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A. Explain THREE (3) ways in which a firm can practice funded retention. (9 marks)

B. Outline the various alternatives available to fund workers’ compensation losses. (5 marks)

C. Discuss TWO (2) potential problems a firm may face if self-insurance is chosen to fund

workers’ compensation losses. (6 marks)

(Total 20 marks)

Question 2

A. Discuss why an agent from a Life Insurance Company will have a one-on-one relationship with the Human Resource Manager for a firm. (8 marks)

B. A new intern has been assigned to your Tatil Motor Insurance branch and as the supervisor, you are tasked with training. In no more than THREE (3) paragraphs, explain to the new intern the underwriting function of insurance. (6 marks)

C. Discuss why insurance is usually heavily regulated. (6 marks)

(Total 20 marks)


21/05 The Council of Community Colleges of Jamaica Page 1

21/05 The Council of Community Colleges of Jamaica Page 1

Trieschmann, Hoyt & Sommer

Risk Management and Commercial Property–Part II

Unit 6

©2005, Thomson/South-Western

Source Material

• Trieschmann J., Sommer, D. & Hoyt, R. E. (2004). Risk

Management and Insurance 12th Edition. KY: South-

Western College




• Various types of policies are used to insure personal property


– Transportation policies that include ships and their cargo as well as

personal property carried by trains and trucks

• Such policies include coverages for items that may be transported by land, air, or sea.

– Floaters that concern property that will be or is capable of being moved

from one place to another.

– Several miscellaneous coverages including

• credit, title, and glass insurance.


Transportation Insurance

• Transportation insurance is one of the oldest and most vital forms of insurance.

• All types of trade depend heavily on the availability of insurance for successful and expedient handling.

• Insurance played a vital part in stimulating early commerce

– In Roman times bottomry contracts and respondentia contracts govern the terms under which money was borrowed to finance ocean commerce.

• The lender of money would took as security for the loan; either the ship itself (bottomry), or the cargo (respondentia).

• However, if the ship or cargo was lost as a result of ocean perils, the loan was canceled.

• If the voyage was successful, the loan was repaid and substantial interest was charged;

– mainly because the interest included an allowance for the possibility of loss of the security.

– Essentially it was an insurance premium.


The Perils of Transportation

• There is an inability to control adequately or completely the forces of nature – or to prevent human failure as it affects the safe movement of goods.

• With ocean transportation, for instance – Storms can capsize even the largest ocean vessels

– Hurricane winds often dump tons of sea water onto a vessel and damage cargo

– Engine failure may drive ship aground

• With ground transportation – Vehicles can overturn

– Rough or careless handling can damage goods


The Liability of the Carrier

• The question arises – “Is not the carrier of the goods responsible for their safe movement?”

• To some extent, yes.

• The common law liability of the carrier differs depending on: – The country in which the transportation conveyances are chartered

– The applicable statutes

– Custom

– The type of shipping, etc.


The Carrier’s Liability in Ocean Transportation

• The carrier or ship owner is responsible only for failure to exercise

due diligence.

• The responsibility of the carrier is to:

– Make the ship seaworthy

– Employ proper crew

– To equip and supply the ship

– Make all holds and other carrying compartments safe and fit for the goods

stored there

– Exercise due care in loading, handling, and storing cargoes


The Carrier’s Liability in Ocean Transportation

• The carrier is definitely not liable for certain things, including loss resulting from: – Errors in navigation or management of the vessel

– Strikes or lockouts

– Acts of god

– Acts of war or public enemies

– Seizure of the goods under legal process

– Quarantine

– Inherent vice of the goods

– Failure of the shipper to exercise due care in the handling or packing of the goods

– Fire

– Perils of the seas

– Latent defects in the hull or machinery

– Other losses where the carrier is not at fault


Need for Transportation Insurance

• Even though the carrier must prove that it was not to blame,

the shipper of the goods has little claim against the carrier for

loss of goods by some force outside the control of the carrier,

such as wind storm or other perils of the sea;

– as many types of transportation losses fall outside the responsibility

of the common carrier.

• Additionally, common carriers have been slow to settle losses

for which they’re legally liable.

– Thus, a shipper may use outside insurance in order to achieve a

prudent level of security and safety.


Ocean Transportation Insurance

• Larger ships and more advanced instruments of navigation made long voyages possible.

– With these changes came the realization that insurance protection was almost a necessity.

• The major source of underwriting capacity was England;

– probably because the country was among the first to develop a complex system of admiralty law;

• a very necessary adjunct to successful insurance underwriting.


Table 10-1: United States Ocean Marine

Insurance Premiums

The table the increase in ocean marine insurance for the U.S. market by almost 120 percent from 1980 to 2002.


Major Types of Coverage

• The chief interests to be insured in an ocean voyage are:

– The vessel, or the hull

– The cargo

– The shipping revenue or the freight received by the ship


– Legal liability for proved negligence

• If a peril of the sea causes the sinking of a ship in deep

water, one or more of these losses can result.

• However, each can be covered under various insurance



Major Types of Coverage

• Hull (vessel)Policies

– May cover the ship only during a given period of time, usually not in

excess of one year.

– It is commonly subject to geographical limits.

• If the ship is laid up in port for an extended period of time, the contract may be

written at a reduced premium under the condition that the ship remain in port.

– May cover builders’ risk while the vessel is being constructed.

• Cargo Policies

– May be written to cover losses only during a specified voyage (under hull

contracts) or on an open basis

• The latter is the most common. W ith such contract, there is no termination date but

either party may cancel upon giving notice, usually 30 days.


Major Types of Coverage

• Freight Coverage (the money paid for the transportation of the goods)

– Is an insurable interest because in the event that freight charges are not paid

• the carrier has lost income with which to reimburse expenses incurred in preparation for a voyage.

– Normally freight coverage is made a part of the regular hull or cargo coverage instead of being written as a separate contract.

– If the ship sinks, the freight is lost and the vessel owner loses the expenses incurred plus the expected profit on the venture.

– The hull may become damaged; thereby discontinuing the voyage or the cargo may be damaged and cannot be delivered.

• In either case, the carrier’s right to earn freight may be defeated.

Major Types of Coverage

• Legal Liability for Proved Negligence – this is based on two clauses:

– Running down clause (RDC) • W ithin this clause, the Hull owner is protected against third-party

liability claims that arise from collisions.

• RDC is intended to give protection in case the ship owner is held liable for negligent operation of the vessel that is the proximate cause of damage to certain property of others.

• The vessel owner or agent that fails to exercise proper care in their operations and caused a collision may become legally liable for damage to the other ship and for loss of freight revenues.

• The RDC normally excludes liability for damages to cargo, harbors, wharves, or piers and for loss of life or personal injuries.


Major Types of Coverage

– Protection and indemnity clause – is usually added to the hull policy.

• This is to provide liability coverage for personal injuries, loss of life, or damage to property other than vessels.

• It is intended to provide liability insurance for all events not covered by the more limited RDC;

– except liability assumed under contract.



Perils Clause

• In 1779, Lloyd’s of London developed a more-or-less standard ocean marine policy containing an insuring clause; – the wording of which has been retained in almost its original form in policies issued


• The clause might be interpreted as an all-risk contract – because it refers to certain named perils “and all other perils, losses, and

misfortunes”. • However, the courts have interpreted the quoted phrase to mean “all other like perils”.

• Thus, the insuring clause covers perils of the sea and not all perils. – Perils on the sea, without an inherent cause arising from the sea, are not insured

unless they’re specifically mentioned.

– Examples of perils on the sea include: action of wind and waves, stranding, and sinking. Fire can be a peril but it is insured by specific mention.

• Most modern policies contain a free-of-capture-and-seizure clause – That excludes all loss arising out of war.

– Pilferage is not typically covered but it may be added by endorsement.


General Average Clause

• Refers to losses that must be partly borne by someone

other than the owner of the goods that were damaged or


• General average losses may be partial or total

– W hereas particular average losses are always partial, by


• All ocean marine policies provide for coverage for general

average claims that may be made against the insured.


