This Module covers the following topics:


INSURANCE - Definition and Purpose

Insurance is a social device based on the concepts of risk pooling and the law of large numbers. A risk pool is a group of similar risks. The law of large numbers states that the impact of financial loss can be reduced by spreading the possibility of loss over a large risk pool.

The purpose of insurance is to restore the insured to the financial position that existed before the loss occurred. This is known as the “Principle of Indemnity”. The Dictionary of Insurance Terms defines indemnity as “compensation for loss”. You may see the terms “indemnity”, “indemnify” and “indemnification” used.

Requirements of an Insurable Risk

To create a viable insurance contract, an insurance company must determine if the risk is insurable. Insurable risks meet the following criteria:

For example, the more insured persons with similar characteristics such as age, sex, body build and health; the more accurately the insurance company can predict losses.

For example, the death of the main wage earner in a family would be significant because it would create financial hardship for the remaining family members.

For example, an auto accident is always a possibility when driving a car, but the event would be unintended and unforeseen. Some may argue that because death is a certainty life insurance defies the definition, but the time of a person’s death cannot be known in advance so it would fall into the category of unknown, unforeseen or uncertain.


Insurance companies are categorized according to their place of domicile:

For example, an insurance company formed under the laws of North Carolina and doing business in North Carolina is a Domestic company.

For example, an insurance company formed under the laws of New York but doing business in North Carolina is considered a Foreign insurer in North Carolina.

For example, an insurance company formed under the laws of Canada but doing business in North Carolina is considered an Alien insurer in North Carolina.

Note: All insurers offering products and services in North Carolina must be Admitted Insurers. An Admitted Insurer is one that has been issued a Certificate of Authority from the North Carolina Department of Insurance (NCDOI). This license allows the insurer to legally operate within the state.

Types of Insurers

Insurance can be obtained through:

Traditional Insurance Sources

Traditional insurance sources include Stock Insurance Companies and Mutual Insurance Companies.

One way of looking at a Mutual is that each member (policyowner) pays a specified amount into a common fund from which members are entitled to indemnification in case of a loss. Because of this arrangement, some Mutuals are referred to as “Assessable Mutuals”. If losses and expenses exceed deposits, the company can assess additional money to cover losses.

Other Insurance Sources

Other insurance sources include the following:

Reciprocal Insurance Exchange - A Reciprocal Insurance Exchange is an unincorporated association of members in which each member insures the other members. In this arrangement, each member is both an insurer and an insured. Each member shares profits and losses in the same proportion as the amount of insurance purchased by that member.

A Reciprocal Insurance Exchange is administered by an attorney-in-fact whose duties include soliciting new members, paying losses, investing funds and assessing premiums.

Reinsurance - Reinsurance is an arrangement in which an insurance company (the reinsurer) agrees to indemnify another insurance company (the ceding company) against all, or a portion of, the primary insurance risks underwritten by the ceding company under one or more insurance contracts.

Reinsurance is basically insurance that an insurance company buys for its own protection. It allows companies to spread the risk of loss so that a disproportionately large loss under a single policy does not fall on a single company. To do this, an insurer known as the reinsurer agrees to accept a portion (ceded) of a risk covered by another insurer known as the reinsured company. In addition to sharing large risks with other companies, reinsurance allows a company to:

Reinsurance terms

The two basic types of reinsurance are as follows:

o       Individual risks not covered by reinsurance treaties

o       Amounts in excess of the limits on their insurance treaties

o       Unusual risks

Both automatic (treaty) and facultative reinsurance can be written as follows:

Lloyd’s of London is one of the world’s largest commercial insurers. However, Lloyd’s of London is not an insurance company but a society of members (corporate and individual) who underwrite in syndicates. Professional underwriters accept risk on behalf of the syndicates. Supporting capital is provided by investment institutions, specialist investors, international insurance companies and individuals. Lloyd’s is famous for insuring unusual and even speculative risks.

Self-Insurers are individuals or organizations (such as large corporations) that designate certain monetary reserves to be used to cover potential losses. Companies often use self-insurance to fund employee group health plans, Workers Compensation and pension plans.

Note: The term “self-insured” is often used colloquially as a euphemism for “uninsured.” However, in this case, there may not necessarily be any designated funds available to cover potential losses.

Rating Systems

The financial strength of insurers is published regularly by rating services such as A.M. Best, Standard & Poor’s, and Moody’s and Fitch. A.M. Best uses the following rating system:



A++ to A+


A to A-


B++ to B+

Very Good

B to B-


C++ to C+


C to C-



Below minimum standards


Under state supervision


In liquidation



There are three recognized systems that are used to market insurance products:

Note: Captive (exclusive) agents generally represent one insurance company and submit all business to that company. In exchange, the company usually provides an allowance for expenses and employee benefits to its captive agents.

