Understanding Liability Insurance: Types, Losses, and Exposures - Prof. Jennifer Atkinson, Study notes of Introduction to Business Management

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Fire, natural disasters, etc..○ Some risks faced by international firms are the same as those faced by firms that do business only in their home country. • Liability risks vary from country to country.○ Some risks depend on where the risks are• Advantage is that its easy to adminiter □ Disadvantages includes being illegal, tax advantages might be loss, language barriers that negativley effects the Risk Manager. □ Buy insurance locally (whatever is approriate for that area) They may say in our country it is required for the property to be covered for $40,000. ◊ So you buy the policy from locally from a south african insurance company. ◊ You also buy 1 million liability.◊ Example: south Africa England requires for workers compensation◊ So you buy it from England.◊ Example: England Bought some insurance locally here too.◊ Example: Mexico Now, we have something called a master controll program who keeps up with this. They know what they buy in each country and have someone there locally to read and understand the legal mumbo jumbo.  This policy allows us "fill in the gaps" with respect to each policy of each country. ◊ So south afican policy has no policy for lighetning. So, we have the DIC/DIL pay for the lighening. ◊ This essentially gives us that coverage that we expect to happen in the US. ◊ Then we have a Master Policy (Difference in Conditions/Difference in Limits (DIC/DIL))  Buy locally, what we need to buy locally.□ Global Control Master Program (Important) So how do they do this?○ So international firms have take in account of this• 7B Monday, March 21, 2011 11:48 AM RMIN4000 Page 1 Your house cataches on fire ○ If its your stuff, it is a property Risk.• If the fire spread to your neighbor's house.○ If you could be responsible for damage to someone else's stuff or for bodily injury to someone else, it is a liability risk • Note***• Land, all structures permanently attached to the land, and whatever is growing on the land ○ Examples include buildings, attachments to buildings, crops ○ You walk into a house to buy it and you see the couches and lights. When you buy the house - the lights will prolly be there but the couch will be taken out  Couch is personal and lights are real. Think of Real Estate○ Real property • Examples include cars, money, clothes, furniture, textbooks, airplanes, animals All property other than real property ○ Personal property • Property Loss Exposures • Occurs when there is damage to property ○ When your house burns down. The loss of the house is the direct.○ Direct loss • Occurs when a direct loss causes expenses to increase or revenues to decline ○ You need to rent a place cause you have no house - this is indirect loss.○ Loss of Business Income is indirect losses.○ Indirect loss • You and the insurance company.  The insured and the insurer ○ When dealing with property insurance, there are usually only two parties to the contract • Property Loss Exposures • Coverage cannot be purchased for loss of goodwill or loss of a copyright ○ Raw land is difficult to insure ○ Hard to insure cause we can't really quantify the value. ○ Not all types of property are insurable • Property Loss Exposures• Its easy to guess the losses for a property and its easy to know the value of the property. Rate of Risk * Value = You get your premium. ○ Liability is more complex because• Loss through legal liability for harm caused to others ○ One of the most serious financial risks that risk managers must deal with • Because people other than the insured and the insurer are involved ○ Insurance for liability losses is more complex than property insurance • Liability is usually determined by proving negligence • Liability Exposures • Chapter 9 - Property and Liability Loss Exposure Wednesday, March 23, 2011 11:32 AM RMIN4000 Page 2 It's slowly fading away because for any accident, you will have some degree of fault If you do anything that causes the injury - you don't get any claims.○ Under the pure rule, you can collect damages even if you are negligent, but your reward is reduced in proportion to your fault ○ Under the 50 percent rule, you cannot recover if you are 50 percent or more at fault○ Under the 51 percent rule, you cannot recover if you are 51 percent or more at fault○ The lady was 20% at fault so they took away 20% of her money. McDonalds○ Under a comparative negligence law, the financial burden of the injury is shared by both parties according to their respective degrees of fault • The conduct of the defendant  The condition of the premises  The defendant’s product  Defendant may raise the defense that the plaintiff has no cause for action because the plaintiff assumed the risk of harm from ○ Getting hit with a baseball when you go see a baseball game.  