C1

LOSS EXPOSURE

Loss exposure is simply defined as the possibility of financial loss due to risk. The severity of an individual or entity’s loss exposure increases or decreases depending on their habits, location, and many other characteristics.

[EXAMPLE: A person that commutes 30 miles back and forth to work every day has a higher loss exposure connected to their automobile than a person who works from home and does not need to commute. The commuter’s loss exposure is higher because the act of driving increases their chance to experience loss from an automobile accident.]

Here we will distinguish between two (2) types of loss exposure:

• Property loss exposure; and
• Liability loss exposure.

Property Loss Exposure

Property loss exposure is the possibility of loss to the value or usability of property or a physical, tangible asset. An important concept in property insurance is recognizing that an insured can experience loss due to property being physically damaged or lost as well as loss because the property can no longer serve its intended purpose.

[EXAMPLE: An insured vehicle used as a taxicab is damaged in an accident, requiring it to be in the shop for a week while repairs are completed. The insured has experienced loss in the form of the repair costs as well as the lost income from the week the vehicle was unable to be used to accept passengers for pay.]

Examples of property loss exposures include:

• Physical damage;
• Destruction;
• Loss of functionality; and
• Loss of use. 

Liability Loss Exposure

Liability loss exposure is loss resulting from injuries or damages the insured causes to another party as a result of negligence, requiring the insured to compensate the other party for the injuries or damages caused.

[EXAMPLE: Herman is not paying attention when driving to work and he rear-ends another vehicle at a stop light. The other vehicle’s bumper is significantly damaged, and the other driver spends three days in the hospital recovering from their injuries. The damage to the other vehicle and the other driver’s medical costs are examples of liability losses, and the chance of those losses occurring are liability loss exposures from the act of driving a vehicle.]

LOSS/ECONOMIC LOSS

In the insurance industry, loss is defined as any injury or damage suffered by the insured because of an accident or event covered under an insurance policy. Covered losses are what form the basis for insurance claims.

Both property and liability loss exposures may lead to loss, depending on whether the insured suffers the damages or injury themselves or if the insured inflicts damages or injury to another party.

[EXAM TIP: Make sure you distinguish “loss exposure” from “loss.” “Loss exposure” is the POSSIBILITY that loss may occur while “loss” is the damages or injuries that are actually incurred.]

PERIL

A peril is an event, situation, or circumstance that results in property damage or loss. Insurance policies define what perils are covered and which are not within the language of the insurance contract. Knowing which perils are covered or excluded from a policy is one of the most important responsibilities of an insurance agent. Common examples of perils include:

• Fire;
• Theft;
• Windstorm; and
• Vehicle accidents.

A more in-depth discussion of perils will appear in a later chapter. For now, it is only important to know the basic definition of a peril as it applies to insurance.

HAZARDS

A hazard is a condition, circumstance, or situation that increases the chance of a loss occurring or increases the severity of a loss. Hazards fall under one of four (4) basic categories:

• Physical hazards;
• Moral hazards;
• Morale hazards; and
• Legal hazards.

A more in-depth discussion of hazards and how they are categorized will appear in a later chapter. For now, it is only important to know the basic definition of a hazard as it applies to insurance.

INSURANCE

Insurance is defined as a means of managing financial risk by transferring the risk from one party to another through a legal contract or other arrangement. This means that one person (known as the applicant, the policyowner, or the insured) is transferring their possible financial loss if certain events were to occur to another party (i.e., the insurer), who assumes the risk in exchange for receiving premium payments. Insurance allows individuals and organizations the opportunity to apply their own limited financial resources more cost-effectively and efficiently, so they do not have to set aside funds for potential large loss payouts that are otherwise covered by insurance contracts.

Insurance spreads the risk of loss from one person to a large number of persons through the pooling of premiums collected from the group as a whole. By pooling premiums together in this way and creating a large monetary fund to cover losses, insurers are able to offer large amounts of coverage in return for a relatively small amount of premium. This system works because not everyone that pays premium into the pool will experience a loss, but the few that do are able to control for possibly catastrophic losses they may experience because a large number of people are contributing to the premium pool. Often, premium amounts are lessened when an insured implements common sense loss control measures to lower the chance of loss occurring in the first place (e.g., a smoke detector that warns of a fire and gives the insured a chance to contain it before it gets out of hand).

