Chapter 3: insurance policy selection.
Most individuals are required to purchase at least some types of insurance. Most states mandate that insurance be carried to cover potential liability arising out of the use of an automobile. Additionally, very few lenders would consider issuing a loan for the purchase of a home or an automobile without requiring that their financial interests be protected by insurance. In addition to these, many individuals purchase a personal umbrella policy for financial protection in the event of their being held liable for high damages to others. Businesses are subject to mandatory insurance laws and requirements of lenders just like individuals in areas such as workers compensation, auto, and general liability. Businesses can even insure for loss of income in the event of a business interruption
This chapter focuses on issues that individuals should consider when selecting property and casualty insurance protection.
Insurance policies are contracts that are used to transfer the financial consequences of possible future events, such as fires, floods, hurricanes, or auto accidents, from one party, the insured, to another party, the insurer. The insurer may be an insurance company, a risk retention group, or another type of alternative risk transfer mechanism. For the purposes of this book, we confine the discussion to insurance policies provided by traditional insurance companies. Information about insurance company selection is provided in Chapter 4.
Insurance policies are used as a means of budgeting a relatively small, known amount of money up front (the premium) in place of funding a much greater amount at the time of a large--and possibly catastrophic -future event (a possible loss). Individuals and businesses may use insurance to protect their own property--homes, commercial buildings, autos, and other property. This is called first-party coverage. They also may purchase insurance to protect themselves against legal liability for injuring other people or damaging their property. This is called third-party coverage.
Many insurance policies provide both first- and third-party coverages. For example, a typical homeowner insurance policy provides first-party protection on the insured's house as well as third-party personal liability coverage for injury or damage to visitors for which the homeowner is legally liable. This type of policy would apply to, for example, damage to the insured home caused by fire. It also would pay for damages assessed if a visitor falls on an icy sidewalk that the homeowner failed to clear. Likewise, auto insurance is designed to offer coverage for liability resulting from bodily injury or property damage resulting form an auto accident to an injured third party. First-party coverage is available as an option to pay for damage to the policyholder's own vehicles.
The insurance policy is a contract that spells out the terms and conditions of coverage. Insurance differs from other contracts in that it typically is not negotiated by parties that are on equal footing. Most insureds, other than very large businesses, have little, if any; say in the content or language of the policy. Most insurance contracts are written by the insurance company, filed for approval in the states in which the policies are being used, and then offered to potential customers on a take-it-or-leave-it basis. Large businesses may negotiate for specific coverage wording, or they may seek out a nonadmitted insurance company that may be able to offer customized coverage language. The coverages offered to individuals and small businesses, however, tend to be similar. We expect a certain amount of uniformity in the coverages offered by the various companies. This allows the consumer to compare policies offered by different companies. That has not always been the case.
As discussed in Chapter 2, the first standardized policy was adopted in 1918 when the state of New York adopted the "200 line form" fire policy. That policy was modified in 1936 to add lightning and fire caused by riots. The "165 line form" was adopted in 1943. Since that time policies have become increasingly consumer-friendly and easy to read.
An insurer collects premiums from the many, pools those premiums, and out of that pool pays its insureds' losses and company expenses. Anything left is profit to be reinvested or distributed to shareholders. Insurance premiums are based on the law of large numbers. Insurers want to be certain that they have enough similar exposure units insured so that they can accurately predict future losses. The law of large numbers is based on the regularity of events. When a company does not have a large enough volume of business to accurately predict future losses, they may purchase statistical information form third party reporting agencies, such as the Insurance Services Office (ISO).
Insurance is time based. In order to have coverage under the policy, a claim must occur during the period of time when the policy provides coverage. The "policy period" is the period of time when the policy coverages are in effect. The inception date is the date coverage begins; the expiration date is the date coverage ends. The time between the inception date and the expiration date is the policy period. Most policies begin and end at 12:01 a.m. local time. Some polices may be effective as of 12:01 p.m. (noon) local time. Such particulars are listed on the declarations page of the policy.