If you do some activity there is some inherent risks.○ Assumption of Risk Doctrine • A plaintiff who is endangered by his or her own negligence can still recover damages from the defendant if the defendant has a last clear chance to avoid the accident but fails to do so If you have the ability to make it so the damages doesn’t happen, then you have the duty not to do it If someone is running a red light and you have green light - and you see this happening, then you have the duty to stop. The last clear chance rule • Relate to the standard of care by an automobile driver to a passenger  Guest-host statutes (Not on test)• Defenses Against Negligence Claims• “The thing speaks for itself” ○ Plaintiff may sometimes collect without actually proving negligence on the part of the defendant ○ Lets say you get surgery and couple of days later you have pain. You go to doctor and doctor say everything is fine. Then they realize they left surgery sicizzors in your body. You really don't have to prove this - cause its just there.  In negligence claims○ Res Ipsa Loquitur• The event is one that normally does not occur in the absence of negligence○ The defendant has exclusive control over the instrumentality causing the accident○ The injured party has not contributed to the accident in any way○ Three requirements must be met for res ipsa loquitur to apply:• Factors Leading to Higher Standards of Care• The plaintiff may sue and collect from one or more of the negligent parties□ When an accident occurs and several different parties are negligent  Band has pyrotechniques Rhode Island night club fire.□ In a accident more than one party is at fault Joint and several liability ○ Expansion of imputed liability • Factors Leading to Higher Standards of Care• RMIN4000 Page 5 Band has pyrotechniques Nightclub venue had shitty fire doors. Estimated that more than 80 percent of the funds spent on the Superfund enforcement is for overhead (legal fees, etc.) and less than 20 percent for cleaning up the environment □ Who ever owns the land that is polluted has to pay for it. Georgia Dome□ Created by the Federal government to help fund the cleanup cost of major pollution sites  Superfund legislation ○ Damages have been awarded for such things as mental anguish  In california, if 10% or more of your stress comes from work - you have workers comp. More liberal interpretation of what types of damages may be allowed in negligence actions ○ Awards used to punish defendants because their actions constituted gross negligence or willful and wanton misconduct  Punitive damages are allows in most sttates□ NOTE: In many states, Punitive Damages are UNinsurable. Every state allows punitive damages except Massachusetts, Nebraska and Washington ○ Changing concepts of damage • Factors Leading to Higher Standards of Care• State of economy has effect on awards○ But lets say you don’t have good health insurance□ So bad economy = more people sue. □ If you go to store and slip, most of the time you have insurance and they pay for it. So you're really not going to sue.  The effect of inflation in reducing the purchasing power of the dollar has undoubtedly contributed to the increased amounts of damage awards ○ Than they would be if they knew the plaintiff would pay the damages personally  Your in a jury and your listening to the person who was injured.□ This is a a lot of bias. Some people might be more symapatethic while others could be more stingy□ In a bad economy  Perhaps the existence of liability insurance has caused juries to be more generous ○ Imposing restrictions on the right to sue  Abolishing punitive damages in civil suits  State of the art defense (plane built in 1980, accident in 211)□ Reducing the standard of care to the standard existing at the time the product was made instead of at the time the loss occurred  Placing a ceiling on non-economic damages  A couple has baby and both parents has MBA.□ They decide wife stays home for one year and now will work next year.□ The husband gets killed in car accident.□ The court has to look at the family at the time of of accident. So it doesn't matter if wife will work nx year. □ So repealing the collateral source rule would be trying to see other factors□ Repealing the collateral source rule  For big companies □ Sometimes juries have no fucking idea whats going on.□ So you can hire an arbritator to come to a decesion.□ Altnerative dispute resolutions The insurance industry is supporting various types of tort reform, including ○ Increased damage awards (read book about this)• Factors Leading to Higher Standards of Care• RMIN4000 Page 6 So you can hire an arbritator to come to a decesion.