[EXAMPLE: Omar owns a home worth $250,000 dollars. There is a risk that an accidental fire could completely destroy Omar’s home, leaving him with a huge bill to rebuild the home and other losses in the form of his destroyed personal property. Like most people, Omar does not have $250,000 or more in the bank to cover these losses and would be financially ruined if such an event were to occur.

However, Omar purchases a homeowners insurance policy from ACME Insurance Company and pays $1,000 a year in premium. Assuming ACME Insurance has 1,000,000 policyholders that each pay $1,000 for homeowners coverage, that means that there is a pool of $1,000,000,000 the policyholders (specifically, Omar) can draw from to cover any losses that may be experienced. ACME is able to charge so little to access the $1,000,000,000 pool because it knows that not everyone paying into the pool will experience a loss and need to draw from it.

This is how Omar, for only $1,000 a year, is able to control for a possible $250,000 loss by purchasing an insurance policy and transferring his risk of loss to ACME Insurance Company.]

INDEMNITY/PAY ON BEHALF OF 

Indemnity refers to compensation that is paid or promised to be paid to a party for losses that have already occurred or may occur in the future and is the principal concept that all property and casualty insurance is based upon. An individual or entity must have ownership or some other stake in the subject of an insurance policy before an insurance company will pay them for the purposes of indemnification.

The principle of indemnity states that the purpose of an insurance contract is to make a policy whole again after a loss is experienced. An insurance company fulfills this obligation through the payment of claims to restore the injured party to their previous financial condition before the loss occurred.

Additionally, the principle of indemnity states that a policyholder may not receive compensation that exceeds the value of the actual loss they have experienced. Simply put, a policyholder is not allowed to profit from an insurance policy.

Payment of a claim may either be made directly to the insured or to another party on behalf of the insured depending on the circumstances of a claim.

METHODS OF HANDLING RISK/RISK MANAGEMENT TECHNIQUES

The process of analyzing exposures that create risk and designing programs to handle them is referred to as risk management. Risk management may be accomplished by:

• Detecting the potential loss exposure;
• Selecting a method or tool in order to reduce risk;
• Executing a course of action; and
• Periodically reviewing the measures taken. The risk may be reduced or managed by purchasing an insurance contract.

The proper management of risk is important for both individuals and multinational corporations, but the risk management methods and techniques used to manage risk change depending on surrounding circumstances. Risk management by itself is a rich and intricate field within the study of insurance, and it may even be a career path you decide to follow in the future! Unfortunately, a detailed study of risk management as a field of study is outside the purview of this course. However, for your state exam it is important that you are familiar with the five (5) primary methods of handling risk:

• Risk retention;
• Risk sharing;
• Risk avoidance;
• Risk reduction; and
• Risk transfer.

Depending on the circumstances, one of these methods may be used or multiple methods may be combined in an individual or entity’s risk management plan. Let us now look at each of these methods individually.

RETENTION

Risk retention is when the person, business owner, or professional decides to retain part or all of an exposure to a given risk. This means that they will be fully responsible for any losses that occur regarding the retained risk and will need to pay any necessary repair, replacement, or compensation required out of pocket without the help of an insurance company.

SHARING

Risk sharing (also known as risk distribution) occurs when multiple entities form a group for the purpose of creating a plan where each group member pays into a fund to be used for anticipated future losses that any group member may experience. In this way, the risk is shared or distributed among each member of the group and no one member shoulders the full cost of a possible loss. This is generally considered a form of self-insurance and there is typically no insurance company involved in the plan.

AVOIDANCE

Risk avoidance is when the person, business owner, or professional consciously seeks to avoid or eliminate loss exposure to a specific type of risk. The idea is that if you never expose yourself to a certain risk, you never have to worry about suffering a related loss.

[EXAMPLE: There are risks associated with skydiving and anyone who participates in the activity is exposed to those risks. A person may avoid skydiving related risks by deciding to never go skydiving.]

REDUCTION

Risk reduction is when the person, business owner, or professional is making a conscious effort to minimize the frequency or the severity of losses. Instead of avoiding a risk entirely, the strategy of risk reduction accepts that loss could occur and instead takes steps to mitigate how often a risk may occur or how expensive a loss from such a risk would be.

[EXAMPLE: It is impossible for a warehouse to completely avoid the risk of fire. However, the warehouse owner can reduce the severity of any losses a fire may cause by installing a sprinkler system and ensuring that it is well maintained.]

