cars." Instead, many companies may offer the same service or product, seeking always to do the job better than the other person.
The idea is that the cream rises to the top. The consumers -- those who buy the service or product -- see to it that the strong survive. The companies that best serve the public gain the upper-hand and thrive, while those offering shoddy products or poor service are driven out of business.
Competition, then, should help maintain quality. In many cases it does, but with insurance, competition cannot be left alone as the sole mechanism guaranteeing the efficient running of the insurance industry.
Much of competition's limitations in this area has to do with the long-term nature of what you sell as an insurance agent. The old adage "Let the buyer beware" hardly holds true when dealing with insurance, for the quality of what your customer has purchased is only apparent many years down the road.
This expanded time-frame of insurance is why the professional trust that we discussed earlier is so very important. Your customer often does not know how long it will take him or her to collect on his or her benefits; in the case of death benefits, he or she will not be around to see if the contract they have formed with you will be honored.
We already discussed how insurance is a knowledge product. Most of your customers would have to really study their policy to fully understand all its aspects. Human nature informs us most will not; rather, they will trust you to tell them the truth, and trust you that your company is solvent and ethical, and trust that you are competent.
Obviously, it is a very different transaction from a "normal" state of business affairs when one buys insurance. For example, when one purchases shares in a mutual fund, the results and performance of that fund are accessible daily. Buying insurance is very different from hiring contractors to put in a sprinkler system, or having a dentist fill a cavity, or leasing a car. In all of these cases, the results are readily and immediately observable.
The performance of an insurance policy, on the other hand, is observable only after the passage of time. More than almost any product, insurance is bought on faith.
Moreover, the very dynamics of competition create a scenario in which abuses can occur. For example, unlike most products, where low prices are thought of as a benefit to the consumer, insurance is in greater danger of being under-priced than over-priced.
Again, it is the long-term nature of the insurance product that creates this seeming reversal of common sense. For if an insurance company does not accumulate adequate capital to meet its obligations, all of which are temptingly distant in the future, it will be insolvent when claims finally come due -- as they ultimately will. Any financial mistakes the insurance company makes, from charging insufficiently low premiums to paying too lucrative a commission to its agents, will ultimately be carried by the consumer. The great competition among the multitude of active insurance companies creates tremendous pressure to offer the lowest rate to attract customers, pay the best commission to motivate agents, etc. In other words, competition can create pressure to do what is best in the short run for a small group of people, but is potentially ruinous in the long run for a large group of people.
Insurance Regulation
By regulation, we intend here to mean a set of laws that a governing body can employ to set a standard of service and competence for the industry it monitors. Its intent is to preserve the public interest, protect the consumer, and promote the general welfare of the industry. It prohibits abusive acts, establishes guidelines for practice, set minimum standards, and provides a mechanism for the enforcement of those standards.
Insurers are regulated through three vehicles. First, legislation in all states covers insurance practice in a regulatory mode. These laws determine the requirements and procedures for the formation of insurance companies, the licensing of insurance practitioners, the financial practices of insurers and their taxation, the rates charged by insurers and their general sales and marketing practices, and the liquidation of insurers.
Also, the federal government can play a legislative role in the regulation of insurance company practices. For example, the sale of annuities is regulated by the Securities and Exchange Commission, and the private pension plans of insurers come under the scope of the Employee Retirement Income Security Act of 1974.
The insurance industry is also occasionally subject to the power of judicial review. Both state and federal courts can determine the constitutionality of any insurance practice, and the decision handed down by the court must be respected as the law of the land.
Third and finally, state insurance departments regulate insurance companies' business practices. In many states, an elected or appointed official known as the insurance commissioner administers the state's insurance laws.
The state insurance commissioners belong to the National Association of Insurance Commissioners (NAIC). Although this body bears no legal authority to enforce decision, it can make recommendations. Indeed, it is largely through the NAIC that state regulations possess a workable level of uniformity.
The states regulate five principle areas of insurance practice. The first, contract provisions, is in which the fruits of the NAIC's efforts are readily apparent. One of the reasons for the regulation of contracts is the complexity of the language. The NAIC has helped mitigate this problem. Indeed, it has led the way to high level of uniformity by getting the states to employ standardized policies and provisions.
Nevertheless, the state keeps close scrutiny over any insurance policy contract because the language is still technical, and can contain so may complex clauses that there is too much room for the unscrupulous to operate within. Therefore, the state insurance commissioner has the authority to approve or disapprove any policy form before it is sold to the public.