Sue-and-Labor Clause

• The insured is required to do everything possible to save and

preserve the goods in case of loss.

• The insured who fails to do this has violated a policy condition and

loses the rights of recovery.

• This means that the insured must incur reasonable expenses

– such as salvage, attorney, or storage fees

– which may be reimbursed by the insurer even if the expenses fail to recover

the goods.

• It is possible to recover for a total loss plus sue-and-labor-charges

even if the face amount of the policy proceeds is exhausted.



Two types of total loss are recognized:

• Actual Total Loss

– Occurs when the property is completely destroyed.

• Constructive Total Loss

– It occurs even when the ship or other subject matter of insurance is not totally

destroyed, it would cost more to restore than it is worth.

– The damage must equal 50 percent or more of the ship’s value in an undamaged

condition under U.S. law before constructive total loss can occur, but 100 percent of

sound value under British law.

– In most hull policies, the British rule is stated as a policy provision to the effect that if

it costs more to repair the ship than its agreed-on value as stated in the policy, the

ship may be abandoned to the insurer and the insured collects the full amount of the


• The insurer is better abled to deal with salvage due to their connections and

experience in such matters.


Ocean Transportation Insurance

• Warehouse-to-Warehouse Clause

– Protection afforded under the insuring agreement extends

from the time the goods leave the warehouse of the shipper

• Until they reach the warehouse of the consignee

• Coinsurance

– There is no coinsurance clause in ocean marine policy but

losses are settled as though each contract contained a 100

percent coinsurance clause.


Warranties in Ocean Marine Insurance

There are two types of warranties in marine insurance.

• Express Warranties

– W ritten into the contract and become a condition of the

coverage relating to potential causes of an insured event.

• Implied Warranties

– Not written into the policy but become a part of it by custom.

• Breach of warranty in marine insurance voids the

coverage, even if the breach is immaterial to the risk.


Types of Express Warranties

• Free of Capture & Seizure (FC & S) warranty

– Both parties agree that there should be no coverage in the case of loss from such perils as capture, seizure, confiscation, weapons of war, revolution, insurrection, civil war, or piracy

• Strike, Riot & Civil Commotion (SR & CC) warranty

– It is agreed that the insurer pay no loss due to strikes, lockouts, riots, or other labor disturbances

• An endorsement is available to add coverage for these exposures

• Delay warranty

– Insurer excludes loss traceable to delay of the voyage for any reason

• Unless such liability is assumed in writing

• Trading warranty

– Examples include those

• Restricting the operation of the ship to a given area; such as a certain coastal route

• Specifying that the insurance issued represents the true value of the ship or other interests

• Restricting the time during which the ship may operate


Implied Warranties

• Seaworthiness

– If the ship leaves port without being in safe condition

• the implied warranty as to seaworthiness has been breached.

– The entire coverage is immediately void.

– If the ship leaves port seaworthy but became unseaworthy later on

• the warranty is not breached.

– Seaworthiness involves such factors as having a sound hull, engines in good running order, a qualified captain and crew, proper supplies for the voyage to be undertaken, and sufficient fuel


Implied Warranties

• Deviation

– The warranty is breached when a vessel, without good and sufficient reason, departs from the prescribed course of the voyage;

• but without the intention of abandoning the voyage originally contemplated.

– Liability of the insurer ceases the moment the ship departs from its course.

– Undue delay may constitute a deviation.

– Even if the ship later resumes course and then suffers a loss

• no coverage is available unless later negotiations with the insurer have restored the insurance.

– Unavoidable necessity (such as deviate to avoid capture, carried off course by a war ship, etc.) and aiding in saving human life may excuse a deviation that has not been authorized by contract


Implied Warranties

• Legality

– The implied warranty of legality is one that is never waived.

– If the voyage is illegal under the laws of the country under

whose dominion the ship operates the insurance is void.

– Hence providing insurance for illegal enterprise is obviously

against public policy.


Floater Contracts

• The practice of insuring property at a fixed location or while it is being

transported by a common carrier is well established.

• The need for coverage is universally recognized.

– Owners of such goods rely on fairly standard contracts to protect them.

• A more difficult insurance problem is the risk of loss associated with

property that is either not at a fixed location or not being transported by

a common carrier.

– For example, equipment (such as those for building roads and bridges) are

seldom located at any one place for long, and the equipment is neither being

moved by nor in the custody of common carrier.

– Coverage under traditional property insurance forms is not suitable.

• A Floater Policy and more so a Contractor’s Equipment Floater is



Floater Contracts

• Floater policy

– Has never been satisfactorily defined.

– However, it is generally understood to be a contract of property

insurance that satisfies these requirements:

• Under its terms, the property may be moved at any time.

• The property is subject to being moved

– That is, the property is not at a location where it is expected

to remain permanently.

• The contract insures the goods while they’re being moved from

one location to another (in-transit), as well as while at a fixed



Bailed Property

• A bailment exists when one has entrusted personal property to another – such as in the case of laundries, repair establishments, and garages.

• Special forms of insurance are available to some bailees to cover loss to bailed goods for which they might be liable.

• Homeowners forms also cover such losses but only with respect to the bailor’s (the individual’s) interest.

• Other bailees use floater policies to cover losses to bailed property.


Business Floater Policies

• Block policies

– In insurance language, the term “block” connotes the general

idea of a contract that is somewhat broader than the traditional

form of inland marine or fire insurance.

– A block policy covers en bloc (collectively), on an all-risk basis,

the stock in trade or the equipment belonging to a business firm

• no matter where the property is located.

• Block policies exist for jewelers, furriers, camera and musical

instrument dealers, and agricultural and equipment dealers.


Business Floater Policies

• Jewelers’ block policy – Written to insure all the stock in the trade of the typical jeweler on an all-

risk basis.

• The items are covered whether they belong to the jeweler or to a customer.

• Items are also covered if they belong to another firm and are in the store on consignment so that the jeweler is legally liable for their safety or has a financial interest in them.

– The policy covers not only property belonging to the jeweler as an owner but also property of the customer bailor

– Thus, the policy is an example of a bailee liability insurance.

– Coverage may be extended to insure property anywhere in the world and while in transit to or from the jeweler’s place of business.


Scheduled Property Floater Risks

• Scheduled property floater

– This is a general or skeleton form to which is attached an endorsement describing specific types of property and the conditions under which they are insured. Two main types are:

• Contractors’ equipment floater

– Is typical of most floaters on scheduled property.

– Contractors have a special need for protection against the many perils that can cause loss to movable equipment.

– Large sums are often invested in a single piece of equipment that is used under basically dangerous conditions.

• This floater insures such items as tractors, steam shovels, cement mixers, scaffolding, pumps, engines, generators, hoists, drilling machinery, hand tools, cable, winches, and wagons.

• Electronic data processing floater (EDP)

– Can cover special perils not addressed in the BPP.

– As computer equipment becomes more portable this property is often utilized by firm’s employees away from the insured premises.

– Can provide coverage for data and media and for business income and extra expense associated with loss of use of EDP equipment.

– Valuation can also be on an upgraded value basis which allows for replacement with the latest state-of-the-art equipment


Title Insurance

• Title insurance is a device by which the purchaser of real estate may be protected against losses in case it develops that the title obtained is not legitimate, or can be made legitimate only after certain payments are made.

• Defects in titles may stem from sources such as: – Forgery of titles, forgery of public records, invalid or undiscovered wills,

defective probate procedures, and faulty real estate transfers.

– A person may occupy real property for years only to find that the one who conveyed the title was not the rightful owner.

• If the title is defective, title insurance does not guarantee possession of the property.


The Title Insurance Contract

• No standard title insurance contract exists. – But the general form of the insuring clause is fairly uniform.

• The insurer agrees to indemnify the owner against any loss suffered

– “By reason of the unmarketability of the title of the insured to or in said premises or … from all loss and damage by reason of liens, encumbrances, defects, objections, estates, and interests, except those listed in schedule B”.

• Schedule B is a separate endorsement which lists all title defects or rights in the property found during the title search.