TRANSFER

Risk transfer is the strategy of shifting the risk of potential losses to another party, typically through a formal contract and in exchange for some form of compensation.

Sound familiar? Hopefully so, as this is the exact way we have already described the function of insurance. Insurance is the most common risk transfer method used today.

ELEMENTS OF INSURABLE RISKS/IDEALLY INSURABLE RISK

Not all risks are ideal, and most can be categorized as undesirable (below-average) or desirable (above-average). Insurance companies typically seek to insure risks that are mostly above average, but it is not as simple as it sounds. Generally, the following elements must be present for a risk to be considered insurable:

• Losses must be definite and definable;
• Loss must be great enough to create a hardship for the insured;
• Losses must not be completely catastrophic in nature (war or nuclear attack, for instance);
• Losses must be accidental; and
• The insurance company must be able to calculate the chance of a loss occurring.

In this section we will review the concept of adverse selection and the mathematical principle that is used to combat it, the Law of Large Numbers.

ADVERSE SELECTION

In general terms, adverse selection refers to situations where one party entering into a contract has more knowledge about information relevant to the contract than the other. When applied to insurance, adverse selection describes situations where an insurer issues an insurance contract to an applicant whose actual risk exposure is higher than what was represented to the insurer.

Insurers rely heavily on an insurance applicant’s truthful answers to questions that appear on an application to gauge the applicant’s risk exposure and determine an appropriate premium to charge for coverage. Whether through unintentional omission, intentional misrepresentation, or concealment of information, sometimes an applicant will not provide important information regarding their level of risk. This can lead to an insurer offering a policy to the applicant for a premium that does not accurately reflect the level of risk the applicant truly represents as a below-average risk. This has an adverse effect on the insurance company because it is unaware that it is undercharging for the risk, thus it has adversely selected that risk.

Insurers must therefore minimize adverse selection, which can be challenging given that poorer risks or those risks more likely to file claims more frequently seek insurance coverage. Insurance underwriting is therefore intended to make certain insurers are fairly compensated for the actual risks they accept exposure to when issuing insurance contracts.

[EXAMPLE: When applying for an automobile policy, Keith estimates that he drives 5,000 miles total a month. Based in part on this information, ACME Insurance Company issues Keith a policy for a monthly premium of $150. However, Keith unintentionally severely underestimated how many miles he drives a month and in reality, the total is closer to 15,000 miles. 15,000 miles driving a month represents a significantly higher risk exposure than 5,000 miles.

If ACME had known the true amount that Keith drives a month, it would have offered the policy for $200 a month to reflect Keith’s true risk exposure. Offering a policy to Keith for $150 a month because ACME did not have access to accurate information regarding his monthly miles is a prime example of adverse selection.]

LAW OF LARGE NUMBERS/ SPREAD OF RISK

While insurers do all within their power to avoid adverse selection, they recognize that it is not entirely avoidable. Fortunately, there is a mathematical principle in statistics that allows insurers to effectively mitigate the negative effects of adverse selection.

The Law of Large Numbers is a probability theory stating that as a sample size grows larger, the average of the sample results will begin to approach the expected value more closely.

For example, there is a 1/6 chance, or 17% chance, that a die will land on six when rolled. If you roll the die six times and never land on a six, then so far, the die has landed on six 0% of the time, far less than the expected value of 17%. However, if you increase the sample size by rolling the die 1,000 times instead, the number of times it lands on six will begin to approach the expected value of 17%. If you roll the die 10,000,000 times the results will approach even closer to the expected 17%.

The Law of Large Numbers also applies to insurance. As an insurance company increases the number of policyholders it has issued policies to, its estimated losses in the form of claims payments become closer to what is estimated or expected. This holds true in practice because any below-average risks are offset by risks that are above average and people who are less likely to file claims.

Insurers understand there will be claims from the risks they accept; this is why insurers must charge adequate premiums to offset the losses they will unavoidably experience through claims as well as account for the inevitability of adverse selection.

REINSURANCE

Reinsurers are a specialized branch of the insurance industry that provides financial protection to insurance companies. Simply put, a reinsurer is an insurer that insures insurers.

The purpose of reinsurance is to limit the liability of the original insurer, allowing the original insurer to assume more risk than they could handle otherwise. This could be done for the purpose of transferring the risk of catastrophically large losses that would lead to the company’s bankruptcy or to give the original insurer some breathing room and allow it to expand its business. By reinsuring a portion or all of its existing risk, an insurer is able to assume even more risk than it otherwise could because it is no longer liable for paying claims on the reinsured amount.