□ Exhibit 19.2: Tort Costs Relative to GDP ($billions)• Exhibit 19.3Where the Tort Dollar Goes• Types of Liability Exposures • For example, a city may require that its street paving contractor hold the city harmless for all negligence arising out of the operations of the contractor ○ One’s liability maybe imputed to another by contract • I enter into a contract with you and I defaulted - well that’s uninsurable because it was my fault. ○ Hold-harmless agreements. What is contracted is liability assumed under that contract.○ We mean it very differnetly in 2 different ways• Contractual liability (1)• Must provide a safe place to work  Must employ individuals reasonably competent to carry out their tasks  Must warn of danger  Must furnish appropriate and safe tools  Must setup and enforce proper rules of conduct of employees as they relate to safe working procedures  Duties owed to employees ○ Employers are still subject to the law of negligence with respect to employment not covered by workers’ compensation laws • Employer-employee liability (2)• Types of Liability Exposures• Individuals who are invited on the premises for their own benefit as well as for that of the landlord or tenant  Invitees ○ Include meter readers, milk delivery drivers, police officers □ Cable guy - there doing business.□ Those who are on the premises for legitimate purpose with the permission of the occupier  Licensees ○ No care is owed to a trespasser but an owner cannot set a trap for or deliberately injure a trespasser □ All those other then invitees and licensees who enter on the premises  Trespassers ○ Current trend is to abolish the classifications and to hold the occupier of the land liable under most circumstances for failure to exercise due care ○ The tenant or owner owes a certain degree of care to those who enter the premises • Property owner–tenant liability (3)• Types of Liability Exposures• Property Owner-Tenant Liability cont. Generally, the tenant takes on whatever duty the landlord owes to members of the public ○ When an individual leases a building, the question arises as to what extent the landlord is responsible for injuries to tenants • Assumption of liability by tenant • Liability of the occupier of land may be changed so that a trespassing child is considered, in many jurisdictions, to be an invitee • Children and pools○ If something is attactive to a child and they are injured on it, you are liable for it.• Attractive nuisance doctrine• Consumption or Use of Products Liab. (4) • RMIN4000 Page 7 The type of business it writes, the degree to which it has shifted certain duties to others, the financial resources available, the size of the insurer, the type of organization used, etc. ○ The functions performed by any insurer necessarily depend on • Production○ Underwriting○ Rate making○ Managing claims and losses○ Investing and financing○ Accounting and other recordkeeping○ Such as legal advice, engineering, and personnel management  Providing miscellaneous other services○ These functions, which are normally the responsibility of definite departments or divisions within the firm, are • Functions of Insurers • They don't really have an internal sales force○ Most is done through agents & brokers.• Is securing a sufficient number of applicants for insurance to enable the company to operate ○ One of the most vital needs of an insurance firm • Corresponds to the sales or marketing function in an industrial firm ○ Often called production in the context of the insurance industry • Insurance is an intangible item and does not exist until a policy is sold ○ This is a proper term for insurance because the act of selling is production in its true sense • Production (Sales)• Refers to sales and marketing (but marketing in insurance is trying to get someone to sign on) activities of insurers • Marketing Research, Advertising & Sales• Independent agents, exclusive agents & direct writers○ Usual link between the consumer and the insurance company for personal lines.○ Commercial insurance often involves brokers.○ Insurance Agents• Agent Represents insurance company• Broker represents the one buying insurance• Production• Refers the priceing of insurance• With insurance, we don't know how much a product will cost us (as an insurance company)• Actuary thinks about all the statistics invovled. ○ Develops statistics and classification for insurance rates○ Reviews past and projected future results○ Regulatory compliance issues○ Calculations of parcipating divends.