The Title Insurance Contract

• Defense

– Under the typical policy, the insurer agrees to defend the insured in any legal proceedings brought against the insured concerning the title;

• assuming that the action involves a source of loss not excluded under the contract

– The insured is required to notify the insurer of any such proceedings and to cooperate in any legal action by the insurer.

• Premium

– Paid only once, and it keeps the policy in force for the named insured for an indefinite period

– If the property is transferred, a new premium must be paid for the protection of the new purchaser

• The old policy is not assignable to the new buyer and no reduction in premium usually occurs even if the property in transferred a short time after the prior purchase.


Insurance vs Bonding

• Bond

– A legal instrument whereby one party (the surety) agrees to reimburse

another party (the obligee)

• should this person suffer a loss because of some failure by the person bonded (the

the principal or obligor)

– If a contractor furnishes a bond to the owner of a building

• the surety will reimburse the owner if the contractor fails to perform as agreed and

thereby causes a loss to the owner.

• A bond may appear to be a contract of insurance, but some

important differences should be considered.


Insurance vs Bonding

– In bonding, the surety sees as its basic function the lending of credit for a premium

• It expects no losses and reserves the legal right to collect from the defaulting principal.

• Insurance contracts are set up with the presumption that there will be losses.

– The nature of the risk is different • Usually a bond guarantees the honesty of an individual and the capacity and ability of that

individual to perform. These matters are controlled by the individual.

• Insurance contracts covers losses outside the control of the individual

– In bonding, if the principal defaults and the surety makes good to the obligee

• The surety enjoys the legal right to attempt to collect for its loss from the principal

• In insurance, the insurer does not have the right to recover losses from the insured.

– The bonding contract involves three primary parties • Whereas the insurance contract normally involves only two

– In insurance, the contract is usually cancelable by either party • In bonding, the surety is often liable on the bond to the beneficiary, regardless of breach of

warranty or fraud on the part of the principal. Also, the bond often cannot be canceled until it has been determined that all the obligations of the principal have been fulfilled


Fidelity and Surety Bonds

• Strictly speaking, all bonds are surety bonds.

– However it is convenient to classify them as fidelity bonds and surety bonds

• Fidelity bonds

– Indemnify an employer for any loss suffered at the hands of dishonest employees.

• Surety bonds

– Sometimes known as financial guaranty bonds are contracts among three parties

• The principal (obligor), the person protected (obligee), and the insurer (surety)

– The surety agrees to make good on any default on the part of the principal in the principal’s duty toward the oblige.

– For example, the contractor (obligor) has agreed with the obligee to construct a building meeting certain specifications. The obligee may request the posting of a bond from the obligor to effect faithful performance. In the event the contractor fails, the surety must “make good” to the owner and the recover any losses from the contractor.


Types of Fidelity Bonds

There are two types of fidelity bonds:

• Bonds in which an individual is specifically bonded

– Individual bond – Names a certain person for coverage.

• If the employer suffers any loss through dishonest or criminal act of the employee, either

alone or in collusion, while the employee holds a position with the employer, the surety will

be good for the loss up to the limit of liability (penalty) of the bond.

– Schedule bonds

• May list many employees by name and bond them for specific


– The bonds are known as name schedule bonds.

– Additional names may be added or old names deleted on written

notice to the surety (insurer).


Types of Fidelity Bonds

• Blanket Bonds – Have several advantages over individual or schedule bonds

• Automatic coverage of a uniform amount is given on all employees.

• New employees are automatically covered without need of notifying the surety.

• If the loss occurs, it is not necessary to identify the employees who are involved in the conspiracy in order to collect.

• Because blanket bonds are subject to rate credits for large accounts

– The cost may be no more than that of schedule bonds.

– Heavily favored among most business firms.

– Two major types of blanket bonds

• Blanket position bond – has penalty ranging from $2,500 to $100,000 applicable to each employee

• Commercial blanket bond – has a penalty ranging upward of $10,000 applicable to any one loss.


Types of Surety Bonds

• Construction Bonds

– Contract construction bond

• Sometimes called a final or performance bond

• Guarantees that the principals (contractors) involved in construction

activities will complete their work in accordance with the terms of the

construction contract and will deliver the work to the owner free of any

liens or other debts or encumbrances.

– Bid bond

• In contrast to construction bonds, guarantees that if the bidder is

awarded the contract at the bid price and under the terms outline, the

bidder will sign the contract and post a construction bond.


Burglary, Robbery, and Theft Insurance

• Burglary – Defined somewhat narrowly to mean the unlawful taking of property from within premises

closed for business; • entry to which has been obtained by force.

– Visible marks of the forcible entry must be present.

• Robbery – The unlawful taking of property from another person by force, by threat of force, or by


– Personal contact is the key to understanding the basic characteristic of the robbery peril.

– Thus, if you stole the wallet of a sleeping night guard, that’s not robbery. • Robbery means forcibly taking property from a messenger or a custodian.

• Theft – Includes all crimes of stealing, robbery, or burglary and any stealing crime not meeting the

definition of burglary or robbery.

• Forgery – Losses involves the passing of bad checks are among the most common of types of

dishonesty losses and are among the easiest to prevent • Only one third of all check losses are caused by professionals (game of amateurs)


Crime Insurance and Bonds

• Surety bonds and fidelity bonds

– Provide guarantees against loss through the dishonesty or

incapacity of individuals who are trusted with money or other

property and who violate this trust

• Theft insurance

– Provides coverage against a loss through stealing by

individuals who are not in a position of trust

Trieschmann, Hoyt & Sommer

W orkers’ Compensation and Alternative Risk Financing

Unit 7

©2005 Thomson/South-Western

Source Material

• Trieschmann J., Sommer, D. & Hoyt, R. E. (2004). Risk

Management and Insurance 12th Edition. KY: South-

Western College



Workers’ Compensation Insurance

• W orkers Compensation covers loss of income and medical and rehabilitation expenses that result from work-related accidents and occupational disease. – It is the single largest line of commercial insurance.

• W orker’s Compensation developed in the latter half of the 1800s in Europe and in the early 1900s in the United States

– because of hardships placed on workers by common law.

• Under worker’s compensation, a worker receives a guarantee of compensation.

• The employer is protected from employees seeking damages for work-related injuries.


Major Reform

• The National Commission on State W orkmen’s Compensation laws was created to determine the extent to which state laws provided adequate, prompt, and equitable compensation to injured workers. – Generally, studies raised doubts about the effectiveness of workers’

compensation as it operated in the United States at the time the studies were made.

• Since then state legislatures have passed numerous reforms to comply with the commission’s recommendations, including: – Full coverage for medical care and rehabilitation

– Adequate income replacement

– Coverage of all workers

– Cost-of-living adjustments

– Improved data systems


Insurance Methods

• There are three methods by which an employer can

provide employees with the coverage required by law

– Purchase a worker’s compensation and employer’s liability

policy from a private commercial insurer

– Purchase insurance through a state fund or a federal agency

set up for this purpose

– Self-insure


Private Insurance

• The standard workers’ compensation and employer’s liability policy has two major insuring agreements – Coverage A

• To pay all claims required under the workers’ compensation law in the state where the injury occurred, including: occupational disease benefits, penalties assessable to the employer under law, and other obligations.

– Coverage B

• To defend all employees’ suits against the employer and pay any judgment resulting from the suits. Employee suits are surprisingly frequent because methods are constantly being found to bring an action against the employer in spite of the intention of the statutes to discourage such suits.

• While there is a contract between the employer and the insurer, the insured deals directly with the employee and is primarily responsible to the employee for benefits. – Thus, even if the employer should go out of business, the injured employee’s security is

not jeopardized.


State Funds and Federal Agencies

• In 20 states, an employer has the choice of using a private insurer

or a state fund as the insurer of workers’ compensation.

• In five states, the employer does not have this choice;

– Must insure in an exclusive state fund or, in three of those states, may


• In addition to state funds, federal agencies provide for workers’

compensation coverage.