Personal insurance policies, such as auto and homeowners, are written on an occurrence basis. That means that if a claim for damages of a type covered by the policy occurs during the specified policy period, coverage is provided regardless of when the claim is presented. For example, a homeowner policy is written from January 1, 2007, to December 31, 2007. There is coverage when the house catches fire and burns to the ground on December 31, even if the claim is not presented until January 5. However, if same fire occurs on January 2, 2008, there would be no coverage.
Not all policies are written on an occurrence basis. Some policies, such as professional liability policies, typically are written on a "claims made" basis. That means that the only claims considered for coverage are the ones presented during the current policy period. Many claims-made policies further require that the incident from which damages arise occur during the policy period and that the claim be made during the policy period. Additional information on the application of claims-made coverage is contained in Chapters 12, 13, and 14.
Length of Time Required Individuals may be able to purchase personal insurance policies in a relatively short period of time. They typically complete an application for coverage, sign it, and submit it through a licensed agent along with a premium down payment. Unless coverage is being submitted through a nonstandard market such as a state FAIR Plan or surplus lines market, the agent is usually able to make the coverage effective immediately.
Independent agents represent a number of insurance companies, so they may submit the application to several insurers in order to obtain the broadest coverage at the best available premium.
Some agents work as exclusive agents or direct writers. Exclusive agents represent only one insurance company. Direct writers are employees of insurance companies and, as such, sell only that particular company's policies. When exclusive agents or direct writers are used, the application will be sent only to the company that is represented.
Small, uncomplicated businesses may be able to obtain insurance coverage in a relatively short period of time as well. The process for them is similar to that for individuals. Large, complex businesses typically require much more time to obtain coverage. This is because the number of options available to them--in regard to coverage, premium, interested insurance companies, and premium payment options--increases as the size of the business increases. In other words, the larger the business, the higher the premium and the more options available. Because of this, it may take several months to design, quote, and bind a complex commercial insurance program for a large business.
Most property and casualty insurance agents have what is called "binding authority" with the companies they represent. This means that when they may accept the application, they bind the company to the risk. Coverage begins at that time. Coverage remains in force - under the binder--until a policy is issued, the insurer declines to write the policy, or the insurer sends a notice of cancellation. During this time, coverage is available just the same as if the policy had been issued.
Risk tolerance typically refers to the amount of risk that an individual or a corporation wants to bear on its own, without transferring it to another party, such as an insurance company. For example, an auto owner with a small tolerance for risk may purchase a policy with a $250 deductible on first-party damage to her vehicle. An individual with a high risk tolerance may choose to self-insure coverage for damage to his own vehicle and not purchase the first party coverages (comprehensive and collision) to save premium dollars. He is willing to risk the full cost of replacing the vehicle if it is damaged beyond repair.
In like fashion, corporations need to decide how much risk they want to retain and how much they want to transfer to the insurance company. Corporations retain risk through high deductibles, self-insuring a portion of their exposures, and even deciding not to insure an exposure at all. Some may be forced into a position of retaining a high degree of risk on exposures that are very difficult or expensive to insure. For example, a business may not insure a product it manufactures because insurance is too expensive. Instead, it may set up a self-insured program to fund liabilities it may incur because of the product.
BUSINESS AND PERSONAL USES
Insurance policies are used by property owners to protect the items they own. If a home or office building is destroyed by fire, for example, the insurance policy that covers the structure is called upon to pay to rebuild it. Banks and finance companies that issue mortgages and property loans often require that the property being financed be covered by insurance. They also require that their interest be listed on the policy so they are notified by the insurer if the policyholder cancels the coverage. Many states require insurers to notify lienholders or mortgage holders before their interest in the policy is terminated. In some cases this will extend their coverage beyond that given to the policyholder. This serves as a guarantee that the property being used to back up, or collateralize, the loan will be replaced if it is destroyed by a cause of loss that is covered by the policy.
