Key Features of Insurance Contracts: Property-Liability, Life, and Health, Study notes of Credit and Risk Management

Download Key Features of Insurance Contracts: Property-Liability, Life, and Health and more Study notes Credit and Risk Management in PDF only on Docsity! 1 10/22/00 Reading #5 Insurance Lines and Products By Robert Klein Reading Objectives 1. Discuss the principal features of the major types of insurance contracts. 2. Outline the basic types of insurance products sold by insurers and the perils that they cover. 3. Explain how insurance products have evolved to respond to changing consumer needs and market competition. Insurers sell a diverse array of products and services to consumers, including: property-liability insurance; health, accident and disability insurance; and life insurance, annuities and other retirement and investment-related products. Insurance contracts comprise not only financial reimbursement for covered losses and scheduled benefits, but also an array of services. In some cases, insurers may enhance these services as an aspect of their product offerings to consumers or unbundle and sell some of these services separately, such as claims management and loss prevention to customers who self insure. Insurance products and services continue to evolve in response to changing consumer needs and competition from alternative risk management mechanisms and other financial products. This section outlines the primary products sold by insurers. A. Property-Liability Property-liability insurance policies protect insureds against losses stemming from damage to or loss of property and legal liability. Many lines of property-liability coverage have been developed over time to meet the needs of a growing and increasingly diverse 2 economy. These lines can be divided into four basic categories: fire; marine; casualty; and surety. Property-liability insurance covers direct losses from damage to property, indirect losses resulting from direct losses (e.g., loss of income from damages to a business facility), and loss of possession. Homeowners multi-peril insurance and commercial multi-peril insurance package various property and liability coverages for homeowners and businesses, respectively. Box 1 summarizes the basic types of property/liability insurance contracts. Box 4.1 Property-Liability Insurance Fire General Liability Allied Lines Products Liability Earthquake Aircraft Ocean Marine Boiler and Machinery Inland Marine Burglary and Theft Crop Multi-peril Glass Auto Mortgage Guaranty Homeowners Multi-peril Fidelity Farmowners Multi-peril Surety Commercial Multi-peril Nuclear Medical Malpractice Title Workers’ Compensation 1. Fire and Homeowners Multi-Peril Insurance Fire insurance covers losses to buildings and personal property from fire and may cover other specified perils, such as windstorms. Individual homeowners can purchase dwelling or residential fire insurance or, more commonly, buy fire protection for their home as part of a homeowners multi-peril policy. Homeowners insurance provides protection for a person’s home and belongings against a specified number of perils. Four basic types of coverages are typically included in a homeowners policy: 1) property 5 air. Floater inland marine policies cover a broad range of other property that can be moved, such as jewelry. 3. Casualty Insurance Casualty insurance provides protection against damages to property and losses from legal liability that are not covered under the policies describe above. A wide range of lines of insurance fall into this category, including: • auto insurance; • commercial multi-peril; • medical malpractice; • workers’ compensation; • general liability; • mortgage and financial guaranty; • aircraft; • glass; • burglary and theft; and • boiler and machinery. a. Automobile Insurance A detailed description of each of these coverages is beyond the scope of this reading, but it is useful to describe several of the more prominent lines of casualty insurance. Of these lines, personal auto insurance often receives considerable attention. In states in which accident victims can sue in tort to collect damages, auto liability insurance 6 typically covers liability for bodily injury (BI) and property damage (PD), and uninsured/underinsured motorists losses (UM/UIM). Bodily injury liability coverage indemnifies the insured against claims for damages to others from accidents caused by the insured. These damages include medical expenses, lost wages and pain and suffering. Property damage insurance covers damages caused to the property of others. Uninsured and underinsured motorists coverage protects the insured directly for damages the insured suffers because of accidents caused by other drivers who do not have sufficient liability insurance. These various coverages are subject to specified benefit limits and many states mandate the purchase of liability insurance with minimum limits for these coverages. This is to ensure that accident victims are able to receive some compensation, regardless of the financial status of the negligent driver. In the 1970s, a number of states enacted no-fault auto insurance laws intended to lower costs and expedite benefit payments to accident victims. Under the purest form of no-fault, insureds would have no legal right to sue in tort for damages caused by another driver. In this system, accident victims would be covered by their own insurance policy for medical expenses and