EXL Insurance Academy

AINS 21

Chapter 1 Insurance: What is It? ………………………………………………... 4

Chapter 2 Who Provides Insurace and How Is It Regulated? ........................... 30

Chapter 3 Measuring the Financial Performance of Insurers ………………….. 55

79
Chapter 4 Marketing …………………………………………………………........

Chapter 5 Underwriting …………………………………………………………...

103

Chapter 6 Claims ………………………………………………………………...... 125

Chapter 7 Insurance Contracts …………………………………………………... 152

Chapter 8 Property Loss Exposures and Policy Provisions …………………….. 178

Liability Loss Exposures and Policy Provisions ……………………..

Chapter 9 209

Chapter 10 Managing Loss Exposures: Risk Management ……………………… 239

Copyright of EXL Service.com (I) Pvt. Ltd.

Usage restricted to the Insurance Academy
Property and Liability Insurance Principles EXL Insurance Academy

Insurance: What Is It? Chapter 1

Almost every person, Family, and organization needs insurance of some type to protect
assets against unforeseen events that could cause financial hardship.
Sometimes insurance is even required to satisfy a contractual obligation, such as when a
homeowner buys insurance on a home to protect the mortgage company's investment in
the event the home is damaged or destroyed. Almost everyone needs insurance, but not
everyone fully understands it. What exactly is insurance?

Insurance is essentially the following four things:

1. A risk management technique that enables a person or an organization to deal with

loss exposures and their financial consequences. A loss exposure is any conditions or
situation that presents the possibility of a loss.
2. A transfer system, in which one party – the insured – transfers the chance of financial
loss to another party – the insurer.
3. A business, which includes various operations that must be conducted in a way that
generates sufficient revenue to pay claims and provide a reasonable profit for its
owners.
4. A contract between the insured and the insurer that states what potential costs of loss
the insured is transferring to the insurer and expresses the insurer's promise to pay for
those costs of loss in exchange for a stated payment by the insured.

This chapter discusses these four aspects of insurance.

INSURANCE AS A RISK MANAGMENT TECHNIQUE

Individuals, families and organizations face loss exposures every day. Many of these loss
exposures can have serious financial consequences. For example, a person operating an
automobile may cause an accident leading to thousands of dollars of damage to the
property of property of others and medical expenses for those involved. Businesses face a
variety of loss exposures, such as damage to premises, injury to workers, and harm to
customers from defective products or workmanship.

A person or an organization can retain some loss exposures. For instance, a flat tire is a
nuisance and a minor expense, but it does not threaten a family's financial situation. Some
loss exposures have the potential to create financial ruin; prudent persons and
organizations must find other ways to deal with these exposures. The process of making

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

and implementing decisions to handle loss exposures is known as risk management and is
explored fully in a subsequent chapter. To mitigate the financial consequences of loss
exposures, several risk management techniques are available.

A person or an organization may choose to avoid a particular type of loss exposure. For
example, a city dweller may avoid the loss exposures arising from the ownership,
maintenance, and use of an automobile be not owning one and choosing public
transportation. Loss exposures may also be controlled by loss prevention measures (such as
safety goggles and helmets for construction workers to reduce the frequency of injuries)
and loss reduction measures (such as placement of fire extinguishers in the home or
workplace to reduce the severity of fire losses).

Some loss exposures are not easy to retain, avoid, or control, consider the following
example: Ming lives sixteen miles from his workplace and no public transportation is
available. He also needs a car for grocery shopping, running errands, and seeing friends,
Owning and operating a motor vehicle makes sense for him. However, this creates loss
exposures for Ming: the bodily injury or property damage that can result from his negligent
operation of the automobile could reach hundreds of thousands of dollars. He cannot afford
to retain such loss exposures and it is not practical to avoid them. Though he may choose a
sturdy car and drive safely to control these loss exposures, he cannot be certain of avoiding
or minimizing the financial consequences of a serious accident. For Ming, the best risk
management technique may be transfer so that the financial consequences of loss will be
borne by another party. Ming could use forms of non-insurance transfer, but insurance is
probably the most economically viable choice for him.

INSURANCE AS A TRANSFER SYSTEM

Insurance is a system that enables a person, a family, or an organization to transfer the
costs of losses ( the potential financial consequences of certain loss exposures) to an
insurer, The insurer, in turn, pays for covered losses and, in effect, distributes the costs of
losses among all insured (that is, all insureds share the cost of a loss). Thus, insurance is a
system of both transferring and sharing the costs of losses.

Transferring the Costs of losses

By transferring the costs of their losses to insurers, insureds exchange the possibility of a
large loss for the certainty of a much smaller, periodic payment (the premium that the
insured pays for insurance coverage). This transfer is accomplished through insurance
policies. An insurance policy is a contract that states the rights and duties of both the
insured and the insurer regarding the transfer of the costs of losses.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Transferring the costs of losses to an insurer would be unnecessary, however, if there were
no exposures to loss-that is, no possibility that losses would occur. A loss need not occur for
a loss exposure to exist: there simply must be the possibility of a loss. For example; every
home has a fire loss exposure; in other words, the possibility exists that a fire could occur
and cause a financial loss to the homeowner.

Sharing the costs of Losses

Insurance also involves sharing the costs of losses. The insurer pools premiums paid by
insureds, and insureds who incur covered losses are paid from the insurer's pooled funds.
The total cost of losses is thereby spread (or shared) among all insureds. Insurers estimate
future losses and expenses to determine how much they must collect from insureds in
premiums. Predicting future losses is bases on past loss experience.

The law of large numbers is a mathematical principle that enables insurers to make
predictions about losses. According to the law of large numbers, as the number of similar
but independent exposure units increases, the relative accuracy of predictions about future
outcomes (losses) based on these exposure units also increases. An exposure unit is a
measure of the loss exposure assumed by the insurer. Exposure units are independent to
the exposure assumed by the insurer. Exposure units are independent to the extent that
they are not generally subject to the same loss causing event. Because insurers have large
numbers of independent exposure units (the cars and houses of all their insureds, for
example), they can predict the number of losses that all similar exposure units combined
are likely to experience.

For example, a homeowner is uncertain whether a fire will damage his or her home and
transfers this uncertainty to an insurer. The insurer insures thousands of homes whose
owners face the same uncertainty. Because of the large number of homes the insurer can,
with a great deal of accuracy, predict the number of homes that will be damaged by fire
during a given period. Based on this prediction, the insurer can determine the amount of
premiums that it needs to pay for the fire losses during that period.

Types of Loss Exposures

Before types of loss exposures are discussed, consider the following scenario. A fire sweeps
through the ballroom and lower floors of a crowded hotel, killing or injuring 200 hotel
guests and employees. An investigation later reveals that the number of people occupying
the ballroom exceeded its legal capacity and that a disgruntled former employee
intentionally started the fire. It also becomes apparent that the hotel owners had not taken
proper steps to deal with a possible fire emergency. For example, the owners had not

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

installed an automatic sprinkler system, firewalls were insufficient, exits were unlighted,
and no plan was in place for safe evacuation of the hotel occupants.

The hotel fire illustrates the following three major types of loss exposures that are useful in
identifying and categorizing potential losses:
 Property loss exposures
 Liability loss exposures
 Personal and personnel loss exposures

Property Loss Exposures

A property loss exposure is any condition or situation that presents the possibility that a
property loss will occur. Property includes real property and personal property. Real
property is land, buildings, and any other property attached to it. A house, a storage shed, a
swimming pool, a factory building a flagpole, and an underground sewer pipe are all items
of real property, as is the land where each is situated. All tangible or intangible property
that is not real property is personal property. Examples of personal property include the
inventory of a retail merchant, furniture and tableware in a restaurant, equipment and
machinery in a factory building, contents of a dwelling, computers, money, securities,
automobiles, patents, and copyrights.

In the case of the hotel fire, damage to the building and the personal property of the
owners and others totaled several million dollars, the hotel building was badly damaged
and had to be repaired. Much of the furniture and carpeting in the hotel was damaged or
destroyed and had to be replaced.

Damage to property can also cause an indirect loss, such as a net income loss. Net income is
revenue minus expenses and taxes during a given time period. Generally, individuals,
families, and business must generate revenue that covers expenses in order to remain
financially sound. A reduction in revenue, an increase in expenses, or both is commonly
called a net income loss in the risk management and insurance communities. The net
income losses of a business after greatly exceed the property loss that caused them, as in
the case of the hotel fire.

While the damaged rooms in the hotel were being repaired and cleaned, the hotel's
revenue fell because guest rooms were empty. The hotel had to cancel social and business
functions, and close its restaurants and shops. Because of negative publicity about the fire,
the hotel permanently lost some of its revenue to competition. The hotel also incurred
increased expenses for overtime pay for some employees while it was being restored.

Liability Loss Exposures

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

A Liability loss exposure is any condition or situation that presents the possibility of a claim
alleging legal responsibility of a person or business for injury or damage suffered by another
party. Some liability claims result in a lawsuit. Even if the lawsuit is groundless, the
defendant may incur substantial expenses to defend against the suit. Liability claims may
result from bodily injury, property damage, libel, slander, humiliation, or invasion of privacy.
A liability loss is a claim for monetary damages that results from one party negligently
causing injury to another party or causing damage to another party's property. In the hotel
fire example, the hotel owners were judged to be negligent for various reasons, including
failure to take proper precautions to handle a fire emergency. As a result of the fire, the
hotel incurred liability losses that included payments for medical expenses, rehabilitation
costs, and pain and suffering experienced by the guests, employees, and others injured in
the fire. Liability losses also included payments for damage to property belonging to guests
and payments to survivors of people who were killed in the fire.

Personal and Personnel Loss Exposures

A personal loss exposure is any condition or situation that presents the possibility of a
financial loss to an individual or a family because of death, disability, or unemployment. For
example, a family would face a loss of income if a wage earner died or became disabled or
unemployed.

Personal loss exposures, on the other hand, affect businesses. A personnel loss exposure is
any condition or situation that presents the possibility of a financial loss to business because
of the death, disability, retirement, or resignation of key employees. For example, a
business could face a financial loss if a key executive, sales representative, or product
developer died, became disabled, or resigned and could not be quickly replaced.

In the case of the hotel fire, if a key employee (such as the master chef) died in the fire, the
hotel owners would experience a personnel loss. The chef's family and the families of
others killed or injured by the fire would suffer personal losses.

Ideally Insurable Loss Exposures

Insurance covers events that may or may not happen. When covered events do occur, a
financial loss usually results. By transferring the potential costs of the uncertain event to an
insurer, the insured reduces or eliminates the possibility of suffering a large financial loss.
By charging a premium in return, the insurer can make a profit if it handles a volume of
similar transactions efficiently. Therefore, each party to the contract receives some benefit

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

from the transaction. However, the transaction is not likely to be advantageous to the
insurer unless the loss exposure has certain characteristics that make it ideally insurable
from the insurer's standpoint. Insurers generally prefer to provide insurance for the
potential financial consequences of loss exposures that have the following characteristics:
 Loss exposure involves pure, not speculative, risk.
 Loss exposure is subject to accidental loss from the insured's standpoint.
 Loss exposure is subject to losses that are definite in time and that are measurable
 Loss exposure is one of large number of similar, but independent, exposures
 Loss exposure is not subject to a loss that would simultaneously affect many other
similar loss exposures, loss would not be catastrophic.
 Loss exposure is economically feasible to insure.

Loss Exposure Involves Pure, Not Speculative Risk

One purpose of insurance is to make the insured financially whole after a loss, that is, to
restore the insured to the same financial position the insured had before the loss. A
speculative risk offers the possibility of gain as well as loss. Therefore, if a loss exposure
involved a speculative risk and the insured gained as a result of that risk, this purpose of
insurance would be defeated.

Loss Exposure Is Subject to Accidental Loss from the Insured's Standpoint

An ideally insurable loss exposure also involves a potential loss that is accidental from the
insured's standpoint. If the insured has some control over whether a loss will occur, the
insurer is at a disadvantage because the insured may have an incentive to cause a loss. If
losses are not accidental, the insurer cannot calculate an appropriate premium because the
chance of a loss could increase as soon as a policy is issued. If the loss exposure involves
only accidental losses, the insurer can better estimate future losses and calculate an
adequate premium for the exposure.

A loss that is not accidental may be a case of insurance fraud – as when an insured
intentionally deceives an agent or an insurer to collect money. Controlling insurance fraud is
considered as one way to keep insurance rates reasonable. For such reasons, it is contrary
to public policy for insurers to cover intentional losses.

Loss Exposure Is Subject to Losses That Are Definite in Time and That
Are Measurable

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

To be insurable, a loss should have a definite time and place of occurrence, and the amount
of the loss must be measurable in monetary terms. If the time and location of a loss cannot
be precisely determined and the amount of the loss cannot be measured, writing (that is,
issuing) an insurance policy that defines what claims to pay and how much to pay for them
becomes difficult. Also, losses are impossible to predict if they cannot be measured. For
example, the sudden bursting of a water pipe that causes water damage in the insured’s
bathroom is an occurrence that has a definite time and place. It can therefore be measured
and insured. However, if a slow leak in the pipe causes decay and rooting of the insured’s
bathroom floor over several years, the resulting loss does not have a definite time of
occurrence and is generally not insurable.

Loss Exposure Is One of a Large Number of Similar, But Independent,

Exposures

An ideally insurable loss exposure must be common enough that the insurer can pool a
large number of homogeneous, or similar, exposure units. This characteristic is important
because it enables the insurer to predict losses accurately and to determine appropriate
premiums.

Loss exposures that satisfy this requirement, such as the possibility of damage to homes,
offices, trucks, or automobiles, allow the insurer to take advantage of the law of large
numbers. The insurer can determine appropriate premiums based on the experience of
thousands of similar exposure units and make reasonably accurate predictions of similar
exposure units and make reasonably accurate predictions about losses.

On the other hand, predicting the number of losses each year to space stations in outer
space would be difficult, because there are very few exposure units. Moreover, each loss
could drastically affect the profitability of an insurer and the insurance business as a whole.
The inability of insurers to predict losses, and thus to determine adequate premiums, makes
most insurers reluctant to insure unusual loss exposures such as those represented by
space stations.

Loss Exposure Is Not Subject to a Loss That Would Simultaneously Affect

Many Other Similar Loss Exposures; Loss Would Not Be Catastrophic

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Effective pooling of exposure units assumes that the exposure units are independent.
Independence means that a loss suffered by one insured does not affect any other insured
or group of insured’s. If exposure units are not u\independent, a single catastrophe could
cause losses to a sizable proportion of insured’s at the same time. For example, if all of the
homes and business in a particular city were insured by the same insurer, the insurer would
probably suffer a financial disaster if a hurricane leveled the city. The insurer would be
unlikely to have the financial resources to pay all claims of all the insured’s affected by the
hurricane.

The tendency of insurers to avoid insuring catastrophic losses does not mean that hurricane
damage to property is not insurable. Coverage for windstorm damage, including hurricane
and tornado damage, is readily available throughout most of the United States. However,
an insurer avoids possible financial disaster by managing its insured’s exposed to loss in any
single event. For windstorm coverage, the insurer must diversify the homes and businesses
it insures so that it does not have a large concentration of insured’s in any one geographic
area. Consequently, the insurer maintains as much independence as possible among its
insured’s. If each of many insurers issued a relatively small number of policies in the city
devastated by the hurricane, no one insurer would face financial ruin. Some insurers failed
to maintain such independence among loss exposures in 1992 when Hurricane Andrew
swept across Florida, resulting in several insurer insolvencies.

Loss Exposure Is Economically Feasible to Insure

Insurers seek to cover only loss exposures that are economically feasible to insurers.
Because of this constraint, loss exposures involving only small losses as well as those
involving a high probability of loss are generally considered uninsurable. Writing insurance
to cover small losses does not make sense when the expense of providing the insurance
probably exceeds the amount of potential losses. Insurance to cover the disappearance of
office supplies from a company, for example, could require the insurer to spend more to
issue claim checks than it would to pay for the claims. It also does not make sense to write
insurance to cover losses that are almost certain to occur. In such a situation, the premium
would probably be as high as or higher than the potential amount of the loss. For example,
insurers generally do not cover damage due to wear and tear of an automobile because
autos are certain to incur such damage over time.

INSURANCE AS A BUSINESS
The insurance business (including property-casualty insurers, life and health insurers,
agents, and brokers) provides about 2.3 million jobs in the U.S. IN the most recent figures

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

insurance premiums in the U.S. were nearly $1.1 trillion, and worldwide premiums totaled
$2.9 trillion. More than 3,300 insurers sell property and liability insurance in the U.S.
Property-casualty insurers employ about 606,000 people. In addition, another 628,000
people work in insurance-related agencies and brokerage firms, and about 209,000 in other
insurance activities

Private (non-government) insurers vary enormously in size and structure, the products they
sell, and the territories they serve; collectively they represent substantial segment of
business in the U.S. Despite their size and number, however, private insurers do not fill
every insurance need. In some instances, federal and state governments provide insurance
to meet the property and liability insurance needs of the public.

Through their insurance departments, state governments closely regulate the business of
insurance. Private insurers must be licensed (for most types in insurance) in the states
where they sell insurance. Because regulation of licensed insurers encompasses all insurer
operations, state insurance regulators review insurance rates, policy forms, underwriting
practices, claim practices, and financial performance. Regulators can revoke the licenses or
insurers that do not fully comply with state regulations.

This section provides a brief overview of insurance as a business, regarding the following:
 Types of insurers
 Insurer operations
 Financial performance of insurers
 State insurance regulation
 Benefits of insurance
 Costs of insurance
These topics are all covered in greater detail in later chapters.

Types of Insurers
Many different types of private insurers offer various types of insurance. The federal
government and state governments also provide insurance. In some cases, government
insurance plans supply the same types of insurance as private insurers; in other cases,
government insurance provides coverage that is not available from private insurers.

Private Insurers
There are three major types of private insurers as follows:

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

1. Stock insurers, which are corporations owned by stockholders.

2. Mutual Insurers, which are corporations owned by their policyholders
3. Reciprocal insurance exchanges (also known as an interinsurance exchange), which are
unincorporated associations that provide insurance service to their members, after
called subscribers

Other private providers of insurance include Lloyd’s American Lloyd’s captive insurers, and
reinsurers. A later chapter will discuss these types of insurance providers in more details.

Federal Government Insurance Programs

Some federal government insurance programs exist because of the huge amount of
financial resources needed to provide certain types of coverage to citizens and because the
government has the authority to require mandatory coverage. Social Security is the best
example of such a program. Private insurers provide some benefits similar to those
provided by the Social Security program, but the number of Social Security beneficiaries (in
effect, claimants) and the range of coverages make providing this type of insurance beyond
the resources of private insurers. Further, eligibility for payments – retirement – is a
certainty, so this is not an ideally insurable exposure.