• In most states, under specified conditions, an employer is permitted to self-insure the workers’ compensation coverage.

• Self-insurance is generally not permitted in Canada.

• Self-insurers are generally large concerns with adequate diversification of risks and financial resources that enable them to qualify under the law.


Evaluation of Insurance Methods

• Data from National Academy of Social Insurance shows that: – Private insurers incurred 55 percent; Self-insurers 23 percent; and Federal and state funds 22

percent of the cost of workers’ compensation in 2001

• Private insurers are preferred by most employers in states where they’re permitted to operate. – It offers the employer an opportunity to insure in one contract all the liabilities likely for damages

arising from work-connected injuries.

– Private insurers offer more certainty in handling out-of-state risks.

• W hile the expenses of state funds are somewhat lower than those of private insurers – The difference is not as great as rough comparisons often have you believe

• Self-insurance has the handicap that it is necessary for the insured to enter the insurance business – Which is essentially unrelated to the insured’s main operations.

– Also, contributions to a self-insurance fund are often not tax deductible

• Experience rating and retrospective rate plans enable large firm to use a private insurer’s facility in transferring as much or as little of the risk as is desired at a modest cost


Major Features of State Laws

Employment Covered

• Compensation laws do not cover all workers. – For example, domestic labor and farm labor are often excluded.

– Employers with only a few employees are excluded under compulsory laws.

• Only about 9 out of 10 workers are covered.

• Liability suits are necessary if an excluded worker is to recover anything; – even though a basic purpose of compensation legislation was to eliminate this condition

as a prerequisite for employee recoveries.

• It is a small employer who is excluded from compensation laws and who is most likely to be the object of such suits. – This often means that:

• A successful suit will bankrupt the employer.

• If the employer is more or less judgment-proof, the injured worker will recover nothing.


Features of State Laws

Income Provisions

• Compensation laws recognize four types of disability for which income benefits may be paid:

– Permanent total disability

– Temporary total disability

– Permanent partial disability

– Temporary partial disability


Income Provisions

• For permanent total disability benefits, most states permit lifetime payments to the injured worker who is unable to perform the duties of any suitable occupation.

– In the remaining states, typical limitation is between 400 and 500 weeks of payments;

• and there is often a limitation on the aggregate amount payable.

• There is a common limitation that income benefits cannot exceed about 2/3 of the worker’s average weekly wage or some dollar amount.

• W eekly benefits for temporary total disability are usually the same as for permanent total disability;

– except that often there is a lower maximum aggregate limitation and a shorter time duration for such payments.

• Most workers’ compensation laws specify that lump sums may be paid to a worker as liquidating damages for a disability;

– such as the loss of a leg or an eye that is permanent but does not totally incapacitate the worker.


Features of State Laws

Survivor Benefits

• In the case of fatal injuries, the widow or widower and children of the worker are entitled to funeral and income benefits;

– subject to various limitations.

• The maximum benefits to the widow or widower are generally less than they would have been to the disabled worker.

– If the survivor has children, these benefits are comparable to what the worker would have received for permanent total disability.


Features of State Laws

Medical Benefits

• Most workers’ compensation laws provide relatively

complete medical services to an injured worker;

– including allowances for certain occupational diseases.

• In all jurisdictions unlimited medical care is provided

for accidental work injuries;

– and broad coverage for occupational disease is provided.


Features of State Laws

Rehabilitation Benefits

• Both physical and occupational rehabilitation benefits are provided by

most states.

– The quantity and quality of the services are subject to wide variation.

• Rehabilitation programmes include :

– light-duty or modified-duty programs intended to reintroduce the worker to the

workplace following industrial injury.

• Federal Vocational Rehabilitation Act includes:

– federal funds to aid states in vocational rehabilitation of individuals who are

injured in the workplace.


Features of State Laws


• In terms of benefits, there is

great variability between the


• The table shows descriptive

statistics for some states.

• Besides the various state plans,

a Federal Employees

Compensation plan covers

federal employees.

– It has the highest benefit of

any plan.


Experience Rating

• Experience rating plans are widely used in workers’ compensation insurance.

• The general theory is that an employer has some control over the loss ratio and is entitled to a credit for good loss record; – or should pay a higher rate if the loss record is poorer than average.

• The details of the plan are very complex. – General procedure is to determine, for each occupational class, some expected

loss ratio against which the insured’s actual loss ratio is compared.

• Not all losses suffered by an insured are counted. – The plan uses a stabilizing factor so that unusually large losses cannot operate to

increase the small employer’s rate unreasonably.

– For the large employer, the employer’s loss experience becomes more important as its expected losses become greater.

• Experience rating in workers’ compensation gives employers an incentive to do whatever is within their control to prevent accidents.


Retrospective Rating

• This is entirely a voluntary agreement between the insured and the insurer.

• If the employer’s payroll is such that a standard of premium of $1,000 or more is incurred; – it is considered that the firm is large enough to develop experience that is partially


• Standard premium is defined as what the employer would have paid at manual rates after adjustment for experience rating; – but before any adjustment for retrospective rating.

• In practice, an employer likely to use retrospective rating is generally considerably larger than this. – For example, one accident could easily cause a loss in excess of $1,000.


Retrospective Rating

• There are various plans of retrospective rating. The choice for the employer is dependent on the level of risk the employer is willing to assume.

• The basic retrospective rating formula is given by:

R = [BP + (L)(LCF)]TM

• R = retrospective premium payable for the year in question

• BP = a basic premium designed to cover fixed costs of the insurer

• L = losses actually suffered by the employer

• LCF = loss conversion factor designed to cover the variable cost of the insurer

• TM = tax multiplier designed to reflect the premium tax levied by the state of the insurer’s business

• The basic premium declines as the size of the employer increases and it differs with the type of plan used.

• LCF and TM are constant percentage regardless of size of the employer.

– The formula is subject to the operation of certain minimums and maximums

• Both of which decline as the size of the employer increases except where the maximum the employer pays is the standard premium.

Calculation of Retrospective Rating

• If basic premium is 100,000, Loss Conversion Factor is

10% and the Tax Multiplier is 5%. What is the

retrospective rating if the employer suffers a loss of


• R = [BP + (L)(LCF)]TM

• R = [100,000 + (250,000)(1.10)] x 1.05

• R = (100,000 + 275,000) X 1.05

• R = 375,000 X 1.05

• R = $393,750 20


Workers’ Compensation and Self-Insurance

• Workers’ compensation is one of the most frequently self- insured coverages in the risk management area.

• Characterized by relatively high-frequency and low-severity losses.

• In recent years, the motivation to self-insure a portion or all of this exposure has increased; – due to rapidly rising premium levels.

• W hen premiums are high, the cash flow benefits of self-insurance are greater.

– Thus, self-insurance becomes more attractive.

• The basic factor that lead to a firm self-insure revolves around lower costs.


Factors Favoring Self-Insurance

• Lower Administrative Expenses – W hen a firm establishes a self-insured workers’ compensation program, it eliminates

most of the premium paid to an insurer.

• Cash Flow Benefits – Cash flow benefits are probably greater than the cost saving aspects of self -insuring

workers’ compensation.

– Under a traditional insured plan, the insured pays the premium • And at some later date the insurer pays all the claims

– In the aggregate, this arrangement provides the insurance company with a large amount of money that can be invested in income-producing securities until the claims are paid.

– W hen a firm self-insurers, it holds the money until the claims are paid. • Since it takes several years to pay all the claims from a given year’s loss exposure

– the self-insurer has the use of some of the funds for a fairly long time.

– Thus, there’s a perpetual sum available for investment in securities or in the self – insured’s own operations.


Factors Favoring Self-Insurance

• Claims-Conscious Management

– Management often becomes more claims conscious when it is paying

directly for workers’ compensation losses.

• W hen insurers are paying the claims, only an indirect effect is seen by operating


– When firms self-insure, they pay the claims as they occur.

• As such there is no delay in seeing the increased costs when accident rates start

to increase.

– As a consequence, workers’ compensation losses often decline when

a firm initiates a self-insurance program.


