Chapter 1 – Uncertainty and Insurance

 

 

Introduction

 

There is probably no country on earth that places greater importance on the right to own property than the United States.  For most of us, the national yearning to own property translates into the "American Dream" of owning our own homes.

 

Since World War II, there has been a veritable explosion in the number of people who own and live in their own residential property.  In recent years, despite inflated prices and high interest rates, many still have been fortunate enough to fulfill this desire.  With the fulfill­ment comes risk, the potential of losing one's home due to physical destruction of the prop­erty.  Homeown­ers Insurance is designed to mitigate the consequences of these losses. Before we focus on the specifics of the homeowner’s coverage, we will focus the first three chapters on the basics of insurance.  This will lay the foundation of better under­standing of the manner in which homeowner's protection is designed.

 

In this chapter we will deal with the uncer­tainties of financial loss, tech­niques for treat­ing Loss Exposures, benefits of insurance in society, the social costs of insurance and the various types of insurance.

 

Uncertainties of Financial Loss

 

A financial loss is a decrease in value arising out of an unexpected event. 

 

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Financial losses may result when prop­erty is either destroyed or damaged. 

 

Loss Exposures

 

A Loss Exposure is a possibility of loss.  A Loss Exposure exists if there is a possibility of loss occurring and if such an occurrence causes a financial loss.  It is the possibility, not the certainty, of a financial loss that creates insecurity and the need for insurance.

 

Every Loss Exposure has three elements:

 

• the item subject to loss
• the perils or forces that may cause the loss
• the potential financial impact of the loss

 

Example:  owning a home creates a Loss Exposure because all three elements are present.  The house and its contents are sub­ject to loss or damage by various perils in­cluding fire, wind and explo­sion.

 

If such an event were to occur, obvi­ous­ly the cost of rebuilding or repairing would be a financial loss to the owner.

 

Types of Loss Exposures

 

Property Losses - Property consists of such items as buil­dings, furniture, equipment, merchan­dise, money, securities, valuable pa­pers and works of art.  Property can be de­stroyed, damaged, lost or stolen.

 

Property damage can also cause net income losses. All individuals, families and businesses must generate an excess of income over expenses in the long run.

 

A net income loss consists of either:

 

• a reduction in income or revenue
• an increase in expenses

 

Liability Losses - A Liability Loss Exposure occurs when some other individual sues an individual for alleged wrongdoing.  Even if the suit is groundless, substan­tial legal fees for defense may be paid.  The lawsuit may allege bodily injury, property damage, humiliation, libel, slander, loss of reputation and other forms of personal injury.

 

Personal Losses - Personal or human losses result from events such as death, disability and unemployment.  While injury to mem­bers of the public is a Liability Loss Exposure, injury to members of the family itself is con­sidered a Personal Loss Exposure.  A personal loss to a family could cause a loss of income (death of the breadwinner).

 

Techniques for Treating Loss Expo­sures

 

When a family analyzes its Loss Exposures, it must decide how these Loss Exposures will be treated.  The major techniques for treating Loss Exposures are:

 

• avoidance
• loss control
• retention
• transfer other than insurance
• insurance

 

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It is common for families to use more than one technique for each identified loss expo­sure.  Insurance policies often include a form of retention, as well as, insurance.  Insurance company under­writers sometimes require insureds to adopt safety measures as a condi­tion of an insurance policy.  Such safety mea­sures are a form of loss control.

 

Avoidance - When feasible, avoidance is the most effective technique for treating Loss Exposures.  Avoidance means a family avoids potential losses by choosing not to own cer­tain property or engage in certain activities.  This technique is not very realistic and the least used in pre­venting losses.

 

Loss Control - Losses can be controlled through:

 

1.   loss prevention (lowering the fre­quency of          loss)

 

2.   loss reduction (lowering the severity of the          losses that occur)

 

3.   a combination of 1 and 2

 

Loss frequency refers to how often a loss occurs or how many losses occur during a given time period.  Loss Se­verity refers to the size of the losses that have occurred or might occur in the future.

 

A good example of loss prevention would be to encourage insureds to drive defensively, and wearing seat belts as an example of loss reduction.  Seat belts cannot prevent an acci­dent form occurring but it may lower the size of the loss, the extent of the injury and the resulting medical expenses and recovery time.

Unlike avoidance, loss control does not elimi­nate the possibility of loss.  Some chance of loss remains although it may be minimized.

 

Retention - Retention means keeping or absorbing all or part of the financial impact of a loss.  An example of retention would be a deductible on a Homeowners Policy.  Reten­tion is not merely a last resort.  It can be the most cost-effective way to deal with high frequency (occurring often), low severity (not large) losses.  The insured, in fact, agrees to self in­sure the first $100, $500 or $1,000 of Loss Exposure.