○ We have to Actuary invovled• Rate Making• Underwriting• Job is to accept exposures at appropriate rate• Reject application if underwriting rules do not allow acceptance• Must be a skillful judge of people• Goal is to produce a group of insureds by categories whose actual experience will approach • Chapter 8 - Functions and Organizations Monday, April 04, 2011 11:33 AM RMIN4000 Page 10 Goal is to produce a group of insureds by categories whose actual experience will approach expected. • What we don’t want is the losses to be excessive then what they should be.○ Goal is NOT to reject people going to have losses.• Conflict: Production vs. Underwriting• Reports to a Chief Underwriter Officer.• Sometimes agents can bind insurance company to the client.• Includes all the activities necessary to select risks offered to the insurer in such a manner that general company objectives are filled • Who scrutinize applications for coverage and make decisions as to whether they will be accepted ○ And by agents, who produce the applications initially in the field ○ In life insurance, underwriting is performed by home or regional office personnel • Underwriting • Underwriting• But these decisions may be subject to postunderwriting at a higher level because the contracts are cancelable on due notice to the insured • In the property-liability insurance area agents can make binding decisions in the field • In life insurance, agents seldom have authority to make binding underwriting decisions • In all fields of insurance, agency personnel usually do considerable screening of risks before submitting them to home office underwriters • The Objective of Underwriting • To see that the applicant accepted will not have a loss experience that is very different from that assumed when the rates were formulated • Certain standards of selection relating to physical and moral hazards are set up when rates are calculated • The underwriter must see that the standards are observed when a risk is accepted • Conflict Between Production and Underwriting • Because the underwriting department may have turned down business that previously has been sold by an agent or generated by a broker. • An apparent conflict of interest arises between the underwriting department and an agent • Will choke off acceptable business and may create unnecessary expenses in canceling business already bound by the agent ○ Too strict • Invites substantial losses such that the company may be forced to withdraw entirely from a given line ○ Too loose • Neither the agent nor the underwriter will profit long by writing underwriting that is • Rate Making • Extremely technical in most lines of insurance • Involves the selection of classes of exposure units on which to collect statistics regarding the probability and severity of loss • Because the major task is to estimate mortality rates according to age and other factors such as sex, smoking, drinking habits, and occupation • In life insurance, this task is relatively uncomplicated • Elaborate classifications are necessary • In other fields, such as liability and workers’ compensation • Rate making is usually supervised by specialists known as actuaries • Rate Making• The problem becomes one of developing reliable loss data for each class over a sufficiently long period of time • Once the appropriate classes have been set up • Requires incorporating estimates of the cost of doing business into the premium structure on an • The next step is converting that data into a useful form for the purpose of developing a final premium • RMIN4000 Page 11 Requires incorporating estimates of the cost of doing business into the premium structure on an equitable basis • Premium Calculation• Insurance “Rate”: Charge per unit of exposure• “Premium” = (Rate)*(# of exposure units)• GP = (PP) + (LP)*(GP)  GP = (PP) / (1 – LP) LP = Expense loading ratio GP = Gross premium Where: PP = Pure premium And: PP = E(L) / (# of exposure units) Rate Making Process• PV of Expected Claims Costs: Pure Premium)• PV of Expense Loading: Administrative Costs• Profit Loading: Return/Reward to investors for providing capital• Interest rates  Premiums □ Investment Income (Interest Earnings): Premiums  by amount of investment income earned on premiums • Gross Premium Rate Determinants: The Underwriting Cycle (Chapter 4 pp 68 -70) • Insurance is expensive and hard to get. ○ Good for insurance company○ Hard Market: Tight Underwriting Standards & High Premiums (An Insurer’s Market)• Insurance is easy and cheap to get○ Good for buyers.○ Underwriter is not happy○ Soft Market: Loose Underwriting Standards & Low Premiums. (An Insurance Buyer’s Market)• The Property & Liability Insurance markets fluctuate between:• Insurance Industry Capacity• Investment Returns• Two major factors influencing the markets:• The Underwriting Cycle: Capacity& Profitability • Policyholder’s Surplus = Insurers Assets – Liabilities• Think capacity like inventory in other industries.• It is the money you have to be able to sell insurers.