Through a process known as cession, the insurance company that transfers its loss exposure (risk) to another insurer is called the primary insurer or ceding company. The company assuming the risk is the reinsurer, or assuming company. Just as with a normal insurance contract, the ceding company pays premium to the assuming company in exchange for the assuming company insuring the risk.

Reinsurance is an important part of the insurance industry, providing for continued insurance business growth, protection from catastrophic loss event, and overall stability to the insurance industry through the distribution of risk.

RATE FILING AND FORMS SERVICES

While there are certainly insurers that develop their own policy forms and file all of their own regulatory documents, many use or adapt standardized forms developed by different entities or outsource the complicated process of regulatory filings. In this section we will discuss some of the more prominent entities that provide these services to the insurance industry.

INSURANCE SERVICES OFFICE (ISO)

The Insurance Services Offices (ISO) is an advisory organization responsible for developing standard policy forms, coverages, structure, provisions, agreements, clauses, deductibles, definitions, conditions, exclusions, endorsements, and other conventions for use by the insurance industry.

ISO also serves insurers, reinsurers, agents and brokers, insurance regulators, risk managers, and other participants in the property/casualty insurance marketplace. Here is an outline of ISO’s products and services:

• Data facilitating insurers to make pricing decisions;
• Statistical and actuarial services;
• Creation of insurance policy language;
• Rules required for writing and rating insurance;
• Tools enabling predictive modeling and risk scoring;
• Specified property and community information;
• Underwriting information for claims data;
• Tools enabling the identification and preventing of insurance fraud; and
• Risk consulting services.

ISO standards and forms are the most common found in use throughout the industry.

[EXAM TIP:  ISO industry standards and policy forms will form the basis for most examination topics. However, these standards may be modified by state laws, which are important for your state exam, and any relevant modifications are detailed in the state law chapter of this course.]

AMERICAN ASSOCIATION OF INSURANCE SERVICES (AAIS)

The American Association of Insurance Services (AAIS) is an organization responsible for collecting statistical data, distributing rating information, developing standard policy forms, and filing information with state regulators on behalf of insurers that purchase its services. The AAIS is one of the two prominent multiline advisory rating organizations serving the insurance industry, the other being the ISO as previously discussed.       

SURETY AND FIDELITY ASSOCIATION OF AMERICA (SFAA)

The Surety and Fidelity Association of America (SFAA) is a trade association working with all segments of the surety and fidelity bonding industry, acting as a resource to promote and maintain outreach to the public as well as industry and government regulators. The SFAA is involved in various activities related to bonding, including:

• Analyzing default rates within the industry and developing strategies to reduce those rates;
• Providing education scholarships;
• Providing guidance on how to manage risk through the use of bonds; and
• Advocating to the public and government regulators on behalf of the bonding industry.

Insurance and bonds are somewhat similar in concept but have many important differences. As such, do not focus on the details of bonding for now. Only a very small part of your exam will concern bonds and the concepts you may be tested on will appear in a later chapter.   

NATIONAL COUNCIL ON COMPENSATION INSURANCE (NCCI)

The National Council on Compensation Insurance (NCCI) provides comprehensive data, statistics, and solutions for the workers’ compensation industry. The NCCI seeks to promote a functional and viable workers compensation system across the nation, accomplishing this goal by:

• Gathering and disseminating workers’ compensation data;Analyzing industry trends; andProviding objective insurance rate and loss cost recommendation.

FEDERAL REGULATION

The insurance industry is regulated by a number of authorities, including some inside the industry itself. The primary purpose of this regulation is to promote public welfare by maintaining the solvency of insurance companies. Other purposes are to provide consumer protection and ensure fair trade practices and fair contracts at fair prices. Market Conduct Regulations are state laws that regulate insurer practices regarding underwriting, sales, rate making, and claims handling. It is critical that insurance agents understand and obey the insurance laws and regulations. Most of these will be discussed in the last chapter of this course but here we will discuss a few federal laws that apply to the insurance industry.

THE MCCARRAN-FERGUSON ACT OF 1945

The McCarran-Ferguson Act of 1945 solidified the idea that insurance is regulated at a state level and not a federal level. That being said, the insurance industry is still subject to federal antitrust laws unless certain conditions are met, as follows:

• The activity in question must fall within the business of insurance;
• The activity must be regulated by state law; and
• The activity must not involve boycott, coercion, or intimidation.

