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Introduction to insurance

Montana Test Takers Chapter 1 is not emphasized on your Limited Lines Credit exam. You may review this chapter for background and general information purposes, however do not devote substantial time to this chapter

Introduction to Insurance

1

Chapter

CHAPTER HIGHLIGHTS

Definition of Insurance

Chapter 1 Quick Start

C

Types of Insurance

hapter 1 provides a broad overview of insurance and gets into some of the more basic definitions used in the field of insurance. We also cover techniques used to manage risk, which includes the purchase of insurance. Pay special attention to the material marked by your instructor as Critical Points and the Rapid Fire Q&A Drills. Once you complete your chapter, go to your CD and review the chapter slide show, which includes additional Rapid Fire Q&A Drills. Then review the Critical Points and Super Sheets (The Super Sheets are a life saver for that last minute prep before walking into the exam.) Once you are ready to simulate the exam, try the Learn Mode Exercises (where you answer and review one question at a time) or go ahead and use Exam Simulation Mode (where you go through exam questions as if you were taking a live test). The choice is yours. Rest assured that this combination of topical coverage and learning tools will give you the edge on the credit exam that you need. There is no other training package for the credit exam like this in the United States. And, if you feel that you need direct access to a live instructor to assist you along the way, sign up for the My Instructor Access Service. Students tell us that this service gives them the extra bit of confidence and knowledge that they need to pass on the first try. For more information or to sign up for this service, go to our Web site’s home page (www.180Licensing.com) and select My Instructor Access Service under the Product Tour section.

Risks Exposure Perils Hazards Losses Covered Law of Large Numbers Managing Risks Adverse Selection Indemnity

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Limited Lines Credit Instructor’s Edition

Overview of Insurance Definition of Insurance CRITICAL POINT

Understanding the essence of insurance is very important. And, as you might imagine, there are different ways to define insurance.

Insurance involves the

• Insurance is a contract whereby an insurer agrees (promises) to indemnify an insured

transfer of risk through

against a loss (injury, damage, or liability) arising from some future and unknown event. (1.01)

a contract whereby an insurer promises to indemnif y an insured against a loss arising from some future and unknown event. (1.01-1.02)

• Insurance may also be defined as the transfer of risk. Risk is transferable – an insurance policy transfers the insured’s risk of loss to the insurer. (1.02)

• We may also define insurance as a social mechanism through which insureds, by paying a premium fee, transfer a defined and limited portion of their risk to an insurance company. (1.03) The underlying principle is that the clients (or customers or insureds, or whatever you wish to call them) agree to accept a small, immediate loss (the policy premium) in exchange for protection against a potential, larger loss later (a totaled car, a large hospital bill, the loss of life, or a burned building). This is the essence of insurance. (1.04)

Types of Insurance Generally insurance falls into four fairly neat categories: life, health, property, and casualty. The lines between these blur a bit from time to time, but each of these types of insurance meet needs that are recognizable and common place. Some basic definitions and examples are in order: (1.05) Life insurance covers the life of a person in order to protect the survivors (e.g., a wife insures the life of her husband in order to provide monies needed for raising her children). In the context of credit insurance, credit life insurance covers the life of the debtor in order to protect the creditor (the lender). (1.06) Health Insurance, sometimes referred to as Disability Insurance, provides benefits connected to sickness or accident losses (e.g., an employer provides a group medical expense policy that pays benefits to an employee to reimburse the employee for costs incurred as a result of hospitalization, or a person buys a $3000 per month benefit that pays the insured when the insured becomes disabled due to accident or sickness). In the context of credit insurance, credit disability insurance pays a stated amount benefit (like the $500 per month auto loan payment) to the creditor (the lender) when the insured debtor becomes disabled due to sickness or accident. (1.07)

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Introduction to insurance

Property Insurance provides the property owner with protection against losses sustained as a result of damage to property (e.g., you purchase a homeowners policy to cover damage to your house by fire). In the context of credit property insurance, credit property insurance pays to repair or replace the damaged property so that the creditor’s (lender’s) collateral is protected. (1.08) Casualty Insurance, sometimes called liability insurance, protects the insured from liability for harm caused to the insured or others (e.g., a business purchases a policy to protect itself against a lawsuit in case of injury sustained by a customer’s fall in the business’ store). In the context of credit casualty insurance, credit casualty insurance pays a benefit to your creditor for legal obligations you may owe. As an example, in the case of an Involuntary Unemployment Policy (a form of credit casualty insurance), if you are involuntarily unemployed (fired, laid off, etc.), a credit involuntary unemployment policy pays a benefit to your creditor (your lender), so you will not fall behind on a legal liability (the debt that you owe the creditor). (1.09) From the 180 Info File Did you know that the term casualty is defined as “an accident, occurrence, or event or the person to whom it happens; the general term applied to insurance coverages for an accident, occurrence, or event. Casualty includes liability and workers’ compensation”. If insurance doesn’t fit neatly into the categories of life, health, or property, it typically falls into the category of casualty insurance. So when you are concerned about getting fired and not able to make your auto loan payments, and you want to insure against that possibility, you buy casualty insurance. Or, if you are concerned about being sued and want to insure against the cost of an attorney, you may consider buying casualty insurance, which is insurance for covering potential future legal bills. And, the list of potential “casualties” and related insurance products goes on. (1.10) Susan is a single mom with four children. She is covered by a comprehensive group health insurance plan and has a $50,000 life insurance policy from her work. She also carries homeowners and auto insurance. She is considering purchasing a disability income policy to replace lost income in case she becomes disabled due to sickness or accident. (1.11)