In addition to the Social Security program, the federal government provides insurance for
certain kinds of catastrophic losses. The National Flood Insurance Program provides
insurance for owners of property located in flood prone areas and for others concerned
about the exposure of flooding. The Federal Crop Insurance Program insures farmers
against damage to their crops by drought, insects, hail, and other causes. The federal
government also insures depositors against loss resulting from the failure or insolvency of
banks (through the Federal Deposit Insurance Corporation) and credit unions (through the
National Credit Unions (through the National Credit Union Administration).

State Government Insurance Programs

State governments also offer insurance programs to ensure that certain types of coverage
considered necessary to protect the public are available. All states require that employers
meet the financial obligations to injured workers, based on workers’ compensation
insurance. In place of or in addition to private insurers, some states sell worker’s
compensation insurance to employers. Depending on the state, the state workers’
compensation insurance program may be the employer’s only option, or it may be one of
several options available to employers to meet their obligations.

In addition, state governments operate unemployment insurance plans, which provide

some measure of continuing income for eligible workers who become unemployed. Fair
Access to Insurance Requirements (FAIR) plans have been implemented in many states to

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

provide basic property insurance for property owners who cannot otherwise obtain needed
coverage in the open market. Through automobile insurance plans and other programs,
states make auto insurance available to drivers who have difficulty obtaining such insurance
form private insurers.

Insurer Operations
An insurer must take great care in arranging the insurance it agrees to provide, not only to
ensure that it can meet its commitments to insureds to pay for covered losses, but also to
collect enough premiums to earn a reasonable profit after paying those losses. The insurer
must market its products and services effectively to gain enough customers to operate
economically. The insurer must also decide which potential customers to insure, what
coverages to offer, and what premiums to charge so that customers are adequately insured
and the insurer can operate profitably. On a daily basis, the insurer must determine which
losses sustained by its customers are covered and, if covered, the amount to be paid.
To accomplish these objectives, insurers engage in the following operations, all of which are
discussed briefly here and covered in greater detail in later chapters:
 Marketing
 Underwriting
 Claim handling
 Ratemaking

Marketing is the process of determining customers’ needs and then promoting and selling
products or services to meet those needs. Insurance marketing enables insurers to reach
potential customers and retain current ones. Insurance producers (agents and brokers) are
an integral part of insurance marketing because they represent insurers to the public. Other
important aspects of marketing are advertising, producer supervision and motivation, and
product management.
Underwriting is the process by which insurers decide which potential customers to insure
and what coverage to offer them. Underwriters are responsible for selecting insureds,
pricing coverage, and determining policy terms and conditions. For some types of insurance,
such as personal automobile, policy terms and conditions are largely standardized, and
pricing is performed by computer rating programs. Still, the underwriter affects the
outcome by determining the insured’s eligibility for any of the insurer’s policy provisions,
and by properly classifying the insured for the automatic rating system. Effective
underwriting enables insurers to provide the coverage needed by insureds and to be
reasonably certain that the premiums collected will be sufficient to pay for their losses.
Claim handling enables insurers to determine whether a covered loss has occurred and, if
so, the amount to be paid for the loss. The role of a claim representative is to satisfy the
insurer’s obligations under an insurance policy by promptly responding to claims and

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

gathering the information necessary to evaluate a claim properly and reach a fair
settlement.

Ratemaking is the process by which insurers determine the rates for each category, or
classification, of similar but independent insureds. Insurers need appropriate rates to have
enough money to pay for losses, cover operating expenses, and earn a reasonable profit.

To support their operations, insurers process vast amounts of data, relying on computers to
process most of that data and to generate information necessary for running their
businesses. Insurers use computers to process applications, to issue and renew policies, to
generate invoices, to keep records of claims and loss payments, and to maintain accounting
records and statistical reports. In addition to insurance-related information, insurers use
computers in the same way that other businesses do: to generate management information
reports and to store and retrieve data relating to employees, investments, customers,
suppliers, and other matters.

Financial Performance of Insurers

An insurer’s revenue must, in the long run, match or exceed the amount it pays for claims
and administrative expenses if the insurer is to remain financially viable. Therefore, an
insurer’s financial performance is very important, but not just to the insurer. State
insurance regulators, insurance producers, stockholders, and insureds also need to be
assured of an insurer’s financial health.
The primary sources of revenue for insurers are premiums and investment income. Insurers
have investments because they receive premiums before they pay for losses and expenses.
Insurers invest the money in the meantime and receive investment income as a result. One
of the goals of insurers is to generate enough revenue from premiums and income from
investments to pay for losses, meet other expenses, and earn a reasonable profit.
In addition to loss payments, insurers incur several other types of expenses. Insurers have
loss settlement expenses, which include the costs of investigating and settling claims. They
also incur expenses to acquire new business (such as advertising costs and producers’
commissions), and general expenses (such as salaries, employee benefits, utilities
telephones, and computer equipment). Insurers pay premium taxes, income taxes, and
various licensing and other fees. Insurers have expenses associated with investment
activities, such as the salaries of investment department staff members. The ability to pay
these expenses and still make a reasonable profit is a measure of an insurer’s solvency, that
is, its long-term financial strength.

State Insurance Regulation

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Insurers must be able to meet their obligations to insureds. A financially weak insurer may
not have the resources necessary to meet its obligations. Therefore, insurance regulators
closely monitor the financial condition of insurers and take actions necessary to prevent
insurer insolvency.

Every state has and insurance department that regulates the insurers doing business in that
state. The insurance department regulates almost all aspects of the assurance business to
some degree, but most insurance regulation deals with rates, insurer solvency, and
consumer protection.
State insurance departments regulate insurance rates to protect consumers from
inadequate, excessive, or unfairly discriminatory rates. Adequate rates are necessary for
insurers to earn enough premium revenue to pay for losses and other expenses while
generating a reasonable profit. At the same time, regulators believe that excessive rates are
unfair to insurance consumers. Though regulators in some states trust open competition to
produce lower rates for customers, many place tight caps on rates and enforce restrictions
on changes to existing rates.
Insurance rates should reflect the insured’s loss exposures. Therefore, insureds with similar
loss exposures are grouped together in a single rating class and charged the same rate.
Although other insureds may be grouped in a different rating class and charge a different
rate, that rate must reflect the group’s loss exposures. It would be unfair, however, if the
different rate reflected characteristics of the group that had no bearing on their loss
exposures. Therefore, rates based on such characteristics would not be permitted because
they would be unfairly discriminatory. What constitutes unfair discrimination varies by
state, and some states no longer allow discrimination based on such characteristics as age
and sex for certain types of insurance, such as personal auto.
Insurance regulation also deals with insurer solvency. Through solvency surveillance,
insurance regulators monitor the financial condition of insurers. Such surveillance enables
regulators to work with insurers that have financial difficulties to keep the insurers in
business and maintain their ability to meet obligations to insureds.
Finally, insurance regulation deals with consumer protection. Insurance regulation protects
consumers in several ways. Insurance must be licensed to write insurance policies (for most
types of insurance) in a given state, and licensing requires an insurer to meet tests of
financial strength. In addition to licensing insurers, states require that certain
representatives of insurers also be licensed. Such licensing requirements apply to insurance
producers and may also apply to claim representatives and others.

Most states require that insurers file their policy forms with the insurance department so
that the department can approve policy language. States also monitor specific insurer

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

practices concerning marketing, underwriting, and claims. In addition, state insurance

departments investigate complaints against insurers and their representatives and enforce
standards regarding their conduct. All of these activities help to protect consumers.

Benefits of Insurance
Insurance provides many benefits to individuals, families, businesses, and society as a
whole. These benefits include the following:
 Indemnifying for the costs of covered losses
 Reducing the insured’s financial uncertainty
 Promoting insurers’ loss control activities
 Using resources efficiently
 Providing support for credit
 Satisfying legal requirements
 Satisfying business requirements
 Providing a source of investment funds
 Reducing social burdens

Indemnifying for Losses

The primary role of insurance is to indemnify individuals, families, and businesses for
covered losses. To indemnify means to restore a party who has sustained a loss to the same
financial position that party held before the loss. Consider the aftermath of a loss for those
who have no insurance to recognize the value of payment for losses. If fire destroys the
home of a family with no insurance, the family members may be left without the financial
resources to repair their home or to replace their belongings; they may also have no place
to live. A business can incur bankruptcy as the result of a liability judgment it cannot pay,
and the employees and owners of the business are suddenly unemployed. By indemnifying
insureds, insurance provides some degree of financial security and stability for individuals,
families, and businesses.

Reducing Uncertainty
Because insurance provides financial compensation when covered losses occur, it greatly
reduces the uncertainty created by many loss exposures. A family’s major financial
concerns, for example, often center on the possibility of a wage earner’s death or the
destruction of a home. If the family transfers the uncertainty about the financial
consequences of such losses to an insurer, the family practically eliminates these financial
concerns. Insurers have greater certainty than individuals about losses, because the law of
large numbers enables them to predict the number of losses that are likely to occur and the
financial effects of those losses.

Promoting Loss Control

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Insurers often promote loss control by recommending loss control techniques that people
and businesses can implement. Loss control means taking measures to prevent some losses
from occurring or to reduce the financial consequences of losses that do occur. For
example, individuals, families, and businesses can use loss control measures such as burglar
alarms, smoke alarms, and dead bolt locks to prevent or reduce property loss exposures.
Loss control generally reduces the amount of money insurers must pay in claims.
Consequently, loss control helps to improve the financial results of insurers and to reduce
insurance costs to consumers. Thus, society benefits from activities that prevent and reduce
losses.

Using Resources Efficiently

People and businesses that face an uncertain future often set aside funds to pay for future
losses. Insurance makes it unnecessary to set aside a large amount of money to pay for the
financial consequences of loss exposures that can be insured. Money that would otherwise
be set aside to pay for possible losses can be used to improve a family’s quality of life or to
contribute to the growth of a business. In exchange for a relatively small premium, families
and businesses can free up additional funds that they would otherwise need to reserve to
pay for unforeseen future losses, such as the loss of a house because of fire.

Providing Support for Credit

Before making a loan, a lender wants assurance that the money will be repaid. When a
lender loans money to a borrower to purchase property, the lender usually acquires a legal
interest in that property. The lender often can repossess a car or foreclose a home
mortgage if the loan is not repaid. However, the lender would be less likely to make loans if
it did not have some assurance of getting back its money if the car or house were destroyed
or if the borrower died or became disabled before the loan was paid in full.
Insurance facilitates loans to individuals and businesses by guaranteeing that the lender will
be paid if the collateral for the loan (such as a house or a commercial building) is destroyed
or damaged by an insured event, thereby reducing the lender’s uncertainty.

Satisfying Legal Requirements

Insurance is often used or required to satisfy legal requirements. In many states, for
example, automobile owners must prove they have auto liability insurance before they can
register their autos. All states have laws that require employers to pay for job-related
injuries or illnesses of their employees, and employers generally purchase workers’
compensation insurance to meet this financial obligation.

Satisfying Business Requirements

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Certain business relationships require proof of insurance. For example, building contractors
are usually required to provide evidence of liability insurance before a construction contract
is granted. In fact, almost anyone who provides a service to the public, from an architect to
a tree trimmer, may need to prove that he or she has liability insurance before being
awarded a contract for services.

Providing Source of Investment Funds

One of the greatest benefits of insurance is that it provides funds for investment. When
insurers collect premiums, they usually do not need funds immediately to pay losses and
expenses. Insurers use some of these funds to purchase stocks and bonds. Such
investments provide businesses with money for projects such as new construction,
research, and technology. Investment funds promote economic growth and job creation.
Investment brings additional funding to insurers in the form of interest; this additional
income helps to keep insurance premiums at a reasonable level for individuals and
businesses. Insurers also invest in social projects, such as cultural events, education, and
economic development.

Reducing Social Burdens

Uncompensated accident victims can be a serious burden to society. Insurance helps to
reduce this burden by providing compensation to such injured persons. For example,
workers’ compensation insurance provides payment to injured employees for medical
expenses, lost wages, and rehabilitation, as well as death benefits to survivors of employees
killed by workplace accidents or diseases. Compulsory auto insurance is another example,
because it provides compensation to auto accident victims who may otherwise be unable to
afford proper medical care or who may be unable to work. Without insurance, victims of
job-related injuries or auto accidents may need state welfare or the assistance of another
social program.

Costs of Insurance
The benefits of insurance are not cost-free. However, the benefits of insurance outweigh
the costs, and insurance is generally considered to provide a meaningful economic and
social purpose. Among the costs of insurance are both direct and indirect costs, including
the following:

 Premiums paid by insureds

 Operating costs of insurers
 Opportunity costs
 Increased losses
 Increased lawsuits

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Premiums Paid by Insureds

Insurers must charge premiums to have the funds necessary to make loss payments. In fact,
an insurer’s total revenue (premiums and investment income) must equal or exceed the
amount needed to pay for losses and to cover its costs of doing business. For example, an
insurer may use eighty cents of every premium dollar to pay for losses and twenty five cents
for other expenses. If the insurer can earn an amount equal to five percent of its premiums
on its investments, it can break even. By law, insurance premiums must not be excessive;
however, insureds may believe that their premiums are too high. Realistically, insurance
premiums may also be considered as a cost of living and doing business in an industrialized
society.

Operating Costs of Insurers

Like any business, an insurer has operating costs that must be paid to run the day-to-day
operations of the company. Those costs include salaries, producers’ commissions,
advertising, building expenses, equipment, taxes, licensing fees, and many others. In
addition, most insurers are in business to make a profit, just like any other business.
Therefore, a reasonable amount of profit must be calculated in the cost of insurance that
insureds pay.

Opportunity Costs
If capital and labor were not being used in the insurance business, they could be used
elsewhere and could be making other productive contributions to society. Therefore,
whatever resources the insurance industry uses in its operations represent lost
opportunities in other areas – in other words, opportunity costs. These opportunity costs
are one of the costs of insurance.

Increased Losses
The existence of insurance may encourage losses to some extent. Although insurers have an
economic incentive to provide and encourage loss control measures, insurance may
sometimes provide an economic incentive for insured’s to have losses. For example, a
person may internationally cause a loss or exaggerate a loss that has occurred. It is
estimated that 37,500 structural fires and 30,500 vehicle fires in 2003 were intentional.
Property damage from these fires amounted to approximately $692 million in structural
damage and $132 million in vehicle damage. These figures do not include indirect costs,
such as business interruption, loss of use, and temporary shelter costs, nor do they take into
consideration human suffering and human loss exposure costs, such as medical expenses
and funeral costs. Many cases of arson or suspected arson involve insurance-some property
owners would rather have the insurance money than the property.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Arson in an intentionally staged accident and it represents one form of insurance fraud. The
intentional exaggeration or loss in an otherwise legitimate claim is a more common form of
insurance fraud. These exaggerations are also referred to as claim buildup. For example, an
insured may claim that four items were lost rather than the actual three or that the items
were worth more than their actual value. In liability claims, claimants may exaggerate the
severity of their bodily injury or property damage. Physicians, lawyers, contractors, and
auto body shop operators can also be participants in claim buildup.

Insurers are actively involved in the fight against insurance fraud and use various techniques
to detect and investigate suspicious claims; nevertheless, insurance fraud is a serious
problem that results in billions of dollars in excess insurance payments each year.
Fraudulent claims increase costs for both insurers (in terms of both payment for fraudulent
claims and the costs of investigating and resisting fraud and insureds (who pay increased
premiums to help cover the cost of those who defraud insurers.

Some losses may not be deliberately caused, but they may result from carelessness on the
part of an insured because insurance is available to pay for losses if they do occur. Routinely
leaving the keys in an unlocked car is an example of such carelessness. If the car is stolen,
the insured would suffer only minimal financial consequences because the insurer will pay
for the loss. The additional losses that result from insured’s carelessness increase the cost
of insurance for everyone because insurers often pay for injuries and damage that insureds
could have prevented.

Increased Lawsuits
The number of liability lawsuits has increased steadily in recent years. One reason for this
increase is that liability insurers often pay large sums of money to persons who have been
injured. Liability insurance is intended to protect people who may be responsible for injury
to someone else or damage to some one’s property. However, some people may view
liability insurance as a pool of money available to anyone who has suffered injury or
damage, with little regard given to fault. The increase in frivolous lawsuits is an unfortunate
cost of insurance in today’s society.

INSURANCE AS A CONTRACT
An insurance policy is a contract between the insurer and the insured. Through insurance
policies, insured’s transfer the possible costs of losses to insurers, In return for the
premiums paid by insured’s; insurers promise to pay for the losses covered by the insurance
policy. As noted, this promise reduces the uncertain or insecurity that insured’s have about
paying for losses that may occur. The coverage provided by insurance policies enables

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

individuals, families, business, and organizations to protect their assets and minimize the
adverse financial effects of losses.

The four basic types of insurance – property, liability, life, and health – are generally divided
into two broad categories, as follows:
 Property/liability insurance
 Life/health insurance

Property insurance provides coverage for property and net income loss exposures. It
protects an insured’s assets by paying to repair or replace property that is damaged, lost,
or destroyed, or by replacing the net income lost and the extra expenses incurred as a result
of a property loss. Liability insurance covers liability loss exposures. It provides for payment
on behalf of the insured for injury to others of damage to other’s property for which the
insured is legally responsible.

Life insurance and health insurance cover the financial consequences of personal and
personnel loss exposures. Life insurance replaces the income earning potential lost through
death and also helps to pay expenses related to an insured’s death. Health insurance
protects individuals and families from financial losses caused by sickness and accidents.
Disability insurance is a form of health insurance that replaces an insured’s income if the
insured is unable to work because of illness or injury.

Property Insurance
Property insurance covers the costs of accidental losses to an insured’s property. The
insured could be a family insuring its house and personal property or a business insuring its
building, inventory, and equipment. When the insured experiences a loss, such as fire
damage to a house, the insured deals directly with the insurer to settle the loss and receive
payment.

Many types of insurance are classified as property insurance, such as the following:

 Fire and allied lines insurance

 Business income insurance
 Crime insurance
 Ocean marine insurance
 Inland marine insurance
 Auto physical damage insurance

Fire and allied lines insurance generally covers direct damage to or loss of insured property,
such as buildings and personal property, at a fixed location or locations described in the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

policy. The term “allied lines” refers to insurance against causes of loss usually written with
(allied) fire insurance, such as windstorm, hail, smoke, explosion, vandalism, and others.
Examples of fire and allied lines insurance policies are a dwelling policy and a commercial
property policy.

Business income insurance, traditionally called business interruption insurance, covers the
loss of net income or additional expense incurred by a business as the result of a covered
loss to its property. For example, when a business has a serious fire, it may have to close
until repairs to the building are made and personal property is replaced. A resulting loss of
net income occurs over time. Business income insurance pays the insured for the loss of
income or additional expenses that the insured incurs insured because of the loss during
the time needed to restore the business to its pre-loss condition.