wage loss, regardless of who is at fault. In practice, no state has implemented a pure no-fault system and restrictions on lawsuits vary widely among the states.2 In states with some form of no-fault law, drivers purchase personal injury protection (PIP) insurance to cover their medical and wage losses from auto accidents. They also purchase residual liability insurance to cover any damages they are obligated to pay to others for accidents caused by their negligence. In some states, it is also possible to buy PIP coverage even though there are no or very limited restrictions on lawsuits (these 7 are typically referred to as “add-on” systems). Recently, a few states have experimented with choice no-fault systems whereby the insured, at the time of purchase, elects the type of system that they wish to govern their rights and obligations. Collision coverage pays for physical damage to the insured’s vehicle caused by its collision with another vehicle or object. Other than Collision or Comprehensive coverage pays for damages to the insured’s auto from most other causes, including weather, theft and vandalism. States typically do not mandate the purchase of these coverages. These coverages are purchased with various deductibles that lower the required premiums. Other incidental coverages can be purchased for items such as medical payments, auto rental reimbursement, and towing. b. Workers’ Compensation Insurance Workers’ compensation insurance differs from other insurance lines in that benefits are set by law and most employers are required to have coverage or qualify as a self- insurer. The workers’ compensation system is designed to provide a statutory-based set of benefits that must be accepted by employees as their exclusive remedy for work- related injuries. The basic benefit structure is the same among the states, but there are differences in the types of injuries covered and the amount of benefits paid. In all states, workers’ compensation will pay for accidental injuries and occupational diseases that arise in the course of employment. Medical benefits are essentially unlimited and are not subject to deductibles or co-insurance provisions. Indemnity or disability benefits cover 2 A few states use a verbal threshold for the ability to use, which typically allow lawsuits only for very severe injuries or death. Other no-fault states impose a monetary threshold, which sets a dollar limit on the damages incurred before the victim can sue in tort. 10 to perform certain acts. Fidelity bonds also are issued that protect an employer against fraud or dishonest on the part of employees. Title insurance protects against the financial loss from defects in insured titles. Lenders typically require the purchase of title insurance in conjunction with a home loan to protect the principal of the loan. Actual losses from title defects are rare and the primary service provided by title companies is research to find title defects before transactions are completed. Consequently, loss ratios for title insurance are relatively low and its expense ratios are fairly high, reflecting, at least in part, expenditures for title research. Some regulators have expressed concern that title insurance prices are too high, because a portion of the premium is used to provide financial incentives to lenders to channel business to a particular insurer. B. Life and Annuities An important distinction between life insurance and other types of insurance is that the event that life insurance covers, death, is uncertain in any given year but certain in the long term. The risk of premature death poses undesirable financial contingencies for the insured’s survivors. The probability of death generally increases over the term of life insurance policies and, hence, insurers must accumulate funds to pay claims that will eventually occur. Life insurers use mortality tables to chart the probability of a death claim based on the age and sex of the insured and set appropriate reserves to pay the claims expected to occur from the insurers’ portfolio of policies during a given period. There are four basic types of life insurance contracts: term; whole life, endowment; and 11 annuities. Box 2 summarizes the basic types of life insurance and annuity policies, which are described below. Box 2 Life Insurance Products Life Insurance Indeterminate-Premium Whole Life Term Modified Life Insurance Ordinary Family Income Variable Second-to Die Life Insurance Universal Vanishing Premium Variable Universal Savings Bank Life Insurance Current Assumption Whole Life Industrial Life 1. Term Life Term life provides protection for a finite number of years. The premium can increase over the term of the policy or be set at a constant level. The face value of the policy is paid if death occurs but nothing is paid if no death occurs. In other words, the insured does not accumulate a cash value in the policy that is refunded if death does not occur. Insurers accumulate only enough funds to pay death claims. Renewable term policies can be purchased for periods of 1, 5, 10, 15, and 20 years or longer. Multi-year term policies are typically purchased on a level-premium basis. The renewable feature allows the insured to renew the policy without evidence of insurability. Although premiums will increase as the insured gets older, this feature ensures that insureds can still get insurance even if they have developed a life-threatening condition that would cause insurers