EXAMPLE Overiew of Insurance Coverages

The policies mentioned in this example include ALL FOUR TYPES OF INSURANCE POLICIES: property coverage, casualty coverage, life coverage, and health coverage of two typesmedical expense insurance and disability income coverage. Her auto and homeowners policies cover both property damage and liability (casualty) connected to operating her automobile and owning her home. The group health plan from work provides reimbursement or coverage for medical expenses incurred, and her life insurance plan from work provides life insurance benefits for the protection of her children. The disability income policy is a type of health or disability policy that will replace at least a portion of her lost income in case of accident or sickness that results in disability. These same insurance concepts can be applied to credit transactions, where the creditor (and not the debtor or the debtor’s family) is the beneficiary. (1.12) www.180licensing.com

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Limited Lines Credit Instructor’s Edition These definitions are gross oversimplifications and the study and mastery of the material required to pass your licensing exam will necessitate going into much more detail- specifically as these policy types relate to limited lines credit insurance. And this book does just that for the areas of life, health, property, and casualty as they are applied to credit transactions. (1.13) CRITICAL POINT A loss occurs when there is a reduction or destruction in value, and insurance is a technique for transferring at least some of the risk of such a loss. (1.14)

Risk Risk is defined as the chance of suffering a loss or the uncertainty of loss (loss that is measurable in dollars is known as an economic loss). A loss occurs when there is some reduction or destruction in value (e.g., your house burns and is now worth $50,000 less). Such a loss is known as an economic loss and involves a loss that can be measured somehow in dollars. And, that risk (of economic loss) is transferable to the insurer via a contract known as an insurance policy. (1.14) Two Types of Risk. We’ve just defined risk as the chance of loss. Now, risk can be further broken down into speculative risk and pure risk.

CRITICAL POINT Speculative risk involves

Speculative risk involves speculation (gambling), and speculation is defined as engaging in a game of chance where there is a chance to win and a chance to lose. A speculator accepts the chance of loss in the hope of realizing a gain. So, during the dot.com bubble, when short term stock traders were “speculating” on whether tech stocks would continue to rise dramatically in value, these speculators were hoping for a short term gain. Of course, many incurred short term and significant losses when the tech bubble popped. Speculative risk is not insurable. (1.15)

Pure risk on the other hand involves the chance of loss only- there is no chance of gain. So, the risk of loss due to illness and hospitalization is an example of pure risk, where there is a chance of loss, but not a chance of gain. Insurance covers pure risk, not speculative risk. (1.16)

the chance of winning and losing. Pure risk involves only the chance of loss. Speculative risk is not insurable. Insurance deals only with pure risk. (1.151.16)

CRITICAL POINT The possibility and extent to which you may incur a loss is called “exposure.” The greater the extent of your exposure, the more your insurance will cost, if you are insurable at all. (1.17)

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Exposure If you are subject to the “possibility of a loss,” you are “exposed.” The extent to which you are subjected to the possibility of a loss is a measure of your exposure. While it may sound sexy, it’s neither sexy nor illegal. In fact, all of us are “exposed” to all kinds of risks (causes of loss) every day. Just wake up in the morning, and go out to fetch the paper, and you are “exposed” to the risk of loss. The paper delivery boy may have a bad tossing day and hit you in the head with the morning news. It must be Monday! Apply the concept of exposure to your business. Let’s say you sell radioactive products. From a business insurance perspective, the more sales you have of your radioactive products, the more “exposure” you have to the risk of loss, and the more your “radioactive liability insurance” is likely to cost you. So, coal miners are more exposed to loss at work than are school teachers. Some professions and activity present too much exposure for insurers, so those exposures are not insurable. (1.17)

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Introduction to insurance

Perils Losses are caused by perils. Therefore, perils are causes of losses. Examples include accidents that cause hospitalization, sicknesses that cause death, fires that causes property damage, and sales of defective products that expose a business to liability losses. (1.18)

CRITICAL POINT Life insurance deals with insuring against the perils of sickness and accident

Life and Health Insurance. In the field of life and health insurance, we deal primarily with the perils of accidents and sicknesses. Accidents and sicknesses cause us to be hospitalized, need surgery, need doctor’s care, lose income from work, and die. Accidents and sicknesses are causes of loss known as perils and are insured against with life and health policies. (1.19) Property and Casualty Insurance. In the field of property and casualty insurance, we deal with a wide range of perils. On the property side of insurance, these perils include such things as theft, fire, wind, hail, and smoke that cause damage to property. On the casualty or liability side, these perils include such things as auto accidents, selling defective products and careless conduct, all of which expose individuals and businesses to potential legal liability. (1.20)

Hazards

that cause death. (1.19)

CRITICAL POINT Property insurance deals with insuring against many perils such as theft, smoke damage, hail, windstorm, and fire that cause damage to property. (1.20)

CRITICAL POINT

A discussion of insurance, losses and perils cannot be complete without mentioning hazards. A hazard increases the risk of loss because it either makes a peril (or cause of loss) more likely or it increases the severity of the loss. In other words, a hazard increases the probability that a peril will result in a loss and/or that the loss will be larger than it normally would have been. (1.21)