 

Transfer Other-Than Insurance

 

Transfer other than insurance occurs when the Loss Exposure of one person is assumed by another, usually through a contact.  An exam­ple of a contractual transfer of Loss Exposure would be a hold harmless agreement.  A contract between a softball team and its spon­sor absolving the sponsor from any liability for injury.  The sponsor has transferred its liability to the team itself.  Such contracts shift responsibility for the financial conse­quences of a Loss Exposure to another party.

 

Insurance

 

Insurance is the most popular technique for treating Loss Exposures.  The key elements are transferring the risk to an insurance com­pany, thus sharing the risk with the company.

 

Transfer Loss Exposures - by transfer­ring their Loss Exposures to insurance

 

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companies, the insured exchanges the possi­bility of a large loss for the cer­tainty of a much smaller, periodic pre­mium (the insured's payment for insur­ance cover­age).  The transfer is accom­plished through insurance policies.  An insur­ance policy is a contract that states the rights and duties of the insurance com­pany and the insured.

 

Sharing the Cost of Losses - Sharing, like transfer, is another element of insurance.  Each insured pays its insur­ance premium to the insurance compa­ny that "pools" the premi­ums into a loss fund.

 

Insureds who incur covered losses are paid from this fund.  The total cost of losses is spread among all insureds.  Insurance compa­nies predict future losses and expenses to determine how large a pool of funds will be necessary.  They can do this because of the law of large numbers, the foundation of in­surance operations.  The law of large numbers is a mathematical principle that states, when the number of similar, independent (not sub­ject to the same loss event) exposure units (such as cars or houses) increases the relative oc­currence of predictions about future out­comes (losses), based on these expo­sure units, also increases.  This principle enables insur­ance companies to improve the predictability of losses by pooling a large number of similar independent exposure units.

 

If an insurance company insured only one person's home against fire, it would have as much uncertainty as that individual.  It would also be unable to calculate an appropriate premium.  The law of large numbers reduces the uncer­tainty and increases the accuracy with which the insurance company can pre­dict the number of fires in all the homes it insures.

 

The idea involves 2 distinct mea­sures:

 

1.   the probability of an event occurring

 

2.   the uncertainty connected with the occurrence or non-occurrence of that event

 

Insurance is designed to reduce uncer­tainty by accepting Transfers of Loss Exposures and improving predictability through the law of large numbers.  Insurance does not reduce the under­lying probability of the event occur­ring.  The probability of lightning strik­ing a house is very small but the un­certainty to the home­owner is high.  In these cases, the uncertainty is high because the number of exposure units is small.

 

The underlying probability of obtaining a "head" or a "tail" when flipping a coin is 50-50.  If a coin is flipped 10 times, however, the result could be 3 heads and 7 tails.  If the coin is flipped 10,000 times, the result could be 4,600 heads and 5,400 tails.

 

Although the underlying probability is the same, in the first case there were too few cases for the law of large num­bers to reduce the uncertainty significa­ntly.  In the second case, the large number of coin tosses reduces the vari­ance considerably.

 

Benefits of Insurance

 

Insurance provides many benefits to individu­als.  The most obvious benefits of insurance are that it provides pay­ment for losses and reduces uncertainty.  Less

 

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obvious are some of the indirect benefits of those loss payments.  Since insurers have a financial incentive to control losses, society has benefited from insurer's loss control activities.  Insurance also helps provide credit and solve social prob­lems.  It enables peo­ple to satisfy legal re­quirements.

 

Payment for Losses

 

To indemnify is to restore a party who has had a loss to the same financial position that would have existed had no loss occurred.  The primary role of insurance is to indemnify individuals, businesses and organizations that incur losses.

 

To recognize the value of payment of losses, consider what happens after a loss to people who have no insurance.  Families burned out of their homes or apartments find themselves on the street, without money, clothes or a place to stay.

 

Insurance provides some measure of financial security despite these events by paying claims to indemnify insureds. Thus, insurance pro­vides stability to individuals, families and businesses.

 

Reduction of Uncertainty

 

Individuals enjoy greatly reduced uncer­tainty because insurance provides finan­cial compen­sation for covered losses.  Some of a family's greatest financial concerns, such as death of the breadwin­ner or fire destroying the home, are almost completely eliminated through the transfer of the uncertainty of loss to an insur­ance company, thereby reducing anxiety and stress.  We are not

referring to the emotional trauma of losing a loved one but rather the financial concern of such an event occurring.

 

Society as a whole experiences a reduc­tion in uncertain because insurers, using the law of large numbers, are better able to predict losses that individ­uals or businesses incur.

 

Loss Control

 

Insured losses require insurance com­panies to make claim payments.  Loss control reduces the amount of money insurers must pay in claims.  The result is reflected both in im­proved financial results and in reduced insur­ance costs to the consumer.

