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Principles of Risk Management and Insurance

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Principles of Risk Management and Insurance GLOBAL EDITION Principles of Risk Management and Insurance Rejda • McNamara Rejda THIRTEENTH EDITION George E. Rejda • Michael J. McNamara The Pearson Series in Finance Berk/DeMarzo Keown Corporate Finance†* Personal Finance: Turning Money into Wealth* † Corporate Finance: The Core * Keown/Martin/Petty Berk/DeMarzo/Harford Foundations of Finance: The Logic and Practice of Fundamentals of Corporate Finance†* Financial Management†* Brooks Madura Financial Management: Core Concepts†* Personal Finance* Copeland/Weston/Shastri Marthinsen Financial Theory and Corporate Policy Risk Takers: Uses and Abuses of Financial Derivatives Dorfman/Cather McDonald Introduction to Risk Management and Insurance Derivatives Markets Fundamentals of Derivatives Markets Eakins/McNally Mishkin/Eakins Corporate Finance Online* Financial Markets and Institutions† Eiteman/Stonehill/Moffett Moffett/Stonehill/Eiteman Multinational Business Finance†* Fundamentals of Multinational Finance† Fabozzi Nofsinger Bond Markets: Analysis and Strategies Psychology of Investing Foerster Pennacchi Financial Management: Concepts and Applications†* Theory of Asset Pricing Frasca Rejda/McNamara Personal Finance Principles of Risk Management and Insurance† Gitman/Zutter Smart/Gitman/Joehnk Principles of Managerial Finance†* Fundamentals of Investing†* † Principles of Managerial Finance—Brief Edition * Solnik/McLeavey Haugen Global Investments The Inefficient Stock Market: What Pays Off and Why Titman/Keown/Martin Modern Investment Theory Financial Management: Principles and Applications* Holden Titman/Martin Excel Modeling in Corporate Finance Valuation: The Art and Science of Corporate Investment Excel Modeling in Investments Decisions Hughes/MacDonald Weston/Mitchell/Mulherin International Banking: Text and Cases Takeovers, Restructuring, and Corporate Governance Hull Fundamentals of Futures and Options Markets† Options, Futures, and Other Derivatives† * Denotes titles with MyFinanceLab. Log onto www.myfinancelab.com to learn more. † Denotes availability of Global Edition. 216 CHAPTER 10 / ANALYSIS OF INSURANCE CONTRACTS Exhibit 10.5 Contribution by Equal Shares (Example 2) Amount of Loss = $500,000 Amount of Insurance Contribution by Equal Shares Total Paid Company A $100,000 $100,000 $100,000 Company B $200,000 $100,000 + $100,000 $200,000 Company C $300,000 $100,000 + $100,000 $200,000 Primary and Excess Insurance The majority of states have adopted part or all of the coordination-of-benefits provisions developed by Primary and excess insurance is another type of other- the National Association of Insurance Commissioners insurance provision. The primary insurer pays first, (NAIC). The rules are complex, and only two of them and the excess insurer pays only after the policy limits are discussed here. First, coverage as an employee is under the primary policy are exhausted. usually primary to coverage as a dependent. For exam- Auto insurance is an excellent example of primary ple, assume that Jack and Kelly McVay are both and excess insurance. For example, assume that Bob employed, and that each is insured as a dependent occasionally drives Jill’s car. Bob’s policy has a liabil- under the other’s group health insurance plan. If Jack ity insurance limit of $100,000 per person for bodily incurs covered medical expenses, his policy pays first injury liability. Jill’s policy has a limit of $50,000 per as primary coverage. He then submits his unreimbursed person for bodily injury liability. If Bob negligently expenses (such as the deductible and coinsurance pay- injures another motorist while driving Jill’s car, both ments) to Kelly’s insurer. Kelly’s coverage then applies policies will cover the loss. The normal rule is that as excess insurance. No more than 100 percent of the liability insurance on the borrowed car is primary and eligible medical expenses are paid under both plans. any other insurance is considered excess. Thus, if a Second, the birthday rule applies to dependents in court orders Bob to pay damages of $75,000, Jill’s families where the parents are married or are not sepa- policy is primary and pays the first $50,000. Bob’s rated. Under this rule, the plan of the parent whose policy is excess and pays the remaining $25,000. birthday occurs first during the year is primary. For The coordination-of-benefits provision in group example, assume that Kelly’s birthday is in January, and health insurance is another example of primary and Jack’s birthday is in July. If their daughter is hospital- excess coverage. This provision is designed to prevent ized, Kelly’s plan is primary. Jack’s plan would be excess. overinsurance and the duplication of benefits if one The purpose of the