Principles of Risk Management and Insurance

GLOBAL EDITION

Rejda • McNamara THIRTEENTH EDITION George E. Rejda • Michael J. McNamara The Pearson Series in Finance

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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 coverage 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 insureds (210) ■ An endorsement, or rider, is a written provision that adds provision (216) Primary and excess to, deletes from, or modifies the provisions in the origi- Declarations (207) insurance (216) nal contract. An endorsement or rider normally takes Deductible (211) Pro rata liability (215) precedence over any conflicting terms in the contract to Elimination (waiting) Special coverage policy (208) which the endorsement is attached. period (212) Straight deductible (212) 218 CHAPTER 10 / AnAlySIS Of InSURAnCE COnTRACTS

REvIEw QuESTIonS 2. a. A manufacturing firm incurred the following insured losses, in the order given, during the current policy year. 1. a. What are the basic parts of an insurance contract? b. Which part is considered “the heart” of an insur- Loss Amount of Loss ance contract? Why? A $ 2,500 2. a. Describe the major types of exclusions typically B 3,500 found in insurance contracts. C 10,000 b. Why are exclusions used by insurers? 3. a. Define the term “conditions.” How much would the company’s insurer pay for b. Does the insurer have to pay an otherwise covered each loss if the policy contained the following type loss if the insured fails to comply with the policy of deductible? conditions? Explain your answer. 1. $1,000 straight deductible 2. $15,000 annual aggregate deductible 4. a. What is the meaning of “insuring agreement?” b. Explain the coordination-of-benefits provision that b. There are two basic forms of insuring agreement in is typically found in group medical expense plans. property insurance. List them and describe briefly. 3. Tom has a bookstore near a river, which is insured for 5. a. What is an endorsement or rider? €120,000 under a commercial property insurance pol- b. If an endorsement conflicts with a policy provision, icy. The policy contains a 75 percent coinsurance how is this problem resolved? clause. Tom’s bookstore suffered a loss worth €80,000 6. a. Describe the following types of deductibles: due to floods. The replacement cost of the warehouse 1. straight deductible at the time of loss is €200,000. 2. calendar-year deductible a. What is the insurer’s liability, if any, for this loss? 3. aggregate deductible Show your calculations. b. Explain the purposes of deductibles in property b. Assume that Tom carried €250,000 of property insur- insurance contracts. ance on the bookstore at the time of loss. If the amount 7. Explain the rationale of co-insurance in a property of loss is €50,000, how much will he collect? insurance contract. 4. Andrew owns a commercial office building that is 8. Explain how a section of definitions influence on insur- insured under three property insurance contracts. He ance policy. has $100,000 of insurance from Company A, $200,000 from Company B, and $200,000 from Company C. 9. a. What is the purpose of other-insurance provisions? a. Assume that the pro rata liability provision appears b. Give an example of the pro-rata liability clause. in each contract. If a $100,000 loss occurs, how 10. Explain the meaning of primary insurance and excess much will Andrew collect from each insurer? insurance. Explain your answer. b. What is the purpose of the other-insurance provisions that are frequently found in insurance contracts? aPPLICaTIon QuESTIonS 5. Assume that a $300,000 liability claim is covered under 1. George has a big house on an island on a small lake. two liability insurance contracts. Policy A has a There is no bridge connecting his island with the land; $500,000 limit of liability for the claim, while Policy B thus, the only way to reach his house is by using a boat has a $125,000 limit of liability. Both contracts provide or helicopter. He owns a boat that he uses every day. for contribution by equal shares. As an insurance he feels that his boat should be covered a. How much will each insurer contribute toward this just like any other personal property he owns. How- claim? Explain your answer. ever, his insurer informs him that boats are excluded as b. If the claim were only $50,000, how much would personal property under his homeowner’s policy. each insurer pay? a. Give some other examples of property that are usu- 6. Ashley has an individual medical expense insurance ally excluded from homeowner’s policy. policy with a $1,000 calendar-year deductible and a b. Are they uninsurable? Explain your answer. 80–20 percent coinsurance clause. Ashley had nOTES 219