Factors Against Self-Insurance

• Size of Firm – A company must be financially capable of retaining self-insured losses.

– It must have a large enough exposure so that it can predict much of its losses.

– Generally, a firm with an annual premium of less than $250,000 will not self-insure.

• Stability of Workforce – Concerns how much turnover the firm has and how rapidly it is expanding.

– Newly employed people, as well as younger employees, have higher accident rates than more mature workers.

– New plants tend to have higher accident rates than established ones.

– W hen a firm closes a plant, a much greater number of employees file claims.


Factors Against Self-Insurance

• Tax Consequences – Under a self-insured program, one cannot take a tax deduction until the funds

are actually paid. • For example, a worker may become disabled an is entitled to a $700,000 liability. The company

cannot make any tax deduction until funds are paid to the employee.

– This rule discourages self-insurers because any loss reserves would have to be funded by after-tax dollars.

• Availability of Services – When a firm self-insures, it must provide or purchase services that were formally

provided by the insurance company.

– These services include loss control activities, claims adjusting, data processing, and program administration.

– A firm can usually buy these services from companies that specialize in such activities; sometimes at unattractive prices; rendering insurance the solution.


Excess Insurance

• Most companies do not completely self-insure the workers’ compensation exposure. – Because of the catastrophic nature of certain types of workers’ compensation

losses such claims as long-term disability or death may add up to hundreds of thousands of dollars.

– To prevent such circumstances, self-insurers purchase excess insurance.

• Two basic types of excess insurance: – Specific

• The self-insurer absorbs the first x dollars on any loss (a deductible) such as the first $75,000.

– Aggregate excess

• The policy operates like an aggregate deductible.

• Typically, the aggregate limit is at least the level of what the workers’ compensation premiums would have been if insurance had been purchased . For example, if insurance premium would have been $200,000, then excess insurance would not pay until the company retains losses of $200,000.

Self-Insurance Workers’ Compensation

• When a worker is injured at the site of or during the

course of employment, then he or she is entitled to

medical care, rehabilitation treatment, a weekly payment

of wages, and possibly an award for permanent injury.

• Any dependents will receive weekly payments if the

employee is killed on the job.

• In return for this guaranteed treatment and partial income

replacement, the worker gives up his right to sue. The

employee may be able to sue others but not the

employer. 27

Self-Insurance Workers’ Compensation

Payment Pattern

• Majority of the payments under worker’s compensation are for medical care.

• Workers’ compensation medical care is one of the few medical services that

is not subject to managed care review.

– Employers especially, believe that this factor contributes to the increased medical costs

for workers’ compensation as there is no party trying to control the costs. As such the

medical community can charge more and order more treatment than occurs under

managed care, or that patients do not return to work as quickly as they otherwise would

because their medical expenses are being paid and they are receiving weekly


• In terms of payout period, most of the medical care occurs in the first two

years on expenses such as hospital, medical doctor, prescription drugs, and

physical therapy charges.


Self-Insurance Workers’ Compensation

• The other major component of workers’ compensation

losses is for the employee’s loss of income.

– Payment can be weekly while the employee is recovering from

his or her injury and/or a payment for some type of partial

permanent injury.

– A partial permanent injury occurs when some part of the body

receives permanent injury (such as back injury) but the worker

can still return to work.

• The employee is awarded some extra weeks of compensation for this

injury which begins after the employee returns to work.


Self-Insurance Workers’ Compensation

Cash Flow Model

• A six-year payout period can be used to demonstrate but

sometimes payments continue until the employee dies.

• If $1,000 in payments were to be made to an employee,

this would be the pattern:


Year 1 2 3 4 5 6


paid out

30 25 20 15 6 4

Year 1 2 3 4 5 6



300 250 200 150 60 40

Self-Insurance Workers’ Compensation

• A cumulative payment schedule can be show over a six

year period assuming each year additional cash flow

accrues to the firm.


Year 1


Year 2


Year 3 ($) Year 4 ($) Year 5 ($) Year 6 ($)

Year 1 300 250 200 150 60 40

Year 2 300 250 200 150 60

Year 3 300 250 200 150

Year 4 300 250 200

Year 5 300 250

Year 6 300

Total 300 550 750 900 960 1000

Float (accrued-paid) 700 1150 1400 1500 1540 1540

Self-Insurance Workers’ Compensation

• In many self-insured plans, employment and losses

increase, which means positive cash flow continues and

the float increases.

• During periods of decline or downsizing, the opposite




Potential Problems of Self-insurance

• Problems include, but are not limited to – Financial ability to retain losses

– A large enough exposure base to be able to predict losses accurately

– Actual management of the plan

– Establishment of a loss prevention and protection program

– Management of a risk management information system

– Availability of excess-of-loss insurance

– Top management commitment to the plan

• A self-insurance program will fail if loss control is not a well- established priority.

Retrospective Insurance

• If the firm does not want to use self-insurance or captive insurance, using

retrospective insurance is one of obtaining some of the best aspects of both

worlds: good cash flow and less administrative detail.

• Under retrospective insurance, the firm purchases insurance and receives all

the benefits of being insured.

Details of a Retro Plan

• A firm pays the standard premium (manual premium times experience

modification factor).

– The experience modification factor is the means by which the rating adjustment takes

into consideration the actual loss of the firm. If the losses are higher than expected then

rates will go up and vice versa.

• No volume discounts are given as the firm is a part of a guaranteed cost

plan. 34

Retrospective Insurance

• A minimum and a maximum premium may be charged. In addition, the

premium is tax deductible.

• The annual premium is paid over a 12-month period which provides added

cash flow benefits.

• At the end of the policy year, the earned premium is determined by the

insurance company and adjustments are made.

– That is, after about 9 months, a retro adjustment is made to the first year

premium and subsequent adjustments are made every year thereafter.

• If there are no losses in a year, the insurance company still earns the

minimum premium.

• If losses are unusually large, the premium is subject to the maximum

premium limitation and the insurance company pays for all losses above the

maximum. 35

Problems with Retros

• Because the standard premium is a function of the

manual premium, various loadings are added to the

premium such as assigned risk assessments that can

amount to 20 percent or higher,

• Also, premium taxes must be paid, as well as marketing

and administrative costs of the insurer and the insurer’s

loading for taking on the risk.

• The cash flow benefits are usually not as good as in a

self-insured plan.


A Creative Alternative

• A large deductible plan can be used with a retro plan.

• The insured pays the losses that are within the deductible

and takes the tax deduction as the benefits are paid.

• When losses become greater than the deductible, the

insurance company pays the loss.

• A large deductible will see a small premium and the

insured receives the benefit of a retro, avoids regulatory

assessments and has many of the cash flow benefits of



Trieschmann, Hoyt & Sommer

Risk Management and Insurance

Unit 10 – The Risk Management Environment

©2005, Thomson/South-Western

Source Material

• Trieschmann J., Sommer, D. & Hoyt, R. E. (2004). Risk

Management and Insurance 12th Edition. KY: South-

Western College



The Field of Insurance

• Insurance coverages can be divided into various opposing categories:

– Personal (life and health) vs property (buildings, homes, autos)

– Government (federal, state, flood insurance) vs private (product liability)

– Involuntary (Social Security) vs voluntary (fire insurance)

• The categories are not mutually exclusive and they may overlap.


Figure 22-1: Major Classifications of Insurance


Personal and Property Coverages

Personal Coverages

• Those related directly to the individual. – The risk they cover is the possibility that some peril may interrupt the individual’s

income, such as death, accidents and sickness, unemployment, and old age.

– Private insurers are active in providing insurance for death, accidents, sickness, and old age

Property Coverages

• Directed against perils that may destroy property that is already acquired – Property insurance as used here includes fire, marine, liability, casualty, and

surety insurance.

– Sometimes referred to as general insurance, property/liability insurance, or property and casualty insurance.


Private and Public Insurance

• Private insurance consists of all types of coverage written by privately organized groups.

– It consists of associations of individuals, stockholders, policyholders, or some combination of these.