Let’s say that there is a chance that your next door neighbor may trip on your steps when coming over for a visit. This would result in your neighbor suffering a loss. The cause of a loss (a peril) is the narrow set of steps that may result in an accident. If you fail to shovel the snow off of your steps, you have created a hazard, which has an impact on the peril, and therefore makes a loss more likely. (1.22)

A hazard increases the risk and/or severity of loss because it makes a peril (cause of loss) more likely. (1.21)

EXAMPLE Perils & Hazards

Hazards may be divided into physical hazards, moral hazards, and morale hazards. • Physical Hazards. These hazards have a tangible, physical existence, such as dirty, oil-soaked rags that you have left in the basement of your house. The house may catch fire (the peril or cause of loss is the fire) and the dirty rags (the physical hazard) may either increase the probability of a loss, or enhance or make the loss larger. (1.23)

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Limited Lines Credit Instructor’s Edition • Moral Hazards. These hazards involve the trait of dishonesty- lying, cheating, stealingand being “immoral.” Those who are dishonest or immoral increase the probability of a loss, or make the loss larger. For example, a person that lies on a claims form to “fake” a claim will likely end up causing the insurance company to suffer a larger loss than it would if the claimant would have been honest. (1.24) CRITICAL POINT A morale hazard involves an individual that is careless or reckless because of a poor attitude or low morale. Morale hazards increase the probability of a loss or cause the loss to be larger than it would be otherwise. (1.25)

• Morale Hazards. These hazards involve the mental state of low morale. We all have seen co-workers that have low spirits (low morale) or have a negative attitude, perhaps because of something that happened at work. Often, an individual with low morale may not be as careful as someone with a high morale. (Morale involves the positive and uplifting belief in oneself and others.) Therefore, behavior like careless driving (driving above the speed limit), reckless driving (driving while under the influence of drugs), being lazy or indifferent may result from someone suffering from a lower than normal morale. These activities certainly increase the probability of a loss and/or the severity of a loss. (1.25)

What Kind of Loss is Covered?

CRITICAL POINT Insurance deals with economic losses, not pure emotional losses. (1.26)

People suffer many types of losses - including emotional, physical, psychological, and economic. Insurance deals solely with the economic kind, causing financial hardship. No amount of insurance could ever replace a severed limb or reduce the heartache of losing a spouse. But insurance can indeed replace a portion of the income lost when a disabled person is no longer able to work or when the family bread winner dies. In addition, insurance is designed to cover only some of the many kinds of economic losses. And, for an event to be insurable, the person or organization purchasing the insurance must stand to lose from the occurrence of the event. This loss may happen when one business partner, who has a financial interest in the other business partner, loses earnings due to his partner’s disability. Another example is when a company is held liable by a customer who is injured by a defective product that the company sells. In life insurance, the loss of the life of a spouse causes emotional as well as financial losses. And in the health insurance area, perhaps one of the greatest of all economic losses is the loss of the ability to earn a living. (1.26) Loss Must be Accidental. For starters, the loss must be accidental and may not arise from an intentional act on the part of the insured. Therefore, you can insure against your plane falling out of the sky, but not against losing at the blackjack table. You can insure against getting sick, but not against hospital costs incurred due to the insured’s intentional participation in an armed robbery. And, insurance seeks to make you whole again, and seeks to not allow you to profit from your loss. (1.27)

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Introduction to insurance

Loss Must Be Predictable. This simply means that the loss (death, for example, in the case of life insurance) must be foreseeable enough so that the company can reliably predict its likelihood and therefore establish a reasonable premium. Computing the likelihood of death for a person of a specific age and gender is relatively easy because of all the mortality data in existence today. And, the chances of loss can be calculated for just about any activity that is repeated often enough. Therefore, predictability involves losses that occur over a large number of homogenous individuals or businesses subjected to the same risk. (This is known as the Law of Large Numbers and is discussed below.) So, coal miners in the northeast would constitute a group of workers with similar risk profiles at work. These individuals would be considered homogenous (a group with similar characteristics), since they all fit into a similar loss profile. (1.28) Loss Must Be Measurable. In order to be measurable, a loss must occur more or less at a specific time, in a specific place, and be capable of appraisal (calculation) in terms of dollars. And the cause of loss must be ascertainable- which often translates into the fact that a loss must be an “economic loss” in order to be insurable. Now, it doesn’t take a rocket scientist to envision a loss that breaks one or more of these rules - say a chronic health problem or the shattering of a truly priceless artifact. The value of these types of losses is virtually not ascertainable and measurable. To make up for this problem (remember, insurance can only be written on measurable losses), insurance companies make these losses measurable simply by putting a limit on their coverage. So every insurance policy you buy (or sell) these days will delineate the company’s maximum exposure to loss, thereby making the loss “measurable.” As a result, total coverage limit for your loss may be much less than your full or actual loss. For example, your health insurance policy may have a lifetime limit of $250,000. So, it doesn’t matter how much your hospitalization costs run up, the insurance company will only be liable up to policy limits. So, the company has made this loss “measurable” by specifying policy limits. (1.29) Loss Must Not Be Catastrophic. No insurer is going to suffer a catastrophic loss just because its customers did. So, in addition to establishing a dollar limit on each policy, insurance companies typically exclude from coverage all losses from catastrophic events like war and flood that could overwhelm the company with large, simultaneous claims. (1.30)

CRITICAL POINT To be covered by insurance, losses must be economic, accidental, predictable and measurable. (1.26-1.29)

CRITICAL POINT The technique that insurance companies use to make a loss measurable is to place a limit on the coverage. (1.29)

CRITICAL POINT Catastrophic losses (such as wartime losses) are normally excluded from coverage. (1.30)

180 Quick Review Kinds of Losses Covered Losses must be: • Economic, not just emotional • Accidental, not intentional • Predictable • Measurable (create policy limits) Note that catastrophic losses (such as wartime losses) are normally excluded from coverage.