 

Insurance companies employ loss con­trol representatives whose job is to help control the losses that might be suffered by insureds.  These inspectors and engineers help insureds identify and evaluate Loss Exposures and re-commend ways to minimize the frequen­cy and severity of potential losses. The knowl­edge and experience gained from one insured are shared with insureds that face similar Loss Exposures.

 

Support for Credit

 

Before lending money, a lender wants assur­ance that the money will be repaid. When money is lent to purchase proper­ty, the lender usually acquires an inter­est in that property.  The lender can repossess a car or foreclose on a house if the loan is not paid. A len­der would have less recourse if the car, of course were destroyed, or if the worker

were killed or disabled.  Insur­ance

 

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guarantees that the lender will be paid if the car or house is destroyed or if the borrower dies or becomes dis­abled.

 

Reduction of Social Burdens

 

Uncompensated accident victims can be a serious burden for society.  Insurance helps to reduce such burdens by provid­ing compensa­tion for lost wages, medi­cal expenses, and death benefits to survivors.

 

Satisfaction of Legal Requirements

 

Many legal requirements necessitate the purchase of insurance policies.  In many states, owners of autos must prove they have auto liability insurance before they can regis­ter their autos.

 

Certain business relationships also de­pend upon the existence of insurance. Just as lend­ers often require insurance before granting a loan, building con­tractors usually receive construction contracts only if they can provide proof of Liability Insurance Protection in order to receive a contract for services.

 

Social Costs of Insurance

 

Insurance provides many benefits to society as a whole but these benefits are not cost free.  Premiums must be charged in order to collect the money to make loss payments.  Because there are expenses involved with oper­ating an insurance company, the money collected for premiums is greater than the amount ulti­mately paid for losses.  Example:  an insur­ance company might use $0.85 of every insur­ance dollar to pay

 

claims, with $0.15 ab­sorbed by salaries, commissions and overhead expenses.  In addition to these direct costs, society may bear certain other costs of insur­ance because it cre­ates moral and morale hazards and perhaps because it encourages depen­dence on insurance.

 

Moral and Morale Hazards

 

To some extent, the existence of insur­ance actually encourages losses.  Although insurers have an economic in­cen­tive to encourage loss control, insur­ance sometimes provides an economic incen­tive for insureds to have losses.

 

Moral Hazard - is a condition that exists when a person may intentionally try to cause a loss or may exaggerate a loss that has oc­curred.  Nobody knows for sure how many building fires are started intentionally by people who would rather have the insurance money than the building.

 

More common are exaggerated or in­flated claims.  An insured may claim that four items were lost rather than the actual three or that the items were worth much more than their actual value.  In liability situations, third party claimants often exaggerate their person­al injuries and property damage, and sympa­thetic physicians, lawyers, auto body shops and contractors may sup­port these exaggera­tions and drive up the cost of the claims.

 

Morale Hazard - is a condition that exists when a person is less careful because of the existence of insurance.

 

 

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Morale hazard does not involve intent to cause or exaggerate a loss. Instead, the in­sured becomes careless about potential losses because insur­ance is available. Leaving the keys in an unlocked car or having oily rags placed near a furnace are examples of careless­ness and morale hazards. The result is morale hazards cause additional losses that drive up the cost of insurance because of injuries and damages that could have been prevented.

 

Dependence on Insurance

 

There is some tendency in today's society to rely too heavily on insur­ance or to ask insur­ance to do things for which it was not de­signed.  This ten­dency can have undesirable results.

 

Example:   liability lawsuits have been on the rise in recent years.  One reason is that liabil­ity insurance some­times pays large sums of money to a person who has been insured.

 

Liability insurance is intended to pro­tect people who may be responsible for injury to somebody else or damage to another’s prop­erty.  There is a growing tendency to look upon liability insur­ance as a pool of money available to anyone that has been injured or dam­aged, regardless of negligence.

 

Closely related are the problems associ­ated with compulsory insurance, espe­cially auto insurance. In order to assure a source of re­covery for people, who are injured in auto accidents, drivers in many states are required to purchase insurance, even those with bad driving records.

 

This requirement may cause some of the costs of insuring these bad drivers to be included in the premium charged to good drivers.

 

Types of Insurance

 

The security needs of individuals center on the continuity of their income, the protection of their assets and the minimiz­ation of their liabilities. Life insurance replaces the in-come-earning potential lost through death or disability. Health insurance provides addi­tional economic security through the payment of medi­cal expenses.  Protection of tangible assets is the function of Property Insur­ance.  Liability insurance covers situa­tions in which an individual or a busi­ness may incur finan­cial responsibility for harm inflicted upon someone else.  For this course, we will focus on Property and Liability Insurance.