• Capacity – (1) Refers to the relative level of surplus; the greater the surplus, the more willing underwriters will write new business or reduce premiums; therefore (2) Capacity also refers to the maximum limit of insurance, the insurance company will provide to any one Insured. • The Underwriting Cycle: Capacity& Profitability • Premiums Losses + Loss Adjustment Expenses + Underwriting Expenses If the ratio is greater than 1, the underwriting operations are UNprofitable.• If the ratio is less than 1, the underwriting operations are Profitable.• Combined Ratio (aka combined Loss Ratio)• Investment Earnings• Does not make a direct allowance for investment income to be earned on policyholders’ funds held by the insurer until they must be paid out as losses • The basic rate-making method used in property-liability insurance • In life insurance, an allowance is made for a minimum assumed rate of return on policyholders’ funds • From the 1950s through the early 1980s, a steady rise occurred in interest rates in the United States • RMIN4000 Page 12 So you can have two buildings (built the same time, same materials, same size) but differnet locations. ○ You will charge more for the building the worseer location○ Each individual building is considered separately and a rate is established for it ○ The insured is rewarded in advance for features it is hoped will yield a lower loss cost for all similar structures as a group  The physical features of the structure are analyzed and rate credits are given for good features in the form of a listing, or schedule ○ The best example is in the field of commercial fire insurance • • Different from loss ratio because we're coming up stuff on our own.○ So that it is reasonable to expect a reduction of losses through special efforts  If such special efforts are made, the insured is permitted lower insurance rates for the coming period  Permeated in cases where the hazards affecting the insured’s operation are sufficiently within the insured’s control ○ Requires that the insured prove the ability to keep loss ratios down before being qualified for loss reduction ○ An individual risk may receive special consideration through experience rating • Individual, or Merit Rating, Method• Your encoureging yoru client to have less premium. Insurnace companies can actually see actual losses. If your losses for a certain period is higher than expected, then insurance can increace your premium and vice versa. So insureence company will give you money or charge you more depedning on your actually losses. ○ Permits an adjustment in rates for the period just ended ○ The premium is determined by the actual record of losses suffered by the insured during the policy year ○ The final premium is determined after all the facts have been determined ○ Retrospective rating • Individual, or Merit Rating, Method• Combination Method • In many lines of insurance, a combination of manual and merit rating is used in different degrees • If certain requirements are met • The rate maker may develop an annual rate and then proceed to set up a system whereby individual members of a group may qualify for reductions from the manual rate • They may be subjected to increased rates under certain other conditions • The Rates can be differnet even with the same information because differnet companies factor in differeent things. • • Refers to the degree to which the rate maker can rely on the accuracy of loss experience observed in any given area • Or is there a considerable likelihood that the previous year produced higher- than-average losses only by chance? □ Should future rates be based on the experience of these losses  The loss ratio on these policies indicates that losses have been considerably higher than anticipated ○ For example, assume that the rate maker is faced with the task of revising a rate for a certain type of policy issued by the company in a given geographical area • It is not fair for one group to subsidize another group if each group is large enough to develop a loss experience that is reasonably credible • Credibility • The Credibility Formula (don't have to know the formula)• PP = PPi(Z) + PPp(1 – Z)• RMIN4000 Page 15 PP = pure premium to to be developed for a given insured i • PPi = pure premium based on the insured’s past loss experience • PPp = pure premium based on the past experience of the largest population to which the insured belongs • Ranges from 0 to 1 ○ Z = the weight (credibility factor) to be applied to the insured’s past experience • PP = PPi(Z) + PPp(1 – Z)• Settling losses under insurance contracts and adjusting any differences that arise between the company and the policyholder ○ These adjusters may have considerable legal training  Often accomplished in the field through adjusters who are employed to negotiate certain types of settlements on the spot ○ Claims management • This is why claims are important.