Crime insurance covers money, securities, merchandise, and other property from various
causes of loss such as burglary, robbery, theft, and employee dishonesty. Coverage for
crime losses that a business may incur is usually provided by separate policies that insure
specific types of property against specific crime losses. Crime losses that a person of family
may suffer are usually insured under a homeowner’s policy.

Ocean marine insurance, one of the oldest forms of insurance, covers ships and their cargo
against such causes of loss as fire, lightning, and “perils of the seas,” which include high
winds, rough waters, running aground, and collision with other ships or objects.

Inland marine insurance covers miscellaneous types of property, such as movable property,
goods in domestic transit, and property used in transportation and communication. It was
originally developed to provide coverage for losses to cargo transported over land but now
covers many different types of property in addition to goods in transit.

Auto physical damage insurance covers loss of or damage to specified vehicles from
collision, fire, theft, or other causes. It is usually part of a policy that also provides auto
liability coverage such as a personal auto policy or a business auto policy.

Liability Insurance
Because an insurance policy is a contract between the insured and the insurer, these two
are usually the only parties involved in property loss. Liability insurance, however, is
sometimes called third-party insurance because three parties are involved in a liability loss:
the insured, the insurer, and the party who is injured or whose property is damaged by the
insured. (The third party is usually called the claimant.) The insurer pays the claimant on
behalf of the insured if the insured is legally liable for the injury or damage. An insured’s

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

legal liability for injury or damage is often the result of a negligent act, but there are other
sources of liability as well. Examples of liability insurance include the following:

 Auto liability insurance

 Commercial general liability insurance
 Personal liability insurance
 Professional liability insurance

Auto liability insurance covers an insured’s legal liability arising out of the ownership,
maintenance, or use of an automobile. The legal costs of defending the insured against
lawsuits are also covered when such defense is necessary. The personal auto policy and the
business auto policy are the most widely used auto insurance policies. These policies can
include coverage for both auto liability and auto physical damage losses.

Commercial general liability insurance covers liability loss exposures arising from a business
organization’s premises and operations, its products, or its completed work. The following
examples of liability claims against an appliance store illustrate the various ways that a
business can be liable for the bodily injury or property damage suffered by others:

 Premises. A customer whose finger was caught in a revolving door incurred medical
expenses for treatment in a hospital emergency room.

 Business operations. Employees broke a water pipe while installing a dish washer in an
apartment, causing substantial water damage to property in the apartment below.

 Products. A customer’s face was cut when an electric mixer sold to the customer
malfunctioned and shattered a glass mixing bowl.

 Completed operations. A short circuit developed in an electric stove incorrectly installed

by employees and caused a fire that damaged the customer’s kitchen.

Personal liability insurance provides liability coverage to individuals and families for bodily
injury and property damage arising from the insured’s personal premises or activities. As
mentioned previously, in most instances, the liability arises from the insured’s negligence.
For example, a visitor to the insured’s home may slip and fall on the insured’s icy driveway,
or the insured may hit a golf ball that accidentally strikes a pedestrian in the head. This type
of coverage in included in all homeowners policies.

Professional liability insurance provides liability coverage to professionals for errors and
omissions arising out of their professional duties. Medical malpractice insurance, which

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

covers doctors and other healthcare providers, is probably the best known type
professional liability insurance, but similar coverage is available to other types of
professionals, including insurance producers, attorneys, architects, and engineers.

Life Insurance
One of the most severe causes of financial loss to a family is the premature death of a
family member, especially the primary wage earner. Life insurance can greatly reduce the
adverse financial consequences of premature death by providing funds to replace lost
income to pay uncovered medical expenses (when necessary) and cover the funeral costs.
Although there are many variations of life insurance, the following three basic types are
commonly sold:
 Whole life insurance

 Term insurance

 Universal life insurance

Whole life insurance provides lifetime (for the insured’s whole life) protection, accrues cash
value, and has premiums that remain unchanged during the insured’s lifetime. Cash value is
the monetary amount, considered to be a form of savings that accumulates in the policy. A
policy holder can borrow the cash value after a policy has been in effect for a specified
number of years. Whole life insurance is purchased when a consumer wants lifetime
protection with a level (constant) premium and a savings element.

Term insurance provides coverage for a specified period, such as ten or twenty years, with
no cash value. A term life insurance policy is used when the consumer wants the maximum
amount of life insurance protection available at the lowest cost. Parents of young children
may buy twenty-year term insurance to provide financial security until their children are
grown.

Universal life insurance provides life insurance protection and a savings component. The
policyholder has a cash value account that is credited with the premiums paid, less a
deduction for the cost of the insurance protection and expenses charged. The balance in the
account is then credited with interest at a specified rate. If the policyholder surrenders the
policy, the cash value account may be reduced by surrenders the policy charger to
determine the surrender value paid to the policyholder. Some life insurance policies are
sold directly to individuals, while other life insurance policies cover a group of insureds.
Such group policies are usually term insurance policies arranged through an employer or an
association.
Health Insurance
Health insurance is designed to protect individuals and families from financial loss caused
by accidents and sickness. Like life insurance, health insurance is issued on either an

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

individual or a group basis. The various types of health insurance policies can be classified as
either medical insurance or disability insurance. Medical insurance covers medical expenses
that result from illness or injury. Disability income insurance provides periodic income
payment to an insured who is unable to work because of sickness or injury. Disability
Insurance is primarily income replacement insurance that pays weekly or Monthly benefits
until the insured can return to work or until a maximum Period has elapsed

SUMMARY
Every individual, family, and business organization needs insurance. Insurance is actually
four things: a risk management technique, a transfer system, a business, and a contract.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

For loss exposures that an individual or organization cannot easily retain, avoid, or control,
insurance is often the best available risk management technique.
The key elements of insurance as a transfer system are transfer and sharing. An insured
transfers the potential financial consequences of loss exposures to an insurer, there by
exchanging the possibility of a large loss for the certainty of a much smaller periodic
payment (the premium). The sharing aspect of insurance requires the insurer to pool the
premiums paid by insureds into a loss fund from which covered losses are paid .Although
the insurer does not expect all insureds to experience a loss, all insureds share in the cost of
losses because their premiums make up the loss fund .Because of the law of large numbers,
insurers can predict the number of losses that may occur and thus the amount of premium
to be paid by each insured.
The need for insurance exists because everyone faces exposures to loss, that is, the
possibility that a loss will occur. Loss exposures can give rise to three major types of loss:
property loss (including net income loss) liability loss, and personal and personal loss. The
role of insurance is to protect insureds’ assets from the financial consequences of loss.
However, insurers prefer t provide insurance for loss exposures that are considered ideally
insurable.
The insurance business provides jobs to millions of workers in the U.S. private insurers
provide most insurance, but federal and state government Insurance programs also provide
insurance for loss exposures that private Insurers are unable or reluctant to insure.
Insurer operations include marketing underwriting, claim handling, and ratemaking, as well
as information processing. The states regulate many of the operations of insurers.
Regulators, insureds, and others need to be assured of insurers’ financial stability. To
protect consumers, state insurance departments regulate insurance rates and monitor
insurer solvency.
In addition to payment for losses the insurance business offers many benefits to insureds
and to society as a whole. However, there are both direct and indirect costs associated with
insurance.
An insurance policy, which is a contract between the insured and the insurer, states the
right and duties of each party with regard to losses. The four basic types of insurance are
property insurance, liability insurance, life insurance, and health insurance. Each of teach
types of insurance is provided trough contracts between the insured and the insurer.

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Who Provides Insurance and Chapter 2

How Is It Regulated?
2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Insurance is a risk management technique, transfer system, a business, and a contract, and
it is provides by several types of insures. This chapter describes these different types of
insurers and how state governments regulate them. Regulatory mechanisms are designed
to maintain the integrity of insures, govern rates, and address the needs of customers who
cannot purchase insurance from "mainstream" insurance companies.

The insurance industry is not well understood or held in high regard by much of the
purchasing public. The mechanism of insurance is relatively complex in comparison to
purchases of other goods and services. A family that buys a car examines and compares
vehicles to determine which provides the best value for the lowest price. In contrast, the
purchase of insurance is an exchange of money now for a future promise (payment for
covered claims) as stated in a contract. In choosing an automobile insurance policy for the
new car, it may be difficult for a family to compare the promises made by various insurers
and their track records in fulfilling those promises. In the past, some unscrupulous
insurance companies may have taken advantage of policyholders by failing to fulfill the
promises made in their contracts, heightening the public's suspicions regarding all insurers.

To maintain and strengthen the integrity of the insurance industry, regulations govern the
actions and practices of insurers. This chapter describes some of those regulatory activity as
well as the insurers who provide coverage.

TYPES OF INSURANCE ORGANIZATIONS

Private (non-governmental) insurers provide most of the property-casualty insurance in the
United States. Private insurers also provide some insurance through government -
sponsored insurance programs. The federal government and the various state governments
also act as insurers for certain types of loss exposures. This section discusses the various
types of private insurers and then examines common federal and state government
insurance programs.

Private Insurers
Numerous kinds of private insurers provide property and liability coverage for individuals,
families, and business. Private insurers differ from one another in several ways, primarily in
terms of:

 The purpose for which they were formed.

 Their legal form of organization
 Their ownership

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Their method of operation

Some of these differences developed through historical circumstances; other resulted from
legislative action or the interests of the parties that formed the insurer.

All insurers provide a means to indemnify insureds if a covered loss occurs, and to spread
the cost of losses among insureds. Although all insurers perform these basic functions, the
underlying motives of the parties forming different types of insurers are not the same.
Some types of insurers are formed in the expectation that the insurer's operations will
make a profit or provide some on behalf of groups of insureds with the motive of making
insurance more readily available or making insurance available at a cost lower than if it
were purchased through the general insurance market.
This section discusses the following types of private insurers:
 Stock insurers
 Mutual insurers
 Reciprocal insurance exchanges
 Lloyd's
 American Lloyds
 Captive insurers
 Reinsurance companies

Exhibit 2-1 outlines the major differences among these kinds of private insurers. Insurers
may also differ according to their licensing status, the marketing systems they use, and the
types of insurance coverage they provide. Each type of insurer is discussed in greater detail
next.

Differences Among Major Types of Private Insurers (and Lloyd’s)

Purpose for
Type Legal form Ownership Method of Operation
which formed
To earn a profit
The board of directors, elected by stockholders,
Stock Insurer for its Corporation Stockholders
appoints officers to manage the company.
stockholders
To provide
Insurance for its The board of directors, elected by stockholders,
Mutual Insurer Corporation Policyholders
owners appoints officers to manage the company.
(policyholders)
Reciprocal To provide
insurance reciprocity for
Unincorporated Subscribers Subscribers choose an attorney-in-fact to operate
exchange subscribers (to
association (members) the reciprocal.
(interinsurance cover each other’s
exchange) losses)
Lloyd’s To earn a profitUnincorporated Investors Lloyd’s is regulated by the U.K. Financial

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

for its individual

investors
services Authority (FSA), which delegates much
(“Names”) and its association
authority to the Council of Lloyd’s
corporate
investors

Stock Insurers
Insurers formed for the purpose of making a profit for their owners are typically organized
as stock corporations. As such, a Stock insurer is owned by its stockholders and formed as a
corporation for the purpose of earning a profit for the stockholders. By purchasing stock in
a for - profit insurer, stockholders supply the capital the insurer needs when it is formed or
the additional capital needed to expand the insurer's operations. These stockholders expect
to receive a return on their investment in the form of stock dividends, increased stock
value, or both. Therefore, one of the primary objectives of a stock insurer is returning a
profit to its stockholders. Many of the largest property-casualty insurers in the U.S. are
stock insurers. These companies have been able to attract and retain stockholders by the
expectation of investment returns.

Stockholders have the right to elect the board of directors, which has the authority to
control the insurer's activities. The board of directors creates and oversees corporate goals
and objectives and appoints a chief executive officer (CEO) to carry out the insurer's
operations. The CEO and a team of senior management personnel are given authority by
the board of directors to implement the programs necessary to operate the company.

The stock form of ownership also provides financial flexibility for the insurer. For example,
the management of a stock insurer may decide to expand its operations by purchasing
another insurance company, by expanding into new territories, developing new product
lines, or by purchasing a non-insurance company to diversity its operations. One way that a
stock insurer can finance such expansion is by selling additional shares of common stock.
The ability to raise additional funds by selling common stock is an important aspect of the
stock form of organization.

Mutual Insurers
A mutual insurer is owned by its policy holders and formed as a corporation for the purpose
of providing insurance to them. The corporation of a traditional mutual insurer issues no
common stock, so it has no stockholders. The policyholders of a mutual company have
voting rights similar to those of the stockholders of a stock company. They elect a board of
directors that performs the same functions as the board of directors of a stock company.
Mutual companies include some very large national insurers and many more regional ones.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Although initially formed to provide insurance for their owners, mutual insurers today
generally seek to earn profits in their ongoing operations as do stock companies. A mutual
insurer needs profits to ensure the future financial health of the organization. A stock
company may choose to share profits with its stockholders by the payment of dividends,
which are a return on the stockholders investment. Mutual insurers also may opt to share
profits, but pay dividends instead to policyholders as a return of a portion of premium paid.

Some mutual insurers have the right to charge insureds an assessment or additional
premium, after the policy has gone into effect. Such an assessment might be made after the
insurer has endured a series of losses from a catastrophic event such as a hurricane. These
insurers are known as assessment mutual insurance companies, and they are less common
than in the past.

From the perspective of the insured, differences between stock and mutual insurance
companies are becoming less significant. Such things as potential assessments, which were
a disadvantage, and dividends, which could be a competitive advantage, are less common
features of mutual insurers today. In facts, the structure of mutual companies is gradually
changing, making them more similar to stock companies. Some state laws now allow mutual
insurers to sell stock to the public by creating mutual holding company, and other states are
considering the adoption of similar regulations. In recent years, some mutual companies
have converted to stock companies through a process called demutualization. Some mutual
companies have made these structural changes because they wanted to raise additional
capital through the sale of stock to better compete with stock companies, which can benefit
from favorable stock market conditions.

Reciprocal Insurance Exchange

A reciprocal insurance exchange, or an underinsurance exchange, (also simply called a
reciprocal) is an insurer owned by its policyholders, formed as an unincorporated
association for the purpose of providing insurance coverage to its members (called
subscribes), and managed by an attorney-in-fact. The term "reciprocal" comes from the
reciprocity of responsibility of all subscribers, who agree to insure each other. Each member
of the reciprocal is both an insured and an insurer. Because the subscribers are not experts
in running an insurance operation the contract with an individual or organization to operate
the reciprocal; this manager is called an attorney - in-fact. The attorney-in-fact is the
contractually authorized manager of the reciprocal who administers its affairs and carries
out its insurance transactions.
An agreement (known as a subscription agreement) authorizes the attorney - in - fact to act
on behalf of the subscribers to market and underwrite insurance coverage, collect
premiums, invest funds, and handle claims. The existence of an attorney - in -fact,

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

empowered by the subscribers, is one of the main features that distinguish a reciprocal
from other types of insurers.

Reciprocals make up a small percentage of the total number of insurance companies in the
U.S., but they do include some major national and internal insurers. Small regional
reciprocals also operate on a state - by -state basis.

Lloyd's
Although not technically an insurer, Lloyd's (formerly Lloyd's of London) is an association
that provides the physical and procedural facilities for its members to write insurance. In
other words, it is a marketplace, similar to a stock exchange. Members of Lloyd's do not
take an active part in the day - to - day operation of Lloyd's. They are investors (companies,
individuals, and Scottish Limited Partnerships) that hope to earn a profit from the insurance
operations that occur at Lloyd's.

Each individual investor, called a "Name," of Lloyd's belongs to one or more groups called
syndicates. A syndicate's underwriter or group of underwriters conducts its insurance
operations and analyzes applications for insurance coverage. Depending on the nature and
amount of insurance requested, the underwriters for a particular syndicate might accept
only a portion of the total amount of insurance. The application is taken to other syndicates
for their evaluations.

The insurance written by each Name is backed by his or her entire personal fortune.
However, each Name is liable only for the insurance he or she agrees to write, not for the
obligations assumed by any other Name. In 1994, Lloyd's began admitting corporations as
members. Unlike its individual members, corporate members of Lloyd's have limited
liability. Corporate members today make up the dominant share of Lloyd's members.

Lloyd's has earned a reputation for accepting application for very unusual types of
insurance, such as insuring the legs of a famous football player against injury. These
applications may be the subject of newspaper articles, but the bulk of Lloyd's business does
not involve such unusual coverage's. In fact, most of the insurance written through Lloyd's is
commercial property - casualty insurance, such as marine, aviation, catastrophe,
professional liability, and automobile insurance.
Lloyd's has operated continuously for more than 300 years, and Lloyd's underwriters are
considered to be among the world's leaders in their fields. Over the years, despite serious
natural disasters and occasional mistakes in underwriting judgment, Lloyd's members have
had the financial resources to survive catastrophes, pay claims, and move forward to more
profitable times. For most of its history, many members have received an excellent return

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

on their investments, and Lloyd's has had little trouble attracting new members. More
recently, large losses over several years have created a strain on some of Lloyd's syndicate
members. Nevertheless, Lloyd's remains one of the world's most important sources of
insurance.

American Lloyd's
American Lloyds associations are much smaller than Lloyd's, and most are domiciled in
Texas, with a few in other states. Most of the Texas Lloyds associations were formed or
have been acquired by insurance companies. Unlike the individual Names of Lloyd's,
members (called underwriters) of American Lloyds have limited liability. The liability of
underwriters at American Lloyds is limited to their investment in the Lloyds association.
State laws require a minimum number of underwriters (ten in Texas) for each Lloyd’s
association. American Lloyds are usually small and operate as a single syndicate under the
management of an attorney - in - fact.

Captive Insurers
When a company, an organization, or a group of affiliated organizations forms a subsidiary
for the purpose of having the subsidiary of having the subsidiary provide all or part of the
insurance on the parent company or companies, the subsidiary is known as a captive
insurer, or simply a captive. Although captive insurers have been in existence since the early
part of the twentieth century, the widespread use of captives is more recent, with the
major growth occurring since the late 1970s.

Three factors have contributed to the growth of captives in recent years:

(1) Low insurance cost, (2) Insurance availability, and (3) Improved cash flow.
First, captives might be able to provide insurance coverage at a lower cost than other
private insurers because acquisition costs are eliminated. For example, captives might not
have to pay producers' commissions or advertising expenses because they provide
insurance primarily to the parent company.