This is an example of how regulation serves to address the shortcomings of competition. As insurance is a knowledge product, any consumer would have to possess a broad, general understanding of the insurance he or she desires in order to make an intelligent decision regarding its quality. Unfortunately, consumers simply lack the necessary information to adequately compare and determine the relative merits of different contracts. And, as consumers lack the knowledge needed to select the best product, the competitive incentive for the insurers to constantly improve their product is lessened. Regulation steps in to produce a constant market effect that imitates what would ideally occur naturally if consumers were informed, rational, economic actors.
Another area of state regulation is that of rates. This is largely an attempt at managed competition. It must be noted, however, that rate regulation is not uniform. Still, despite the lack of uniformity, the regulatory goal is to see that rates are not inadequate, meaning they are not too low. Remember, the insurer has the responsibility of meeting significant financial claims in the future.
At the same time, rates cannot be excessive, or too expensive. The industry operates with a notion of the fair and correct range of prices for insurance. And lastly, rates cannot be discriminatory in any way. Thus, while not everyone pays the same amount for insurance, the insured at a higher premium cannot unfairly subsidize the other insureds at a lower premium if they are representative of virtually the same risk.
Rating laws are diverse and multitudinous. There are state-made rates, prior approval laws, mandatory bureau rates, file-and-use laws, open competition laws, and flex rating laws.
State-made rates are those set by the state agency. All licensed insurance practitioners must follow these rates.
The majority of states employ some form of prior approval law for the regulation of rates. This simply means that rates must be filed and approved by the state before they can be offered to the public.
Mandatory bureau rates are those rates determined by a rating bureau. A small number of states employ this system.
Open competition laws are sometimes referred to as no-filing laws, and are at the opposite end of the spectrum of our above three varieties of rate regulation. Under this scheme, insurers do not have to file their rates, based upon the premise that competition in the market will ensure reasonable rates. This does not mean, however, that the rates are made without any oversight. The regulatory body maintains the right to require the insurance companies to provide a schedule of rates if there is a perceived problem or abuse, but this is a very liberal scheme that leans upon a trust of the market's efficacy.
Flex rating law is another liberal rating law. This situation requires that rates be submitted to the state for prior approval only when the rate increase or decrease exceeds a predetermined range.
The states also seek to maintain insurer solvency. Insurance, as we have discussed, is a product bought upon faith as a hedge against potentially serious occurrences; insurance seeks to allay our fears of the uncertainty that risk bears.
To this effect, the state regulatory commission seeks to guarantee that the practicing insurance companies are able to evince solidity, or fiscal health. Even before an insurance company can form, it must meet minimum capital and surplus requirements. The insurer's balance sheet must reflect a certain level of admitted assets. These can consist of cash, bonds, stocks, real estate, and various other legal investments. Only those assets classified as admitted assets can be used to show the company's financial situation.
Opposite admitted assets on the company's balance sheet are reserves. These are liability items, and represent the company's financial obligations.
The difference between the insurance company's assets and its liabilities is called the surplus. This figure is very significant, as it is the basis for how much insurance the company can safely offer. Even more important, the surplus is the fund used to offset any potential underwriting or investment loss.
The state also regulates the securities that insurance companies hold. The state discourages high-risk investments, as these run contrary to the insurance mission.
The financial condition of an insurance company is an ongoing affair of the state. It is strictly and consistently monitored. Insurance companies must file an annual statement with the state insurance commissioner. This statement is also called the Annual Convention Blank, and shows the current status of reserves, assets, total liabilities, and investment portfolio. In addition to this, an insurer is normally audited at least every three to five years.
If a company becomes insolvent, the state is obligated to act. The company becomes managed by the state. If the company cannot be fiscally restructured into solidity, it is liquidated.
The states also provide the licensing for the insurance industry. In many ways, this is the "big stick" for the regulating body. For example, a new insurer is normally formed in incorporation. It can only receive its charter or certificate of incorporation from the state, and it is only through the state office that its legal existence can be formed. After being formed, the company must then get licensed to be able to conduct business.
In addition, all states demand that agents and brokers be licensed. A written examination generally has to be passed, and many states are requiring continuing education requirements to maintain a licensed status.