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Limited Lines Credit Instructor’s Edition

180 Rapid Fire Q & A Drills 1.02

Q. Does insurance involve transferred risk or split risk?

A. Transferred risk

1.18

Q. A cause of loss is known as a hazard or a peril?

A. Peril

Q. Does risk involve the causes of loss or the chance of a loss?

A. Chance of loss

1.16

Q. Does insurance cover speculative risk or pure risk?

A. Pure risk

1.25

Q. When an insured is lazy, indifferent and has a bad attitude, is that an example of a moral hazard or a morale hazard?

A. Morale hazard

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Q. When an insured lies, cheats and steals, is that an A. Morale hazard example of a moral hazard or morale hazard?

1.23

Q. Are dirty, oily rags in the garage an example of a peril or a physical hazard?

A. A physical hazard

1.20

Q. Is fire and windstorm an example of a peril or a physical hazard?

A. A peril

1.19

Q. Is an accident or sickness an example of a peril or a hazard?

A. A peril

Q. Do insurance company actuaries rely on large databases of mortality data or small databases of mortality data?

A. Large databases, which are required under the Law of Large Numbers

1.14

Q. Insurance deals with emotional losses or economic losses?

A. Economic losses

1.28

Q. Do insurance companies exclude predictable losses or losses that are not predictable?

A. Losses that are not predictable are excluded; only predictable losses are covered

1.29

Q. Must losses be measurable or catastrophic to be insurable?

A. Measurable

1.27

Q. Do insurance companies exclude intentional, self-inflicted injuries or predictable losses?

A. Intentional, self inflicted injuries are excluded; predicable losses are insurable

1.30

Q. Are catastrophic losses such as earthquakes excluded or covered by most insurance policies?

A. Excluded, because catastrophic losses, like war time losses and earthquakes, are typically excluded

1.14

1.28, 1.33

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Introduction to insurance

Spreading (Sharing) the Risk Insurers specialize in spreading the risk by having policyholders share in some of the risk. A goal of every insurance company is to spread the risk among a large number of policyholders. The insurance company, of course, does not accept all this risk out of the goodness of its heart. Rather, it intends to make a profit. The company agrees to take on some of the risks in exchange for consideration (value given in the form of the premium and application for insurance). In fact, the insurance company does not entirely take on the risk itself, but rather serves as a sort of middle person that spreads the risk among all of its customers. By charging premiums that are slightly in excess of what it needs to cover losses, the company also earns a profit. (1.31) To calculate the premiums needed so that a company could cover losses and have the potential to profit, insurance companies collect tons of statistical data. The practice of data collection started many years ago. In 1692, a gentleman named Edmond Halley (the royal astronomer of England and the man for whom a comet is named) compiled the first known chart of life expectancy, probably making him the world’s earliest actuary. (The statisticians who compile mortality data for the purpose of predicting losses and establishing premiums for insurance companies are called actuaries.) (1.32)

CRITICAL POINT The statisticians who compile mortality data for the purpose of predicting losses and establishing premiums for insurance companies are called actuaries. (1.32)

From the 180 Test Bank Which of the following best describes a peril? a) Sharing losses among many insureds b) A cause of loss such as a heart condition that results in death c) Losses that are economic, not merely emotional losses d) The results of the calculations of an actuary Answer: A peril is a cause of loss. In the field of life and health insurance, accidents and sicknesses are considered perils. Both accidents and sicknesses cause losses such as medical expenses, lost income and death. Therefore, the correct answer is B.

The Law of Large Numbers The insurance pioneers did, however, discover a second, very important rule for the successful operation of the insurance business - a rule that deals with the predictability of losses just discussed. This principle is often referred to as the law of large numbers. Reduced to its basics, the law of large numbers says that statistical data is of no predictive value if your pool of customers is too small. However, increase the client pool to a few thousand insureds, and they will indeed die, on average, when they are supposed to. The Law of Large Numbers makes losses more predictable and it underlies all risks accepted by insurance companies. (1.33)

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Limited Lines Credit Instructor’s Edition EXAMPLE Law of Large Numbers

CRITICAL POINT The theor y of shared risk and the law of large n u m b e r s p ro v i d e t h e

Let’s say you’re going to insure the lives of five men, all age 30. The actuaries have determined that 30-year-olds have, on average, another 40 years to live. So, you charge these individuals a relatively low premium for, say, $100,000 worth of life insurance each. Then you sit back and plan to collect and invest premiums for a good long time. But these guys, for various reasons, all lose their fight with the Grim Reaper during the first year of coverage. Suddenly, you have $500,000 worth of death benefits to pay and only a pittance in the premium piggy bank. (1.34)