• Public insurance includes all types of coverage written by government bodies (federal, state or local) or operated by private agencies under government supervision.


Voluntary and Involuntary Coverages

• Most private insurance comes under the rubric of voluntary coverage; some may be required by law (auto insurance and workers’ compensation).

• A major part of government insurance is involuntary coverage.

– This is because it is required by law that insurance be purchased by certain groups and under certain conditions.


Types of Insurers

• Insurers are generally classified according to ownership arrangements. Four distinct types are: stock companies, mutual companies, reciprocals and Lloyd’s Association.

Stock Companies

• A corporation organized as a profit-making venture in the field of insurance – They are organized with authority to conduct certain types of insurance business

and can be authorized to deal in all types of insurance under multiple-line laws.

• They usually, but not always, operate by setting a fixed rate with the approval of the insurance commissioner.

• Some pay dividends to policyholders on certain types of insurance.

• Stock companies never issue what is called an assessable policy. – That is, the insured cannot be assessed with an additional premium if the

company’s loss experience is excessive.

• The stockholders are expected to bear any losses and they also reap any profits from the enterprise.


Types of Insurers

Mutual Companies

• These are organized under the insurance code of each state as a nonprofit corporation and is owned by the policyholders.

• It has no stockholders.

• No profits are made – Because any excess income is returned to the policyholder-owners as dividends

• Or is used to reduce premiums, or retained to finance future growth.

• The company is managed by a board of directors elected by the policyholders.

• The bylaws of a mutual may provide for additional assessments to policyholders in the event that funds are insufficient to meet losses and expenses.

• Many types of mutual organizations exist and operate under different laws and with different types of businesses.


Types of Insurers: Mutual Companies

Class Mutuals • Operate in only a particular class of insurance

– Such as farm and property, lumber mills, factories, or hardware risks

• Farm mutuals – Specialize in farm property insurance

– Insure a large portion of farm property in some states, primarily because of the specialized nature of the risks.

– Farm mutual operate on assessment plans and each policy holder is bound to a pro-rata share of all losses and expenses of the company.

• Factory mutuals – Specialize in insuring factories

– Place emphasis on loss control

– Generally do not solicit small risks due to the relatively high cost of inspection, engineering services, surveys, and consultations that are provided by the organization in an attempt to prevent losses before they occur.


Types of Insurers: Mutual Companies

General Writing Mutuals

• One that accepts many types of insureds

• They require an advanced premium calculated on roughly the same basis as that of a stock insurer.

• They operate in several states or even internationally.

• They may or may not pay a refund of the portion of the premium of the dividend if experience warrants it.

• Many mutuals insist on relatively high underwriting standards – Taking only the best risks so that a dividend will more likely be paid

• Some mutuals are both participating and deviating – That means they plan to cut the initial rate somewhat below stock company levels and to

pay dividend if warranted.


Types of Insurers: Mutual Companies

Fraternal Carriers

• Designed as a nonprofit corporation, society, order, or voluntary association, without capital stock, organized and carried on solely for the benefit of its members and their beneficiaries

• They offer only life and health insurance.

• Fraternal carriers have a lodge system with a ritualistic form of operation and a representative form of government that provides for the payment of benefits in accordance with definite provisions in the law.

• As charitable, benevolent associations, they usually are exempt from taxation.


Types of Insurers


• Sometimes called an interinsurance exchange.

• Similar to mutual in that both are formed for the purpose of making the insurance contract available to policyholders at cost (no profits).

• Basic differences exist between the legal control and capital requirements of reciprocals and mutuals. – In a reciprocal, the owner-policyholders appoint an individual or a corporation

known as an attorney-in-fact to operate that company, as opposed to the board of directors

– A mutual is incorporated with a stated amount of capital and surplus

• Whereas a reciprocal is unincorporated with no capital as such

• Reciprocals operate mainly in the field of automobile insurance.


Types of Insurers

Lloyd’s Associations

• An organization of individuals joined together to underwrite risks on a cooperative basis.

• Each member assumes risks personally and does not bind the organization for these obligations.

• Each investor is individually liable for losses on the risks assumed to the fullest extent of personal assets – Unless the liability is intentionally limited.

• It is similar to reciprocals in that each underwriter is an insurer. – However, a reciprocal is composed of individuals who are both insurers and

insureds at the same time.

• Whereas a Lloyd’s association is a proprietary organization operated for profit


Types of Insurers: Lloyd’s Association

London Lloyd’s

• Lloyd’s of London started in 1688 as an informal group of merchants taking marine risks.

• Their operations are now worldwide and sold through brokers – Operate extensively in the United States largely in the surplus line

market • This market consist of risks that domestic insurers have rejected for one

reason or another.

• A at December 31, 2019 there were 93 underwriting syndicates. – Syndicates are groups of names (investors) that combine their

resources and employ a manager who determines which risks to insure.

Channels of Distribution in Insurance

• Many kinds of arrangements may be made to distribute

insurance contracts.

• For example, life insurance generally takes a short, direct

channel whereas property insurance normally uses a

long, indirect channel with one or more independent

intermediaries involved.



Direct Distribution in Life Insurance

• Life insurance is distributed in two main ways:

– Salaried group insurance representatives

– Individual insurance agents who usually work on commission

• Life insurance is also sold by direct contact with the consumers

through advertising, mail order, or the internet (direct response).

– The insurer maintains a one-on-one relationship with the insured.


Direct Distribution in Life Insurance

Group Insurance

• Life insurers offer many of their products on a group basis

– Under contracts covering groups of persons rather than individuals.

• Customers from group coverage are generally business firms.

• Persons employed to sell and service businesses usually receive a salary and bonus.

• The group representative often works closely with a commissioned agent who may first locate a potential customer for the group insurance and would receive a commission if the group representative succeeds in making the sale.


Direct Distribution in Life Insurance

Individual Agents

• Policies sold to individuals are usually handled by persons known as agents, underwriters, or financial planners.

• The agent or underwriter contacts the ultimate consumer and reports directly to the insurer or intermediary(general agent) who in turn reports to the insurer. – The general agent is an individual employed to hire, train, and supervise agents

at lower levels.

– The company normally is not bound by the general agent in putting a contract in force.

• The general agent exercises no control over the amount of premium, has no investment in inventory, does not own any business written, and has no legal right to exercise any control over policyholders once he or she leaves the employment of the company.


Reasons for Direct Distribution in Life Insurance

• The system of direct, or short channel distribution has grown in life insurance because of several basic factors:

– The insurer’s need to maintain close control over the policy product – due to its complicated nature, its long duration, and the fiduciary relationship required between the insurer and the insured.

– The insurer’s need to exercise control over sales promotion and competition – extra promotion and competition can represent the difference between mediocre rates of growth for the insurer.

– The infrequent purchase of life insurance – a buyer usually purchase life insurance infrequently, has an infrequent need for claims service and has little day-to-day contact with the agent regarding endorsements on policies, request for information, etc.

– The agent’s ability to make a better living through specialization – due to its technical nature, the most successful life insurance agent specializes in life, health and disability insurance as well as pension planning.


Functions of Insurers

• The functions performed by any insurer depend on: – The type of business it writes, the degree to which it has shifted certain duties to others,

the financial resources available, the size of the insurer, the type of organization used, etc.

• These functions, which are normally the responsibility of definite departments or divisions within the firm, are: – Production (sales)

– Underwriting

– Rate making

– Managing claims and losses

– Investing and financing

– Accounting and other recordkeeping

– Providing miscellaneous other services • Such as legal advice, marketing research, engineering, and personnel management



• Includes all the activities necessary to select risks offered to the

insurer in such a manner that general company objectives are


• In life insurance, underwriting is performed by home or regional

office personnel;

– Who scrutinize applications for coverage and make decisions as to

whether they will be accepted;

– And by agents, who produce the applications initially in the field.



• In the property-liability insurance area agents can make binding decisions in the field; – But these decisions may be subject to post-underwriting at a higher level

because the contracts are cancelable on due notice to the insured.