Simply put, a license is a badge that indicates a base level of trustworthiness and competence to operate in a profession. Secondarily, it is a badge that can and will be taken away if both or either the base level of trustworthiness and competence are found wanting.
Review Questions
1. Churning occurs when a policy is replaced with a new policy from the same company. This typically happens to policies that have built up significant cash value.
a) true
b) false
2. Churning is also referred to as external replacement.
a) true
b) false
3. Areas that are typically misrepresented during the insurance sales transaction are the benefits and features of the policy. Misrepresentations might include presenting an incomplete comparison, using misleading terms, or implying a feature or benefit exists when it does not.
a) true
b) false
4. Illustrations following the new NAIC model must be self-supporting, and must use interest rates based on actual recent historical experience.
a) true
b) false
5. Under the guidelines of the new NAIC model, agents cannot represent the policy as something other than a life insurance policy. However, the non-guaranteed elements do not have to be noted as non-guaranteed.
a) true
b) false
6. To help protect all parties, agents should ideally make use of disclosure forms and disclosure letters.
a) true
b) false
7. Cash value possesses an investment element. Therefore, it is okay to refer to cash value as equity, earnings, or savings.
a) true
b) false
8. The life insurance agent should refrain from calling premiums deposits, payments, or contributions.
a) true
b) false
9. A profession can be defined as an occupation that requires specialized study, training and knowledge.
a) true
b) false
10. Mandated continuing education is a typical licensing requirement for most states.
a) true
b) false
Answers to Review Questions
1. true
2. false
3. true
4. true
5. false
6. true
7. false
8. true
9. true
10. true
Issues of Fairness in Insurance
Various Issues in Fairness
Insurance touches multiple aspects of an individual’s life that are essential. Because of the essential aspect of insurance, questions of fairness can occur.
One of the classic areas of insurance that has been challenged is underwriting. Underwriting is also one of the primary areas that regulators review during market conduct examinations.
Redlining is an example of an underwriting practice that results in discrimination. Originally, redlining was said to have occurred when an insurer refuses to underwrite (or continue to underwrite) risks in a specific geographic area. The phrase redlining came from the drawing of red lines around areas on a map. Today, redlining can refer to a variety of unfair discriminatory practices. For example, refusal to underwrite based on marital status or prior terminations can be termed redlining.
Accusations of redlining typically arise out of economically depressed areas. During the late 1960s, Fair Access to Insurance Requirements (FAIR) Plans were created to make property insurance more readily available to those were shut out of the regular market. Persons unable to find coverage typically found their property was held to be too high risk. FAIR plans have sought to redress this imbalance and ensure that essential insurance coverages are available to all property owners (provided they can meet certain requirements). FAIR plans are operated by the insurance industry in thirty four states. They are based on the stop loss reinsurance method.
1970s, the Unfair Trade Practices Act was amended to prohibit unfair discriminatory behavior that would fit under the description of redlining. The Act does not, however, prohibit discrimination that is based on actuarially sound information. Nevertheless, the perception remains that insurers do not adequately provide fair underwriting in economically depressed areas.
The use of credit reports for underwriting purposes is another area of controversy for insurers. Because some studies have shown a correlation between credit history and insurance losses, some insurance companies incorporate information from consumer’s credit history into their underwriting. This practice has been criticized by consumer advocacy groups, and reviewed by the NAIC.
The 1980s were a difficult decade for the life insurance industry, as allegations grew that agents routinely misrepresented their qualifications, the method of paying premiums, and the products they sold. Along with the negative press, the industry was forced to pay billions of dollars in legal defense and class action lawsuits. In the 1990s, the American Council of Life Insurers (ACLI) created a self-policing membership organization to help clean-up the industry and restore the public’s confidence. This organization is known as the Insurance Marketplace Standards Association (IMSA).
To became a member of IMSA, a company must go through a two-part process. The first step is for the insurer to answer a 73-item questionnaire. Some of the policies and procedure areas covered by the questionnaire include the following:
• handling and answering consumer complaints;
• training agents;
• maintaining policies in state guidelines.
Insurers are required to provide a “yes” response to all 73 questions. If they are not able to respond in the affirmative, the insurer must provide a plan to bring it into compliance with IMSA standards.
The second step for IMSA approval requires the company to secure an independent assessor who will conduct a review to learn whether all mandatory procedures are in place. If a company passes the review, it becomes an IMSA member. The IMSA membership must be renewed every three years. Currently, more than 200 life insurance companies have become IMSA members.