The same is required for autos and other property owned by the insured. For example, a leasing company will require that it be listed on the personal auto policy that covers a leased personal or business vehicle.
Insurance also is used to protect the financial integrity of individuals and companies that may be held legally liable for injuring others or damaging property that is owned by others. Insurance policies that cover an individual's personal liability exposures or a company's general liability exposures provide coverage for both defense costs and damages. So, if a business is sued by an individual who slips and falls on the business premises, the company's general liability insurance policy typically will pay to defend the lawsuit. If damages are assessed, the policy also pays them, absent policy exclusions that preclude coverage. However, insurance will not pay for losses caused by intentional actions.
In like fashion, the personal liability coverage provided to individuals through homeowners or personal auto policies protect the individual insured's financial integrity. Instead of having to pay a liability settlement out of his own pocket, an individual insured may be able to look to his insurance policy to pay. This could prevent personal financial hardship or, in severe cases, personal bankruptcy.
Most insurance policies also will defend insureds should they be sued for negligence. Defense is provided for claims that reasonably can be expected to fall within the coverage provided by the policy. Defense costs typically are paid in addition to the limits of liability provided by the policy and can provide much-needed financial protection. An example of the value of defense costs may be seen when an insured individual is involved in a serious auto accident. Individuals who are injured in the accident may sue the auto owner for damages, and a personal auto policy typically would provide a defense.
Insurance provides a vital link in the financial stability of both individuals and businesses. Without it, money might not be available to repair damaged property and get businesses back into operation. Other insureds may be forced into bankruptcy if they are sued, found legally liable, and do not have sufficient financial means to pay the damages.
1. Insurance presents an individual or business with the opportunity to incur a known, up-front cost (the premium) in exchange for the insurer's taking on the possibility of a large, potentially catastrophic event (the potential for a large loss).
2. Securing an insurance policy may satisfy a contractual requirement. If a retail customer leases a building, he will probably be required to carry insurance that will cover any damage done to the building. The vast majority of all contracts include some insurance requirements.
3. Banks and other financial institutions usually require that insurance be purchased to protect their interest in the buildings on which they hold mortgages. Loans on other types of property, such as cars, furnishings, and equipment, often are conditional on evidence that insurance on the items is in place.
4. Most insurance policies provide that the insurance company adjust and pay claims on behalf of the insured business. This takes a burden off company managers, who probably are not experts in claim-management procedures. This gives the small business access to loss control experts who may help them identify potential causes of loss before they occur.
5. Insurance may be used to satisfy certain statutory or regulatory requirements. For example, state laws in all but Texas require that insurance be purchased to cover workers compensation exposures, unless the business is a qualified workers compensation self-insurer.
1. Spending money for insurance means that the insured has that much less to invest elsewhere--whether for home improvement, vacations, or retirement savings in the case of individuals or in new plant and equipment, new personnel, new training methods, or the acquisition of other businesses in the case of business owners. If the individual can measure that loss, perhaps a trade-off can be made between less insurance and an aggressive investment policy.
2. Unfortunately, even the broadest of insurance policies will not cover every loss. Some individuals may be under the false impression that all claims will be covered by their insurance policies, but that is not possible. The selection of a good insurance producer (see below) will help ease this situation.
3. Most insurance producers are compensated through commissions on the insurance they sell. This has given rise to concern among some insureds about a possible conflict of interest. An alternative is to compensate the agent on a fee basis.
4. Despite the advent of simplified insurance policies, with language that is designed to be more easily understood, insurance policies are difficult to read and understand. It is easy to assume coverage is broader and more complete than it actually is.
Types of Insurance Producers
Black's Law Dictionary defines "Agency" as a relationship in which one person acts for or represents another by the latter's authority, either in the relationship of principal and agent, master and servant, or employer or proprietor and independent contractor. Each state typically
requires that anyone who sells insurance or who discusses insurance coverages be licensed. There are several distinct categories of insurance agent. State laws typically lump them together under the general term of Producer, which generally includes
* Independent agents,
* Exclusive agents,
* Employee agents,
* Direct-writing agents,
* Brokers, and
* Surplus lines brokers.
