Chapter 6 Analysis of Insurance Contracts

A GENDA Basic parts of an insurance contract Deductibles Other-insurance provisions

B ASIC PARTS OF AN I NSURABLE I NTEREST Declarations and definitions(D) Insuring agreement or clause(I) Conditions(C) Exclusions and endorsements(E) Miscellaneous

P OLICY S TRUCTURE (D-I-C-E) Declarations and Definitions Who?Identifies both the insured's and the insurer's name & address. What?Identifies both the real and the personal property insured. Where?Identifies the territory covered by the policy. When?Identifies the policy period (inception and expiration dates & times.) How much? The amount of insurance coverage and the premium. Insuring Agreement or Clause Summarizes covered risks, additional or supplementary coverages, and the insurer's responsibility to indemnify against losses suffered as a result of the perils. Conditions Lists the insured's responsibilities both at the time of application (truthful representations in the application and payment of premium) as well as at the time of loss (notice of and proof of loss, which is a sworn statement made by an insured verifying the amount, date, and cause of a loss). Exclusions & Endorsements Lists the property, perils, and other hazards not covered by the policy or which have a reduction of coverage in the policy.

B ASIC P ARTS OF AN I NSURANCE C ONTRACT Declarations(D) are 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”

D EFINITION OF “I NSURED ” 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 Other insured: A policy may cover other parties even though they are not specifically named(e.g. PAP covers named insured and any other relatives who used the car with the permission of insured. ) Additional insureds may be added using an endorsement( e.g. you rent your farm to a tenant and you add the tenant name to your farm liability policy because you are afraid of legal liability if the tenant injure someone.)

B ASIC P ARTS OF AN I NSURANCE C ONTRACT Insuring agreement(I) summarizes the major promises of the insurer. The two basic forms of an insuring agreement in property insurance are: 1-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.

2-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 not be covered because they are excluded.

W HICH ONE IS PREFERABLE ? N AMED - 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.

B ASIC P ARTS OF AN I NSURANCE C ONTRACT Conditions(C) are insured’s responsibilities and 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

B ASIC P ARTS OF AN I NSURANCE C ONTRACT Insurance contracts contain three major types of exclusions(E) 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 policies Excluded property, e.g., pets are not covered as personal property in the homeowners policy

W HY ARE E XCLUSIONS N ECESSARY ? 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 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

E NDORSEMENTS AND R IDERS (E) In property and liability insurance, an endorsement(E) 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

D EDUCTIBLES A deductible is a specified amount which is subtracted from the total loss payment.

T HE P URPOSE OF D EDUCTIBLE 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. 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.

2- Deductibles are used to reduce premiums paid by the insured. Eliminate of small claims reduce premiums substantially

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.

3- Deductibles are used to reduce both moral hazard and attitudinal hazard(morale hazard).  Deductibles reduces moral hazard because those insured that may deliberately cause a loss they can not profit from 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.

D EDUCTIBLES IN P ROPERTY I NSURANCE There are two types of deductible in property insurance: 1- Straight deductible 2- Aggregate deductible

D EDUCTIBLES IN P ROPERTY I NSURANCE A straight deductible is a certain amount of loss which insured is committed to pay before the insurer is required to make a payment. e.g., an auto insurance deductible. Important: 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 $6,500 and would have to pay the remaining $500 herself.

An aggregate deductible means that all losses that occur during a specified time period, usually a year, are accumulated to satisfy the deductible amount. Important : 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. How much the insurer will pay for these losses? Total losses= $1000+$2000=$3000 Total deductibles= $10,000 Total losses < Total deductible The insurer pays nothing because the deductible is not met.

If the third loss of $8000 occurs during the same time period, how much will be paid by the insurer? Total losses= $1000+$2000+$8000=$11,000 Total deductible= $10,000 The insurer would pay $1000( $11,000 losses – $10,000 deductible) Important: Any other losses occurring during the policy year would be paid in full.

Example(Q 2 Pg.124): 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

O THER - INSURANCE P ROVISIONS 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 protect against the violation of the principle of indemnity.

O THER - INSURANCE P ROVISIONS  1- Pro rate liability provision  2- Contribution by equal shares  3- Primary and excess insurance provision

 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.

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) Total insurance coverage =$300,000+$100,000+$100,000=$500,000 Amount of loss = $100,000

E XHIBIT 6.3 P RO R ATA L IABILITY E XAMPLE The basic purpose of the pro rate liability clause is to preserve the principle of indemnity and to prevent profiting from insurance. 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.

 2-Under contribution by equal shares, each insurer shares equally in the loss until the full amount of the loss is paid.  See example 1 & 2

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)

Exhibit 6.5 Contribution by Equal Shares (Example 2) 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.

O THER - INSURANCE P ROVISIONS 3-Under a primary and excess insurance provision, 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.

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, Which policy is primary and which one is excess? 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.