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[1] A “high degree of uniformity” does not, of course, mean complete uniformity. Terminology, for example, can vary. For example, uninsured motorist coverage can come under a “family protection coverage.”
[2] A common alternative is to list the definitions after each section of the policy.
[3] If the family has children, Social Security benefits can be available upon the death of a primary wage-earning spouse. However, these benefits will usually expire as soon as the child turns 16.
[4] Determining life insurance needs is a very complex process, and different companies use different approaches and different models. Furthermore, each insurance case is unique, and subject to a wide array of influencing factors. This section is only a broad overview of the process.
* This does NOT mean that term insurance is always the most affordable or least expensive form of life insurance over the entire duration of needed coverage. Since term premiums increase with each renewal as the insured grows older, the premium cost for term insurance will ultimately exceed the level premium charged for a whole life policy.
[5] A death benefit is a sum, stated in the life insurance contract, that is to be paid upon the death of the insured. The death benefit equals the face value of the policy, less any outstanding loans.
[6] A rider is an endorsement to a life insurance policy that adds additional features and benefits to the contract.
[7] Annually renewable term is also called yearly renewable term, or YRT, by some companies.
[8] Again, these limits are based on the insurance company’s design choices. However, while a policy may be renewable to ages beyond 65, it becomes less and less cost-effective for the insured to pursue this option.
[9] A term policy that does not possess the option to convert is called a nonconvertible policy.
[10] Other terms for whole life are “straight life,” “ordinary level-premium whole life,” and “traditional whole life.”
[11] The use of the age 100 as a “cut off” is an actuarial device. While some persons obviously do live to 100, the number is statistically insignificant; it is presumed that by age 100 that the insured will be dead.
[12] Living benefits are benefits provided by a whole life policy that the policy owner can access while alive. In addition to cash value, they can include disability income and waiver of premium.
[13] Limited pay policies are subject to a 7-pay test for determining the tax status of a policy loan or partial surrender. If the total premiums paid into the policy during its first year exceed the total amount of premiums that would have been payable to provide a paid-up policy in seven years, the policy is classified a modified endowment contract.
[14] In most cases, single premium life insurance contracts issued on or after June 21, 1988 are modified endowment contracts.
[15] From an asset allocation standpoint, it can also be argued that limited pay plans suffer a major defect in the early years of the contract. This is because the amount of life insurance protection – the difference between the face amount and the cash value – is lower relative to the premium than with traditional whole life or term.
[16] The premium paying period is called the endowment period.
[17] An “endowment” ethos is a value system that places primacy on furthering the economic position of one’s offspring; a “lifestyle” ethos focuses on one’s own well-being throughout the various stages of life.
[18] The Baby-Boomer generation will represent the largest transfer of assets in history.
[19] While the policy owner possesses wide latitude for making decisions, the company sets guidelines by which the policy owner must abide. These guidelines conform to company policy and statutory requirements. In addition, loans from the company’s cash values are capped, typically at 90% of the current cash value. Policy loans do not decrease the death benefit.
[20] While possessing an element of volatility, universal life policies are nevertheless typically guaranteed policies. They provide a minimum guaranteed interest rate and death rate.
[21] A load refers to the sales charge imposed by an insurance company to recover its initial policy expenses. “Front” and “back” refer to when the policy expenses are paid.
[22] Increases in the policy’s premium naturally require that the policy’s face amount state within statutory guidelines. Increases in premium typically require evidence of insurability.
[23] The other terms for current-assumption whole life are problematic. “Fixed premium universal life” is only partially accurate, as the premium and death benefit levels are only fixed for a limited period, based upon anticipated interest, mortality, and expenses. “Interest sensitive” is also incomplete, as the policy is not only sensitive to interest rates but also to the company’s mortality and expense experience. Some current-assumption policies, however, are exclusively interest-sensitive.
[24] Some current-assumption policies do not have stand-alone expense charges. Instead, the policy’s expenses are folded into the mortality charge, or they may be included as “adjustments” to the current rate credited to the cash values.
[25] There are no SEC limitations applicable in whole life or universal life sales charges.
[26] The separate account that backs a variable life insurance contract is usually classified as an investment company and registered as such with the appropriate government regulatory bodies.