to otherwise decline an insured. Term policies also often allow the insured to convert to a permanent policy without evidence of insurability. The face value of term policies can stay level throughout the policy term or increase or decrease according to the financial needs of the insured. Term 12 insurance is the least expensive form of life insurance and is the most suitable for individuals who need to buy the maximum amount of protection (e.g., young parents) for the lowest cost. 2. Whole Life Whole life policies pay the face value of the contract when the insured dies, regardless of when this occurs. Straight life policies assume that equal premiums will be paid throughout the life of the insured. This means that premiums in the early years of the policy will exceed that required to pay death claims that occur during this period. Conversely, the level premium will be less than that necessary to cover death claims in the later years of the insured’s life. The annual premium is set so that sufficient extra funds are accumulated in the early years to compensate for death claims, which will exceed premiums in later years. Because of this build-up feature, the insured accumulates a cash value or savings element in addition to the death protection they receive. Insureds can exercise a number of options in utilizing this cash value. The policyowner can receive the cash value by surrendering the policy or convert the cash value into a paid-up whole life policy for a reduced face value, a term policy for the full face value, or an annuity. In addition, policyowners can borrow from the cash value at interest and a reduced death benefit during the course of the loan. Some whole life policies have limited payment plans that allow the insured to pay all the required premiums during a limited numbers of years at the beginning of the policy. Obviously, these premiums must be higher than what the insured would pay if premiums 15 contingency that he or she will outlive other sources of income or to supplement other sources of income. Immediate annuities are paid with the commencement of the contract while deferred annuities are paid after some specified period of time has elapsed. Annuities with life contingencies only obligate the insurer to pay benefits as long as the annuitant is alive. Annuities without life contingencies require payment of the benefit to the annuitant or the annuitant’s beneficiary for a specified period of time, regardless of when the annuitant dies. Box 4.3 Types of Annuities 1. Time When Payments Begin • Immediate • Deferred 2. Nature of Insurer’s Obligation • Life Annuity • Life Annuity with Guaranteed Payments • Installment or Cash Refund Annuity • Joint-and-Survivor Annuity 3. Fixed or Variable Benefits • Fixed • Variable Immediate annuities are always funded by single premiums while deferred annuities can be funded by single or flexible premiums. The single premium is equal to the present value of the anticipated benefit payments that will be paid under the contract plus a provision for expenses and profit. Guaranteed investment contracts (GICs) are a form of single-premium deferred annuities which provide a guaranteed return to the policyowner or contract holder without 16 exposing the insurer to any mortality or morbidity risk. The contract only guarantees a rate of return for a specified period of time and pays the accumulated contract value on the death of the contract holder, minus appropriate charges. Variable annuities pay the current value of a fixed number of annuity units. The current or dollar value of each annuity unit depends on the investment earnings of a special account, which is typically invested in equity securities. This type of contract is intended to provide a more stable value or purchasing power in response to inflation. C. Disability and Health A broad range of coverages are available to protect individuals against the wage loss and medical costs stemming from illness and disability. These coverages have many similarities with property and liability coverages, including the application of the indemnity concept. There are two primary types of health insurance: disability income insurance and medical expense insurance. A significant proportion of health insurance is sold under group contracts. Under a group contract issued to someone other than the insured, coverage is provided to a number of persons affiliated by employment or some other association. Large groups are often rated at least partially on their own experience. Members of groups are generally not subject to individual underwriting and the underwriting is focused on the characteristics of the group. This is intended to minimize adverse selection and administrative costs. 17 1. Disability Income Disability income insurance provides periodic payments when the insured is unable to work because of illness, disease or injury. This coverage is intended to replace a significant portion of the income lost from the incapacity to work. The partial replacement reflects the expectation that a worker’s income needs are reduced when they are not working. It also guards against moral hazard and gives an incentive to insureds to return to work if they are able to do so. Short-term disability policies typically provide benefits for periods of less than a year. Long-term disability policies provide benefits for longer periods, ranging from one year up to age 65. The definition of disability becomes more stringent as the duration of disability extends. This is because disabled workers are expected to eventually retrain for a different job or occupation if they are able to do so, e.g., a surgeon with a permanent hand injury might eventually move into another specialty or administrative position. 