The problem here is not the quality of the actuarial data, but rather the size of the client pool. It’s like flipping a coin five times and having every toss come up heads. You’d be a bit surprised, perhaps, but this little experience is definitely not destined for some book of strange phenomena. If you toss that coin a few hundred (or better yet a few thousand) times, you’re guaranteed to come very close to the expected 50-50-heads or tails mix. So it is with life insurance. (1.35)

underpinnings for all kinds of insurance. The theory of shared risk suggests that each individual’s potential loss is less when many people participate in one another’s risk, usually via an insurance company. (1.31- 1.35)

CRITICAL POINT One way to manage risk is to avoid the risk- in other words, stop engaging in that particular behavior. (1.37)

Managing Risks Individuals, businesses, governments, and non-profit organizations need to manage their risks and can do so in one of several ways. Most choose to employ a combination of the approaches to managing risks. In order to properly manage risks, a thorough analysis of the organization’s loss exposure is first completed, followed by designing a program that uses one or more risk management tools. (Loss exposure is a measure of the potential impact of perils- in other words, the greater an individual is exposed to causes of loss (perils) the greater the individual’s loss exposure. Therefore, comparing individuals based on the jobs they hold, and perils associated with those jobs, a bungee jumping instructor has more loss exposure than a school teacher.) This section explores the techniques that can be used in managing risks. (1.36) The basic techniques for managing risk include: • Risk Avoidance. Of course, one way to manage risk is to avoid it. So, if you want to manage the risk of an aviation accident, simply don’t fly. Or, if a business wants to reduce its liability risk for delivering pizza in the winter, it may choose not to deliver pizza in the winter. (1.37) • Risk Reduction. Reducing the risk of loss can be accomplished by using a number of approaches, including implementing a safety program to reduce or prevent the risk of injury to workers (loss prevention), such as training drivers to reduce automobile delivery accidents. So, there are many ways to reduce risk through various loss prevention programs and loss control programs. And losses can be controlled so that the losses are smaller than they otherwise might be. Having a nurse on staff at the plant would represent loss control. And making sure that the fire sprinkler system is always in working order would serve the dual purpose of loss prevention and loss control. (1.38)

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• R i s k R e t e n t i o n ( S e l f Insurance). Risk retention essentiall y involves self insurance and can take many forms. For example, when you purchase auto insurance with a $1,000 deductible on glass, you have retained some of the risk of loss due to damage to your auto. A large company may provide health “insurance” by self funding. This is really not insurance in the true sense, but rather is the retention of risk by the company. (1.39) • Risk Sharing (Shifting Risk) . Risk sharing or shifting calls for a number of individuals or businesses to pool risks where each person or business accepts a portion of the total risk exposure. (1.40)

Introduction to insurance What is Risk Sharing or Shifting? When a group of farmers come together to create a cooperative, whereby each agrees to pay member assessments to fund payments to each other for crop damage, the farmers have pooled their risks and distributed the impact across a large number of people. This is risk sharing. (1.41) If a business has its customers sign a waiver of liability, customers are agreeing to assume the risk of any injury. Dude ranches regularly request that their guests sign a waiver of liability – if the horse bucks and injures a guest, the guest agrees not to sue the ranch owner. The problem is that sometimes the courts won’t enforce liability waivers, but many businesses use them anyway. The use of a waiver is an attempt to engage in a form of risk sharing known as risk shifting. (1.42) And the use of a “Hold Harmless Agreement” is another example of risk shifting. Assume that your town wants your company to orchestrate its July 4th fireworks display. Your business might agree on the condition that your town agrees to sign a “hold harmless agreement” specifying that your town will assume all financial responsibility for any accidents. Your town should then check its insurance policy to see if such a “hold harmless agreement” is covered by the policy. This is risk sharing and shifting at its finest! (1.48)

• R i s k T r a n s f e r ( B u y i n g Insurance). Risk transfer i nvo l ve s t h e p u r c h a s e o f insurance,whereby the insurance company agrees to indemnify the policy owner against economic loss from an unknown event. (1.44) Reinsurance as a Technique for Managing Risk. Reinsurance involves one insurance company spreading its risk of loss (risk sharing or shifting) by entering into an agreement with one or more insurers. In other words, reinsurance is insurance for insurance companies. So, if ABC Insurance Company has agreed to insure a large employer for health insurance costs of the employer’s 30,000 employees, ABC Insurance Company may want to buy insurance (enter into a reinsurance agreement) with one or more other insurance companies to limit its loss. When one company enters into a reinsurance agreement, the company that purchases the reinsurance is the ceding company (the company that gives up part of its loss exposure), and the insurer that accepts some of the risk (loss exposure) of the ceding company is known as the reinsurer. (1.45)

CRITICAL POINT Re i n s u r a n c e i n v o l v e s one insurer (the ceding company) transferring a portion of its risk exposure to another insurer (the re i n s u r i n g c o m p a n y ) . (1.45)

A reinsuring agreement is between the ceding insurance company and the reinsurer, not the consumer that purchased insurance from the ceding company. There are two types of reinsuring agreements- Treaty Contracts and Facultative Contracts. (1.46)