[27] There are two methods of determining the death benefit level in a variable life policy. The corridor percentage approach periodically adjusts the death benefit so it is at least equal to a specified percentage of the cash value. The net single premium approach periodically adjusts the death benefit so that it matches the amount of insurance that could be purchased with a single premium equal to the cash value, assuming guaranteed mortality rates and a stated rate of return.
[28] To sell variable life insurance products, an agent must also have a variable contracts license. This license qualification can be earned at the same time that one sits for the life insurance exam. Should the agent successfully pass this section of the exam, the variable contracts qualification will appear on his or her license. Thus, one exam can potentially yield two qualifications for the life insurance agent.
[29] 60 of the 300 total credits required may be elective credits. Elective credits may be earned by earning the CLU, ChFC, CPCU, CFP or FIC designation.
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RISK AS THE BASIS OF INSURANCE
THE FAMILY OF RISK
OBJECTIVE
SUBJECTIVE
OBJECTIVE
SUBJECTIVE
STATIC
DYNAMIC
PURE
FUNDAMENTAL OR PARTICULAR
RISK
FUNDAMENTAL OR PARTICULAR
SPECULATIVE
STATIC
DYNAMIC
OBJECTIVE
SUBJECTIVE
OBJECTIVE
SUBJECTIVE
RISK AS THE BASIS OF INSURANCE
The State Government
Licensure
The State Insurance Department
The
Producer / Agent
Appointment
An insurer appoints the agent to an agency agreement. This agreement is a contract that describes the agent’s working relationship with insurer. The insurer may cancel the appointment by notifying the state and the agent.
The Insurer
INSURANCE AS AN INDUSTRY
INSURANCE AS AN INDUSTRY
ACTING AS THE LICENSED PROFESSIONAL
$100,000 Ten Year Decreasing Term Policy
ETHICS AND THE INSURANCE AGENT
ETHICS
COMPETITION IN THE INSURANCE INDUSTRY
COMPETITION IN THE INSURANCE INDUSTRY
THE USE AND MECHANICS OF REGULATION
THE USES AND MECHANICS OF REGULATION
AUTOMOBILE INSURANCE AND THE PERSONAL AUTO POLICY
Basic Auto Insurance Exclusions
1. The insurer will not provide coverage for any injuries or damages that are intentionally caused. Intentional losses are not fortuitous loss, and receive no indemnification.
2. The insurer does not cover the additional property of the insured, whether it is personally owned or merely transported. The motor vehicle is the only property that receives coverage.
3. Any property in the insured's care or for the insured's use is not covered. This includes rental property.
4. The auto policy does not supplant or supplement workers compensation laws. Employees injured during employment hours are not covered under the auto policy.
5. With the exception of car-pooling and ride-sharing programs, the auto policy does not extend coverage when one is carrying passengers for a fee.
6. The auto policy cannot take the place of liability insurance for a business that is centered on the servicing, repairing, selling, parking or storing of automobiles. Vehicles used in such a business are not covered under the auto policy.
7. The auto policy does not apply when reasonable belief exists that a covered vehicle was used without the owner's permission.
8. Vehicles that are provided for use of a covered person are excluded when they are not the covered vehicle, and when they are provided on a regular, consistent basis
9. Liability coverage also does not extend to vehicles furnished for regular use to a family member (except for a spouse), or when the vehicle is a temporary substitute.
10. Vehicles with less than four wheels are excluded without a miscellaneous-type vehicle endorsement. The auto policy by itself is limited to four wheeled vehicles.
LIABILITY COVERAGE
MEDICAL PAYMENTS COVERAGE
1. Injuries occurring while riding motor vehicles with less than four wheels, such as the mopeds that are so popular on college campuses, are excluded.
2. When carrying persons for a fee, the medical payments coverage does not apply, except in the context of a carpool.
3. If the insured suffers injury while occupying a motor vehicle regularly furnished for his or her use, medical payments coverage do not apply.
4. Medical payments coverage is also excluded to vehicles furnished for regular use by any family member, other than the covered auto.
5. Medical payments are not extended to those who have used the motor vehicle without reasonable belief that the insured gave permission.
6. Injuries sustained while using the motor vehicle as a residence are excluded from coverage.
7. Injuries caused while working one's job. Again, this is a situation for workers compensation laws, and not the auto policy.