outpatient surgery to remove a bunion on her foot and SELECTED REFEREnCES incurred medical bills of $10,000. How much will Ash- ley’s insurer pay? How much will Ashley have to pay? Hopkins, Jamie P., Edward E. Graves, and Burke A. Chris- tensen (Eds.). McGill’s Legal Aspects of Life Insur- 7. Angelique has a small plane. Its replacement cost is ance, 9th ed. Bryn Mawr, PA: The American College, £150,000. She wants to insure it in a local company 2014. (Insurer A), as she owns some stocks in this company. Graves, Edward E. “Policy Provisions,” McGill’s Life However, this insurer covers planes with a maximum Insurance, 9th ed. Bryn Mawr, PA: The American limit of £100,000. Her insurance broker advises her to College, 2013, ch. 27. place another £50,000 with a second company Lorimer, James J., et al. The Legal Environment of Insur- (Insurer B). The broker also mentions that she has three ance, 4th ed., vols. 1 and 2. Malvern, PA: American options of provisions to use: pro rata liability, contribu- Institute for Property and Liability Underwriters, tion by equal shares, and primary and excess insurance. 1993. Since she can make some profits on her stocks, she opts Rejda, George E., and Eric A. Wiening. Risk Management for the cheapest solution from Insurer A. How would and Insurance, Boston: Pearson Custom Publishing, you advise her, taking into account partial loss of 2005, chs. 9–10. £75,000? Explain your answer. Skipper, Jr., Harold D., and Kenneth Black, III. Life Insur- ance, 15th ed. Atlanta, GA: Lucretian, LLC, 2015. Wiening, Eric A. Foundations of Risk Management and InTERnET RESouRCES Insurance. Malvern, PA: American Institute for Char- ■ New York State Department of Financial Services pub- tered Property Casualty Underwriters/Insurance Insti- lishes a number of consumer publications on basic insur- tute of America, 2002, chs. 11–19. ance contracts that can be ordered online. The Wiening, Eric A., and Donald S. Malecki. Insurance Con- publications are helpful in understanding the various tract Analysis, Malvern, PA: American Institute for contractual provisions and coverages that appear in Chartered Property Casualty Underwriters, 1992. homeowners and auto insurance and other insurance contracts. Rating guides are also available. Visit the site at dfs.ny.gov/ noTES

■ Wisconsin Office of the Commissioner of Insurance 1. Eric A. Wiening, Foundations of Risk Management makes available consumer publications on specific insur- and Insurance (Malvern, PA: American Institute for ance contracts. These publications are helpful in under- Chartered Property Casualty Underwriters/Insurance standing the contractual provisions and coverages that Institute of America, 2002), pp. 11.15–11.18. appear in life, health, auto, and homeowners insurance. 2. C. Arthur Williams, Jr., George L. Head, Ronald C. Visit the site at Horn, and G. William Glendenning, Principles of Risk oci.wi.gov Management and Insurance, 2nd ed., vol. 2 (Malvern, PA: American Institute for Property and Liability ■ Insurance Information Institute provides consumer materi- Underwriters, 1981), pp. 200–201. als dealing with property and liability insurance. The pub- 3. Insurance Information Institute, “Nine Ways to Lower lications can help you understand the contractual Your Auto Insurance Costs,”at www.iii.org/article/ provisions and coverages that appear in homeowners, auto, nine-ways-to-lower-your-auto-insurance-costs personal liability, and flood insurance, as well as other property and casualty insurance coverages. Visit the site at iii.org

■ Texas Department of Insurance provides a considerable amount of consumer information on auto, homeowners, Students may take a self-administered test on this life and health, and other types of insurance. Rating chapter at guides are also available. Visit the site at www.pearsonglobaleditions.com/Rejda www.tdi.texas.gov ChaPTER 11 life insurance

“Death is one of the few things that can be done as easily lying down.” Woody Allen

“There are more dead people than living, and their numbers are increasing.” Eugene Ionesco

Learning Objectives

After studying this chapter, you should be able to ■ Explain the meaning of premature death. ■ Describe the financial impact of premature death on different types of families. ■ Explain the needs approach for estimating the amount of life insurance to own. ■ Describe the basic characteristics of term life insurance. ■ Explain the basic characteristics of ordinary life insurance. ■ Describe the following variations of whole life insurance: – variable life insurance – Universal life insurance – Indexed universal life insurance – variable universal life insurance ■ Describe the basic characteristics of current assumption life insurance.

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