Chapter 6 Analysis of Insurance Contracts

1. Chapter 6 Analysis of Insurance Contracts

2. Agenda • Basic parts of an insurance contract • Definition of “Insured” • Endorsements and Riders • Deductibles • Other-insurance provisions

3. Basic parts of an Insurable Interest • Declaration(D) • Definition • Insuring agreement(I) • Exclusions(E) • Conditions(C) • Miscellaneous

4. Basic Parts of an Insurance Contract • Declarationsare statements that provide information about the particular property or activity to be insured • Can usually be found on the first page of the policy • In property insurance, it contains name of the insured, location of property, period of protection, amount of insurance, premium and deductible information • Insurance contracts typically contain a page or section of definitions • For example, the insured is referred to as “you”

5. Basic Parts of an Insurance Contract • The insuring agreement summarizes the major promises of the insurer • The two basic forms of an insuring agreement in property insurance are: • Named perils coverage, where only those perils specifically named in the policy are covered Example: In homeowner policy , personal property is covered for fire, lightening, windstorm, and certain other named perils. Only losses caused by these perils are covered. Flood damage is not covered because flood is not a listed peril.

6. All risks or Open-perils, or special coverage, where all losses are covered except those losses specifically excluded. • “If the loss is not excluded, then it is covered” • Example: A bear in a national park damages the vinyl top of a covered auto. The losses would be covered because they are excluded.

7. Which one is preferable? Named-peril or all-risks coverage • All-risks coverage is more preferable. • In all-risks coverage the greater burden of proof is placed on the insurer to deny a claim. In contrast, under a named-perils contract, the burden of proof is on the insured to show that the loss was caused by a named peril.

8. Basic Parts of an Insurance Contract • Insurance contracts contain three major types of exclusions • Excluded perils, e.g., flood, intentional act • Excluded losses, e.g., failure of an insured to protect the property from further damage after a loss in the homeowner policys • Excluded property, e.g., pets are not covered as personal property in the homeowners policy

9. Why are Exclusions Necessary? • Some perils are not commercially insurable • e.g., catastrophic losses due to war • Extraordinary hazards are present • e.g., using the automobile for a taxi • Coverage is provided by other contracts • e.g., use of auto excluded on homeowners policy

10. Why are Exclusions Necessary? • Moral hazard problems • e.g., coverage of money limited to $200 in homeowners policy • Attitudinal hazard problems • e.g., individuals are forced to bear losses that result from their own carelessness • Coverage not needed by typical insureds • e.g., homeowners policy does not cover aircraft

11. Basic Parts of an Insurance Contract • Conditions are provisions in the policy that qualify or place limitations on the insurer’s promise to perform • If policy conditions are not met, the insurer can refuse to pay the claim • Insurance policies contain a variety of miscellaneous provisions • e.g., cancellation, subrogation, grace period, misstatement of age

12. Definition of “Insured” • An insurance contract must identify the persons or parties who are insured under the policy • The named insured is the person or persons named in the declarations section of the policy • The first named insured has certain additional rights and responsibilities that do not apply to other named insureds • A policy may cover other parties even though they are not specifically named • Additional insureds may be added using an endorsement

13. Endorsements and Riders • In property and liability insurance, an endorsement is a written provision that adds to, deletes from, or modifies the provisions in the original contract • e.g., an earthquake endorsement to a homeowners policy • In life and health insurance, a rider is a provision that amends or changes the original policy • e.g., a waiver-of-premium rider on a life insurance policy

14. Deductibles • A deductible is a provision by which a specified amount is subtracted from the total loss payment that otherwise would be payable • The purpose of a deductible is to: • Eliminate small claims that are expensive to handle and process Savings from reduced expenses and payments for small losses are reflected in lower premium. • Reduce premiums paid by the insured • Reduce moral hazard and attitudinal (morale) hazard

15. The Purpose of Deductible • 1-Deductible eliminate small claims that are expensive to handle and process. Example: an insurer can easily incur $500 or more for a $100 claim. • Savings from reduced expenses and payments for small losses are reflected in lower premium.

16. 2- Deductibles are used to reduce premiums paid by the insured. Eliminate of small claims reduce premiums substantially • Small claims can be better budgeted by personal and business income. • Insurance should be used to cover significant losses such as medical expense of $500,000 or more from an extended terminal illness.

17. Large-loss principle: using insurance premiums to pay for large losses rather than for small losses. Purpose of large-loss principle: To cover large losses that can be financially ruin an individual and exclude small losses than can be budgeted out of the person’s income.

18. 3- Deductibles are used to reduce both moral hazard and attitudinal (morale hazard). • Deductibles reduces moral hazard because those insured that may deliberately cause a loss they can not profit form insurance. • Deductibles reduce attitudinal hazard(morale hazard) because they encourage people to be more careful with respect to protection of their property and prevention of loss.

19. Deductibles in Property Insurance • With a straight deductible, the insured must pay a certain number of dollars of loss before the insurer is required to make a payment • e.g., an auto insurance deductible • The deductible applies to each loss and there is no annual limit on the number of times the deductibles applies. Example: Ashely has collision insurance on her new Toyota, with a $500 deductible. If a collision loss is $7000, she would receive only $65000 and would have to pay the remaining $500 herself.