A producer who is an independent agent is an independent businessperson who represents the insurer. In fact, he typically represents several insurers. The independent agent is appointed by insurers to represent them in a given state (although an insurance agent may hold licenses to transact insurance business in multiple states). Independent agents are compensated with commissions paid by the companies based on the amount of premiums collected.
The advantage of working with an independent agent is his access to multiple markets. The independent agent should be able to find a good match for the customer--both in terms of coverage and price. Examples of insurers who market their products through independent agents are the Cincinnati Insurance Companies, Fireman's Fund Insurance Co., and The Hartford.
The exclusive agent is also an independent businessperson. However, exclusive agents represent only one insurance company. Unlike the independent agent, the exclusive agent may or may not own policy expirations (i.e., renewal rights), depending on the company. Either party may terminate the arrangement at any time. State Farm Insurance(r) and Nationwide are examples of insurers that market their products through exclusive agents. Exclusive agents, like the independent agents, are compensated by commissions paid by the company based on the amount of premiums collected.
Employee agents are licensed as insurance agents (producers) but are employees of the insurer. They do not own their expirations and are usually employed at will by the insurer. Employee agents usually are compensated through a salary paid by the company for which they work. Employee agents usually do not own the business they produce. It belongs to the company.
A direct-writing agent is an employee of a company that typically does business over the telephone or Internet. Insurers that use direct-writing agents are often are referred to as direct writers. GEICO is an example of a direct writer. Direct writers usually compensate their agents with salary rather than commission. Like employee agents, direct writers usually do not own the business they produce.
A broker is considered an agent of the insured. In general, there is no agency contract between the insurer and the broker. There may or may not be a formal service agreement between the broker and the insured. The broker has permission to place coverage with certain insurers. When a customer goes to a broker, the broker will try to place the customer with one of the companies with whom he has a relationship. However, the broker usually may not bind coverage for that customer without the express permission of the insurer.
In larger commercial settings, brokers have the advantage of finding the best match for the applicant, without being tied to any company or system. Brokers may be compensated by insurance policy commissions or by fees paid by the businesses they represent.
Consultants have no contracts with insurers. They do not sell insurance. They are compensated by fees charged for services rendered.
Surplus Lines Brokers
A surplus lines broker is a specialized insurance producer who places business with companies not licensed to write business in the state. Typically, the coverages offered are those not offered by the mainstream companies. In many cases, the broker must be able to prove "due diligence" before placing business in the surplus lines market. This means that between three and five companies that write that kind of business turned that particular risk down before it is eligible for the surplus lines market. Such companies are nonadmitted insurers and are not subject to rate and form regulation by the various states. In most states, large companies are allowed to contract with surplus lines insurers directly, under certain circumstances. However, an individual insured cannot approach a surplus lines company directly. Rather, a licensed intermediary, the surplus lines broker must be used.
Premiums paid to a surplus lines company are not protected by state guaranty funds. So, if a surplus lines insurer becomes insolvent and not able to pay claims, the insured has no way of recovering premium that it may have paid. The insured also may have to assume responsibility for any outstanding claims. Additionally, the purchaser of surplus lines insurance is responsible for the payment of any premium tax directly to the state. Surplus lines brokers usually are compensated by a combination of commissions and fees.
An insurance policy is a contract of adhesion--the insurer has drafted the contract and the insured must adhere to it. Although this may not seem advantageous to the insured, it is important to remember that, because of this, courts typically interpret insurance policies in the light most favorable to the insured. If the insurer was not clear about the intent, the benefit of the doubt must be given to the insured. Coverage grants will be interpreted broadly and exclusions narrowly. Also, any undefined words will be given their ordinary meaning.