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Limited Lines Credit Instructor’s Edition • Treaty Contracts. A treaty is a fancy word for agreement. These standardized and long term reinsuring arrangements can be set up whereby one insurance company agrees to automatically take a certain percentage of all of the insurance written by the ceding company. (Think about treaties being a long term agreement as it has been with the American Indians and the U.S.) The reinsurance process using a Treaty Contract is considered an automatic risk transfer process and can involve large volumes of reinsurance being purchased on a proportional basis as described in the treaty or agreement. (1.47) EXAMPLE Treaty Contract

For example, suppose that ABC Insurance Company enters into an agreement with XYZ Insurance Company whereby ABC “cedes” 25% of all insurance that it writes to XYZ. In this case, ABC and XYZ would share on a pro rata basis the premium revenue and the losses for various loss exposures over a long period of time on a prearranged basis. Note that this Treaty Contract represents an agreement between the two insurance companies and that the consumer purchasing insurance from the ceding insurer (ABC) is not involved. Who is the ceding company and who is the reinsurer? ABC is the ceding company and XYZ is the reinsurer. (1.48)

• Facultative Contracts . A Facultative Contract or agreement involves negotiating reinsurance on a per policy basis. Facultative reinsurance normally involves policies that are not standardized; therefore, each reinsurance contract has to be negotiated on an individual policy basis between the two insurance companies. Therefore, the term of the Facultative Contract (reinsurance agreement) coincides with the term of the original underlying policy and the arrangement is not a standardized, automatic reinsurance agreement as are the treaty agreements described above. (1.49) EXAMPLE Facultative Contract

Let’s say ABC Insurance Company has decided to insure a shipment of diamonds from Africa to the United States and that ABC Insurance Company does not have a longstanding Treaty Contract with a reinsurer. If ABC Insurance Company locates XYZ Insurance Company and negotiates a one time reinsurance contract so that XYZ will cover 37 percent of the loss exposure, ABC has ceded 37 percent of its risk exposure on a one time negotiated basis to XYZ (the reinsurer) in a Facultative Contract. (1.50)

180 Rapid Fire Q & A Drills 1.44

1.45

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Q. Does insurance involve risk retention or risk transfer?

A. Risk transfer

Q. What is another name for reinsurance? Risk avoidance or risk shifting?

A. Risk shifting (aka risk spreading)

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Introduction to insurance

Q. Does implementing a safety program at work involve risk retention, risk transfer, risk avoidance, or risk reduction?

A. Risk reduction

Q. What is another name for self insurance? Risk avoidance or risk retention?

A. Risk retention

Q. What is it called when a business decides to no longer engage in an activity because the activity is too risky? Risk shifting or risk avoidance?

A. Risk avoidance

1.38

Q. Implementing a loss prevention program or a loss control program is known as? Risk sharing or risk reduction?

A. Risk reduction

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Q. Which would best describe a safety program? Loss prevention or loss control?

A. Loss prevention

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Q. Which would best describe a program designed to provide first aid to injured factory workers by having an onsite nurse? Loss prevention or loss control?

A. Loss control

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Q. Which type of reinsurance program requires one insurer to automatically accept a certain percentage of the business written by another insurer on a long term basis? Treaty Contract or Facultative Contract?

A. Treaty Arrangement

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Q. Is the insurer that is giving up some of the risk called the ceding company or the reinsuring company?

A. The ceding company

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Q. Is the insurer that is taking on some of the risk called the ceding company or the reinsuring company?

A. The reinsuring company

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Q. Which type of reinsurance program results in reinsurance negotiation on a per policy basis? Treaty Contract or Facultative Contract?

A. Facultative Arrangement

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Q. Facultative Arrangements and Treaty Arrangements are types of what kind of program? Reinsurance program or risk avoidance program?

A. Reinsurance Program

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Q. Are insureds involved in negotiating reinsurance agreements? Some negotiations or no negotiations?

A. No negotiations

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Limited Lines Credit Instructor’s Edition CRITICAL POINT Adverse selection refers to the tendency for insurance applicants to be the people who most need to be insured. (1.51)

CRITICAL POINT The indemnity principle s a y s t h a t a n i n s u re d should be made whole,

Adverse Selection - Protection From Excessive Risks. Rating policies (charging some people higher premiums than others) is one way that insurance companies guard against something called “adverse selection.” Simply put, adverse selection is the tendency for insurance applicants to be the very people who need the insurance most - that is, the people most likely to die or get sick. Who feels the need to buy a health insurance policy? A 23 year old male that thinks he’s invincible or a 58 year old male that is starting to feel sick and old? The 58 year old male of course! That’s adverse selection in action. And, insurers have to figure out creative ways to guard against adverse selection. (1.51) In addition to rating an applicant’s policy, other techniques used by insurance companies to protect themselves against adverse selection include: rejecting applicants outright; excluding preexisting conditions; issuing impairment or exclusion riders; requiring the completion of a detailed application; requiring medical exams; charging deductibles; and requiring the payment of coinsurance. (1.52)

but should not profit from a loss. Insurers attempt to keep an insured from over insuring and violating the indemnity principle. (1.53-1.55)

Indemnity - Another Way of Managing Risks. Perhaps the most basic insurance principle is that the purpose of insurance is for the insured who suffers a loss to be made whole but not to profit or come out ahead. This concept is known as indemnity, indemnify, or indemnification. If the insured is coming out ahead (gaining from a loss), the principle of indemnification is violated and MAY be prohibited by the fine print of the policy. (1.53)