Note: Traditionally, insurers were often known as direct writers if they used a direct selling system or an exclusive agency system.


An Agent is an individual or company that has been authorized by an insurance company (principal) to act as its representative and offer its insurance products to the public. An agent:

In addition, an insurance agent, by law, is a Fiduciary because he or she holds a position of trust and confidence in handling funds and other matters associated with an insurance policy. For example, if an insured paid a premium to the agent, the agent would be responsible to remit the payment to the insurance company.

The authority of an agent to undertake these functions is defined in a Contract of Agency that is executed between the agent and the insurance company.

Agency represents the relationship between insurance agents and insurance companies. Every insurance agent operates under the Principles of Agency which includes the following:

o       Express Authority is the authority expressly given to the agent to act on behalf of a principal (insurer). This is given in the agent's contract.

For example, an agent is given express authority to solicit applications for insurance from the public.

o       Implied Authority is authority that is NOT expressed (given) in the contract, but the principal (insurer) endorses the agents actions as necessary to carry on business on its behalf. Generally, this will be incidental to the Express Authority given in the Agency Contract.

For example, an agent may rent an office and advertise that he or she is in business. This would be a normal business practice and would not be forbidden by the insurance company.

o       Apparent Authority is very different from Express and Implied Authority. Apparent Authority is between the insurance agent and the public and not between the insurance agent and the insurance company. If an individual holds that he or she is an agent representing an insurance company, the public has no way to know if the individual has the right to represent the insurance company or not. If you say you do and your actions appear to give you the authority, then it is “apparent” to the public that you have the right.

      For example, if an agent completes an application for an insurance policy that exceeds his or her writing authority, the person to be insured has no way of knowing that the agent could not take the application. If a loss occurs, the agent may be responsible for compensating the claimant for the loss if the insurance company does not stand behind the agent.

Agent as a Fiduciary

A fiduciary is a person who holds a position of trust and confidence in handling the premiums and other monies involved with an insurance policy. The agent has fiduciary responsibilities to both the principal and the insured.

For example, if you were given the wrong amount of change after a purchase you made, you are not legally obligated to return the money. As a Fiduciary, you would be obligated to return the money if a similar situation occurred in an insurance transaction.

Underwriting - Agent's Responsibilities

The following activities are considered an agent's responsibilities in connection with the initial underwriting process:

Underwriting Insurance Risks – Home Office

When an application for coverage is made, the application will be sent to the home office underwriters. The underwriting staff in the insurance company will examine the risk for the risks acceptability – that is, whether the company will issue a policy or not.

Insurance involves the pooling of similar (homogenous) pure risks. The insurer finds these similar risks by underwriting each risk on qualities acceptable to the company. A classic example of risk classification would be determining the construction of a building. The question would be, is the building made of brick or wood? Brick houses would be classified as one type of risk and wood houses another.

Sources of Underwriting Information

Insurers use various public and private reports to develop information on a risk. These sources include:

Risk Classification

Insurance companies typically set their criteria for what is an acceptable risk. Remember that insurers are in business to insure risks, so the insurer will want to insure risks. However, some risks will not meet the company’s requirements.

In some cases, the insurer can reject the proposed coverage or seek to adjust the coverage. In some cases, the requested coverage is rejected but the applicant has an alternative. In North Carolina, the applicant can seek coverage through the North Carolina Reinsurance Facility. Persons seeking property, auto and Workers Compensation can find assistance through the Facility.

Professional Liability (Errors and Omissions Insurance)

Agents and brokers face legal consequences for actions taken and not taken. A breach of responsibilities may result in a lawsuit.

Agents and brokers should carry a professional liability policy called Errors and Omissions (E & O) coverage. This liability policy helps indemnify against claims from consumers.

Note: This coverage only covers mistakes. It does not cover illegal actions taken by agents and brokers.


A contract is an oral or written agreement that is enforceable in a court of law or through arbitration. Written contracts are preferable. All contracts, including insurance contracts, must adhere to the following rules:

For example, a contract to sell illegal drugs is not a legal contract.

Special Characteristics of Insurance Contracts

All insurance contracts contain the following characteristics:

Useful to Know Insurance Terms

As you study the course material you will need to understand insurance terms. Here are a few that you will see or apply:

Acceptance: Agreement to an offer in contract law; formation of a contract. In insurance “Acceptance” is when the insurer agrees to provide coverage for a risk.