Second, a captive helps to eliminate the problems some corporations might face because
necessary or desired insurance coverage is unavailable or costs more than the corporation
is willing or able to pay. Forming a captive insurer eases the problems of availability and
affordability for a parent company that has loss exposures that may be difficult to insure.

The third and most important factor is improved cash flow. A premium paid to a captive
remains within the corporate structure until it is used to pay claims. Instead of paying
premiums to an unrelated insurer, the corporation is able to invest its funds until the time
they are needed for claims. Thus, the corporation can receive can receive a significant cash

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

flow advantage by creating a captive. This advantage becomes even greater when interest
rates are high, as was the case during the late 1970s and early 1980s when the number of
captive increased dramatically.

Captive insurers have becomes an important alternative in the insurance - buying decisions
of corporations. The relative importance of the factors affecting the growth of captives
changes over time, but it appears that captives will remain an important source of
insurance.

Reinsurance Companies
Some private insurers provide reinsurance, which is a contractual agreement that transfers
some or all of the potential costs of insured loss exposures from policies written by one
insurer to another insurer. The insurer that transfers some or all of the potential costs of
insured loss exposures is the primary insurer (also called the reinsured). The insurer that
assumes some or all of the potential costs of insured loss exposures of the primary insurer is
the reinsurer. Some reinsurers are companies or organizations that specialize in the
reinsurance business. Other reinsurers are also primary insurers that enter into reinsurance
arrangements with other insurers.

A primary insurer might buy reinsurance for a variety of reasons. One of the most important
reasons is that reinsurance permits the primary insurer to transfer some of its loss
exposures to the reinsurer. For example, an insurer that writes a large amount of property
insurance in an area where tornadoes commonly occur can use reinsurance to reduce its
exposure to windstorm losses.

Reinsurance also enables a small insurer to provide insurance for large accounts (such as
large national or multinational corporations) whose insurance needs would otherwise
exceed the insurer's capacity. For example, consider a primary insurer that writes a
commercial liability policy for a large company that manufactures sports helmets. Because
the potential for heavy liability losses resulting from injuries caused by defective helmets is
great, the primary insurer might contract with a reinsurer to cover all of its liability losses
for this insured over a certain amount, such as $ 1 million. Therefore, the primary insurer
and the reinsurer are sharing the liability loss exposures for this insured.

Government Insurance Programs

Despite the size and diversity of private insurers in the U.S., private insurers do not provide
all types of insurance. Some loss exposures do not possess the characteristics that make
them commercially insurable, but a significant need for protection against the potential
costs of losses resulting from loss exposures still exists. Both federal and state governments

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

have developed insurance programs, such as Social Security, to meet these needs. These
programs are discussed next.

Federal Government Insurance Programs

Some federal government insurance programs serve the public in a manner that only the
government can. For example, only the government has the ability to tax in order to provide
the financial resources needed to insure some loss exposures and the power to make the
system viable by requiring mandatory participation. One federal government insurance
program that requires such participation is the Social Security program.

The Social Security program, formally known as the Old Age, Survivors, Disability, and
Health Insurance Program (OASDHI), is a comprehensive program that provides benefits to
millions of Americans. The Social Security Administration, a federal governmental agency,
operates the program and provides the following four types of benefits to eligible citizens:

1. Retirement benefits for the elderly

2. Survivorship benefits for dependents of deceased workers
3. Disability payments for disabled workers.
4. Medical benefits for the elderly (under the Medicare program)

Mandatory participation in the Social Security program for those eligible for coverage
eliminates the need for individual underwriting and helps to generate premium revenues to
operate the system. Private insurers provide similar benefits (retirement benefits, life
insurance, disability insurance, and health insurance) to some insureds, but they cannot
approach the scope of the Social Security program. Some private insurers provide insurance
to supplement specific Social Security benefits.

Other federal government insurance programs provide coverage for loss exposures that
private insurers have avoided largely because of the potential for catastrophic losses.
Examples of such plans are the National Flood Insurance Program and the Federal Crop
Insurance Program. The need for each of these programs is highly concentrated - only a
specific portion of the population needs the coverage. Those who have property in areas
exposed to flooding need flood protection, and farmers in areas subject to hailstorms have
the greatest need for crop insurance. This concentration of exposure units generally makes
private insures reluctant to provide coverage for flood and crop losses. In other words, the
exposure units are not independent and thus are subject to catastrophic losses that private
insurers cannot insure economically.

State Government Insurance Programs

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

State governments are actively involved in providing insurance for their citizens. Among the
most common types of insurance programs provided or operated by state governments are
as follows:
 Worker's compensation insurance funds
 Unemployment insurance programs
 Automobile insurance plans
 Fair Access to Insurance Requirements (FAIR) plans
 Beachfront and windstorm pools

In addition, all states have some types of insurance guaranty fund to pay for covered losses
should an insurer become financially unable to meet its obligations to its insureds.
Many states provide workers' compensation insurance through a variety of funds. North
Dakota, Ohio, Washington, West Virginia, and Wyoming operate monopolistic state funds,
which means that state fund is the only source of workers' compensation insurance allowed
in that state. All employers in the state who need workers' compensation insurance must
obtain it from this fund. Puerto Rico and the U.S. Virgin Islands operate territorial funds,
which are similar to monopolistic state funds. Some states operate a competitive state fund,
which is a plan that competes with private insurers to provide workers' compensation
insurance. Employers may choose between the state fund and some other means of
meeting their obligations under worker's compensation statutes. Still other states provide
workers' compensation to some employers through residual market plans. A residual
market plan, also known as a shared market plan, is a program that makes workers'
compensation insurance available to those who cannot obtain voluntary coverage from
private insurers. In some states, private insurers provide the coverage for the residual
market; in other states, the residual market is served by the state fund. In this way, the
state is performing the function of satisfying a demand for coverage that private insurers
are unwilling or unable to meet.

Whether provide by a private insurer or a state fund, workers' compensation insurance

covers lost wages only for a job-related injury. Five states (California, Rhode Island, New
Jersey, Hawaii, and New York) provide workers with disability insurance that will replace
wages lost because of pregnancy and injuries or sickness that are not job related.

All state governments operate unemployment insurance programs, but the benefits
provided vary by state. Minimum federal standards, however, as well as some federal
financing, ensure that eligible workers have some unemployment insurance protection.
Private insurance covering the loss of income due to unemployment is not available
because of the catastrophic potential of widespread unemployment.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Most states now require that owners of motor vehicles obtain auto liability insurance
before registering an automobile. However, applicants with poor driving records of persons
with little or no driving experience might have difficulty of Columbia have implemented
automobile insurance plans through a residual market system to make auto liability
insurance available to nearly every licensed driver. The form and operation of these plans
vary by state, but all of the plans spread the cost of operating the plan among all private
insurance companies writing business in the state. In most cases, the state has mandated
the creation of automobile insurance plans but has left the administration of the plans to
private insurers, which then share the costs.

In most states, FAIR plans make property insurance available where it would otherwise be
unavailable. These state-run plans spread the cost of operating the plan among all private
insurers selling property insurance in the state. FAIR Plans were originally created in
response to the urban riots of the 1960s so that property owners in urban areas could have
access to property insurance. These plans now make property insurance more readily
available to property owners who have exposures to loss over which they have no control.
Therefore, eligible property includes, for example, property in urban areas as well as
property exposed to brush fires.

Beachfront and windstorm insurance pools are residual market plans similar to FAIR plans.
These plans exist in share along the Atlantic and Gulf Coasts and provide insurance to
property owners against wind damage from hurricanes and other windstorms. Because
these states have been severally affected by hurricanes in recent years, some property
owners along the coasts have had difficulty obtaining windstorm coverage from private
insurers. In beachfront states without such pools, property insurance is usually available
through a FAIR plan.

Each state, as well as the District of Columbia, has a property-casualty insurance guaranty
fund that provides a system to pay the claims of insolvent insurers licensed in the state. The
money to pay the claims generally comes from assessments made against all private
insurers licensed in the state. In most states, licensed insurers operating in the state are
assessed for their proportionate share of the estimated obligation only after an insurer has
become insolvent. In New York, licensed insurers are assessed in advanced to ensure the
solvency of the guaranty fund.

INSURANCE REGULATION
The possibility that an insurer might not be able to pay legitimate claims to or for its
policyholders is the primary concern of insurance regulators. This scrutiny helps to protect

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

the public from irresponsible, unwise, or dishonest activities that could leave consumers
with worthless insurance policies.

Historically, state governments for the most part have regulated the insurance business,
beginning when state legislatures granted charters to new insurers and specified certain
conditions regarding their minimum capital requirements, their investments, and their
financial reports. State insurance departments were first established to monitor the
operations of insurers and to investigate complaints from insureds. These departments
generally have broad powers to regulate the insurance business in the public interest.

Insurance relegations vary by state. Despite the differences among the states, the primary
objectives of insurance regulation are as follows:

 Rate regulation
 Solvency surveillance
 Consumer protection

Although many insurance professionals believe that state regulation of insurance has
advantages over federal regulation, inefficiency can result when over fifty different
insurance departments separately perform similar tasks and address the same issues and
problems. Before examining rate regulation, solvency surveillance, and consumer
protection, it is useful to understand the role of the National Association of the National
Association of Insurance Commissioners (NAIC) in fostering cooperation among these
departments, which may help to mitigate some inefficiency.

National Association of Insurance Commissioners (NAIC)

The National Association of Insurance commissioners (NAIC) was established to encourage
coordination and cooperation among the various state insurance departments. The
members of the NAIC are the heads (usually called commissioners) of the insurance
departments of each of the fifty states and the District of Columbia. The commissioners of
Puerto Rico, Guam, American Samoa, and the U.S. Virgin Islands also belong to the NAIC.
The NAIC facilitates cooperation, coordination, and uniformity in insurance regulation
among the states, but has no direct regulatory authority.

The NAIC meets quarterly, but it functions, throughout the year with the assistance of its
staff. NAIC standing committees meet periodically during the year and report to the NAIC at
its regularly scheduled meetings.

When a new problem or issue arises, the NAIC studies the matter and issues a statement
describing its position. In many cases, the NAIC drafts a model law, written in a style similar

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

to that of a state statute, that reflects the NAIC's proposed solution to a given problem or
issue, Each state legislature then considers the model law for possible enactment. A model
law might not be passed in its exact form by every state legislature, but it provides a
common basis for drafting state laws that after the insurance industry. In this way, certain
aspects of insurance regulation have a degree of uniformity among states.

The NAIC has also created a uniform financial statement for property casualty insurers. Each
insurer completes an annual finical statement in the prescribed manner and submits it to
the issuance department of each state in which it is licensed to satisfy the financial
reporting requirements of state. This uniformity not only lessens the reporting burden for
insurers, but also simplifies the insurance department's task of comparing the financial
reports of many different insurers.

In a further effort to help states monitor insurer's financial condition, the NAIC has
implemented an accreditation program to increase uniformity and improve state regulation
of insurance. The program's purpose is to ensure that states have the appropriate
legislation and authority to regulate the solvency of the insurance industry. It also attempts
to ensure that states apply the required legislation consistently. Under this program, states
that have been accredited by the NAIC cannot accept the results of insurer examinations
performed by states that have not been accredited.

Through its various programs and committees, the NAIC enables state regulators to pool
their resources while preserving state regulation. The NAIC encourages unfortunate, but
each state can tailor its regulatory approach to meet the state's unique needs.

Rate Regulation
Because insurers develop insurance rates that affect most people, the laws of nearly all
states give the state insurance commissioner the power of enforce regulation of insurance
rates. Acting in the interest of insureds, regulators try to ensure that rates are adequate,
not excessive, and not unfairly discriminatory.

Ratemaking
An insurer must collect sufficient premiums to pay for the insured losses that occur, to
cover the costs of operating the company, and to allow a reasonable profit. Typically, the
profit comes not from an excess of premiums over losses and operating costs, but from the
investment of those premiums until losses are paid. Determining the proper rate to charge
each insured for coverage involves ratemaking.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Ratemaking is the process insurers use to calculate the rates that determine the premium
to charge for insurance coverage. The rate is the amount per exposure unit for insurance
coverage (for example, $100 worth of coverage). The premium is the price of the insurance
coverage provide for a specified period. To arrive at the premium (a process called rating),
the rate is multiplied by the number of exposures units purchased. For example, if an
insurer charges a rate of $ 1.20 per $ 100 of coverage on jewelry, the premium for a ring
insured for $1,000 would be $12, according to the following formula:

Premium = Rate x Number of exposure units

= $ 1.20 x 10 units
= $ 12

This is a simplified rating example, but in fact it is a complex process to develop a final rate.
For example, the $1.20 rate may reflect the expected cost of future losses, adjustments for
factors such as territory and past loss history, and projections of the effects of inflation.
Developing rates that accurately reflect each insured's share of predicted losses is one of
the most important operations performed by insurance organizations. Because a given rate
is the basis of an insured's premium, it is important to both the insured and the insurer that
the rate, and therefore the premium, be a fair measure of the insured's exposure to loss.

To determine the premiums to charge, insurers predict, as accurately as possible, the

expenses they will incur to pay for losses, recognizing that this prediction is uncertain.
Insurers add an amount sufficient to cover the expected administrative costs of company
operations to the predicted claim expenses. In addition, the premium includes a charge for
profits and contingencies, such as possible catastrophic losses. This amount is often
modified to reflect the investment income that can be earned on the funds held for future
claim payments.

Insurers use rate classification system that differentiate among insureds based on each
insured's loss potential. For example, insureds with frame houses are placed in one
classification for fire insurance, and insureds with brick houses are placed in another,
because the probable severity of a fire loss is greater for a frame house Similarly, where
permitted, insurers group drivers into separate classifications so that young, inexperienced
drivers are charged more than experienced drivers, and insureds who use their cars for
business are charged more than insureds who do not. Insureds with similar characteristics
are placed in the same class and charged the same rate.

One goal of an insurer's actuarial staff is to develop a ratemaking system that generates fair,
equitable rates and meets corporate objective. Attaining this goal requires actuaries to

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

constantly monitor and update loss data to develop rates that state regulatory authorities
will approve.

Objectives of Rates Regulation

Rate regulation serves the following three general objectives:
1. To ensure that rates are adequate.
2. To ensure that rates are not excessive
3. To ensure that rates are not unfairly discriminatory.

The first objective of rate regulation is to ensure that rates are adequate. When rates are
adequate, the price charged for a given type of insurance coverage should be high enough
to meet all anticipated losses and expenses associated with coverage while generating a
reasonable profit for the insurer. Rate adequacy helps insurers remain solvent so that they
can meet obligations to policyholders. Therefore, rate regulation attempts to ensure that
rates are adequate.

Adequacy is not always easy to achieve. It is virtually impossible to guarantee that

premiums paid by insureds will be adequate to cover insureds losses. Even when a large
group of similar exposure units is covered, unexpected events - such as a natural disaster -
might lead to losses significantly higher than those predicted when rates were originally set.
For example, when Hurricane Andrew hit the southeastern U.S. in 1992, the resulting
unexpected losses exceeded the predictions that had been used to rate the policies that
covered these losses.

The goal of rate adequacy conflicts with pressures to keep insurance premiums at a
reasonable level. An insurer might have difficulty competing if its rates are substantially
higher than those charged by other insurers providing similar coverage and service. Also,
although insurance regulators desire rate adequacy to maintain insurer solvency, other
pressure encourage regulators to keep rates low.

The second objective of rate regulation is to ensure that rates are not excessive. States also
require that insurance rates not be excessive. Excessive rates could cause insurers to earn
profits that regulators deem to be unreasonable. Determining whether rates are either
excessive or inadequate is difficult, especially because insurers must price insurance policies
long before the results of the pricing decision are known. Nevertheless, when regulators
determine that insurers have earned substantial profits in a particular type of insurance,
they may require insurers to reduce rates or to return the "excess profit" to policyholders.

One concept involves actuarial equity - basing rates on actuarially calculated costs of losses.
Under this concept, actuaries define rate classifications and calculate rate based on the loss

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

experience of each given class. Insureds with similar characteristics are placed in the same
rating class charged the same rate. Thus, the premium should accurately reflect each
insured's expected contribution to the losses of a group of similar insureds.

On the other hand, social equity holds that rate structures discriminate unfairly if they
impose a higher rate on an insured for factors beyond the insured's control, such as age or
gender. The notion of social equity is also used to suppress rates for classes of insureds
when affordability is a concern or when insurance rates can be used to further public policy.
For example, regulators may believe that employed people need cars to drive to work, but
that high insurance rates may prohibit them from owning a vehicle or compel them to drive
uninsured. The concept of social equity is applied in such cases when regulators enforce
rate caps for inexperienced or urban drivers. In certain states, age and gender are no longer
allowed as factors in rating auto insurance on the grounds that they are unfairly
discriminatory.

Rate regulation attempts to balance the concepts of actuarial equity and social equity in
determining whether a particular rating plan involves unfair discrimination.

Insurance Rating Laws

States have developed a variety of laws to regulate insurance rates in an attempt to balance
conflicting objectives. Rate regulation varies by state, and different laws might apply to
different types of insurance within a state. Despite these differences, the various insurance
rating laws fall into the following categories:

 Prior-approval laws. These are used in many states and require that rates be approved
by the state insurance department before they can be used. Insurers must also provide
data that show that the rates are not excessive, inadequate, or unfairly discriminatory.
The commissioner has a certain time period, typically thirty to ninety days, to approve
or reject the filing. Some states have a “deemer provision” (or “delayed effect” clause)
that deems the rates approved if the commissioner does not respond to a rate filing
within the specified time period.
 Flex rating laws. Under these laws, prior approval is required only if the new rates are a
specified percentage above or below previously filed rates. Insurers are permitted to
increase or reduce their rates within the specified range without prior approval.
Percentage ranges vary by state and by type of insurance, but they are generally
between3 percent and 25 percent.
 File-and use laws. These laws require insurers to file rates with the state insurance
department before the rates become effective. However, insurers are not required to
wait for approval before using the rates.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Use-and-file law. These laws require that rates be filed within a specified period, often
fifteen or thirty days, after they are first used in the state.
 Open competition, or no-file laws. In some states, insurers are not required to file rates
or rating plans with the state insurance department. This approach is called open
competition, because it permits insurers to compete with one another by quickly
changing rates without review by state regulators. Market forces rather than
administrative action determine rates under this approach. Advocates of open
competition often cite the Illinois private passenger auto insurance market, free of rate
regulation since the early 1970s. yet with lower rates, fewer uninsured drivers, higher
numbers of competing insurers, and a smaller residual market than other states with
comparable urban areas.
 State-mandated rates. These laws require all insurers to adhere to rates established by
the state insurance department for a particular type of insurance, such as worker’s
compensation.