EXAMPLE Indemnity

Assume that you wreck your old pickup. You naturally want the insurer to replace it with a brand new truck. Of course that would violate the concept of indemnification because you would be coming out ahead. We will see that it is tough to set up an insurance system where everything comes out exactly equal. In real life, sometimes the insured comes out ahead or behind, but generally speaking, insurers are trying to provide indemnification, not profit for losses. (Making the insured whole, but not allowing the insured to profit from a loss). (1.54)

In order to uphold the indemnity principle in practice, insurers attempt to keep an individual from taking out too much insurance (called over insurance). (1.55) EXAMPLE Indemnity

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Assume that Bob has an income of $5,000 per month and wants to buy an income replacement policy (known as a Disability Income policy) to replace his lost income in the event he becomes disabled. Just because Bob wants a $5,000 per month benefit level does not mean that the company will sell him that amount of insurance. The insurance company certainly will not sell Bob a $6,000 monthly benefit since a disability would result in Bob “profiting” from becoming disabled. And, the company would not even likely sell Bob a $5,000 benefit level, because Bob may have a tendency to become disabled and stay that way. Likely, the company would only sell Bob an 80% benefit level, so that Bob has an incentive to return to work. This is the principle of indemnity in action. (1.56)

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Introduction to insurance

In the context of limited lines credit insurance, state law normally limits the amount of insurance coverage to the amount of contract indebtedness, which is an example of the indemnification principle in action. We will cover the specifics of credit insurance limits in detail later in this manual. (1.57)

180 Rapid Fire Q & A Drills 1.51

Q. What is the concept that says that those that A. The adverse selection principle need insurance the most are the most likely to buy insurance? The “over insurance” principle or the “adverse selection” principle? (1.51)

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Q. What principle says that an insured should not “profit” from a loss? The reimbursement principle or the indemnity principle?(1.53)

A. The indemnity principle

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Q. What is it called when you buy more insurance than you need to cover the loss? Over insurance or under insurance? (1.55)

A. Over insurance (also known as over insured)

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Q. What is the limit on the amount of credit A. The amount of the insurance that can be purchased in a credit indebtedness transaction? $100,000 or the amount of the indebtedness? (1.57)

Conclusion This chapter dealt with basic forms of insurance, key terms, the indemnity principle, adverse selection principle, and how to manage risk. This Chapter 1 material has laid a good solid foundation for Chapter 2. In this next chapter, we will dig into rules of contract law. Since all insurance policies are contracts, the examiners want you to have a basic understanding of contract law, and the unique aspects of insurance contracts. So, let’s go! (1.58)

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Limited Lines Credit Instructor’s Edition

From the 180 Test Bank Note: These are just a sample from the 180 Test Bank. The 180 Test Bank found on the CD, which is part of this set, is one of the most comprehensive test banks in existence for preparation for your state’s insurance exam. And, unlike some of the competitor’s test banks, this one is state specific so you are better prepared for your state’s version of the exam. 1. Risk is defined as: a) b) c) d)

Certainty of financial (economic) loss Chance of winning Insurance Uncertainty or chance of financial (economic) loss

Answer: Risk does not deal with winning; it deals with the chance or uncertainty of losing. Insurance involves the transfer of risk. Therefore, the correct answer is D. 2. Perils: a) Are “causes of loss” b) May include sicknesses c) May include accidents d) All of the above Answer: Perils are causes of loss- the things that you insure against. In life and health insurance, a peril includes accident and sickness that results in death or causes one to be hospitalized and incur medical expenses. In property and casualty insurance, a peril may include wind, fire or theft that may cause a loss or damage to property, and careless behavior that may result in the driver of an automobile being held liable for such conduct. Therefore, the correct answer is D. 3. For insurance purposes, losses must be all of the following except: a) Economic b) Accidental c) Catastrophic d) Measurable Answer: Insurance will not be issued on losses that are intentional (losses must be unintentional), purely emotional (losses must have an economic or financial aspect), not capable of being measured (losses must be measurable), or catastrophic (losses must be predictable and reoccurring and not financially too burdensome for the company). Therefore, the correct answer is C.

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Introduction to insurance

4. Which of the following is NOT TRUE about insurance? a) It involves the transfer of risk b) It involves the sharing of risk c) It involves the exchange of consideration d) It involves the assumption of all risks by an insurance company in exchange for a premium Answer: An insurance company takes your premium (consideration) for transfer of some (not all) of your risk exposure. You and the company share the risk. Therefore, the correct answer is D. 5. The transfer of risks to another in exchange for a premium is known as: a) Hazards b) Risks c) Insurance d) Risk retention Answer: Insurance involves the transfer of risks to another in exchange for consideration (premium). Risk is defined as a cause of loss, like sickness or accident. A hazard involves a situation (like oily rags in the garage) that increases the probability of a loss, and risk retention involves the insured choosing not to insure a portion of the risk. Therefore, the correct answer is C.