8. Injuries caused by the use of nuclear weapons or a nuclear accident are excluded.
MEDICAL PAYMENTS COVERAGE
UNINSURED MOTORIST COVERAGE
1. Vehicles that do not have uninsured motorists coverage.
2. Vehicles owned or operated by self-insurers or government bodies.
3. Farm equipment, off-road vehicles, rail and crawler tread vehicles are excluded.
4. Any auto used for a fee, except in the case of a carpool.
5. If the insured settles with the negligent party without the insurer's consent, the coverage does not apply.
6. The uninsured motorists coverage is excluded if it provides benefits for a workers compensation insurer. The auto policy cannot act as a supplement to workers compensation insurance.
7. The uninsured motorists coverage provides no benefits to a person operating the vehicle without reasonable belief that he or she has the owner's permission.
UNINSURED MOTORIST COVERAGE
PHYSICAL DAMAGE COVERAGE
1. There is no physical damage for normal wear and tear. This includes freezing, mechanical breakdowns, and electrical failures.
2. Sound reproduction equipment not permanently installed in the vehicle is excluded, as is any electronic reception equipment. This includes CB's, car phones, televisions, etc
3. CD's, cassette tapes, VCRS, and any of their support materials are excluded.
4. Camper bodies and trailers not specifically listed in the declarations are not covered.
5. Radar detection equipment is not covered.
6. Customized furnishings, whether interior such as refrigerators or sleeping devices, or exterior such as awnings or cabanas, are excluded.
7. Losses due to radiation, whether from war or a nuclear accident, are excluded.
8. A vehicle used as a temporary substitute for an owned vehicle is not covered.
9. A vehicle used for a public fee, except in a carpool situations, is excluded
10. A vehicle confiscated or damaged by civil authorities is not a covered vehicle
11. Physical damages to a nonowned vehicle are not covered if no reasonable belief exists that permission was granted for its use by the owner.
PHYSICAL DAMAGE COVERAGE
POLICY CONDITIONS AND DUTIES AFTER AN ACCIDENT OR LOSS
POLICY CONDITIONS-DUTIES AFTER AN ACCIDENT OR A LOSS
COMMON GENERAL PROVISIONS
GENERAL PROVISIONS
NO-FAULT AUTOMOBILE INSURANCE
Principles of P-C, Special
Chapter 1: Ethics, Professionalism and the Insurance Industry…………1
Chapter 2: Law and Insurance Contracts…………………………….....56
Chapter 3: Automobile Insurance and the Auto Policy…………………80
Chapter 4: Introduction to Homeowners Insurance…………………...140
Chapter 5: Fire Insurance……………………………………………...208
Chapter 6: Surety Bonds………………………………………………231
INTRODUCTION TO HOMEOWNERS INSURANCE
1. Money and its related forms: $200.00
This includes cash, bank notes, bullion of any type, medals, and coin collections. Coin collections are exceptionally important to note, because they are fairly common and can be valued up to thousands of dollars. To insure a valuable coin collection for its true amount of worth, it must be scheduled for a specific amount.
2. Theft of firearms: $2000.00
3. Theft of silverware and goldware: $2500.00
4. Theft of jewelry, watches, and furs: $1000.00
As theft becomes an increasingly large problem in our society, it is important that the insured be aware that certain property articles are "target items," and that there is a named limit on the liability for these items. These limits are applicable only in the case of theft, however, and the full amount is available if a loss occurs by other means. All of the above items can be scheduled for a specific amount.
5. Electronic apparatus used in motor vehicles that can also be used in other places and operated from other sources: $1000.00
This coverage refers to cellular phones, recording devices, computers, etc.. This limit is also the result of high rates of occurrence. The limit can be increased by endorsement when deemed appropriate.
1. Fire department charge
If an insured is liable for a fire department
service charge after calling the fire department in
order to save covered property from an insured
peril, the insurance company will pay the charge
(up to $500.00).
2. Stolen or lost credit cards
The additional coverages section of the
Homeowners 3 Special form covers the named
insured for up to $500.00 for the loss, theft, or
authorized use of any credit cards.
Both of the above two coverages are considered additional insurance. They are both provided without a deductible. All of the following coverages are subject to the policy's stated deductible.
3. Debris removal
The Homeowners 3 Special form will pay the expenses for removing debris from a covered property. Debris removal covers a broad variety of materials. The debris could be dust, ash, shattered glass, or trees.