2. Medical Expense Insurance Medical expense coverage provides benefits for various medical services, including: physician services, nursing serves, hospital services, supplies, and equipment. Typically, benefits are structured along the lines of these services, supplemented by major medical benefits that cover costs for hospital and surgical services that exceed the benefits provided for these specific services. These benefits are subject to a number of limits to encourage insureds to use these services judiciously and contain costs. These limits typically take the form of deductibles, co-insurance provisions, and maximum caps. 20 expenses also are excluded such as routine physicals, dental care, foot care, hearing aids and many prescription drugs. Consequently, private insurers have developed Medicare supplement insurance to provide additional coverage for expenses that Medicare does not cover. Medicare supplement insurance is strictly regulated by federal and state law. Federal law establishes 10 standard types of policies (in addition to two high-deductible versions) that insurers are allowed to offer and also imposes minimum loss ratio requirements that must be considered in pricing these contracts. The states regulate insurers’ and agents’ marketing practices to prevent consumers from purchasing duplicate or unnecessary coverage. Long-term care (LTC) insurance is another form of coverage that is becoming increasingly important as the population ages and more individuals require extended medical or custodial care at home or in an institution. One study found that 40-45 percent of persons reaching age 65 will stay in a nursing home at least once during their lifetime with an average stay of six months (Rejda, 1998). Nursing home care is very expensive and Medicare and Medicaid will cover the cost of this care for only a fraction of the individuals that will need it. The LTC market is evolving and insurers offer a variety of plans at different rates. LTC policies typically cover skilled nursing care, immediate nursing care, custodial care, and home health care. However, policies differ in terms of aggregate benefits, elimination periods, eligibility for benefits, and inflation protection. Insurers’ financial solidity is an important consideration given the length of time that can elapse between when premiums are paid and benefits are received. LTC insurance also can be very expensive, with rates increasing dramatically with the age of the insured when the policy is purchased. Because 21 of these issues and the concern about consumer protection, LTC insurance receives significant regulatory attention. Synopsis of Key Concepts 1. Insurers provide a diverse range of products and services that are continuing to evolve to serve consumers’ needs. 2. Property-liability insurance policies protect insureds against losses stemming from damage to or loss of property and legal liability. The principal lines are fire, marine, casualty and surety. 3. Life insurance covers an event, death that is uncertain in any given year, but certain in the long term. 4. Term life insurance pays the face value of the policy upon the death of the insured during a specified number of years, but not does not accumulate a cash value or pay anything if death does not occur during the policy term. 5. Whole life policies pay the face value of the contract when the insured dies, regardless of when this occurs. Whole life policies accumulate a cash value, which the insured might utilize in different ways. 6. For other types of life insurance policies, such as universal life and variable life, the rate of cash accumulation will depend, at least in part, on the investment earnings of supporting assets, and offer various options to policyowners to adjust their coverage. 7. Annuities are designed to systematically liquidate a principal sum over a specified period of time, with or with out a life contingency. The value of variable annuities is based on the investment earnings of assets supporting the contract. 8. Disability income insurance provides periodic payments when the insured is unable to work. 9. Medical expense coverage provides benefits for physicians’ services, nursing services, hospital services, and supplies and equipment. Many medical expense plans are implementing managed care approaches such as HMOs and PPOs. 10. Medicare supplement insurance covers certain medical expenses for retirees that are not covered by Medicare. Long-term care insurance provides extended medical or custodial care that is not typically covered by medical expense insurance. 22 Suggested References Black, Kenneth, Jr. and Harold D. Skipper, Jr., 1994, Life Insurance, 12th ed. (Englewood Cliffs, N.J.: Prentice Hall). Rejda, George E., 1998, Principles of Risk Management and Insurance (Reading, Mass.: Addison-Wesley). Redja, George E., Constance M. Luthardt, Cheryl L. Ferguson, and Donald R. Oakes, 1997, Personal Insurance, 3rd ed. (Malvern, Pennsylvania: Insurance Institute of America). Webb, Bernard L., Arthur L. Flitner and Jerome Trupin, 1996, Commercial Insurance, 3rd ed., Volumes I and II (Malvern, Pennsylvania: Insurance Institute of America).