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Limited Lines Credit Instructor’s Edition

End of Chapter Directions IMPORTANT NOTICE: To get the most out of your 180 Licensing course, we recommend

that you read one chapter at a time and then immediately go through the 180 Interactive CD presentation and exercises FOR THE CHAPTER THAT YOU JUST READ. DO NOT GO THROUGH ANY OF THE CD PRESENTATIONS UNTIL YOU HAVE FIRST THOROUGHLY READ THE CORRESPONDING CHAPTER IN THIS MANUAL. Study Directions. The following steps will help you master the material and prepare for your licensing exam: Our course design is based on over 20 years of professional training helping over 10,000 exam takers just like you, and our system works- the manual coupled with the presentations and exercises on your CD literally teach you the material as you go! A summary of your course study strategy is set out below: (The details of each strategy listed below are set out in the front of your manual under the divider tab called 180 Guide and on your CD under the Attachments tab.)

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Read Each Chapter in Your 180 Instructor’s Edition Manual (Read one chapter in your manual, and then do the corresponding activities found on your CD.)

View the 180 Course Presentations on Your CD (After you have read a chapter in this manual, view the corresponding chapter presentation.)

Review the 180 Critical Points Sheets (Found on your CD under the Attachments tab and Resources Area)

Review the 180 Rapid Fire Q&A Drills (Found in each chapter of your manual and on your CD under the Attachments tab and Resources Area)

Review the 180 Super Sheets (Found on your CD under the Attachments tab and Resources Area. Super Sheets should be reviewed only after you have mastered the material.)

Do the 180 Learn Mode Exercises (There are Learn Mode Exercises for each chapter on your CD. These exam questions and learning exercises let you try one question or exercise at a time- then immediately receive feedback. Some students prefer to do an exam simulation first, and then do the Learn Mode Exercises. The choice is yours.)

Use the 180 Exam Simulator (There are Exam Simulations for each chapter on your CD. You are permitted to do UNLIMITED EXAM SIMULATIONS. The program is designed to rotate questions and answers so that you are provided with a fresh look for each question.)

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Introduction to insurance

Take the 180 Comprehensive Exam Simulations (Take these only when you have completed the appropriate chapters as labeled on each Comprehensive Exam found on your CD. These are designed to mix up the questions from different chapters just like on your real licensing exam.)

Feedback. Please feel free to email us at comments@180Licensing.com with any feedback. We are striving to continuously improve this course and would appreciate any suggestions. You can also reach us at 1-800-279-8507. License Mentor - Our Free Licensing Assistance Service. 180 Licensing knows how confusing it can be to understand the ins and outs of getting your license in your state. We have found states to be inconsistent in where they place information on how to get a license. And once you have found the information, it is sometimes unclear. To add to the confusion, many states are now “contracting out” either part or all of the licensing process to third party companies. And in some states you can file for your license on a paper application that you mail to your state or file an electronic application with a third party vendor. In other states, you can only file electronically. We have spent 20 years sorting through these issues for over 10,000 test takers just like you. And we want to assure you that we understand your frustrations- that’s why we offer our free License Mentor Program to anyone purchasing our course materials. If we do not have the answers already, we will find them and promptly respond to your request for information- all at no charge to you. My Instructor Access Service. If you are already a member of our My Instructor Access Service, you have direct access to our live exam prep instructors during posted office hours via chat, forum, and Voice Over Internet (VOI) for any questions on your course content and your exam. If you would like to know more about this unique service or to sign up for the service, go to www.180Licensing.com and click on the My Instructor Access Service link found under the Product Tour section on the home page. Join this very affordable service today and let us personally help you gain that added edge to pass the exam.

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1-19


Limited Lines Credit Instructor’s Edition

Using The 180 Licensing Mentor To get your licensing questions answered we highly recommend that you follow these steps in the following order: Step 1:    On the 180 Licensing Web page, go to your state’s Insurance Exam Prep At A Glance page. To get there, on our home page, www.180licensing.com, click on the top left tab called Courses By State. Step 2:    Spend some time on the Insurance Exam Prep At A Glance page. Review the following information and documents, and also review the information found in the links provided. Do the following: •

Read the bulleted material that provides a summary of your state’s rules (found to the left of your state’s photo)

Then read the document Steps to Getting Your Insurance License

Then read the document Related Links for Insurance Licensing

Then read the Important Information found on the right side of the Insurance Exam Prep At A Glance page

Lastly, refer to the Additional Resources links at the very bottom of the Insurance Exam Prep At A Glance page

Step 3:    If you still do not understand the licensing process for your state, email us at licensementor@180licensing.com. Try to be as detailed and specific as possible in your email and provide us with the following: •

The specific license you are seeking (such as Life, Health, Credit, etc.)

The state that you seek to be licensed in

 Your state of residence

The approximate date that you purchased your 180 Manual and CD

The date on your manual

The status of your studies (in progress or complete)

The status of your exam effort (passed or not passed yet or not taken yet).

The best telephone number and time to reach you by phone if we feel that a phone call to you is needed

The specific licensing issue or problem you are having 

All of this information is used to assist us in finding the exact answer to your question. The more information we have, the better position we are in to assist you with your specific needs and to avoid unnecessary delay. We promise to email you back within 24 hours. Step 4:   If you prefer to leave the details described in Step 3 (above) on our License Mentor Telephone Hotline, please call us at 1-800-279-8507, then select Option 4 License Mentor Program, and leave us a message with the details requested in Step 3. We promise to call you back within 24 hours.

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