Adverse Selection (also referred to as Anti-selection): Term used to indicate that the selection of such a risk has a greater than average chance of producing a loss. Adverse Selection may occur if an applicant concealed information relative to the risk.

For example,  if someone is trying to buy coverage on already damaged property without revealing the damage. Insurers underwrite risks to avoid adverse selection.

All Risk: Insurance that covers each and every risk (peril) except for those that is specifically excluded. In some contracts this may be referred to as “Special Risk” contracts

Appraisal: Valuation of property for damage resulting from a covered peril. If an insured and insurer disagree on the amount of a claim, the claim may be settled through appraisal. (The Appraisal Clause in Property policies will be explained later in the course.)

Bailee: Individual who has temporary rightful possession of another person’s property. A Bailee is often a business such as a dry cleaner. Most insurance policies do not provide a benefit for a Bailee.

Broker: An insurance agent who searches marketplaces in the interest of clients, not insurance companies, for insurance coverage. Brokers do NOT hold appointments with insurers that they do business with as a Broker. In North Carolina, a Broker must have special license from the NCDOI and post a surety bond of $15,000. 

Claim: Request for payment of a loss insured against in an insurance policy. Claims are paid when the policyholder has met the conditions of the policy. In order for a claim to be paid, the policy conditions must be met. Conditions will vary from contract to contract. Conditions are requirements such as preparing an inventory of damaged property.

Friendly Fire: A fire that is contained in the vessel in which it is set. Fire insurance does not pay for losses from a friendly fire.

For example, a fire set in a fireplace is a friendly fire.

Hostile Fire (also called Unfriendly Fire): Losses due to Hostile Fire are covered under fire insurance contracts. A hostile (unfriendly) fire is a fire that is not contained in a vessel used for fire such as a fire place or stove.

For example, a fire may have been set in the fireplace, but if a spark “escapes” the fireplace and causes the carpet to catch on fire it would be considered a hostile fire that burned the carpet. The contract would cover this loss.

Note: Arson is NOT covered under the policy if the act is committed by an insured. Arson by others would be covered.  

Indemnity Contracts: Contract promising to pay an amount for losses covered under the policy. All insurance contracts could be considered “indemnity contracts”, but to be precise, Property contracts follow the definition of indemnity very strictly.

Parol Evidence Rule: A doctrine that applies to written contracts stating that no changes in the contract are allowed unless they are executed in writing and with the consent of both the insurer and the insured. The word "Parol" is an insurance term.

Pro-rata: Both the insured and the insurer normally have the right to cancel a contract of insurance. If the insurance company cancels the contract (with proper notice) during the policy period, the insurer must fully return any unearned (advance) premiums to the insured.

The opposite of this is called Short Rate. Short Rate would apply if the insured cancelled the policy before the expected expiration date of the policy. The insurer is obligated to refund any unearned premiums; however, the insurer may deduct administrative costs from the refund.

Representation: A legal statement of fact that is “true to the best of one's knowledge”. All statements made by the applicant in the insurance application are legally considered representations.

Valued Contract (also referred to as Stated Value): A contract in which the insurer agrees to pay a specific sum of money no matter what the amount of loss may be. Property contracts may be written as valued contracts.

Waiver and Estoppel: Waiver is the voluntary relinquishment of a known legal right. If an insurer waives a legal right under a contract, it cannot later deny a claim based on a violation of that right. Estoppel is the legal impediment to attempt to restore the waived right after the fact.

For example: an insured under a Homeowners Policy informs the agent of his intentions to store explosives in his home and the agent grants permission. The agent has effectively waived the insurer’s defense against increased hazards.  If the house is destroyed by the dynamite, the insurer cannot try to reassert the waived right after the loss.

Warranty: A provision in a policy that pledges a condition does or will exist at some point in the future.

For example, a Commercial Property policy may contain a warranty that a sprinkler system will be maintained in the building covered.

Insurance Support Organizations

The following organizations assist in the insurance industry in a variety of ways:

Insurance Services Office (ISO): Organization that calculates rates and creates policy forms such as Homeowners and Auto for Property and Casualty insurers. State agencies such as the North Carolina Rate Bureau use the ISO forms and adopt them to the needs of the insured’s.

National Association of Insurance Commissioners (NAIC): Governing organization for all state insurance commissioners, directors or superintendents. The NAIC works towards standardization of insurance codes in the various states. Legislation passed by the NAIC is non-binding on the states until passed by the state legislative body.

North Carolina Rate Bureau (NCRB): this organization helps to set rates and standards for Property and Casualty risks in the state.