States have established minimum coverage requirements that insurance policies must meet. Most of these statutes are based on the coverage that was originally offered in the 1943 New York Standard Fire Policy. Many states have adopted this policy as the minimum standard for property insurance. These requirements involve such items as minimum notices for cancellation and nonrenewal, allowable exclusions, and policy terms. For auto insurance, mandated provisions may include a term of at least six months and minimum acceptable limits of liability. Additional coverages that must be offered may include personal injury protection and uninsured motorist bodily injury or uninsured motorist property damage coverages. There are very few instances where a company is allowed to cancel an insurance policy with less than a ten-day notice to the policyholder.
States set minimum standards because of the so-called public policy aspect of the insurance transaction. The importance of the insurance contract to the general welfare of the public-at-large requires that insurance transactions meet a high standard of review. In addition to the contract of adhesion aspects of the insurance policy, there are also other differences between the insurance policy and other contracts. One of the most important differences is that breach of a contract in a usual business situation does not allow the breached party to recover punitive damages awards.
The issue of bad faith in insurance transactions has developed at law such that insureds that can prove breach of an insurance contract by an insurer can, in some circumstances, sue for and recover punitive damages or bad faith dealing awards. Bad faith is not the same as negligence. When the rights of someone else are intentionally or maliciously infringed upon, such conduct demonstrates bad faith. Charges of bad faith are brought against insurers when they refuse to pay claims which seem to be clearly covered by the policy or when the company changes the conditions under which it will pay a claim after the claim occurs. Punitive damages, attorney's fees, or both, may be awarded to a party who succeeds in an action for bad faith.
PARTS OF THE INSURANCE POLICY
Insureds should review their policies when they are issued. The various parts of a property and casualty insurance policy are discussed in the following section of this chapter.
The first section of the policy is the Declarations Page. This section of the policy contains much important information--it is a guide to the rest of the policy. Items that are included on either the common policy declarations or the declarations page of a specific coverage part include the following:
1. Named insured--In most insurance policies the named insured has special rights and responsibilities above and beyond those of an insured. One responsibility is the payment of the premium. One right is the right to be notified of policy cancellation. Some policies automatically confer insured status on all family members or all subsidiaries of a company. However, the best advice is, of course, to read the policy.
2. Address--This is the mailing address to which premium notices, policy changes, and cancellation notices should be sent.
3. Address of insured location--Coverage, especially property insurance, may apply to only certain locations or properties of the insured. Those locations are listed here.
4. Forms and endorsements that apply--This section will list the coverage forms and endorsements that apply. For example, the property coverage part, auto part, or liability part and the form numbers would be listed in a commercial package policy. In general, the coverage form provides the basic insuring language. Endorsements modify the contract by broadening or limiting coverage and must be read in context with the coverage part. For example, one endorsement may exclude coverage for certain activities or locations of an insured. Another type of endorsement may add coverage for an additional insured, loss payee, or mortgage company that has a financial interest in the insured business or property.
5. Policy period--This states when coverage begins and when it ends. Most policies begin at 12:01 a.m. on the inception date of the policy and end at 12:01 a.m. on the expiration date. The exact time is important when determining which insurance policy applies to claims that may happen near the expiration date of a policy.
6. Agent's name and address--This identifies the producer who sold or services the policy. This is who the insured should turn to with questions about the policy's coverages or to submit a claim for damages under the policy.
7. Name of insurance company--This is the insurer. The insured needs to verify that it is the same as on any binder or the same name discussed with the intermediary. The financial rating should be checked again, as well.
8. Premium--This is the amount the customer pays for coverage. If it differs from what was agreed upon, clarification should be obtained. The premium section may also show a breakdown into a payment plan.
If all of the items on the declarations page are correct, then move to the policy itself. Does the policy presented to the insured match the binder and insurance specifications?