• In life insurance, agents seldom have authority to make binding underwriting decisions.

• In all fields of insurance, agency personnel usually do considerable screening of risks before submitting them to home office underwriters.


The Objective of Underwriting

• The main objective is to see that the applicant accepted will not

have a loss experience that is very different from that assumed

when the rates were formulated.

• As such, certain standards of selection relating to physical and

moral hazards are set up when rates are calculated.

• The underwriter must see that these standards are observed

when a risk is accepted.


Policy Writing

• In property-liability insurance, the agent frequently issues the policy to the customer, filling out forms provided by the company – Or the form may be printed in the agent’s office on a printer controlled by the issuer’s


• A check to determine accuracy of the rates charged, whether a prohibited risk has been taken, and other matters is done by the examining section of the home office.

• In life insurance, the policy usually is written in a special department

– Whose main task is to issue written contracts in accordance with instructions from the underwriting department and to keep a register of them for future reference.


Conflict Between Production and Underwriting

• An apparent conflict of interest may arise between the underwriting department and an agent – because the underwriting department may have turned down business

that previously has been sold by an agent.

• Neither the agent nor the underwriter will profit long by writing underwriting that is: – Too strict

• W ill choke off acceptable business and may create unnecessary expenses in canceling business already bound by the agent.

– Too loose • Invites substantial losses such that the company may be forced to withdraw entirely

from a given line.


Rate Making

• Rate Making involves the selection of classes of exposure units on which to collect statistics regarding the probability and severity of loss.

• In life insurance, this task is relatively uncomplicated – because the major task is to estimate mortality rates according to age and

other factors such as sex, smoking, drinking habits, and occupation.

• In other fields, such as liability and workers’ compensation – elaborate classifications are necessary.

• Rate making is usually supervised by specialists known as actuaries.

• Once classes have been set up, rate making involves an estimation of costs including certain policy benefits or of changing policy provisions or underwriting rules, as well as the cost of writing business for which no data have been accumulated.


Rate Making

Makeup of the Premium

• The insurance rate is the amount charged per unit of


• The premium is the product of the insurance rate and the

number of exposure units.

– Thus, in term life insurance, if the annual rate is $1.50 per

$1,000 of face amount of insurance

• The premium for a $1 million policy is $1,500


Rate Making: Makeup of the Premium

• The premium is designed to cover two major costs: – The expected loss, or the pure premium

• Determined by dividing the total expected loss by the number of exposures ($750,000/1000 cars = $750 per car)

– The cost of doing business, or the loading

• Includes such items as agents’ commissions, general company expenses, premiums, taxes and fees, and allowance for profit

• Gross Premium – the sum of the pure premium and loading – The loading is usually expressed as a percentage of the expected gross premium

– The pure premium is the estimate of loss cost

• The ratio of the loss cost to the gross premium is called the loss ratio.


Rate-Making Guidelines & Adequacy

• The rate should be adequate to meet loss burdens, yet not be excessive.

– An underwriter may reason that to have an adequate premium it is necessary to collect

an amount sufficient for all possible contingencies

• Whereas another underwriter may have a much different view of the size of these possible


– This problem arises because the insurance rate must be set before all the costs are known.

• If costs cannot be determined, the entrepreneur usually will insist that the contract of sale be subject to later adjustment to reflect the actual cost or will insist on a cost-plus type contract.

• The rate should allocate cost burden among insureds on a fair basis.

• The rate should encourage loss control among insureds, if possible.

• W hile these criteria seem simple enough, applying them raises many difficult problems.


Rate-Making Methods

• The calculation of an insurance rate is in no sense

absolute or completely scientific in nature.

• The scientific method in insurance makes its greatest

contribution in narrowing the area within which executive

judgment must operate


Rate-Making Methods

Manual or Class (Pure) Method • Sets rates that apply uniformly to each exposure unit falling within some predetermined

class or group.

– Everyone falling within a given class is charged the same rate.

• The major areas of insurance that emphasize use of this method are

– Life, workers’ compensation, liability, automobile, health, homeowners’, and surety

Loss Ratio Method • It may be impractical to employ the manual rating method in developing a rate

– because of too many classifications and sub-classifications resulting in insufficient exposure on which to base decisions from a statistical point of view.

• The new rate is developed by comparing the actual loss ratio of the combined group with the expected loss ratio.


Rate-Making Methods

Individual or Merit Rating Method

• Recognizes the individual features of a specific risk and gives a rate that reflects the particular hazard. – One generally used device is to set up special rating classes

for which discounts from the manual rates are made either beforehand in the form of a direct deviation or as a dividend payable at the end of the period.

• Schedule Rating

– Each individual building is considered separately and a rate is established for it based on the rate credits given for good physical features in the form of a listing, or schedule. A prime example is fire insurance where each building is considered separately.


Rate-Making Methods

Combination Method

• In many lines of insurance, a combination of manual and merit rating is used in different degrees.

• The rate maker may develop an annual rate and then proceed to set up a system whereby individual members of a group may qualify for reductions from the manual rate – If certain requirements are met.

• They may be subjected to increased rates under certain other conditions.



• Refers to the degree to which the rate maker can rely on the accuracy of loss experience observed in any given area.

• For example, if the loss ratio on policies in a geographical area indicates that losses have been considerably higher than anticipated

• Should future rates be based on the experience of these losses

– Or is there a considerable likelihood that the previous year produced higher-than-average losses only by chance?

• It is not fair for one group to subsidize another group if each group is large enough to develop a loss experience that is reasonably credible.


Rate-Making Associations

• Also called rating bureaus.

• The largest bureau is Insurance Services Organization (ISO)

• This type of cooperation is quite essential. – Many companies do not have a sufficiently large volume of business in certain

lines to enable them to develop rates that are statistically sound.

• When the experience of many companies is pooled, a large enough body of data is available to permit a higher degree of credibility.

• Rate making bodies have worked toward uniform policy provisions

and standard policies.

• ISO develops statistical data for use by its member companies in the

calculation of rates in various lines of property and liability research.



• Reinsurance is a method created to divide the task of handling risk among several insurers.

• Often accomplished through cooperative arrangements, called treaties

– specifying the ways in which risks will be shared by members of the group.

• Reinsurance companies purchase reinsurance from one another on specific kinds of risks

– so a catastrophic loss in one part of the world may affect insurance companies and policyholders everywhere.

• Reinsurance may be defined as the shifting, by a primary insurer (ceding company) of a part of the risk it assumes to another company (reinsurer)

– That portion of the risk kept by the ceding company is called the line, or retention

– That portion shifted to the reinsurer is called the cession

• The process by which a reinsurer passes on risks to another reinsurer is known as retrocession.


Types of Reinsurance Agreements

Facultative Reinsurance

• The simplest form is Informal facultative reinsurance or what is called Specific reinsurance on an optional basis. – Under this, a primary insurer shops around for reinsurance attempting to negotiate

specific coverage on a particular contract. – It does not affect the insured in any way.

– This type is usually satisfactory when reinsurance is of an unusual nature or when it is negotiated only occasionally.

• Formal facultative contract – An agreement whereby the reinsurer is bound to take certain types of risks involved if

offered by the ceding company • But the decision of whether to reinsure remains with the ceding company.

– Used when the ceding company is bound on certain types of risks by its agents before it has an opportunity to examine the applications.


Automatic Treaty

• Reinsurance may be provided whereby the ceding company is required to cede some certain amounts of business and the reinsurer is required to accept them. Such is described as automatic treaty.

• Two basic types of treaties have been recognized: – Pro-rata treaties

• Premiums and losses are shared in some proportion.

– Excess-of-loss treaties • Losses are paid by the reinsurer in excess of some predetermined deductible or


• No directly proportional relationship exists between their original premium and the amount of loss assumed by the reinsurer.


Why Insurance is Regulated?

Future Performance

• The management of other people’s money immediately becomes a candidate for


– Insurance is a service paid for in advance but the benefits are reaped in the future; often

the beneficiary is entirely different and is not present when the contract is made to protect

his/her self-interest.