Modified versions of these laws also exist. For example, modified prior-approval laws
permit an insurer to revise rates without prior approval if the revision is based solely on a
change in the insurer’s loss experience.
Another example is a modified open competition law, which allows open competition as
long as certain tests are met, such as evidence of competitive markets or rate increase of
less than a certain percentage per year.
Insurance rating laws that do not require prior approval of rates do not relieve insurance of
their obligation to use rates that are adequate, not excessive, and not unfairly
discriminatory. State insurance departments can and do exercise their legal right to request,
at a later date, the statistics that support the fairness of the new rate.

The following are three broad exceptions to these insurance rating laws:

1. Exempt commercial policyholders. These are organizations of sufficient size and

sophistication that they are permitted to buy property, liability, and automobile
insurance using rates and / or policy forms not filed with state insurance departments.
Many states adopted such a concept in the late 1990s.
2. Non-filed inland marine. Many classes of inland marine insurance (which covers a
wide range of usually land-based risk associated with transportation or
communication) are exempt from filing requirement. Such exemptions differ by state.
The justification is that the types of exposures qualifying as non-filed can vary greatly
from one insured to the next, such that using standard forms and rates is impractical.
3. Excess and surplus lines insurance. When needed insurance is not available in the
standard market, coverage may be provided by insurers that are exempt from rate

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

and form regulation. These coverage and insurers are discussed in greater detail later
in this chapter.

Solvency Surveillance
Solvency is an insurer’s ability to meet its financial obligations as they become due, even
those resulting from insured losses that may be claimed several years in the future. In an
effort to ensure solvency, insurance regulators carefully monitor insurer’s financial
condition. This process is called solvency surveillance and involves determining whether an
insurer’s financial condition is sufficient for it to meet its meet its financial obligations and
remain in business. Two major aspects of solvency surveillance are insurer examinations
and the Insurance Regulatory Information System (IRIS).

Insurer Examinations
Regulatory authorities periodically examine insurers. An examination consists of a thorough
analysis of an insurer’s operations and finical condition. This analysis usually occurs every
few years under the direction of the insurance department of the state where the insurer’s
home office is located. During an examination a team of state examiners reviews a wide
range of activities, including claim, underwriting, marketing, and accounting procedures. In
addition, the insurer’s financial records are carefully analyzed to ensure that the company is
meeting all state financial reporting requirements and to determine whether the insurer has
the ability to meet its obligations. If the examination uncovers problems, the insurance
department usually has broad powers to take control of the situation to correct whatever
problems are identified.

Insurance Regulatory Information System (IRIS)

The Insurance Regulatory Information System (IRIS) is an information and early-warning
system established and operated by the NAIC to monitor insurers' financial soundness. IRIS
uses data from an insurer's financial statements to develop twelve financial ratios that
determine the insurer's overall financial condition. If the insurer has ratios that are outside
predetermined norms, IRIS identifies the company for regulatory attention.
IRIS provides all state insurance departments with a timely and objective method of
identifying companies that might have financial problems. Although the system does not
always identify a problem before a financial crisis occurs, it is an important tool for solvency
surveillance.
Consumer Protection
In addition to rate regulation and solvency surveillance, the activities that regulators
undertake to protect insurance consumers include:
 Licensing insurers

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Licensing insurer representatives

 Approving policy forms
 Examining market conduct
 Investigating consumer complaints

Licensing Insurers
Most insurers must be licensed by the state insurance department before they are
authorized to write insurance policies in that state. A licensed insurer (also called an
admitted insurer) is one that the state insurance department has authorized to sell
insurance in that state. An insurer that is incorporated in the same state in which it is
writing insurance is known as a domestic insurer. An insurer that is licensed to operate in a
state but is incorporated under the laws of another state is known as a foreign insurer. A
licensed insurer that is incorporated in another country is called an alien insurer.

For example, an insurer that is incorporated in Massachusetts is considered a domestic

insurer in that state. However, if the same insurer is also licensed to operate in New
Hampshire and Vermont, it is considered a foreign insurer in those two states. An insurer
that is incorporated in London, England, is considered an alien insurer in the U.S.

A primary requirement for obtaining an insurance license involves tests of financial

strength. Each state has specific requirements concerning the minimum amount of surplus
an insurer must have to be licensed in the state. Surplus, in its simplest form, is assets
(property owned such as money, stocks, bonds, buildings, land, and accounts receivable)
minus liabilities (financial obligations or debts). The required amount of surplus varies,
depending on the state and the state and the type of insurance for which the company
wants to be licensed. If an insurer fails to meet financial standards or fails to operate in a
manner consistent with state insurance laws, state regulators have the authority to revoke
or suspend the company’s license in order to protect consumers’ interests.

Licensing Insurer Representatives

In addition to licensing insurers, all states have licensing requirements for certain insurer
representatives. All states require insurance agents to be licensed to transact insurance
business in the state. A license is usually granted only after the applicant passes an
examination on insurance laws and practices. Most states have similar requirements for
insurance brokers. Claim representatives (also known as adjusters) are also required to be
licensed in some states before they are allowed to handle claims. (Later chapters explain
the roles of insurance agents and brokers and the duties of claim representatives.)

In most states, the agent, broker, or claim representative must complete a prescribed
amount of continuing education during a specified period before renewing a license.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Licensing and continuing education laws vary widely by state, but all attempt to ensure that
insurer representatives have a prescribed minimum level of insurance knowledge.

Approving Policy Forms

Many states require insurers to file their policy forms with the state insurance department
in a manner similar to the method used for rate filings. Whenever an insurer wants to
change the language of a particular policy in these states, it must submit the new form for
approval. Such a requirement is waived for exempt commercial policyholders in states that
have deregulated commercial insurance.

By regulating policy language, the state insurance department prevents insurers from
including unfair or unreasonable provisions in insurance policies. Although the possibility
always exists that that an insured might misinterpret the policy, regulatory approval of
policy forms reduces the possibility of misleading wording. Having clear and readable
insurance policies is a goal of most regulators. In many cases, states also prescribe specific
wording that must be included in insurance policies, such as cancellation requirements and
procedures.

Examining Market Conduct

Regulators also scrutinize specific insurer practices. Market conduct regulation focuses on
the practices of insurers in regard to four areas of operation: sales practices, underwriting
practices, claim practices, and bad-faith actions.

Most states have statutes, usually called unfair trade practices laws that identify certain
practices that are considered unfair to the public. State regulators could suspend or revoke
the licenses of insurance agents or brokers who engage in any of these unfair trade
practices. Similarly, an insurer guilty of unfair underwriting practices could be fined or have
its operating license suspended or revoked in the state. Most states also have statutes that
prohibit unfair claim practices and assess fines against claim representatives and insurers
that engage in such practices.

Investigating Consumer Complaints

Regulatory examinations of insurers identify some of the abuses mentioned previously, but
other abuses are exposed only when and insured or a claimant lodges a complaint. Every
state insurance department has a consumer complaints division to investigate consumer
complaints and help insureds deal with problems they have encountered with insurers and
their representatives.

EXCESS AND SURPLUS LINES INSURANCE

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Most property-casualty insurance policies are standardized, and many insurers use
essentially the same policy forms. Insurers who voluntarily offer insurance coverage’s at
rates designed for customers with average or better-than-average loss exposures are known
collectively as the standard market. Such insurers write the majority of commercial
property-casualty insurance in the U.S.

In most cases, the standard market provides the policies necessary to meet the property-
casualty insurance needs of the public. But what about the unique or unusual exposures
that the standard market is unwilling or unable to insure? Poor loss experience or expected
losses associated with certain classes of business might not meet standard insurers,
underwriting requirements. Changes in business practices or technology might create new
loss exposures not contemplated in traditional insurance policies. These exposures require a
creative, nontraditional insurance market. The term “excess and surplus lines” is often used
to identify this nontraditional market. Likewise, excess and surplus lines (E&S) insurance
consists of insurance coverage’s unavailable in the standard market.

Classes of E&S Business

The following classes of business are often insured in the E&S market:

 Unusual or unique loss exposures

 Nonstandard business
 Insureds needing high limits of coverage
 Insureds needing unusually broad coverage
 Loss exposures that require new forms

Unusual or Unique Loss Exposures

One of the usual requirements of a commercially insurable loss exposure is that a large
number of similar exposure units should exist. If an exposure does not meet this
requirement, the coverage is difficult to price and therefore standard insurers are often
unwilling to provide coverage. For example, suppose a singer does not show up for a
concert. The sponsors of the concert can suffer a financial loss if they have to refund money
to ticket holders. A coverage known as “non-appearance insurance,” written by E&S
insurers, covers the losses of the show sponsors if the performer named in the policy fails to
appear because of a covered cause, such as injury, illness, or death.

Nonstandard Business
Sometimes loss exposures do not meet the underwriting requirements of the standard
insurance market. There may be evidence of poor loss experience that cannot be

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

adequately controlled. Perhaps the premiums that standard insurers normally charge are
not adequate to cover these exposures. For example, consider the case of a restaurant that
has a history of grease fires in its kitchen. Its standard insurer has decided not to renew its
policy because of poor loss experience. An E&S insurer may be willing to write insurance for
this restaurant with a premium substantially higher than standard insurer would charge.

Insureds Needing High Limits of Coverage

Some businesses demand very high limits of coverage, especially for liability insurance. For
example, a corporation involved in shipping oil in large tankers needs higher liability limits
than those available in the standard market. A standard insurer may not be willing to offer
limits as high as an insured needs. The E&S market often provides the needed limits in
excess of the limits written by a standard unsure.

Insureds Needing Unusually Broad Coverage

The traditional insurance market uses standard coverage forms developed through advisory
organization, such as Insurance Services Office (ISO) and the American Association of
Insurance Services (AAIS). When broader coverage is necessary, however, producers and
insureds often seek such coverage from the E&S market.

Loss Exposures That Require New Forms

Creativity has long been a distinguishing characteristic of the E&S market. As new insurance
needs arise, the E&S market is usually quick to respond. Producers and consumers often
turn to the E&S market when they have an immediate need for a new type of coverage,
such as coverage for media liability, including the insured’s Web site.

Excess and Surplus Lines Regulation

Excess and surplus lines insurance is usually written by non-admitted insurers (also called
unlicensed insurers), which are not licensed in many of the states in which they operate.
Non-admitted insurers are not required to file their rates and policy forms with state
insurance departments, providing them with more flexibility than that of standard insurers.
Although non-admitted insurers are exempt from rate and form filing laws and regulations,
the E&S market is subject to regulation. Some states maintain lists of E&S insurers that are
approved to do business in the state; others keep lists of those insurers that are not
approved. Most states have surplus lines laws that require that all E&S business be placed
through an E&S broker. When an insurance producer seeks to insure a customer with a no
admitted insurer, he or she must arrange for an E&S broker to handle the transaction.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

E&S insurers and brokers provide a valuable service to the insurance industry and to the
public. They provide insurance to many insureds who might otherwise be unable to obtain
coverage. They find solutions to problems created by unusual or unique loss exposures.

SUMMARY
In the U.S., private provide most property-casualty insurance, but both federal and state
governments also provide some types of insurance. Most private insurers are either stock or
mutual companies. Other types of private companies or groups that provide insurance

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

include reciprocal insurance exchanges, Lloyd’s, American Lloyds, captive insurers and
reinsurance companies.

Private insurers are generally reluctant to insure loss exposures that do not possess most of
the characteristics of an ideally insurable loss exposure. In some instances, state and federal
governments have intervened to make certain types of insurance available to the public.
Government insurance programs address needs for insurance coverage that are not
satisfied by private insurers. Examples of federal government insurance programs include
the Social Security program, the National Flood Insurance Program, and the Federal Crop
Insurance Program. State government also provide various insurance programs, including
state workers’ compensation funds, unemployment insurance programs, automobile
insurance plans, FAIR plans, and beachfront and windstorm pools. In addition, all states
have insurance guaranty funds that cover insolvent insurers’ unpaid claims.

Because insurance is a business that affects the public, state governments are heavily
involved in the regulation of the insurance industry. State insurance departments are
responsible for most insurance regulation. The NAIC provides coordination among
insurance departments, but has no regulatory authority of its own. Insurance departments
regulate insurance rates to ensure they are adequate, not excessive, and not unfairly
discriminatory. Insurers and their actuaries develop insurance rates in a process called
ratemaking. However, these rates are subject to various state insurance rating laws.

Solvency is another major concern of insurance regulators. Through periodic examinations

of insurers’ financial condition and use of IRIS, regulators conduct solvency surveillance to
monitor insurers’ financial soundness.

Regulators also try to protect consumers by licensing qualified insurers and their
representatives, approving policy forms, examining market conduct, and investigating
consumer complaints. Through the licensing of E&S brokers, state insurance regulators also
regulate the E&S market, which provides insurance coverage’s that are unavailable in the
standard market.

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Measuring the Financial Chapter 3

Performance of Insurers

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Sound management of an insurer requires careful attentions to its financial performance.

One concern about any insurer's financial performance is its profitability: Does the insurer
generate enough profit to survive? A related concern is the insurer's solvency: Does the
insurer have adequate resources to meet all of its financial obligations? Insurers prepare
and analyze financial statements to monitor and report on their financial performance.
Other interested parties also analyze the financial statements of insurers. Other interested
parties also analyze the financial statements of insurers. For example, state insurance
regulators want to monitor insurers' financial performance over time to identity any
financial difficulties; insurers' financial performance over time to identify and financial
difficulties; insureds want to select insurers that have the financial resources to promptly
pay covered losses; and investors want to determine the insurers' potential for growth and
profitability.

INSURER PROFITABILITY
To survive long term, an insurer must generate more money than it spends, that is, the
insurer's revenue must exceed its expenses. In a given month or year, an insurer's expenses
might exceed its revenues, requiring the insurer to pay some of those expenses with
accumulated funds. Such a pattern, however, will eventually deplete accumulated funds,
and the insurer will fail. Like any other business, an insurer must manage its revenue and
expenses to produce and overall income (revenue minus expenses) gain from its operations
and to ensure the profitability on which its survival depends.

Insurers receive income from two major sources: (1) the sale of insurance and (2) the
investment of funds. The first source generates underwriting income. Underwriting income
(gain or loss) is the amount remaining after underwriting losses and expenses are
subtracted from premiums. The second source generates investment income. Investment
income (gain or loss) is the amount earned on investments during the period. While some
insurers receive other income from the sale of specialized services or other incidental
activities, most of the income an insurer receives is either underwriting income or
investment income.

During a particular calendar year, an insurer calculates its written premiums by totaling the
premiums charged on all policies written with effective dates of January 1 through
December 31 of that year. Written premiums are the total premiums on al policies put into
effect, or "written," during a given period. For example, when a policy is written to become
effective on July 1 for a premium of $600, that entire $600 is counted as written premiums
on July 1, even though it may not have yet been collected by the insurer. If the policy is
changed on September 12 and a $75 refund is generated, the insurer's written premiums
are reduced by $75 on September 12. Although written premiums provide a source of cash

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

for insurers, rules of accounting allow insurers to recognize only earned premiums on the
income statement.

Earned premiums are the portion of the written premiums that apply to the part of the
policy period that has already occurred. The remaining portion of written premiums apply
to the part of the policy period that the not yet occurred and is therefore called unearned
premiums, representing insurance coverage yet to be provided.

The concept of earned and unearned premiums can be compared to how a magazine
subscription might operate. When a subscriber pays a %24 annual subscription fee for a
monthly magazine, the publisher does not "earn" the entire $24 subscription amount until
the magazine has been provided for twelve months. If the subscriber cancels the
subscription after receiving only six monthly issues, the publisher might refund $12, or half
of the subscription amount (the "unearned" portion).

Likewise, when an insured pays a premium of $600 on July 1 for a one-year policy, the $600
premium is not fully “earned” until the end of the twelve-month coverage period. The
entire $600, however, is considered written premiums for the current calendar year. As
Exhibit 3-1 shows, only half of the $600 annual premium paid on July 1 is earned as of the
end of the calendar year because only six months, or half of the protection period, has
passed. Therefore, at the end of the calendar year, the insurer calculates $300 of earned
premiums for this policy and $300 of unearned premiums. During the next calendar year,
between January 1 and July 1, the unearned portion of the premium is earned as coverage
provided by the insurer. If this policy is not renewed on July 1 of the second year, the
insurer records no written premiums for this policy in the second year (remember that the
entire $600 was considered to be written during the first year). The insurer records only the
earned premiums of $300 from the previous year's written premium. See Exhibit 3-2 for two
cases showing written premiums, earned premiums, and unearned premiums.

Exhibit 3-1

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Earned Premiums– One-Year Policy Issued on July 1 for $600

1/1 7/1 12/31 7/1 12/31

Policy Issued Policy Expires

Policy Term
$300 $300
Premiums Earned Premiums
Earned

Underwriting Income
As mentioned, underwriting income is the amount of income (gain or loss) after losses and
expenses are subtracted from premiums that are earned. Premiums are the money an
insurer receives from its policyholders in return for the insurance coverage provided. In
effect, premiums are the revenue from the insurer's underwriting operations. The losses
paid by the insurer's policies plus the expenses associated with controlling and adjusting
those losses are the primary underwriting expenses.
When calculating underwriting income for the year, or for any other period, an insurer must
determine the portion of its total policy premiums generated during the period (written
premiums) that it earned (earned premiums) and the portion it did not yet earn (unearned
premiums).

Investment Income
Because an insurer collects premiums from its policyholders and pay claims for its
policyholders, the insurer handles large amounts of money. Insurers invest available funds
to generate additional income. Investment income can be substantial, particularly during
periods of high interest rates or high returns in the stock market.
An insurer has investment funds available for two reasons. First, the insurer is legally
required to maintain a certain amount of funds, called policyholders' surplus, so it can meet
its obligations even after catastrophic losses. (Policyholders' surplus is discussed later in this
chapter.) Provided that the insurer is operating profitably, its policyholders’ surplus is
generally available for investment. Second, the insurer usually receives premiums before it
pays claims on the corresponding policies. Thus, an insurer can invest premiums and earn
additional income until those funds are needed to pay claims. However, when an insurer
settles claims, it must have funds readily available to meet its obligations. Similarly, if a
policy it canceled before the end the policy period, the insurer must be able to refund the
unearned premiums.
Insurers have investment departments whose objective it to earn the highest possible
return from investments while ensuring the funds are always available to meet the insurer's

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

obligations. Thus, the investment department must select high-quality investments that are
relatively secure and that can be readily converted to cash. One investment strategy may
involve buying long-term bonds that are scheduled for maturity to match expected claim
payment needs.

For an insurer to be profitable, its combined revenue from earned premiums and
investment income must exceed its total loss payments and other expenses. Loss payments,
as well as the various other types of expenses that an insurer incurs, are discussed next.