In general, an insurance policy is made up of an Insuring Agreement describing the property or liability risk to be covered, a Definitions section, Exclusions, and Policy Conditions. Any applicable endorsements should be listed on the declarations pages and actually attached to the policy. Each section should be reviewed with the producer delivering the policy to see that it matches the specifications. The insured should become familiar with the policy exclusions, particularly as it is this section of the form that is frequently misunderstood and troublesome.
Use of Deductibles
One way to lower the premium is through the use deductibles. A deductible is the amount the insured is responsible for paying on a loss before the insurance company pays. If the policy has a deductible of $1,000 and the loss is $10,000, the insurer would pay $9,000 and the insured would be responsible for the remainder.
A higher deductible shows the insurer that the insured is willing to share in a greater portion of a loss, and the insurer rewards this willingness with a reduced rate. However, the individual or business must be certain that in case of a loss, it can quickly and easily come up with the amount of the deductible. The important thing is how much premium is being saved for choosing the higher deductible. In some cases, the insurer may insist that an insured assume a higher deductible or it will decline to write the business.
Another way to keep premiums down is with coinsurance. The typical homeowner insurer requires that the home be insured for at least 80 percent of its replacement cost. When the insured maintains at least 80 percent of the replacement cost, the insurer will typically pay the full amount of a covered loss. However, if the home is a total loss, the insurance company will pay only the limit of insurance specified in the declarations.
When the insurer requires at least 80 percent and the actual percentage carried is less, any claims against the policy will be calculated at the actual percentage of insurance carried. This is the coinsurance penalty. For example: The replacement cost of the home is $100,000. The insured carries $70,000 of insurance. The deductible amount is $1,000. A fire causes $5,000 in covered damages. The deductible is applied first leaving a maximum recovery of $4000 if the insured had maintained the required replacement cost percentage. However, since the policy requires at least 80 percent, and the homeowner only carried 70 percent ($70,000), the amount of covered loss will be reduced. The amount of insurance actually carried is divided by the amount required: .7 divided by .8 = .875 times the loss amount--$4,000 = $3,500. The penalty in this case is $500.
In commercial property insurance, an insured may elect to carry an amount of insurance other than 80 percent, but this is not the case in homeowners insurance. Additionally, in commercial property insurance, the coinsurance percentage is applied before the deductible is subtracted.
WHERE CAN I FIND OUT MORE ABOUT IT?
1. Many insurers that specialize in particular industries or groups may have developed checklists. Other sources include coverage applications, which ask many of the questions that are necessary to determine what exposures need to be addressed.
2. Council of Insurance Agents and Brokers (CIAB).
3. Independent Insurance Agents and Brokers of America (IIABA).
4. Professional Insurance Agents association.
5. FC&S(tm) Online, http://www.fcands.com (Cincinnati, OH: The National Underwriter Company, updated monthly).
END OF CHAPTER REVIEW
1. Insurance is based on the law of large numbers, which means that an insurance company must insure a large number of similar types of exposures in order to accurately predict future losses.
2. An independent insurance agent represents only one insurance company and is an employee of that company.
3. Surplus lines brokers must be used when risk managers want to place their business with an admitted insurance carrier.
4. Choosing a higher deductible will result in a lower premium if all other factors remain consistent.
5. An insurance binder represents the insurance coverage that is purchased until the actual insurance policy is issued.
6. First-party coverage is used to protect insured businesses against the legal liability they may incur for injuring other people or damaging their property.
7. Exclusive agents represent a number of insurance companies but may not solicit quotations for insurance coverage from more than one company at a time.
8. One of the difficulties in trying to use insurance to transfer risk is that insurance policies often are difficult to read and understand, so often policyholders misunderstand the extent of coverage.
9. A broker is considered an agent of the insurance company.
The insurance departments in most states do review policy language and approve or disapprove wording. But most insureds have little or no input into the policy language.
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|Publication:||Tools & Techniques of Risk Management for Financial Planners, 2nd ed.|
|Date:||Jan 1, 2007|
|Previous Article:||Chapter 2: legal aspects of insurance and risk management.|
|Next Article:||Chapter 4: insurance company selection.|