20. An aggregate deductible means that all losses that occur during a specified time period, usually a year, are accumulated to satisfy the deductible amount. • Once the deductible is satisfied , the insurer pays all future losses in full. Example : Assume that a policy contains an aggregate deductible of $10,000. Also assume that losses of $1000 and $2000 occur, respectively, during, the policy year. • The insurer pays nothing because the deductible is not met. • If the third loss of $8000 occurs during the same time period , the insurer would pay $1000( $11,000 losses – $10,000 deductible) • Any other losses occurring during the policy year would be paid in full.

21. Example: A manufacturing firm incurred the following insured losses, in the order given, during the current policy year. Loss Amount of Loss A $2,500 B $3,500 C $10,000 How much would the company’s insurer pay for each loss if the policy contained the following type of deductible? 1- $1,000 straight deductible 2- $15,000 annual aggregate deductible

22. Other-insurance Provisions • These provisions apply when more than one contract covers the same loss. • The purpose of other-insurance provisions is to prevent profiting from insurance and violation of the principle of indemnity. 1-Under a pro rata liability provision, each insurer’s share of the loss is based on the proportion that its insurance bears to the total amount of insurance on the property

23. Example: Jacob owns a building and wishes to insure it for $500,000. Assume that an agent places $300,000 of insurance with company A,$100,000 with company B, and $100,000 with company C, for a total of $500,000. If $100,000 loss occurs , each company will pay only its pro rata share of the loss(Exhibit 6.3)

24. Exhibit 6.3 Pro Rata Liability Example IF pro rata clause were not present, the insured would collect $100,000 from each insured or a total of $300,000 for a $100,000 loss. The basic purpose of the pro rate liability clause is to preserve the principle of indemnity and to prevent profiting from insurance.

25. 2-Under contribution by equal shares, each insurer shares equally in the loss until the share paid by each insurer equals the lowest limit of liability under any policy, or until the full amount of the loss is paid. • See example 1 & 2

26. Example1: Assume that the amount of insurance provided by companies A,B,C is $100,000, $200,000, and $300,000, respectively. • Case 1 : If the loss is $150,000 each insurer pays an equal share , or $50,000(Exhibit 6.4). Exhibit 6.4 Contribution by Equal Shares(Example 1)

27. Example2 Assume that the amount of insurance provided by companies A,B,C is $100,000, $200,000, and $300,000, respectively. • Case 2 : If the loss is $500,000 each insurer would pay equal amounts until its policy limits are exhausted. The remaining insurers then continue to share equally in the remaining amount of the loss until each insurer has paid its policy limit in full, or the full amount of the loss is paid. Exhibit 6.5 Contribution by Equal Shares (Example 2)

28. Other-insurance Provisions 3-Under a primary and excess insuranceprovision, the primary insurer pays first, and the excess insurer pays only after the policy limits under the primary policy are exhausted. • Auto insurance is an example of primary and excess insurance.

29. Example: Bob occasionally drives Jill’s car. Bob’s policy has a liability insurance limit of $100,000 per person for bodily injury liability. Jill’s policy has a limit of $50,000 per person for bodily injury liability. If Bob negligently injures another motorist while driving Jill’s car, both policies will cover the loss. How? The rule is that liability insurance on the borrowed car is primary and any other insurance is considered excess insurance. If a court orders Bob to pay damages of $75,000, Jill’s policy is primary and pays the first $50,000. Bob’s policy is excess and pays the remaining $25,000.

30. Application question #4 pg.124 Chapter 6 Andrew owns a commercial office building that is insured under three property insurance contracts. He has $100,000 of insurance from Company A $200,000 from Company B, and $200,000 From Company C. a. Assume that the pro rata liability provision appears in each contract. If a $100,000 loss occurs, how much will Andrew collect from each insurer? Explain your answer. b. What is the purpose of the other-insurance provisions that are frequently found in insurance contracts?

31. Answer: (a) Company A has one-fifth of the total amount of insurance. Thus, based on the pro rata liability clause, it will pay one-fifth of the $100,000 loss or $20,000. Company B and Company C will each pay $40,000. (b) The purpose is to reduce profiting from insurance and violation of the principle of indemnity.

32. Application question #5 pg.124 Chapter 6 Assume that a $300,000 liability claim is covered under two liability insurance contracts. Policy A has a $500,000 limit of liability for the claim, while policy B has a $125,000 limit of liability. Both contracts provide for contribution by equal shares. a. How much will each insurer contribute toward this claim? Explain your answer. b. If the claim were only $50,000, how much would each insurer pay?

33. Answer: (a) Based on contribution by equal shares, each company shares equally in the loss until the share of each insurer equals the lowest limit of liability under any policy, or until the full amount of the loss is paid. Company A and Company B will each contribute $125,000 toward the loss. At that point, the limit of liability under Company B’s policy is exhausted. Therefore Company A will pay the remaining $50,000. Thus Company A pays a total of $175,000 and Company B pays $125,000. (b) $25,000