EXHIBIT 3-2
Examples of Written Premiums, Earned Premiums, and Unearned
Premiums
Case 1
Annual Policy with $600 premium is effective July1.
At the end of the Calendar Year 1:
Written premiums = $600.
Earned premiums = $300(6 of the 12 months of coverage have elapsed).
Unearned premiums = $300 (6 of the 12 months of coverage have not elapsed).
At the end of Calendar year 2(assuming the policy is not renewed):
Written premiums = $0.
Earned premiums = $300(the remaining 6 months of coverage have elapsed).
Unearned premiums = $0 (there is no more coverage; all the premium is earned).

Case 2
Annual Policy with $600 premium is effective December 1.
At the end of the Calendar Year 1:
Written premiums = $600.
Earned premiums = $50(1 of the 12 months of coverage have elapsed).
Unearned premiums = $550 (11 of the 12 months of coverage have not elapsed).
At the end of Calendar year 2(assuming the policy is not renewed):
Written premiums = $0.
Earned premiums = $550(the remaining 11 months of coverage have elapsed).

Unearned premiums = $0 (there is no more coverage; all the premium is earned).

In each case, the written premiums and the earned premiums total $600 by the time the
coverage has expired. However, all of the written premiums are recorded immediately,
while the earned premiums are counted as they are earned over time. In both cases, the
unearned premiums disappear by the expiration date of the policy because all of the
written premiums have been earned by the time the policy period ends.
Expenses

An insurer’s expenses fall into two broad categories: (1) expenses associated with
underwriting activities and (2) expenses associated with investment activities. Expenses

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

associated with underwriting activity include payment for losses, adjustment expenses, and
other underwriting expenses. Some insurers also pay dividends to their policyholders.
Expenses associated with investment activities include salaries and other general expenses
related to running the investment department.

Losses

The major expense category for most insurers is payment for losses arising from claims.
Claims are demands for payments made by insureds based on the conditions specified in
their insurance policies. For property-casualty insurers, loss payments often represent 70 to
80 percent of their total costs.

Claims are not necessarily settled immediately after a loss occurs. Sometimes the loss is not
reported right away. When the loss is reported, the insurer's claim representative
investigates the loss and verifies whether the loss is covered before the insurer pays the
claim. Liability claims may involve lengthy legal proceedings. Some losses occur in one year
but are settled in a later year. In any given year, an insurer knows only the amount of losses
it has paid so far, but not a definite amount it will ultimately have to pay. To compare
revenue and expenses, an insurer must calculate not only its paid losses but also its incurred
losses for the period.

A paid loss is a claim payment that an insurer has made. Because it has been paid, a paid
loss is a definite amount. Paid losses, however, do not include those losses in the process of
settlement or losses that are incurred but not reported losses in the process of settlement
or losses that are incurred but not reported (IBNR). Therefore, another method to measure
losses is to calculate incurred losses for a particular period. Incurred losses are the sum of
paid losses and changes in loss reserves for a particular period and are calculated as follows:

Incurred losses= Paid losses+ Changes in loss reserves

Loss reserves are amounts designated by insurers to pay claims for losses that have already
occurred but are not yet settled. Changes in loss reserves are calculated as follows:

Changes in loss reserves= Loss reserves at end of period- Loss reserves at beginning of period

Because setting loss reserves for individual claims is an important part of the claim process,
it is discussed in more detail later in this text.

Loss Adjustment Expenses

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Insurers also incur loss adjustment expenses related to investigating and settling insurance
claims. For property insurance claims, the claim representative must identify the loss is
covered, the claim representative must determine the covered amount.

For liability claims, the claim representative must determine whether the insured is legally
responsible for the bodily injury or property damage that is the basis of the claim and, if so
for how much. Determining the legal responsibility of the insured for a loss might require a
complex and costly investigation. In addition to paying covered losses, liability insurers
often pay the costs to defend the insured in the event of a lawsuit, regardless of whether
the insured is ultimately held responsible for the damages. Thus, loss adjustment expenses
associated with a liability claim can be substantial.

Other Underwriting Expenses

In addition to losses and loss adjustment expenses, the costs of providing insurance include
other significant underwriting expenses, which can be categorized as follows:
 Acquisition expenses
 General expenses
 Premium taxes, licenses, and fees

The expenses associated with acquiring new business are significant. All property-casualty
insurers have a marketing system to market and distribute their products. This system
includes individuals involved directly with sales (usually called agents, brokers, producers,
or sales representatives) and the administrative staff that manages and supports the sales
effort. Many people who directly generate insurance sales for insurers receive a
commission, which is usually a percentage of the premiums written by the salesperson.
Others receive a salary, or a combination of salary and commission, and sometimes also a
bonus based on sales, profit, or some other measure of productivity. While some insurers
operate without salespeople (usually through direct response systems such as mail,
telephone, and the Internet), these insurers must still employ and pay staff to manage and
administer their marketing operations. Advertising expenses can also be a significant
component of acquisition expenses for most insurers.

Insurers incur still other expenses in the process of underwriting and issuing insurance
policies. They need staff and computer systems to review and analyze applications for
insurance, assemble and issue insurance policies, generate billing statements, collect
premiums, and record necessary information.

Like other businesses, insurers incur various general expenses. While these expenses do not
relate directly to activities such as claims, marketing, and underwriting, they are crucial to

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

the insurers’ operations. These general expenses are associated with staffing and
maintaining departments such as accounting, legal, statistical and data management,
actuarial, customer service, information technology, and building maintenance. In addition,
insurers must provide office space, telephones, computers, and other utility services, as well
as other office equipment and supplies for these necessary support functions.

In the United States, states levy premium taxes, which are usually between 2 and 4 percent
of all premiums generated by the insurer in a particular state.

Unless they function as excess and surplus lines insurers, insurers must hold and pay for
licenses in each state in which they operate. In addition, insurers must participate in various
state insurance programs, such as guaranty funds and automobile insurance plans. Insurers
are typically assessed to fund or subsidize these state insurance programs.

Dividends
Some insurers choose to return a portion of premiums to policyholders as dividends, which
may be paid out on a regular basis or may be associated with a special circumstance.
Mutual insurers may pay a dividend to policyholders when operating results have been
good. Dividends may also be paid by any insurer as a marketing technique. Insurers who
want to provide the lowest cost of their policyholders may prefer to accomplish that by
paying dividends only after their operating results warrant such payments. In this way, the
insurer's solvency is better protected than it would be by charging low rates up front with
little margin for error.

Investment Expenses
An insurer's investment department includes a staff of professional investment managers
who oversee the company's investment program. In addition to devising investment
strategy and implementing it through the purchase and sale of stocks, bonds, and other
investments, the investment department is responsible for a careful and through
accounting of all investment funds. Investment expenses include staff salaries and all other
expenses related to the activities of the investment department. Insurers deduct these
expenses from investment income on their financial statement. Insurers deduct these
expenses from investment income on their financial statements to calculate the net income
from investments, as shown in the following:

Net investment income = Investment income - Investment expenses

Gains or losses realized from the sale of invested assets are added to net investment
income resulting in net investment gain or loss, which represents the total results from
investment activities.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Gain or Loss From Operations

An insurer's net underwriting gain or loss is its earned premiums minus its losses and
underwriting expenses for a specific period. Adding net investment gain or loss to net
underwriting gain or loss shows an insurer's overall gain or loss from operations and is
reported by the following formula:

Overall gain or loss operations = Net investment gain or loss + Net underwriting gain or loss

This overall figure gives a more complete picture or an insurer's profitability than net
underwriting gain or loss because net investment gains generally help to offset underwriting
losses.

Net Income Before Taxes

An insurer's net income before taxes is its total earned premiums and investment income
minus its total losses and other expenses in the corresponding period. Some adjustments
for other income items might be necessary. For example, the insurer might have to write off
some uncollected premiums, or it might have to add premiums that were written off during
the previous period but were ultimately collected during the current period. Adjustments
might also be necessary for a gain or loss on the sale of equipment or other items. Mutual
insurers would also deduct dividends to policyholders from their income.

Income Taxes
Like other businesses, insurers pay income taxes on their taxable income. Taxable income
might differ from net income before taxes because of the special requirements of the tax
code. For example, a portion of interest earnings from qualified municipal bonds are not
taxed, and deductions for certain expenses are limited. Insurers often adjust their
investment strategy in response to changing tax laws.

Net Income or Loss

After an insurer has paid losses and reserved money to pay additional losses, expenses, and
income taxes, the reminder is net income, which belongs to the owners of the company.
The owners may receive a portion of this reminder as dividends. For a publicly held
company, such dividends are payable to the shareholders. The amount that is left after
dividends are paid becomes an addition to the insurer's surplus, which enables the insurer
to expand its operations in the future. When evaluating insurer's rates, regulators permit an
allowance for profits and contingencies that should provide the owners with an adequate
return on their investment. Unless the insurer generates an adequate return or profit, it will
not attract and maintain the investment funds it needs to survive.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

INSURER SOLVENCY
To serve its policyholders in the long term, a property - casualty insurer must remain
financially sound. Although comparing an insurer's revenue to its expenses in a single year
reveals whether the company produced an income gain or a loss, this information alone
does not indicate the insurer's financial condition. The financial position of an insurer at any
particular time is measured by its assets, liabilities, and policyholder's surplus. Exhibit 3-3,
later in this text, shows the balance sheet relationship of assets, liabilities, and
policyholders’ surplus. These are discussed next.

Assets
Insurers accumulate funds when they receive premium and investment income. As stated
previously, insurers do not immediately need all of their premium income to pay claims and
operating expenses. In the meantime, insurers invests them in income - producing assets.

Assets are types of property, both tangible and intangible, owned by an entity. Assets
typically accumulated by an insurer include cash, stock, and bonds; property, such as
buildings, office furniture, and equipment; and accounts receivable from policyholders,
agents, brokers, and reinsurers.

For the purposes of fitting financial reports with state insurance regulators, an insurer's
assets are classified as either admitted assets or non-admitted assets.

Admitted Assets
Admitted assets are types of property, such as cash and stocks, that regulators allow
insurers to show as assets on their financial statements. Regulators allow admitted assets to
be shown on insurers' financial statements because these assets could easily be liquidated,
or converted to cash, at or near the property's market value. In addition to cash, admitted
assets include stocks, bonds, mortgages, real estates, certain computer equipment, and
premium balances due in less than ninety days.

Non-admitted Assets
Non-admitted assets are types of property that cannot be readily converted to cash at or
near their market value if the insurer were liquidate its holdings. For this reason, regulators
do not allow insurers to show them as assets on their financial statements. Non-admitted
assets include office equipment, furniture and supplies, and premiums that are more than
ninety days overdue.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The creation of the two categories of assets - admitted and non- admitted reflects the
conservative view that insurance regulators take when evaluating an insurers' financial
condition. Regulators do not want to overstate their true financial condition. Therefore,
certain types of assets are deemed non-admitted and cannot be counted toward the value
of an insurer's holdings or its financial strength.

Liabilities
Liabilities are financial obligations, or debts, owed by a company to another entity. An
insurer has a financial obligation to its policyholders: It must satisfy legitimate claims
submitted by insureds and other parties. The major liabilities of an insurer arise from this
financial obligation to pay claims. Three types of liabilities are found on an insurer's financial
statements. The two major liabilities are the loss reserve and the loss expense reserve, and
the unearned premium reserve. The third type is "all other" liabilities, typically small
obligations that are considered miscellaneous liabilities.

Loss Reserve and Loss Expense Reserve

The loss reserve is amount estimated and set aside by insurers to pay claims for losses that
have already occurred but are not yet settled. The loss reserve is considered a liability
because it represents a financial obligation owed by the insurer. It is the insurer's best
estimate of the financial settlement amount on all claims that have occurred but have not
yet been settled. Although establishing loss reserves for claims whose value is not yet
definite might seem impossible, insurers use their experience, the law of large numbers,
and their actuarial and statistical expertise to make reliable estimates of future claim
settlement values. Insurers also set up the loss expense reserve to estimate the cost of
settling the claims included in the loss reserve.

Unearned Premium Reserve

The unearned premium reserve is the total of an insurer's unearned premiums on all
policies at a particular time. The unearned premium reserve is a liability because it
represents insurance premiums prepaid by insureds for services that the insurer has not yet
rendered. If the insurer ceased operations and canceled all of its policies, the unearned
premium reserve would represent the total of premium refunds that the insurer would owe
its current policyholders.

Other Liabilities

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

As mentioned, other liabilities on an insurer's financial statements are much smaller than
the loss reserve and the loss expense reserve, and the unearned premium reserve. For
some insurers, there may be a significant obligation reflected in the liability for reinsurance
transactions.

Policyholders' Surplus
Once the total value of an insurer's admitted assets (cash, stocks, bonds, real estate, and so
forth) and liabilities (loss reserve and loss expense reserve, unearned premium reserve, and
other liabilities) is known, the insurer can determine its policyholders' surplus.
Policyholder's surplus equals the insurer's total admitted assets minus its total liabilities.
Policyholders' surplus measures the difference between what the company owns (its
admitted assets) and what it owes (its liabilities).

Policyholder's surplus provides a cushion that is available should the insurer have an
adverse financial experience. While premiums may include a margin for error, that margin
might not be sufficient to offset unexpected losses, particularly catastrophic losses. If losses
exceed expectations, the insurer must draw on its surplus to make required claim
payments. Policyholder's surplus also provides the necessary resources if the insurer
decides to expand into a new territory or develop new insurance products. Thus, the
amount of policyholders' surplus held by an insurer is an important measure of its financial
condition.

Exhibit 3-3 summarizes the admitted assets, liabilities, and policyholder's surplus held by
the property-casualty industry in 2003.

EXHIBIT 3-3

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Consolidated Balance Sheet for the Property-Casualty Industry (2,380 Companies)

(In millions of dollars)

Admitted Assets
Cash and Short-term Investments $89,251
Bonds 642,839
Preferred Stock 9,205
Common Stock 126,560
Real Estate 9,466
Other Assets 297,007

Total Admitted Assets $1,174,328

Liabilities
Loss Reserve and Loss Expense Reserve $445,422
Unearned Premium Reserve 176,311
Conditional Reserve Funds 19,892
Other Liabilities 178,854

Total Liabilities $820,479

Policyholders’ Surplus 353,849

Total Liabilities and Policyholders’ Surplus $1,174,328

MONITORING INSURER FINANCIAL PERFORMANCE

Because the objective of most insurers include being profitable and remaining in business in
the long term, insurers must carefully monitor their financial performance. Regulators,
investors, and others also monitor the financial performance of insurers.

Insurers must record and report financial information in a consistent manner, using various
financial statements. Interested parties can analyze these finance statements to evaluate
the insurers' financial performance. Insurance buyers, agents, and brokers often use the
reports and evaluations of financial rating organizations, such as A.M. Best Company and
Standard & Poor's Corporation, to select insurers that are considered to be in strong and
stable financial condition.

Financial Statements
Insurers must prepare accurate financial statements that describe the company's financial
position in an objective, standardized format. The two financial statements that provide the
most information the financial condition of an insurer are the balance sheet and the income
statement.

Balance Sheet

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The balance sheet shows an insurer's financial position at a particular point in time and
includes the insurer's admitted assets, liabilities, and policyholders' surplus. Exhibit 3-4
shows a condensed balance sheet for Atwell Insurer, a fiction insurer, on the last day of the
year.
Although a balance sheet shows an insurer's assets and liabilities only as of a particular
date, they change constantly. Insurers establish unearned premium reserves for premiums
they receive. The unearned premium reserve for each policy declines with the passage of
time. Also, losses occur and insurers establish loss reserves. Now policies are written, and
old policies expire or are renewed. Meanwhile, the insurer buys and sells stocks, bonds, and
other investments as needed to meet its obligations while earning investment Income.
Therefore, an analysis of an insurer's assets and liabilities is only as current as the date of
the balance sheet, which presents a snapshot of the financial position of the company at
that point in time.

EXHIBIT 3-4

The insurer
Atwell Insurer Balance Sheet as of Insurers
buys and sells December 31 establish
stocks, bonds, Admitted Assets: unearned
and other premium
Cash and short-term investments reserves for
investments as $50,000
needed to meet premiums they
its obligations Bonds 1,100,000 receive. The
Losses
while occur
earning unearned
and insurers Common stock 350,000 The unearned
premium
investment
establish loss premium
reserve is the
income. Total Admitted Assets
reserves. Loss reserve for
total of an
Liabilities:
$1,500,000
reserves are each policy
insurer’s
the amount Loss reserve and loss expense reserve declines
unearnedwith
estimated and $550,000 the
New passage
premiums onof
Policies
set aside by Unearned premium reserve time
all policies
are written,at a
and
insurers to pay 250,000 particular
old policestime.
claims for Other liabilities 200,000 expire or are
losses that
Policyholders’ renewed
Total Liabilities
have already
surplus is an
occurredtotal
insurer’s but $1,000,000
Policy holders’ Surplus 500,000
are not yet
admitted assets
settled.its total
minus Total Liabilities and policyholders’ Surplus
liabilities. $1,500,000

Income Statement
An insurer’s income statement shows its revenues, expenses, and net income for a
particular period, usually one year. Exhibit 3-5 shows a condensed income statement for
Atwell Insurer.

During the year, Atwell Insurer’s revenues from earned premiums totaled $1,000,000. In
the same year, the company’s expenses totaled $1,080,000. These expenses included
incurred losses, loss adjustment expenses, acquisition expenses, general expenses,

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

premium taxes, licenses, and fees. Because losses and underwriting expenses exceeded
earned premiums, Atwell Insurer experienced a net underwriting loss of $80,000. However,
Atwell also earned net investment income of $100,000 during the year. Therefore, Atwell
Insurer realized a net income gain of $20,000, before income taxes.

EXHIBIT 3-5

Atwell Insurer Income Statement for the Year

Ending December 31
Revenues : During the year,
In the same atwell insurer’s
year, the Earned Premiums revenues from
company’s $1,000,000 earned
expenses Expenses: premiums
totaled totaled
Incurred losses $650,000
$1,080,000. Because
$1,000,000.
These Loss adjustment expenses losses and
expenses 100,000 underwriting
include expenses
incurred Other underwriting expenses: exceeded
losses, loss Acquisition expenses 220,000 earned
adjustment premiums,
expenses, General expenses 90,000 Atwell Insurer
acquision experienced a
expenses,
Premium taxes, licenses, and fees
20,000 net
general During the year,
underwriting
Therefore,
expenses, Net Underwriting Gain (Loss) $
Atwell
loss ofinsurer’s
Atwell
premiuminsurer
taxes, (80,000)Total Expenses revenues
realized Net Investment Income
$1,080,000 100,000 $80,000. from
licenses,aand
net
earned
income
fees. gain of Net Income Before Income Taxes $ premiums
$20,000, before 20,000 totaled
income taxes.
$1,000,000.