– The temptations exist for the unscrupulous to use these funds for their own ends instead of

for those to whom the funds belong

• particularly when it has grown to be one of the largest industries in the nation


• The legal battles that have been fought over the interpretation of the contractual wording of a policy – offer testimony to the fact that misunderstandings arise over the meaning of provisions

even after the best legal minds have attempted to make the intent of the insurer clear.

– An insurer would find no difficulty in framing a contract that looked appealing on the surface

• but under which it would be possible for the insurer to avoid any payment at all.


Why Insurance is Regulated?

Unknown Future Costs

• The price the insurer must charge for service must be set far in advance of the actual performance of the service.

• To increase business, an insurer may consciously underestimate future costs in order to justify a lower premium and attract customers. – This may ultimately lead to the bankruptcy of the insurer.

• If the insurer refuses to accept business except at a very high premium – Those who pay may be overcharged and those who cannot pay will go without a vital



Why Insurance is Regulated?

Violations of Public Trust

• These include – Failure by the insured to live up to the contract provisions

– Formulation of contracts that are misleading and seem to offer benefits they do not cover

– Refusal to pay legitimate claims

– Improper investment of policyholders’ funds

– False advertising

• Abuses in insurance have been such that major investigations of the insurance business have taken place. – However, it should be emphasized that most insurers

operate their business in an ethical fashion.


The Legal Background of Regulation

• Insurance has traditionally been regulated by the states

– Each state has an insurance department and an insurance commissioner

or superintendent.

• Before 1850, insurance was operated as a private business with

no more regulation than any other business sector.

• As a result of the early abuses of insurance, the need for

regulation became apparent.


The Legal Background of Regulation

• In 1868 an important U.S. Supreme Court decision, Paul v Virginia – Established the right of states to regulate insurance by holding that insurance was not

commerce • But was in the nature of a personal contract between two parties

• In 1871 an organization that was later named the National Association of Insurance Commissioners was formed – Through whose efforts a considerable measure of uniformity in regulation has been


• The South-Eastern Underwriters Association case overturned the Paul v. Virginia ruling – The court held that insurance was commerce and when conducted across state lines it

was interstate commerce • This made insurance subject to federal regulation


The McCarran-Ferguson Act

• The complete abandonment of state regulation of insurance in favor of federal regulation was not desired by either the insurance industry or state insurance commissioners

• The National Association of Insurance Commissioners propose what later became known as the McCarran-Ferguson Act, which became public law on March 9, 1945 and had these declarations: – It was the intent of Congress that state regulation of insurance should continue

• No state law relating to insurance should be affected by any federal law unless such law is directed specifically at the business of insurance.

– The Sherman Act, the Clayton Act, the Robinson-Patman Act, and the Federal Trade Commission Act would be fully applicable to insurance

• But only “to the extent that the individual states do not regulate insurance”

– That part of the Sherman Act relating to boycotts, coercion, and intimidation would remain fully applicable to insurance.


The McCarran-Ferguson Act

• Except to the extent indicated by the provisions of the

McCarran-Ferguson Act

– The insurance business continues to be regulated by the


• The law does not exempt the insurance business from

federal regulation and provides for limited applicability of

certain federal laws to insurance.


The McCarran-Ferguson Act

• In summary

– Both states and the federal government are currently exercising

regulatory control over the insurance industry.

• States still have basic regulatory functions

– W hile the federal government exercises regulation in specified areas only

– The general trend seems to be for more federal control.


Responsibilities of the Insurance Regulators

• Can be classified into four primary categories

– Licensing and enforcement of minimum standards of financial


– Regulation of rates and expenses

– Agents’ activities

– Control over contractual provisions in insurance policies and

their effects on the consumer


Licensing and Financial Solvency

• The insurance commissioner enforces state’s laws regarding the


– Admission of an insurer to do business

– Formation of new insurers

– Liquidation of insurers who become insolvent

• The commissioner must see that:

– Adequate reserves are maintained for each line insurance written

– The investments of the insurer are sound and within the state



Licensing and Financial Solvency

Minimum Capital

• Licenses are granted according to the type of insurance business to be conducted.

– Different capital standards are applied to each type.

• Minimum financial standards are set forth in each state and they vary considerably from state to state and by type of insurer.

– In the 1990s additional risk-based capital requirements were added beyond the flat dollar minimums.

– The minimum amount of capital an insurer must hold varies according to the insurer’s particular asset and liability portfolio.

• Those with riskier assets and those who write riskier lines of insurance are required to hold more capital.


Licensing and Financial Solvency

Investments • Insurers do not have complete freedom over how to invest

policyholder funds.

– Excessively risky investments may result in an insurer being unable to meet its obligations.

• All states impose investment limitations on insurers.

– The objective is to maintain safety and to give sufficient liquidity to enable insurers to pay all claims when due.


• The insurance commissioner is charged with the

responsibility of liquidating an insolvent insurer

– and must see that obligations are paid

– with an equitable treatment given to policyholders and other creditors.


Licensing and Financial Solvency

Security Deposits

• Most states require that each insurer make a deposit of

securities with the insurance commissioner.

– This is to guarantee that policyholders will be paid claims due

to them.


Regulation of Rates and Expenses

• The state insurance department is responsible for regulating the rates and expenses of insurance companies.

• If inadequate rates are charged

– Insolvency becomes a threat .

• If excessive or discriminatory rates are allowed

– The insurance department must handle public complaints.


Regulation of Rates and Expenses

Property-Liability Rates

• In all states, rates must meet three basic requirements: – The rate shall be reasonable.

– The rate shall be adequate to cover expected losses and expenses.

– The rate shall not be unfairly discriminatory among different insured groups.

• The typical rating law permits insurers to form rating bureaus – And to pool statistical information with these bureaus .

• In about 30 states, prior approval laws dictate that a rate must be filed with the insurance commissioner and approved before it can be used.

• The remaining states have open competition laws. – Rating bureaus can publish advisory rates only.


Regulation of Rates and Expenses

Life Insurance Rates

• Are essentially unregulated by states – Except indirectly through regulation of expenses and


• Life insurance rates are affected by reserve and mortality assumptions set by the state. – Life insurance reserves represent an insurer’s obligation

to the policyholder for the savings element in the life insurance policy.

– Thus the effect of state regulation of reserves is to set a floor on life insurance

• So that insurers will not charge too little that it cannot meet its obligations to the policyholder.


Agents’ Activities

• For most consumers the agent is the only contact with the insurer. – It is vital that the agent be well trained and posses a requisite degree of

business responsibility.

• Failure of insurers to insist on higher standards is due to the fact that agents generally are paid on a commission basis. – The insurer assumes that because nothing is paid out unless the agent

produces business

• The easiest way to obtain more businesses to hire more agents.

• In such an atmosphere, the insurer is not likely to insist that its agents be exceptionally well trained.

• Most states require any insurance representative to be licensed – And to pass an examination covering insurance and the details of the

state’s insurance law.


Agents’ Activities

• Most state laws prohibit the following practices:

– Twisting

• Occurs when an agent persuades an insured to drop an existing insurance policy by

misrepresenting the facts for the purpose of obtaining an insured’s new business.

– Rebating

• Occurs when an agent agrees to return part of the commission to an insured as an

inducement to secure business.

– Misrepresentation

• An example would be making misleading statements about the cost of life insurance.

• An agent’s license can be revoked for these kinds of offences.


Regulation of Contract Provisions

• New policy forms must be approved in most states before they’re offered to the public.

• The purposes of such laws is to: – Ensure that the rates being used meet state requirements as to adequacy, non-

excessiveness, and fairness.

– Protect the public against deceptive, misleading, or unfair provisions.

– Approve the language in policies that is intended to make them more readable and understandable by the consuming public.

• A recent trend has been the deregulation of commercial lines contracts and rates. – The idea is that while individuals may need protection from certain unscrupulous insurers

• Large businesses have the knowledge and resources to be able to take care of themselves

– State regulators can then focus their efforts on personal lines, where consumer protection is likely to be more valuable.

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