 

Property Insurance

 

Property insurance covers accidental losses resulting from damage to the insured’s proper­ty. The insured could be an individual insuring a home and its contents, known as personal property, or a business insuring its building, inventory and equipment.  When the insured experiences a loss, such as fire dam­age to a home, the insured deals directly with the insurance company in the settlement process.

 

Property insurance is often referred to as "fire" insurance, although it is much broader than fire insurance. The reason is found in U.S. insurance history.  Prior to the 1950s there were three categories of insurers: life,

 

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fire/marine, casualty and surety.  Some large insurers still use these terms. When regula­tions enforced these separate categories, "casualty" insurers could write only property.  Thus, property insurance and fire insur­ance become almost synonymous terms.

 

Many types of insurance are classified as Property Insurance.  Some, such as crime or boiler and machinery insur­ance, were once considered casualty insurance and, therefore, developed dis­tinct forms, language and insur­ance practice, some of which continue today.

 

Examples of Property Insurance are:

 

• Fire and Allied Lines
• Loss of Business Income
• Crime
• Ocean and Inland Marine
• Auto Physical Damage

 

Fire and Allied Lines Insurance - gen­erally covers property such as: build­ings and con­tents at a fixed location or at locations de­scribed in the policy.  The term allied lines refers to insurance against perils (causes of loss), usually written with (allied to) fire insurance such as windstorm, hail, smoke explo­sion, vandalism and other perils.

 

Loss of Business Income Insurance - for­merly called Business Interruption Insurance, indemnifies a business for this loss of earn­ings as a result of a covered loss such as fire.  If a busi­ness has a serious fire, it may have to close while repairs are being made.  This loss of business income (or earn­ings) takes place over time. Loss of Business Income Insurance pays for what would have been earned during the period of business interruption caused by a covered peril.

Crime Insurance - covers money, secu­rities, merchandise and other property from various causes of loss: burglary, robbery, theft and dishonest acts of employees. Crime Insurance is often part of a package policy such as the Homeowner's or Business-Owners Policies.

 

Ocean Marine Insurance - one of the oldest forms of insurance, covers ships and cargo against the "perils of the sea".  Inland Marine Insurance was devel­oped to provide coverage to cargo over land, rather than over the seas, and continues to provide transportation cover­age.  Examples are metro truck cargo and mobile equipment coverages.

 

Auto Physical Damage Insurance - is usually part of a policy that also covers Auto Liabil­ity.  It covers loss or damage to the vehicle from collision, fire, theft or other perils.

 

Liability Insurance

 

Liability Insurance, unlike Property Insurance, can involve 3 parties: the insured, the insur­ance company and someone who is in­jured or whose property is damaged by the insured.

 

The insurance company pays the claim­ant on behalf of the insured if the in­sured is legally liable for injury or damage due to negligence.

 

Examples of Liability Insurance are:

 

• Auto Liability
• General Liability
• Personal Liability
• Professional Liability

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Auto Liability Insurance - covers losses due to the insured's liability for bodily injury to others or damage to property of others caused by an auto accident.  The legal costs of de­fending the insured are also covered. The various types of Auto Insurance Policies combine auto Liability Coverage with Auto Physical Damage Coverage (a form of pro­perty convenience and expense savings).

 

General Liability Insurance - covers liability for bodily injury and property damage arising from accidents on pre­mises, business oper­ations in progress, products, manufactured or sold and completed operations.

 

Personal Liability Insurance - like gen­eral liability insurance, provides broad liability coverage to individuals and families.  Bodily injury and property damage liability claims alleging the insured's negligence arising from the insured's premises or activities are cov­ered.  Examples:

 

1.   insured's dog bites a neighbor

 

2.   Avon lady slips on icy steps

 

3.   insured's son, an amateur golfer, tees off and hits another golfer

 

Professional Liability Insurance - is designed to provide liability coverage to professionals such as physicians, law­yers and accountants for errors and omissions arising out of their profes­sional duties. Medical malpractice insur­ance is an example.

 

 

  Chapter 1 - Review Questions

 

1.   An unexpected decrease in value arising out of an event is:

 

A.  Loss Exposure

B.  Morale Hazard

C.  Moral Hazard

D.  Financial Loss

 

2    All of the following are types of loss exposure except:

 

A.  Personal Losses

B.  Property Losses

C.  Educational Losses

D.  Liability Losses

 

3.   A technique for treating loss exposure would be:

 

A.  disability quotes

B.  retention

C.  life insurance term policies

D.  none of the above

 

 4.   When each insured pays his/her insur­ance premium, he/she is practicing what insurance principle?

 

A.  peril

B.  indemnity

C.  transferring

D.  sharing

 

5.   A condition that exists when a person is less careful because of the existence of insurance is known as:

 

A.  Morale Hazard

B.  Moral Hazard

C.  Peril

D.  Loss Exposure

 

 

 

ANSWERS

 

1.  D

2.  C

3.  B

4.  C

5.  A