In the case of fallen trees, however, a number of conditions are present. For one, the cost of replacing a fallen tree is not covered; only the removal of the tree is covered. Furthermore, the cause of the tree's falling cannot be intentional. The damages must occur because of an action of nature that is covered in the policy.
5. Property removal
Whenever property must be removed from the insured's dwelling because a loss is threatened from a peril named in the policy, it is covered against any loss. This expansion of coverage is very temporary, lasting no more than thirty days.
6. Collapse
First of all, we must state emphatically that collapse
is not settling, shrinking or bulging. Rather, collapse is the falling or damaging of a building caused by specific reasons. These reasons might include any of the perils named in "Coverage C," the use of defective material or techniques, excessive weight on the building's structure, or hidden decay, whether caused by natural aging or vermin and insects.
7. Loss assessment
When property is collectively owned, any loss
assessment charged to the insured can be covered
up to $1000.00 if this loss is caused by a peril
insured against in "Coverage A" of the policy.
8. Reasonable repairs
When a covered loss occurs, certain repairs might be necessary to protect the property from additional damage. This is a "reasonable repair" that is temporary in nature, and does not permanently alter the structure of the building. All such repairs are covered under the policy.
9. Glass and safety glazing material
The breakage and damage of glass or safety
glazing material that is a part of a covered building
is covered. This coverage is only good when the
building is actually being used, however, and does
not apply when the building has been vacant for
more than 30 consecutive days directly before the
loss is experienced.
10. Landlord's furnishings
Except for theft, Homeowners 3 Special form covers
all losses caused by perils insured against to the
furnishings in a rental unit. This coverage pays up
to $2500.00 for the appliances, carpets, and
furnishings inside a rental unit that are the property
of the rental unit's owner.
THE FIVE BASIC COVERAGES
THE NAMED PERILS INSURED AGAINST
NAMED PERILS
CONDITIONS
1. Any policy can be canceled by the insurer if the insured has failed to pay the premium, with notice ten days before cancellation;
2. Any policy that is in effect for less than sixty days that is not a renewal can be canceled for any reason, with notice ten days before cancellation;
3. Any policy with a policy period that is longer than one year can be canceled for any reason at the anniversary date of the policy, with notice thirty days before cancellation;
4. Any policy older than sixty days can only be changed when there is evidence of misrepresentation or fraud or a substantial change in risk, with notice thirty days before cancellation.
d.
1. Report the loss
a. Notify the insurer as soon as possible
b. Notify the police in the event of theft
c. Notify the credit card company in event of theft
2. Take steps to limit the loss
a. Protect the property from further damage
b. Make reasonable repairs to limit additional damage
c. Keep an accurate record of repair expenses
3. Submit proof of loss within 60 days
a. Keep an inventory of damaged property
b. Submit a signed and sworn statement of loss to the insurer
4. Cooperate with the insurer
a. Exhibit the damaged property when requested
b. Submit to separate questions under oath
c. Provide any additional data as requested
CONDITIONS AND DUTIES AFTER A LOSS
EXCLUSIONS FOR SECTION I
1. Motor vehicles that are subject to motor vehicle registration are excluded, as is the equipment specific to the motor vehicle. The idea here is to have the coverage fall under the personal auto policy and its appropriate endorsements.
2. Separately described and specifically insured items cannot be covered. This is done on the part of the insurer from providing duplicate coverage.
3. Pets are not insurable under "Coverage C".
4. Business records are not insurable under the homeowners policy.
5. Aircraft and aircraft parts are excluded under "Coverage C".
6. The property of tenants not related to the insured is excluded unless specifically covered by the insured.
1. Trees and shrubs damaged by wind are not covered by the policy.
2. The unauthorized use of a credit card by a resident of the named insured's household is not covered, nor are the credit card losses of an insured covered if he or she has not complied with all the terms and conditions of the cards.
1. Freezing and its proximate causes that damage specified outdoor property is excluded.
2. Theft is excluded under several circumstances. First, theft by an insured is excluded. In other words, an insured cannot collect on a loss caused by an insured. This generally occurs when a family member steals. Also, theft in a dwelling under construction is excluded. Lastly, theft that occurs in a part of the dwelling that is rented to someone not insured is not covered.
3. Vandalism that occurs during vacancy of a dwelling is excluded.
4. Damage from smoke that is the result of agricultural smudging or industry is excluded from coverage.
1. Damage caused by freezing in a vacant building, or a building that is under construction, is not covered. "Vacant" here means that the building is not furnished, and/or has not been occupied for 30 days.