birthday rule is to eliminate gender person is covered under more than one group health discrimination with respect to coverage of dependents. insurance plan. C ASE A PPLICATION Sofia lives in the suburbs of a city and works in the city policy (insurer ABC) is a special bike insurance with a center. Every day she uses her bike to reach her office liability limit of €50,000, the second one is a private and then to return home because she has no driving liability insurance in a homeowners insurance package license and there is no public transportation available with a liability limit of €100,000 (insurer XYZ). How near her house. One day, Sofia injured a child, 7-year old much, if any, will each of Sofia’s insurer pay, if she has Frank, when she failed to stop at a red light. Frank broke the following provisions? both hands and also suffered a mild concussion. He a. Pro rata liability. spent a few weeks in a hospital. After the accident a b. Contribution by equal shares. court awards a liability judgment of €120,000 against c. Primary (insurer XYZ) and excess (insurer ABC) Sofia. She has two third-party liability insurance policies insurance. covering losses occurred while riding a bike. The first KEY CONCEPTS AND TERMS 217 SUMMARY ■ A deductible requires the insured to pay part of the loss. A specified amount is subtracted from the total loss pay- ■ Insurance contracts generally can be divided into the fol- ment that otherwise would be payable. Deductibles are lowing parts: used to eliminate small claims, to reduce premiums, and – Declarations to reduce moral hazard and attitudinal (morale) hazard. – Deinitions Examples of deductibles include a straight deductible, – Insuring agreement aggregate deductible, calendar-year deductible, and elim- – Exclusions ination (waiting) period. – Conditions ■ A coinsurance clause in property insurance requires the – Miscellaneous provisions insured to insure the property for a stated percentage of its insurable value at the time of loss. If the coinsurance ■ Declarations are statements concerning the property or requirement is not met at the time of loss, the insured activity to be insured. must share in the loss as a coinsurer. The fundamental ■ The definitions page or section defines the key words or purpose of coinsurance is to achieve equity in rating. phrases so that coverage under the policy can be deter- ■ A coinsurance percentage clause is typically found in mined more easily. individual and group medical expense policies. A ■ The insuring agreement summarizes the promises of the typical provision requires the insured to pay 20, 25, insurer. There are two basic types of insuring agreements: 30 percent, or some higher percentage of covered – Named-perils coverage expenses in excess of the deductible up to some speci- – Open-perils coverage fied annual limit. ■ All policies contain one or more exclusions. There are ■ Other-insurance provisions are present in many insur- three major types of exclusions: ance contracts. These provisions apply to payment of a – Excluded perils loss when more than one policy covers the same loss. The – Excluded losses purpose of these provisions is to prevent profiting from – Excluded property insurance and violation of the principle of indemnity. Some important other-insurance provisions include the ■ Exclusions are necessary for several reasons. Certain per- pro rata liability clause, contribution by equal shares, ils are considered uninsurable by private insurers; and primary and excess insurance. extraordinary hazards may be present; coverage is pro- vided by other contracts; moral hazard and attitudinal (morale) hazard are present to a high degree; and cover- age is not needed by the typical insured. KEY CONCEPTS AND TERMS ■ Conditions are provisions that qualify or place limita- Additional insured (211) Endorsements and tions on the insurer’s promise to perform. Conditions Aggregate deductible (212) riders (211) impose certain duties on the insured if he or she wishes “All-risks” policy (208) Equity in rating (213) to collect for a loss. Calendar-year Exclusions (208) deductible (212) First named insured (210) ■ Miscellaneous provisions in property and casualty insur- Coinsurance clause (213) Insuring agreement (208) ance include cancellation, subrogation, requirements if a Coinsurance percentage Large-loss principle (212) loss occurs, assignment of the policy, and other- insurance clause (health insurance) Named insured (210) provisions. (214) Named-perils policy (208) ■ The contract also contains a definition of the “insured.” Conditions (209) Open-perils policy (208) The contract may cover only one person, or it may cover Contribution by equal Other-insurance other persons as well even though they are not specifi- shares (215) provisions (214) cally named in the policy. Coordination-of-benefits Other
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