Financial Statement Analysis

Analyzing the relationship of different items that appear on insurers’ financial statements
helps determine how well insurers are performing. Comparing two items produces a ratio
that highlights a particular aspect of financial performance. Several such ratios are widely
used in the insurance industry by many people and organizations. Insurers use them to
identify strengths and weaknesses in their companies’ operations. Investors analyze the
ratios to identify the insurers that are most attractive as investments. Regulators also
examine the ratios to determine whether insurers have the financial strength to remain
viable in the long term and to meet their financial obligations to policyholders and other
parties.

These ratios are important to insurance agents and brokers as well. The financial condition
of an insurer should be one of the factors considered when producers select the companies
with which they place business. Producers should be reasonably sure that an insurer is
financially sound and that it will be able to meet its financial obligations.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Profitability Ratios
There are several ratios for measuring the profitability of an insurer, including the following:
 Loss ratio
 Expense ratio
 Dividend ratio
 Combined ratio
 Investment income ratio
 Overall operating ratio

Profitability ratios are usually converted into percentages for easier analysis of financial
performance.

The loss ratio compares an insurer’s incurred loss to its earned premiums for a specify time
period. The figure for incurred losses includes loss adjustment expenses. The loss ratio is
calculated as follows:

Loss ratio=Incurred losses (including loss adjustment expenses)/Earned premiums

When converted into a percentage, the loss ratio indicates what proportion of earned
premiums is being used to fund losses and their settlement. By looking at this percentage,
insurers, regulators, investors, and others can determine how closely actual loss experience
compares to expected loss experience. For example, at the beginning of the year,
management might have decided that an 85 percent loss ratio is the target for the coming
year. As each month progressed, the loss ratio is recalculated based on the company’s
experience to date to determine whether the insurer is meeting the targeted 85 percent
ratio.

Incurred losses (including loss adjustment expenses)

Loss Ratio =
Earned Premiums
IF

Earned Premiums $1,000,000

Incurred losses (including loss adjustment expenses)
THEN $750,000
Incurred losses (including loss adjustment expenses)
Loss Ratio = Earned Premiums
$750,000
$1,000,000
= = 0.75 (or 75%)

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The expense ratio compares the insurers’ incurred underwriting expenses to its written
premiums in a specific time period. The expense ratio is calculated as follows:

Expense ratio=/Incurred underwriting expenses/Written premiums

When converted into a percentage, the expense ratio indicates what proportion of an
insurer’s written premiums is being used to pay acquisition costs, general expenses, and
premium taxes. In other words, this ratio indicates the insurer’s general cost of doing
business as a proportion of the premiums it has written. (Investment income and
investment expenses are not part of either the loss ratio or the expense ratio.) The expense
ratio gives a general picture of how efficiently the insurer is operating. Insurers watch the
expense ratio carefully over time and attempt to reduce it by managing cash flow and
controlling expenses.

The expense ratio is calculated as follows:

Incurred underwriting expenses
Expense
IF Ratio = Written Premiums

Incurred underwriting expenses $330,000

THEN
Written premiums $1,100,000
Incurred underwriting expenses
Written Premiums

$330,000
Expense Ratio =
$1,100,000

= = 0.30 (or 30%)

The dividend ratio applies to those insurers that pay dividends to policyholders. It indicates
what proportion of an insurer’s earned premiums (if any) is being returned to policyholders
in the form of dividends. The dividend ratio is calculated as follows:

Dividend ratio=Policyholder dividends/Earned premiums

The dividend ratio by itself is not a measure of profitability, but it is sometimes a

component of the combined ratio, described next.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The dividend ratio is calculated as follows:

Policyholder dividends
Dividend Ratio = Earned Premiums
IF

policyholder dividends $10,000

Earned premiums $1,000,000
THEN
Incurred underwriting expenses
Written Premiums
Expense Ratio =
$10,000
$1,000,000

= = 0.01 (or 1%)

The combined ratio is the sum of the loss ratio and the expense ratio and is used to
compare cash inflows and outflows from insurance operations. The combined ratio is
calculated as follows:

Combined ratio=loss ratio + Expense ratio

The combined ratio is calculated as follows:

Combined Ratio = Loss ratio + Expense ratio
Looking at the individual components of the loss ratio and the expense ratio would give the following
formula or calculating the combined ratio:
Incurred losses (including loss
adjustment expenses) Incurred underwriting expenses
Earned Premiums Written Premiums
Combined ratio = +
IF

Earned premiums $1,000,000

Written premiums $1,100,000
Incurred underwriting expenses $330,000
THEN
Incurred losses (including loss adjustment expenses) $750,000

Combined ratio =Loss ratio + Expense ratio =0.75 + 0.30 =1.05 (or 105%)

Looking at the individual components of the loss ratio and the expense ratio would give the
following formula for calculating the combined ratio:

Combined ratio=incurred losses (including loss adjustment expenses)/ earned premiums +

Incurred underwriting expenses / Written premiums

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Notice that both the numerators (top numbers) and the denominators (bottom numbers) in
the loss ratio and the expense ratio are different. The loss ratio attempts to relate the level
of losses as they are incurred to the corresponding earned premiums. Both the incurred
losses and earned premiums reflect the insurance coverage provided over time. Because
these two measurements represent corresponding cash inflows and outflows on an accrual
basis, they provide the most informative basis for the loss ratio.
Expenses are a different matter. Many of the underwriting expenses incurred by insurers
involve acquisition expenses, such as producers’ commissions. Because these expenses
occur at the beginning of the policy period, the use of written premiums, which recognizes
the entire premium as soon as it is written, is appropriate for comparing expenses to
revenues. Therefore, written premiums are used in lieu of earned premiums as the
denominators in the expense ratio.
While the combined ratio is considered the accepted measure of an insurer’s underwriting
performance, this ratio does not take into account the insurer’s investment income, and
thus does not measure the insurer’s overall financial performance. Overall financial
performance includes the results from both the insurer’s underwriting activates and its
investment activates.
For insurers that pay policyholder dividends (not stock dividends), the third component of
the combined ratio is the dividend ratio. The ratio would then be calculated as follows:

Combined ratio=Loss + Expense ratio + Dividend ratio

For clarity, when the combined ratio is calculated using policyholder dividends, it is often
called “combined ratio after policyholder dividends.”

When loss ratios are calculated, the results are decimal expressions such as 0.90 (an insurer
whose outflow equals 90 cents of each premium dollar) or 1.15 (an insurer whose outflow is
$1.15 for each premium dollar). In the industry vernacular, these ratios are typically
expressed without the decimals, such as “90” or “115,” much as one might express that a
baseball player is “batting 333” when the mathematical calculation of getting one hit in each
three at-bats results in a batting average of 0.333.

The lower the combined ratio, the better. Most insurers consider a combined ratio under
100 to be acceptable, because it indicates a profit from underwriting, even before
investment income is considered. In fact, many insurers regularly experience a combined
ratio over 100 and attempt to offset underwriting losses with investment income.

The investment income ratio compares the amount of net investment income (investment
income minus investment expenses) with earned premiums over a specific period. It is
calculated as follows:

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Investment income ratio=Net investment income/Earned premiums

The investment income ratio indicates the degree of success achieved in the insurer’s
investment activities. The higher the ratio, the more successful are the insurer’s investment
activities.

The investment income ratio is calculated as follows:

Net investment income
Investment income Ratio = Earned Premiums
IF

Net investment income $100,000

Earned premiums $1,000,000
THEN
Net investment income
Earned Premiums
Investment income Ratio =
$100,000
$1,000,000

= = 0.10 (or 10%)

The overall operating ratio is the combined ratio (loss ratio plus expense ratio) minus the
investment income ratio (net investment income divided by earned premiums) and can be
used to provide and overall measure of the financial performance of the insurer for a
specific period. It is calculated as follows:

Overall operating ratio=Combined ratio-Investment income ratio

The investment income ratio must be subtracted from the combined ratio because
investment income is used to offset the insurer’s losses and underwriting expenses. Of all
the commonly used ratios, the overall operating ratio is the most complete measure of
insurer financial performance. To obtain a true picture of an insurer’s profitability, overall
operating ratios for a number of years should be analyzed, because any company might
have a single bad year that is offset by a pattern of profitability over a longer period.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The overall operating ratio is calculated as follows:

Overall
IF operating Ratio = Combined ratio – Investment income ratio.

Combined ratio $100,000

THEN
Investment income ratio $1,000,000

Overall operating ratio = Combined ratio – Investment income ratio

= 1.05 - 0.10
= 0.95 (or 95%)

Expressed as percentages, the expense ratio for Atwell Insurer is 30 percent, while its loss
ratios is 75 percent. This creates a combined ratio of 105 percent. When the investment
income ratio of 10 percent is subtracted, the overall operating ratio equal 95 percent. Using
insurer jargon, the overall operation ratio would be expressed simply as "95."
An insurer with an overall operation ratio of 100 percent breaks because revenue from all
operations equals total expenses plus incurred losses. A ration of less than 100 percent
indicates an overall operating gain because revenues are greater than total expenses.
Conversely, if the ratio is greater than 100 percent, an operating loss has occurred because
total expenses are greater than revenue.
Although these ratios are the clearest indicators of insurer profitability, they should be used
carefully and reexamined frequently. The loss ratio includes incurred losses as a key
component. Because measuring incurred losses involves an estimate of the amount that will
ultimately be paid on claims that were incurred during the current year, the loss ratio is
subject to revision as losses develop. Likewise, because the loss ratio is part of the
combined ratio and the overall operating ratio, these two ranks are also subject to change.
The insurer cannot know exactly how it performed in a specific period until all claims for
incurred losses in that period are fully paid, which may not occur for several year.
Monitoring financial results from past years helps to determine the accuracy of the insurer's
loss reserve estimates.

Capacity Ratio

In addition to profitability, important concern for an insurer is its capacity to write new
business and thus to grow. The measure of an insured’s capacity is its capacity ratio, also
known as its premium-to surplus ratio. It is calculated as follows:

Capacity ratio=Written premiums/Policyholders’ surplus

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The capacity ratio compares an insured’s written premiums (which represent its exposure to
potential claims) to its policyholders' (which represents its cushion for absorbing adverse
results). If loses and expense exceed written premiums and investment income, an insurer
must use its surplus to meet its obligations. Therefore, an insurer's new written premiums
should not become too large relative to its policyholders surplus.
Exhibit 3-7 shows the capacity ratio for Atwell Insurer, using data from Exhibits 3-4 and 3-6.
The Ratio of 2.2-to-I is not unusual, because insurers of tern have a premium-to=surplus
ratio close to 2-to 1. While it is not a magic figure, insurance regulation uses the capacity
ratio as a benchmark to determine whether an insurer may be headed toward financial
difficulty. For example, a premium-to-surplus ratio above 3-to-1could be a sign of financial
weakness because the insurer may not have a sufficient cushion of policyholders' surplus to
absorb its increased exposure to claims. However, regulations cannot determine an
insurer's financial condition by this measure alone. In addition to the capacity ratio,
regulators use many other measures of financial performance.

EXHIBIT 3-7
Capacity Ratio for Atwell Insurer

Written premiums $1,100,000

Policyholder’s surplus $500,000

Capacity ratio = Written premiums= $1,100,00

= 2.2
Policyholders’ 0
$500,000 1
surplus

SUMMARY
Sound operation of an insurer requires that great care be given to its financial condition and
performance. To survive long term, an insurer's revenue must exceed its expenses. Insurers
must operate profitably, remain solvent, and provide financial statement so that their
financial performance can be monitored by state insurance departments and others.

The profitability of an insurer is more difficult to measure than the profitability of many
other businesses because of timing differences between the receipt of money (premiums)
and the performance of the corresponding service (claim payments). Earned premiums are
a better measure of premium revenue than written premiums during a specific period.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Similarly, incurred losses are a better measure of losses during that period than are paid
losses.

An insurer's income includes both underwriting income and investment income. Its
expenses, and investment expenses. The company's overall gain or loss from operations is
the sum of its not underwriting gain or loss and its net investment gain or loss for a specific
period. Unless there is an overall gain-that is, profit-the insurer's financial condition will
deteriorate.

Solvency is the primary measure of an insurer's financial condition. Solvency indicates the
insurer's ability to meet its obligations. Its assets or what it owns must exceed its liabilities,
or what it owes. The difference between admitted assets and liabilities is policyholders'
surplus. To be certain that insurers do not overstate their policyholders' surplus, regulators
require insurers to follow conservative accounting procedures. These procedures allow
insurers to show on their financial statements only admitted assets, which include defined
categories of assets that can be readily converted to cash. These accounting procedures for
insurers also require that insurers show as liabilities their loss reserve and loss expense
reserve, and unearned premium reserve.

To monitor financial performance, relation and others examine insurers' financial

statements. The balance sheet, which measures an insurer's financial position, shows the
insurer's assets, liabilities and policyholders' surplus on a given date, such as the last day of
the year. The income statement, which measure profitability, shows the company's
revenues, expenses, and net income before taxes during a given period, such as a year.
Analysis of these financial statements makes it possible to measure an insurer's financial
performance weak insurers.

Analyzing financial statements often involves using ratio to make these comparisons.
Several different ratios measure various aspects of profitability. The most useful ratio for
measuring profitability is the overall operating ratio, which is calculated as the combined
ratio (loss ratio plus expense ratio plus dividend ratio) minus the investment income ratio
(net investment income divided by earned premiums). The capacity ratio (written premiums
divided by policyholders' surplus) is important because a measures an insurer's capacity to
write new business and thus to grow.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Marketing Chapter 4

Marketing enables an insurer to determine which products meet customer’s needs and
then to create, promote, sell, and deliver those products to its customers. An insurer may
have the best product at the best price available, but if customers are not aware of this, the
insurer will sell few, if any, policies. Customers have many different insurance needs. One
insurer may attempt to fill only a few of those needs; another may attempt to fill many.

Insurance marketing does not stop after the customer buys the product. People involved in
insurance marketing also assist customers in dealings with insurers after a policy is issued.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Insurers depend on their marketing personnel to keep them informed about the changing
needs and desires of customers.

There are many insurance marketing systems and most involve a salesperson of some kind.
Various terms, such as agent, broker, producer, solicitor, and sales representative, are used
to refer to this salesperson. This book uses the terms producer and agent interchangeably
to refer to any person who sells insurance (produces business) for one or more insurers. The
terms broker and sales representative are also used for special categories of producers.

THE LEGAL ROLE OF THE INSURANCE AGENT

The legal relationship known as agency is not limited to insurance. An agency exists
whenever one party, the agent, represents or acts on behalf of another part, the principal.
The principal gives the agent authority to act as its representative within certain guidelines.
The principal may authorize the agent to do anything the principal can do. For example, an
insurer (the principal) can authorize its agent to collect premiums from insureds for new
insurance policies and then require the agent to remit those premiums (sometimes after
deducting a commission) to the insurer within a certain amount of time.

The agency relationship requires a high degree of trust between the principal and the agent
because it imposes serious legal obligations on both parties. While the agent has authority
to act for the principal, the principal has control over the agent’s actions on the principal’s
behalf. This authority and control are the two essential elements of an agency relationship.

Creation of the Agency Relationship

An agency relationship is usually created by a written contract between the principal and
the agent. In insurance, the insurer is the principal that appoints insurance agents to serve
as its representatives; a written agency contract specifying the agent’s scope of authority
formalizes this relationship. The agency contract, also known as an agency agreement, is a
written agreement between an insurer and an agent that specifies the scope of the agent’s
authority to conduct business for the insurer. It gives the agent the right to represent the
insurer and to sell insurance on the insurer’s behalf. The contract specifies the
compensation arrangement between the insurer and the agent. It also describes how the
agency relationship can be terminated. Insurance agency contracts usually have no fixed
expiration date and remain in force until one party cancels the contract after giving proper
notice to the other party as required by the contract.

The agency relationship, which is based on mutual trust and confidence, empowers the
agent to act on behalf of the principal and imposes significant responsibilities on both
parties.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Responsibilities of the Agent to the Principal

In an agency relationship, the agent’s fundamental responsibility is to act for the benefit of
the principal. The laws of agency impose the following five duties on all agents, including
insurance agents:

1. Loyalty
2. Obedience
3. Reasonable care
4. Accounting
5. Relaying information

Two of the agent’s most important duties are to be loyal to the principal and to obey the
principal’s lawful instructions. In addition, an agent must exercise a reasonable degree of
care in its actions on behalf of the principal; in other words, the agent must act as a
reasonably prudent person would under the same or similar circumstances. Under the duty
of accounting, the agent is responsible to the principal for all of the principal’s money and
property that comes into the agent’s possession; the agent must account promptly for any
of the principal’s money that the agent holds. The duty of relaying information requires the
agent to keep the principal informed of all facts relating to the agency relationship.

In insurance, an agency contract specifically addresses certain rights and duties of the
agent. For example, the contract explicitly describes the insurance agent’s right to make
insurance coverage effective and any limitations on that right. The contract also specifies
how the agent is to handle funds, including stipulations on how and when the agent must
remit premiums to the insurer. Insurance agency contracts usually give the agent the right
to employ subagents who may act on behalf of the insurer according to the terms of the
agency contract.

Responsibilities of the Principal to the Agent

Just as the agent owes duties to the principal, the principal legally owes certain duties to the
agent. The principal’s primary duty is to pay the agent for the services performed. In the
case of an insurance agent, this duty requires the insurer to pay commissions and other
specified compensation to the agent for the insurance the agent sells or renews.

The principal also has a duty to indemnify, or reimburse, the agent for any losses or
damages suffered without the agent’s fault, but arising out of the agent’s actions on behalf
of the principal. If a third party sues the agent in connection with activities performed on
behalf of the principal, the principal must reimburse the agent for any liability incurred, if
the agent was not at fault. However, no reimbursement is due if the agent acted illegally or
without the principal’s authorization, even though the principal may be liable to others for

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

those acts. An important factor involved in this duty is the exposure of insurance agents to
errors and omissions (E&O) claims, which may arise from the agent’s negligent actions. For
example, when an insurance agent gives a customer misleading or incorrect advice
regarding the customer’s insurance, the customer could bring an E&O claim against the
agent if the customer suffers damage due to the agent’s advice.

Responsibilities of the Agent and the Principal to Third Parties

An agency relationship also creates responsibilities to third parties (parties other than the
agent and the principal). The agent’s authorized actions on behalf of the principal legally
obligate the principal to third parties in the same way as if the principal acted alone.
Therefore, from an insured’s point of view, little distinction exists between the insurance
agent and the insurer.

Because the agent represents the insurer, the law presumes that knowledge acquired by
the agent is the knowledge acquired by the insurer. If, for example, the agent visits the
insured’s premises and recognizes an exposure (such as vacancy of the building) that could
suspend or void the insured’s policy, the insurer cannot deny a claim to the insured merely
because the agent failed to communicate that information to the insurer. According to
agency law, the fact that the agent knew about the exposure means that the insurer is also
presumed to know about it.

