Discussion Questions: Insurance, Chapter 2 “Characteristics of Insurance”

Discussion Questions: information relating to the end-of-chapter “Discussion Questions” from the financial planning coursework material through New York University’s CFP^® Program (in conjunction with Dalton Education).

Discussion Questions for Chapter 2: “Characteristics of Insurance”

Describe the personal risk management process.
1. Page 14:
  1. “Part of the ‘analyze and evaluate’ step in the financial planning process requires that a planner perform the risk management process. The risk management process includes the financial planner reviewing all of the client’s risk exposures and determining the appropriate risk management technique for each risk. The risk management process includes:
    1. Determining the objectives of the risk management program.
    2. Identifying the risks to which the individual is exposed.
    3. Evaluating the identified risks for the probability and severity of the loss.
    4. Determining the alternatives for managing the risks.
    5. Selecting the most appropriate alternative for each risk.
    6. Implementing the risk management plan selected.
    7. Periodically evaluating and reviewing the risk management program.
List the four responses to managing risk.
1. Page 16:
  1. Risk Reduction
  2. Risk Transfer
  3. Risk Avoidance
  4. Risk Retention
Define a peril.
1. Page 20:
  1. “The immediate cause and reason for a loss occurring.”
Define the three main types of hazard.
1. Pages 21 to 22:
  1. Moral hazard – the potential for loss caused by the moral character of the insured such as the filing of a false claim with the insurance company.
  2. Morale hazard – indifference to risk due to the fact that the insured has insurance.
  3. Physical hazard – a physical condition that increases the likelihood of a loss occurring.
List some unique characteristics of an insurance contract.
1. Page 31 to 32:
  1. Adhesion – the insured has no opportunity to negotiate the terms of the contract. It’s “take it or leave it.”
  2. Aleatory – the dollar amounts exchanged between the insured and the insurer are unequal.
  3. Unilateral – there is only one promise made, and it is made by the insurer to pay the beneficiary in the event of a covered loss. The insured is not legally obligated to make premium payments.
  4. Conditional – the insured must abide by all the terms and conditions of the contract if the insured intends to collect under the policy.
  5. Personal:
    1. Property insurance policies are personal contracts between the insurer and the insured. Therefore, the policy cannot be assigned to a third party without the consent of the insurer.
    2. Life insurance contracts can be assigned without the consent of the insurer because the contract continues to cover the insured regardless of who owns the policy.
Explain the differences between pure risk and speculative risk.
1. Page 11:
  1. Pure risk: the chance of a loss or no loss occurring (no chance of experiencing a gain).
  2. Speculative risk: the chance of loss, no loss, or a profit.
Explain the four differences between subjective and objective risks.
1. Page 12:
  1. Subjective risk is the risk that an individual perceives based on their prior experiences and the severity of those experiences.
  2. Objective risk is the difference between the expected and actual losses.
Describe the law of large numbers and why it is useful for insurance companies.
1. Page 13 and 14:
  1. A principle that states that actual outcomes will approach the mean probability as the sample size increases.
  2. The law of large numbers is useful for insurance companies because the larger the insured pool, the more likely actual losses will approach the expected losses, thereby reducing forecasting error and objective risk.
List typical perils covered under a personal auto policy.
1. Page 20:
  1. Fire, storm, theft, collision, hail, flood, contact with a Bird or Animal, falling objects, earthquake, and windstorm.
List typical perils covered under a homeowner’s insurance policy.
1. Page 20:
  1. Fire, lightning, windstorm, hail, riot, falling objects, weight of ice/snow/sleet, smoke, explosion, and theft.
What are the requisites for an insurable risk?
1. Page 22:
  1. It has a large number of homogeneous exposures.
  2. The insured losses must be accidental, form the insured’s point of view.
  3. The insured losses must be measurable and determinable.
  4. The loss must not be financially catastrophic to the insurer.
  5. The loss probability must be determinable.
  6. The premium for risk coverage must be reasonable and affordable.
Describe the elements of a valid contract.
1. Page 26:
  1. Mutual consent.
  2. Offer and acceptance.
  3. Performance or delivery.
  4. Lawful purpose.
  5. Legal competency of all parties.
Define conditional acceptance.
1. Page 26:
  1. Conditional acceptance is if someone completes an auto insurance application and attaches a check for the premium. The insurance agent conditionally accepted the policy, upon final review by the underwriter.
Define the parol evidence rule.
1. Page 27:
  1. The parole evidence rule provides that “What is written prevails.” “Any oral agreements prior to the writing the contract have been incorporated into the contract. Oral agreements not reflected in the written contract are not valid.”
Explain the differences between the principal of indemnity and a subrogation clause.
1. Page 27 and 28:
  1. Principle of indemnity: “asserts that an insurer will only compensate the insured to the extent the insured has suffered an actual financial loss. In other words, the insured cannot make a profit from insurance.”
  2. Subrogation clause: requires that the insured relinquish a claim against a negligent third party if the insurer has already indemnified the insured.
When must an insurable interest exist for property, liability, and life insurance?
1. Page 28:
  1. Property and liability: both at the inception of the policy and at the time of loss.
  2. Life insurance: only needs to exist at the inception of the policy.
Define representation, warranty, and concealment.
1. Page 29 and 30:
  1. Representation: a statement made by the applicant during the insurance application process (can be an oral statement or information disclosed on an insurance application).
  2. Warranty: a promise made by the insured that is part of the insurance contract. Alternatively, a warranty can be a promise by the insured to not do something.
  3. Concealment: occurs when the insured is intentionally silent regarding a material fact during the application process. (The insurer has the right to void an insurance contract based on material concealments by the insured.)
List unique characteristics of insurance contracts.
1. Note: this is the same question as question 5 above, which is answered there.
Describe the differences between express, implied, and apparent authority.
1. Page 33:
  1. Express authority is given to an agent through a formal written document.
  2. Implied authority is the authority an agent relies on to do their job when the expressed authority is insufficiently precise. It is also the authority that a third party relies upon when dealing with an agent, based upon the position held by the agent.
  3. Apparent authority is when the third party believes implied or express authority exists, but no authority actually exists.
Identify the differences between agents and brokers.
1. Page 35:
  1. Agents are legal representatives of an insurer and act on behalf of an insurer. Agents are only permitted to sell the policies written by their company. Agents have the authority to bind the insurer to an individual.
  2. Brokers are legal representatives of the insured and act in the best interest of the insured. A broker may sell insurance policies from any one of a number of different insurance companies. Since the broker does not represent the insurer, they may not bind an insurer.
List the responsibilities of an underwriter.
1. Page 39:
  1. Underwriting is the process of classifying applicants into risk pools, selecting insureds, and determining a premium. An underwriter is responsible for evaluating risks and determining whether the risk is insurable or non-insurable. The underwriter is also responsible for managing adverse selection.
Identify why insurance companies are reinsured.
1. Page 36:
  1. The primary reason an insurance may want to transfer risk (reinsure) is to reduce the exposure in their portfolio of insured risks.
List and define typical sections of an insurance contract.
1. Page 36 to 38:
  1. Definition section: defines key words or phrases used throughout the insurance contract.
  2. Declarations section: describes exactly which property or person is being covered.
  3. Description section: describes exactly what is being insured.
  4. Perils covered: may cover perils on a named peril basis where specific perils are listed as covered in the policy. Alternatively, the policy may cover perils on an open peril basis, which covers all risks of loss that are not specifically identified and excluded int he exclusions section of the policy .
  5. Exclusions: excludes certain perils, losses, and property. (Perils are excluded because they may be uninsurable, there is a moral hazard, or the coverage is potentially financially catastrophic to the insurer.)
  6. Conditions: provisions in an insurance policy that require an insured to perform certain duties. If the conditions are violate,d the insurer may refuse to pay the full amount of the claim.
Differentiate between a rider and an endorsement.
1. Page 38:
  1. Endorsement – a modification or change to the existing property insurance policy.
  2. Rider – a modification or change to a life or health insurance policy.
Describe the purpose of a deductible.
1. Page 39:
  1. The purpose of a deductible is to reduce the filing of small claims, reduce premiums, and eliminate moral and morale hazard.
Describe the purpose of coinsurance.
1. Page 40:
  1. Coinsurance exists primarily in property insurance and encourages insureds to cover their property to at least a stated percentage of the property’s value, or else suffer a financial penalty. Because the vast majority of property losses are partial, without coinsurance clauses many insureds would attempt to save money on insurance by purchasing less insurance than the full value of their property.
Describe the differences between actual cash value, replacement cost, and appraised value.
1. Page 42 and 43:
  1. Actual cash value represents the replacement cost less the depreciated value of the property.
  2. Replacement cost represents the amount to repair or replace property, without any deduction for depreciation.
  3. Appraised or agreed upon value is when items are hard to value or when the insured owns property that exceeds standard limits of a property insurance policy. Typically, jewelry, art, furs, and collectibles are covered using appraised or agreed upon value.
Identify the three levels of state regulation of the insurance industry.
1. Page 43:
  1. Legislative, judicial, and executive or State Insurance Commissioners.
Identify the goal of the NAIC.
1. Page 44:
  1. The goals of the NAIC are to:
    1. Protect the public.
    2. Promote competition.
    3. Promote fair treatment of insurance consumers.
    4. Promote the solvency of insurance companies.
    5. Support and improve state regulation of insurance.
Describe the differences between various methods to regulate insurance rates.
1. Page 44 and 45:
  1. Prior approval law: an insurance company must file the rate increase request with the State’s Insurance Commissioner’s office. The rate increase will either be approved, disapproved, or modified.
  2. File and use law: an insurance company may file the rate increase with the State Insurance Commissioner’s office and immediately implement the rate increase.
  3. Use and file law: an insurer may increase rates, but they must file the rate increase within a specific time period, as determined by state law.
  4. Open competition: insurers may set their own rates, and the State presumes that supply and demand will determine the appropriate rates for various insurance products.

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Discussion Questions: Insurance, Chapter 2 “Characteristics of Insurance”

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