Policy
Year
1. Normal wear and tear is excluded. A physical loss that is the result of normal, restorable deterioration such as marring, chipping, and peeling does not receive coverage.
2. Defects and mechanical breakdowns do not receive coverage. This is a matter for warranties rather than the homeowner's policy.
3. Smog, rust, and all corrosive processes are excluded.
4. Named pollutants do not receive coverage for the damage they cause.
5. The settling, shrinking, bulging and cracking of pavements, patios, foundations, walls, floors, and ceilings of the named property is excluded.
6. Damage caused by birds, rodents, vermin and insects is excluded from coverage
1. Ordinance or law
Any loss that is caused by a law or ordinance is not covered. This loss may take the form of the actual demolition of a building, or it may occur in the form of a repair or improvement that must be made.
2. Earth movement
Earth movement can take many forms, and the earthquake is the most spectacular. It seems that every year one hears of the tragic losses suffered by persons who have lost their homes to earthquake damage, and are not covered because they did not add the necessary endorsement to carry this coverage.
Other forms of earth movement that cause damage are also excluded, however, and these include landslides, earth sinking, ground shifting, and shockwaves from volcanic eruptions.
3. Water damage
Some forms of water damage are covered, and we have detailed these situations in the preceding sections. Other potential forms of water damage are not extended coverage. These include floods, waves and tidal water, water back-up from sewers, drains, or sumps and below-the-surface water that causes damage through pressure or seepage.
4. Power failure
Coverage is not extended to losses that occur because of power failures that originate off of the residence premises.
5. Insured's own neglect
The insurance company will not provide coverage for a loss when the insured does not take reasonable steps to preserve the property after a loss has been realized.
6. War
As with most property insurance contracts, war is considered a catastrophic loss, and is not insurable. It is not covered under any homeowner’s policy.
7. Nuclear hazard
Nuclear radiation, contamination, and explosions are not covered by the homeowner's policy. This exclusion applies to slow contamination from leakage as well as the more apparent damage that occurs through a major accident or malfunction in a nuclear power plant.
8. Intentional loss
Any loss intentionally committed by the insured, or anyone under the direction or pay of the insured, is not covered. Only unexpected and accidental losses can enjoy insurance protection.
1. Weather conditions--when the weather conditions that contribute to a loss that would be otherwise excluded from coverage.
2. Acts or failure to act--when a plan to limit a potential loss is not developed, property damage that results from the failure to make and implement a needed plan is not covered.
3. Faulty, inadequate, or defective actions, designs, or material-losses that occur because of faulty planning or defective materials are excluded.
EXCLUSIONS
HOMEOWNERS 3 SPECIAL FORM - SECTION II
1. Property damage supplements that of Section I- Section II coverage only begins after Section I has paid out, less its deductible;
2. Any intentional damage by an insured, aged 13 or older, is excluded coverage;
3. Property damage caused by motor vehicles, aircraft, and watercraft is not covered;
4. Property damage that results from an insured's home-based business
is excluded;
5. The insured is excluded coverage on damage to its own property.
SECTION II
PERSONAL UMBRELLA POLICY
1. Workers compensation
As with most insuring agreements, workers compensation cannot be supplemented by a policy. Any obligation that the insured owes under workers compensation is not covered.
2. Intentional acts
A covered person who intends to cause personal injury or property damage will not receive coverage.
3. Business operations
Liability arising out of a business pursuit is not afforded coverage.
4. Professional liability
Liability that occurs from professional activities is generally excluded. It can be purchased, however, by a special endorsement.
5. Aircraft
Liability resulting from any aspect owning, maintaining, or using aircraft is most always excluded from the umbrella policy.
PERSONAL UMBRELLA POLICY
Premium
$100,000 Ten Year Level Term Policy
(End of Term)
$0
Policy
Year
Premium
(End of Term)
$0
AGE
Lifetime Protection
PREMIUM PERIOD – 20-PAY LIFE
Lifetime Protection
PREMIUM PERIOD –
TRAD. WHOLE
LIFE
Endowment
Traditional
Whole
Life
DEATH BENEFIT
- - - - - - - - - - - - - - - - -
PURE INSURANCE
CASH VALUE
DEATH BENEFIT
CASH VALUE
................
................
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