This Module covers the following topics:
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.
To create a viable insurance contract, an insurance company must determine if the risk is insurable. Insurable risks meet the following criteria:
There must be a large number of similar exposures: Without a large number of similar exposures, the insurer cannot accurately predict the probability of the loss.
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.
The potential loss must be significant in scope: If the loss occurred, it would cause an economic hardship for the insured.
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.
The potential loss must be measurable: The amount and frequency of a potential loss must be statistically predictable.
The potential loss must be accidental: It must be uncertain, unforeseen and unintentional.
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.
The potential loss must be non-catastrophic: Unless a specialized insurance policy is purchased, catastrophic events such as floods, nuclear disasters and war are not insurable risks because claims from such events could cause insolvency for the insurer.
Insurance companies are categorized according to their place of domicile:
Domestic insurers: These companies are organized and regulated under the laws of the same state in which they are domiciled.
For example, an insurance company formed under the laws of North Carolina and doing business in North Carolina is a Domestic company.
Foreign insurers: These companies are formed under the laws of a different state from the one in which they are doing business.
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.
Alien insurers: These companies are formed under the laws of another country from the one in which they are doing business.
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.
Insurance can be obtained through:
Traditional insurance sources
Other insurance sources
Traditional insurance sources include Stock Insurance Companies and Mutual Insurance Companies.
Stock Insurance Company - This type of company is also known as a “Capital Stock” company because it sells stock and is owned by its stockholders. The stockholders share in the company’s profits through stock dividends. (The stockholders do not have to be a policyowner.)
Mutual Insurance Company - This type of company does not have stockholders; it is owned by its policyowners instead. They share in the company’s profits through policy dividends.
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 include the following:
Reciprocal Insurance Exchange
Lloyd’s of London
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:
Expand its capacity (ability to write more business)
Stabilize its underwriting results
The two basic types of reinsurance are as follows:
Automatic (treaty): This is a form of reinsurance in which a ceding company is contractually bound to cede and a reinsurer is bound to accept prearranged forms or amounts of risk.
Facultative: This is a form of reinsurance that is negotiated separately for each insurance contract. The reinsuring company decides whether to insure or reject individual risks from a ceding company. Facultative reinsurance is normally purchased by ceding companies for:
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:
Excess of Loss Reinsurance: This is a method whereby an insurer pays the amount of each claim for each risk up to a limit determined in advance, and the reinsurer pays the amount of the claim above that specific limit.
Quota Share: this is a reinsurance arrangement where the insurers involved will pay claims in direct relationship with the percentage of the risk that they are insuring.
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.
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+
B to B-
C++ to C+
C to C-
Below minimum standards
Under state supervision
There are three recognized systems that are used to market insurance products:
General Agency: This type of insurance operation typically has a General Agent who contracted with more than one insurance company and operates on an independent basis. The General Agencies may employ a staff of licensed agents (may be referred to as Sub Agents) that are appointed with the various insurance companies the General Agency represents. In most situations the agents are compensated by the General Agency and not by the insurance company. The General Agency will own the business that it writes. This system has also been called the “American Agency System”.
Branch office (district office): A branch office is the local office of an insurance company which markets and services products for that company. Captive (exclusive) agents usually operate branch offices. These agents are employees of the insurer.
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.
Direct response marketing: Direct response marketing is a method of selling insurance directly to insured’s through a company’s own employees or through the mail. A direct writer is an insurer that distributes products through a direct selling system.
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:
Solicits policies of insurance on behalf of the insurance company
Explains insurance policies to prospective purchasers
Provides continuing service to policyowners and policy beneficiaries
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:
An act by an insurance agent, within the scope of his or her authority granted or accepted by his or her principal (the insurance company), are considered to be acts of the insurer. As long as the agent does not violate his of her authority granted by the insurance company, the company will ratify (stand behind) the actions taken by the agent. There are three types of authority:
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.
An application for insurance completed by an insurance agent on behalf of the insurance company (principal) is considered a contract of the insurance company (principal).
A payment made to the insurance agent is considered a payment made to the insurance company (principal). Failure by the agent to remit such a payment does not relieve the insurance company from responsibility to keep the contract in benefit and to pay any claims from the policy.
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.
The following activities are considered an agent's responsibilities in connection with the initial underwriting process:
Report to the principal all required information on the application for insurance
Report any observations or other pertinent information on the risk
Provide the applicant with any legally required forms to inform him/her of methods used to obtain information during the application process
Issue a binder upon payment of the premium deposit
Submit the application, premium and any other required forms to the insurer
Deliver the policy as required by state law
Provide continuing service to the policyholder
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.
Insurers use various public and private reports to develop information on a risk. These sources include:
Applications for coverage
Driving records (MVRs)
Consumer Reports (this information can include field inspection reports and may be obtained from neighbors, co-workers and others on the hazards associated with the proposed risk.)
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.
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:
The parties to the contract must be of competent age and mental capacity. For most contracts, individuals must be at least 18 years old. However, any resident of North Carolina may enter into a Life Insurance or Annuity contract at the age of 15.
Contracts must be for legal purposes and have no illegal elements. If a contract has an illegal element, it is considered void.
For example, a contract to sell illegal drugs is not a legal contract.
There must be an offer and acceptance. In insurance, the offer is the application for coverage. Acceptance occurs when the insurer issues the policy. Life and Health policies are not in full effect until the company accepts the offer.
There must be consideration. In an insurance contract, consideration is the payment of the premium (along with the application) by the proposed insured.
All insurance contracts contain the following characteristics:
The contract is aleatory which means that the values exchanged in the contract are not equal. In insurance, the insured pays a premium for a potentially large return if a claim is filed. Typically, the premium paid will not ever equal the amount of benefit that would be paid in case of a covered loss.
The contract is unilateral which means there is only one party, the insurer, which makes promises legally enforceable in a court of law or through arbitration. The insured in a policy is not required to make legally enforceable promises.
It is a Contract of Adhesion (sometimes known as an Adhesion Insurance Contract) that states if there is any ambiguity in the wording of the contract it will be held against the party writing the contract.
Insurance contracts are conditional because the insurer's promise to pay benefits as stated in the contract is dependent upon the occurrence of a stated risk.
Insurance contracts are based on the legal principle of utmost good faith which means that applicants and policyowners should be truthful with the insurer.
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.
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.