GRAMM-LEACH-BLILEY ACT (20-2121; PUBLIC LAW 106-102)

The Gramm-Leach-Bliley (GLB) Act of 1999, also known as the Financial Modernization Act of 1999, dictates how financial institutions such as banks and insurance companies are to handle the private information of consumers. It consists of three sections:

• The Financial Privacy Rule that regulates the collection and disclosure of private consumer financial information;
• The Safeguards Rule dictating that financial institutions must protect consumer information by implementing effective security programs; and
• The Pretexting Provisions that prohibit accessing private information under false pretenses.

Under the GLB Act, financial institutions are also required to deliver privacy policy notices that detail the institution's information-sharing practices and inform consumers of their rights regarding how their information is shared. For insurance companies, these practices must be shared prior to or at the time of signing the application for an insurance policy.

The GLB Act also repealed most of both the Glass-Steagall Banking Act and the Bank Holding Company Act. The two Acts operated to place a barrier between different types of financial institutions and prevented banks from underwriting insurance policies as they had previously done for years. Through repeals, the Gramm-Leach-Bliley Act removed this barrier and allowed banks and insurance companies to operate as one yet again.

CONSUMER PROTECTIONS

FAIR CREDIT REPORTING ACT (15 USC 1681– 1681d)

The Fair Credit Reporting Act (FCRA) is federal legislation created for the purpose of promoting the accuracy, fairness, and privacy of consumer information that is held and provided by credit reporting agencies. Additionally, it stipulates how such data may be collected, shared, and for what purposes it may be used. Because insurance companies request and use credit information as part of their underwriting process they fall under the purview of and must follow the provisions of the FCRA. The FCRA places the following responsibilities upon companies that use credit information:

• Users can only obtain consumer reports for permissible purposes under the FCRA;
• Users must notify the consumer when an adverse action is taken on the basis of such reports (such as a higher insurance rate); and
• Users must identify the company that provided the report, so that the accuracy and completeness of the report may be verified or contested by the consumer.

Because insurers also provide information back to credit reporting agencies, they must also:

• Provide complete and accurate information to the credit reporting agencies;
• Investigate consumer disputes received from credit reporting agencies;
• Correct, delete, or verify information within 30 days of receipt of a dispute; and
• Inform consumers about negative information which is in the process of or has already been placed on a consumer's credit report within one month.

[EXAM TIP: The FCRA is one of the most important regulations to be aware of for your insurance exam. Make sure that you not only know its purpose but have also memorized the responsibilities and duties that are placed on insurers by the FCRA (present above in the bullet lists).]

TELEMARKETING RULES (16 CFR 310; 15 USC 6101–6108; A.R.S. 44-1282)

FEDERAL TERRORISM INSURANCE PROGRAM (15 USC 6701; PUBLIC LAW 107–297, 109–144, 110–160)

The Terrorism Risk Insurance Act (TRIA) was initially enacted as a temporary three-year program to calm insurance markets through the creation of a government reinsurance program that would share in terrorism-related losses. The program was intended to give the insurance industry time to gather the data and create the structures and capacity necessary for private insurance to cover terrorism risk, but instead has become a staple in the insurance industry that has been renewed constantly throughout the years.

The TRIA will pay certain claims in the event of a loss due to a certified act of terrorism. 

VIOLENT CRIME CONTROL & LAW ENFORCEMENT ACT (20-489; 18 USC 1033, 1034; 15 USC 6101-6108; ARS 44-1282)

The Violent Crime Control and Law Enforcement Act of 1994 made it illegal for any individual convicted of a crime involving dishonesty, breach of trust, or other related crimes to work in the insurance industry and implemented steep penalties for any individual who violates the Act.

An individual convicted of such a crime (Prohibited Person) who wishes to work in the insurance industry is only allowed to do so after receiving written consent from a state insurance regulatory official. The Prohibited Person must submit a written request to the appropriate insurance regulatory official of their state for approval to transact insurance business. After careful consideration, the regulatory official may permit the Prohibited Person to transact insurance by issuing written consent on a document known as Form 1033.

Under the Act, all insurers are also responsible for ensuring that their employees are not prohibited from transacting insurance as stated under the Act.