○ When you buy an insurance policy - your buying a promise to pay.• Managing Claims and Losses • Did the lose happen? Investigate & verify loss○ Did the loss occur during policy period? Does the policy occurred? Determine if policy covers○ Find out how much loss cost? Can be very complicated. Cost of lost business, etc... Determine amount of the loss○ Write the check - pay claim. Pay the claim○ The claims department of an insurer has the responsibility of • The higher frequency of losses, the predominance of partial losses, the uncertainty of the amount of loss in individual cases  Life insurance is pretty straightforward. These functions are more extensive in property-liability insurance than in life insurance because of • Managing Claims and Losses• In many cases the claims adjuster is a salaried staff employee of the insurer • An independent adjuster may be used in territories where an insured does not have a sufficient volume of business to employ a staff adjuster • They are the legal agents of the policyholder and usually work on a contingency fee ○ Often works for the policholders - hired by policyholders.○ Public adjusters who specialize in adjusting functions are also available to represent policyholders in dealings with insurers • Managing Claims and Losses• Managing Claims and Losses• Reluctant claims settlement brings with it public ill will which may take years to overcome • Loss of business, court action, regulatory censure, or suspension of the right to carry on business in the jurisdiction involved ○ A bad impression in a negotiation with the claims department may result in • An overly liberal claims settlement policy may ultimately result in higher rate levels and loss of business to competitors charging lower premiums • Careful management of claim settlements is of paramount importance to the success of a insurer • Investing and Financing• RMIN4000 Page 16 Investing and Financing• When an insurance policy is written, the premium is generally paid in advance for periods varying from six months to a year • As well as funds representing paid-in capital, accumulated surplus, and various types of loss reserves ○ Every insurance company has these funds • This advance payment of premiums gives the insurer funds that must be invested in some manner • Selecting and supervising the appropriate investment for these assets is the function of an investment department • Investing and Financing• For life insurance, solvency of the insured depends on earning a minimum guaranteed return on assets • Investment returns are a vital factor to the success of any insurer • The investment manager must be familiar with the laws of the various states in which the company operates • Government regulation is involved in determining how insurance monies are invested • Table 23-3: Distribution of Life Insurer Assets • Accounting • To record, classify, and interpret financial data in such a way as to guide management in its policy making • Has essentially the same purposes accounting for the operating results of any firm • A special set of accounting rules called Statutory Accounting Principles are applied to the financial reporting of insurers • However, given the highly regulated and complex financial nature of the insurance business • Reinsurance• Reinsurance: Refers to the shifting of part of all of the insurance originally written by one insurer to another insurer. • Process: Cession Retrocession• Table 23-5: Five Largest Reinsurers, 2002• Increases in Underwriting Capacity• Stabilize Profits & Evens Out Loss Ratios• Reduces Unearned Premium Reserves• Provides Protection against Catastrophic Loss.• Facilitates Entry/Exit in Insurance Lines of Business• Facultative Reinsurance • Reasons for Reinsurance• Specific reinsurance on an optional basis • Attempting to negotiate specific coverage on a particular contract ○ A primary insurer shops around for reinsurance • Does not affect the insured in any way • Usually satisfactory when reinsurance is of an unusual nature or when it is negotiated only occasionally • Informal facultative reinsurance• But the decision of whether to reinsure remains with the ceding company ○ An agreement whereby the reinsurer is bound to take certain types of risks involved if offered by the ceding company • Used when the ceding company is bound on certain types of risks by its agents before it has an opportunity to examine the applications • Formal facultative contract • Treaty Reinsurance • Reinsurance may be provided whereby the ceding company is required to cede some certain amounts of business and the reinsurer is required to accept them • Pro-rata treaties • Two basic types of treaties have been recognized • RMIN4000 Page 17