Authority of Agents

The principal is legally bound by any actions of the agent that are within the agent’s
authority. Insurance agents generally have the following three types of authority to transact
business on behalf of insurers that they represent:

1. Express authority
2. Implied authority
3. Apparent authority

Express Authority

The terms of the agency contract define the agent’s express authority. For example, the
contract will state that the agent has authority to sell the insurer’s products or that the
agent has authority to bind coverage up to a specified limit.

Binding authority, generally granted to the agent in the agency contract, is a form of
express authority. Binding authority is the power to make insurance coverage effective on

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

behalf of the insurer. Binding coverage is usually accomplished by issuing binders, which are
agreements to provide temporary insurance coverage until a formal written policy is issued.
Binders can be either written or oral.

For example, assume Christopher owns an old car for which he has an automobile policy
with no collision coverage. Christopher purchases a new car and telephones his insurance
agent, Lisa, to make sure the car is covered before he drives it away from the dealer’s lot.
Reminding Christopher that he has no collision coverage, Lisa gives him a quote for collision
coverage on the new car. Lisa and Christopher agree that Lisa will immediately add the new
car to Christopher’s policy, including collision coverage with a $250 deductible. Christopher
agrees to pay the premium when he receives an invoice, and Lisa assures Christopher that
"coverage is bound". Lisa then begins to process the paperwork necessary to issue a policy
change (called an endorsement) that includes collision and other coverages on
Christopher’s new car.
If Christopher should have an accident before receiving the policy endorsement, he would
have collision coverage on his new car because Lisa issued an oral binder. The binder is
temporary because it will be replaced by a policy endorsement.
As illustrated by the previous example, oral binders are often used until the paperwork
necessary to have an endorsement or a new policy issued is completed. Such paperwork
often includes a written binder completed on a standard form. A written binder provides a
brief summary of who is insured, what is insured, and what coverages and limits apply.

Binding authority gives an agent the power to put specified types and limits of coverage in
force at once rather than waiting for approval from the insurer.
When an insurance agent binds coverage for a new client, the agent commits the insurer to
covering an exposure for, and possibly paying a claim to, a customer who is unknown to the
insurer. Binding authority involves important responsibilities for the agent, and agents are
expected to use their binding authority carefully.
Implied Authority

The scope of an agent’s authority, however, can go beyond the terms of the agency
contract. In addition to express authority, the agent may have implied authority to perform
other tasks necessary to accomplish the purpose of the agency relationship. For example,
assume that XYZ Insurer’s agency contract with Atwell Insurance Agency does not give
Atwell’s agents express authority to collect premiums from XYZ’s insureds. Atwell’s agents
would have implied authority to do so because collecting premiums is an act that is
reasonably necessary for Atwell to accomplish the sale of XYZ’s policies, and the sale of
XYZ’s policies is expressly authorized in the agency contract.

Apparent Authority

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

An agent can also have apparent authority to act on behalf of the principal in ways that the
principal does not intend. Usually, an insurance agent has broadly defined powers to
represent an insurer and to transact the company’s business. Without actual notice or
reason to believe otherwise, a third party cannot be expected to know about any unusual
limitation on the agent’s authority. The insurer is bound by all acts within the agent’s
apparent authority, unless the insurer takes steps to prevent that outcome.
For example, XYZ Insurer furnishes its agents with application forms showing the XYZ name
and logo. XYZ grants its agents binding authority for routine applications for homeowners
insurance. If XYZ terminates its agency agreement with Granton Insurance Agency but fails
to retrieve the blank application forms, a Granton producer may inadvertently take Maria’s
application for homeowners insurance on an XYZ application form, accept Maria’s check for
the premium, and tell her that her coverage is bound effective that day. If a fire occurs in
Maria’s house the next day, XYZ Insurer would probably be required to pay the claim
because it appeared to Maria that the Granton Insurance Agency had the authority to bind
her coverage with XYZ. From Maria’s standpoint, the Granton Insurance Agency apparently
had the authority to bind coverage for XYZ. Maria would not be penalized because she did
not know that XYZ had terminated its agency contract with Granton. XYZ, however, may
attempt to recover the cost of the claim from Granton.

INSURANCE MARKETING SYSTEMS

Insurers use many types of marketing systems, which are also known as distribution
systems, designed to meet their particular marketing objectives. Most insurers typically use
one or more of the following marketing systems:
 Independent agency system
 Exclusive agency system
 Direct writing system
 Alternative distribution channels
Exhibit 4-1 shows some of the differences between these systems. It is important to note
that these marketing systems are not mutually exclusive. Some insurers use a mixed
marketing system, combining two or more distribution systems. In fact, combinations of
marketing systems are becoming increasingly common among insurers.

Exhibit 4-1 Differences Among Insurance Marketing Systems

Type of What company Are the How are the Does the What methods
Marketing (or or companies producers producers agency or of sales are
distribution) do the employed by usually agent own the usually used?
system producers the insurer? compensated? expiration
represent? list(s)?

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Independent Usually more No, the Sales Usually, yes Personal

Agency System than one insurer producers are commissions contact, phone,
employed by and contingent or Internet
the agency commissions

Exclusive Only one Usually, no; Sales Usually, no; but Personal
Agency system insurer or group however, some commissions the agency contact, phone
of related producers begin (commissions contract may or Internet
insurers as employees on renewals provide for the
may be lower agent’s right to
than on new sell the list to
business) and the insurer
bonus

Direct Writing Only the Yes Salary, bonus, No Personal

System producers’ commissions, contact, phone,
employer or a or Internet
combination
Alternative Only the Yes Salary No Mail, phone, or
Distribution producers’ Internet
Channels employer

Independent Agency System

The independent agency system is used by insurers of all sizes. An independent agency is a
business, operated for the benefit of its owner (or owners) that sell insurance, usually as a
representative of several unrelated insurers. The agency can be organized as a sole
proprietorship (owned by an individual), a partnership (owned by two or more individuals),
or a corporation (owned by stockholders). Under the independent agency system, insurance
sales are made through independent agents.
Independent Agents

An independent agent is a producer who works for an independent agency and can be
either the owner or an employee of the agency. In a small independent agency operated by
a sole proprietor who is the only producer, the independent agent and the independent
agency are the same. Larger independent agencies are usually corporations that employ
many producers. Independent agencies enter into agency contracts with one or more
insurers.
One of the main distinguishing features between independent agency systems and other
marketing systems is the ownership of the agency expiration list, which is the record of
present policyholders and the dates their policies expire. The typical independent agency
contract specifies that the independent agency—not the insurer—owns the list of
policyholders, the dates their existing policies expire, and, most importantly, the right to
solicit these policyholders for insurance. If the insurer ceases to do business with a
particular agency, the insurer cannot legally sell insurance to the agency’s customers or give
the expiration list to another agency. Under such circumstance, the independent agency has
the right to continue doing business with its existing customers by selling them insurance

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

with another insurer. The customers, however, are not obligated to keep their business
with the agency, but may choose another agency or company.

Because of the independent agency’s traditional exclusive right to solicit policyholders on

an agency expiration list, the ownership of expiration lists is the agency’s most valuable
asset when an independent agency is bought or sold. The agency has the right to sell its
expiration lists to another independent agent. For example, if the agency were to be sold,
the new buyer would want to keep the agency’s customers and would therefore want the
agency’s expiration lists.

Sometimes, an independent agent determines that a different insurer represented by the

agency can better meet an existing customer’s needs. Occasionally, an insurer may be
unwilling to renew an insurance policy or may have rates that are not competitive.
Therefore, the agent must select another insurer for the customer. In either case, the
independent agency has the right to switch the coverage to another insurer, subject to the
customer’s approval.

Independent Agencies That Represent Only One Insurer

Generally, independent insurance agencies represent more than one, and sometimes a
dozen or more, insurers. However, some independent agencies represent only one insurer
or a group of related insurers. Such an agency may not find it practical to represent more
than one insurer because the agency is small or just starting in business. Other reasons for
representing only one insurer may be that the agency specializes in one type of coverage or
has a special arrangement with a particular insurer.
Some independent agents agree to place all or most of their business with just one insurer
because there may be advantages in doing a large volume of business with one insurer
rather than a smaller volume with each of several insurers. For example, some insurers offer
independent agents incentives for special agency agreements. Those incentives may include
computer systems, higher commission rates, or a more open market for the agent’s
customers.
Closely related to and often working with independent agencies are brokers and managing
general agencies. These are discussed next.

Brokers

An insurer broker is an independent business owner or firm that sells insurance by

representing customers rather than insurers. Brokers shop among insurers to find the best
coverage and value for their clients. Some insurers require that brokers purchase insurance
through one of the company’s agents who, in turn, pays a portion of the agent’s
commission to the broker. Other insurers have contracts with and regularly accept business

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

directly from insurance brokers and pay them a fee or commission for the business.
Because they are not legal representatives of the insurer, brokers are not likely to have
authority to commit the insurer to write the policy by binding coverage, unlike agents, who
generally have binding authority. An excess and surplus lines (E&S) broker is licensed by a
state or states to transact insurance (for coverages usually unavailable in the standard
market) through specialty non-admitted insurers.

In practice, despite the technical distinctions between brokers and independent agents, the
differences are quite limited. Both brokers and independent agents are intermediaries
between insurers and insurance buyers, and both collect premiums from insureds and remit
them to insurers. Both are in the business of finding people with insurance needs and
selling insurance appropriate to those needs. In fact, the same person can act as an agent
on one transaction and as a broker on another. A person acts as an agent when placing
insurance with an insurer for which he or she is licensed as an agent but may act as a broker
when placing insurance with other agents or insurers.

Large brokerage firms have many brokers who generally handle commercial insurance
accounts that often require sophisticated knowledge and service. Many brokerage firms
operate nationally, with offices in many states, and some operate internationally as well. In
addition to insurance sales, large brokerage firms, as well as large agencies, may provide
extensive loss control, appraisal, actuarial, risk management, and other insurance-related
service that large businesses need.

Managing General Agencies (MGAs)

A managing general agency (MGA) is an independent business or organization that appoints

and supervises independent agents for insurers that use the independent agency system.
MGAs serve as intermediaries between insurers and agents who sell insurance directly to
the customer, in much the same position as wholesalers in the distribution system for
tangible goods. The MGA’s exact duties and responsibilities depend on its contracts with the
insurers it represents. The MGA receives a managerial commission—often referred to as an
override— which is a percentage of the premium or the profits on policies sold by
producers placing business with the insurer through the MGA.

E&S brokers resemble MGAs in that they usually transact business primarily with other
brokers and agents, not directly with customers. In fact, some firms operate as both MGAs
and E&S brokers.

Exclusive Agency System

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

An exclusive agent sells insurance exclusively for one insurer or a group of related insurers.
Like the independent agent, the exclusive agent’s business operation is his or her own
insurance sales agency. An agency agreement describes the exclusive agent’s binding
authority and compensation arrangements. Unlike the agency agreement in the
independent agency system, the exclusive agency system limits the agent to selling
insurance exclusively for one insurer or group of related insurers. If a desired type of
insurance is not written by the insurer represented, some contracts allow the agent to place
("broker") the business with an independent agent or another exclusive agent.
Generally, an exclusive agent is not an employee of the insurer but a self-employed
representative of the company. With some exclusive agency insurers, agent trainees begin
as employees and later make the transition to owning their own businesses.

Some exclusive agency contracts provide that the agent owns the agency expiration list and
has the right to sell it to another party, but this is often not the case. Usually, the contract
contains an agreement that, upon termination of the agency contract, the insurer will buy
the expiration list from the exclusive agent using a predetermined formula to establish its
value. An exclusive agent’s expiration list—and the right to consider people on the list as
customers of the agent—can become a valuable asset as an exclusive agent’s business
grows.

Direct Writing System

A direct writing system is a system of insurance marketing that uses sales representatives
who are employees of the insurer. As with the exclusive agency system, agents in this
system sell insurance for only one insurer or group of related insurers. Unlike most
producers in the exclusive agency system, however, agents in the direct writing system are
not self-employed. Rather, they are employees of the insurer and their job is to sell
insurance for the company. Employees who work as insurance producers for a direct writing
insurer are generally called sales representatives. A direct writing insurer’s sales
representatives are sometimes called agents, and they must possess agents’ licenses.
Legally, they function as agents of the insurer, and most insurance buyers would not
distinguish between an agent and a sales representative.
Like employees in general, a direct writing insurer’s sales representatives work from offices
or other business locations provided by the employer. The insurer in this system, unlike an
insurer using the independent or exclusive agency system, pays office expenses as well.
Employees can be transferred from job to job and from office to office to meet the overall
needs of the insurer. Increasingly, these sales representatives can also work from their
homes, using their own or company-provided computers and phone services.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Because the direct writing insurer’s sales representative is an employee of the insurer, the
expiration list belongs not to the sales representative but to the insurer, which can use the
customer information as a source of prospects for follow-up sales by its other sales
representatives.

Sometimes a customer needs a type of policy not available from an insurer that the agent
represents. When this happens, the agent may contact an agent who represents another
insurer and apply for insurance through that agent. The agent who represents the insurer
usually shares the commission with the agent who has the customer.

In this situation, the original agent acts as a broker—the agent shops for insurance on
behalf of the customer. The act of placing the insurance for this customer through another
agent is called brokering. The insurance sold in this manner is referred to as brokered
business.

Exclusive agents and direct writing insurer’s sales representatives, as well as independent
agents, may occasionally broker business for an account whose other coverage’s are
handled by the producer’s insurer. Authority for such transactions would be specified in the
agency or employment contract.

Alternative Distribution Channels

In addition to the three marketing systems just described, insurers as well as producers use
the following alternative distribution channels to sell insurance.

 Direct response
 Internet
 Call centers
 Group marketing
 Financial institutions

Direct Response

The direct response distribution channel markets directly to customers. No agent is

involved; rather the direct response relies primarily on mail, phone, and/or Internet sales.
Although this distribution channel is also called direct mail, customers can also contact
insurers via telephone and the Internet. Direct response relies heavily on advertising and
targeting specific groups of affiliated customers.

Internet

As a distribution channel, the Internet can be used at various times to varying degrees by all
parties to the insurance transaction: the insurer, the producer, and the customer.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Interaction can occur between the producer and the customer, the producer and the
insurer, and the customer and the insurer. Interactions can range from exchanges of e-mail
to multiple policy quoting, billing, and policy issuance. Customers also interact with insurers
on the Internet via Web-based insurance distributors, also called insurance portals or
aggregators. These portals deliver leads to the insurers whose products they offer through
their Web sites.

Call Centers

Call centers sell insurance products and services through telemarketing. The best-equipped
call centers can replicate the activities of producers. In addition to making product sales, call
centers staff can also respond to general inquiries, handle claim processing, answer billing
questions, and process policy endorsements. Call centers operate with customer service
representatives, touch-tone service, or speech-enabled (voice response) service.

Group Marketing

Group marketing sells insurance products and service to individuals or businesses that are
all members of the same organization. Group marketing includes affinity marketing, mass
marketing, and worksite marketing.

Affinity marketing targets various customer groups based on profession, interests, or

hobbies. Mass marketing, also called mass merchandising, offers insurance to large
numbers of targeted individuals or groups, such as senior citizens. Worksite marketing
markets insurance (most commonly life, health, and disability) to employees of a particular
company or organization. Insurance premiums are usually discounted and deducted on an
after-tax basis from employee paychecks through payroll deduction.

Financial Institutions

Insurance and producers can also elect to market their products and service through a bank
or other financial services institution. Marketing arrangements can range from simple to
complex. For example, a small insurance agency may place an agent at a desk in a local
bank, or a large insurer may form a strategic alliance with a regional or national financial
holding company to solicit customers.
Mixed Marketing System

Traditionally, each insurer used just one of the marketing systems or distribution channels
previously described, however many insurers have departed from this practice. The team
mixed marketing system refers to an insurer’s use of more than one marketing system or
distribution channel. For example, some insurers that traditionally sold insurance only
through independent agents are now also using direct response, developing business
without producers and without paying commissions to producers. These insurers generally

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

argue that advertisements and direct mail enable them to reach customers they would not
reach through an independent agent.

Conversely, some direct writing insurers, seeking to expand their business, have entered
into agency agreements with independents agents in some areas. These direct writing
insurers have turned to independent agents as a distribution system partly because they
have found it relatively expensive to establish offices and develop trained employees,
especially in small communities.

PRODUCER COMPENSATION

While some producers receive a salary, commissions provide the primary form of
compensation for producers. Producers typically earn two types of commissions—sales
commission and contingent commissions.

Sales Commissions

An independent agency or an exclusive agency receives commissions from the insurer for all
insurance premiums the agency generates. A sales commission (or simply, commission) is a
percentage of the premium that the insurer pays to the agency or producer for new policies
sold or existing policies renewed. An insurance broker may receive a sales commission or
fee directly from the insurer or may receive a portion of the commission from the agent
who placed the insurance.

For insurance agents, the method of premium collection determines how sales commissions
are received. If the insurer handles billing and collections (direct billing), the insurer
periodically mails a commission check to the agency. If the agency collects the premiums
(agency billing or producer billing), it subtracts its commission on each policy and remits the
balance of collected premiums to the insurer, usually on a monthly basis.

In a small agency with only one agent, the entire commission goes to that agent. In a larger
agency, a portion of the commission goes to the producer who made the sale, and the
remainder goes to the agency to cover other expenses.
Usually, commissions are not fully earned at the time of a sale. If policies are canceled or
premiums are returned to an insured for some other reason (such as deleting or reducing
coverage), the producer must also return the unearned portion of the commission to the
insurer.
The commission compensates the agency not only for making the sale but also for providing
service before and after the sale. Service provided before the sale includes locating and
screening insurance prospects, conducting a successful sales solicitation, getting the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

necessary information to complete an application, preparing a submission to the insurer,

and presenting a proposal or quote to the prospect. To make a sale, the agent must also
evaluate a prospect’s insurance needs and recommend appropriate coverages for the
prospect to select. After the sale, the agency often handles the paperwork that
accompanies policy changes, billing, and claim handling. When it is time for the policy to be
renewed, the agency must again analyze coverage needs and consider any changes in
insurance coverage that have become available.

The producer who is an employee of a direct writing insurer generally receives a salary and
perhaps also a bonus that relates to the premiums of the policies the producer sells. The
compensation arrangements of direct writing insurers tend to emphasize sales to new
customers, because these companies generally assign service after the sale to employees
who specialize in the applicable areas, such as claims. With some insurers, drive-in claim
service offices and other customer service centers handle most of the services required
after the sale, including policy changes and billing issues.

Contingent Commissions

In addition to commissions based on a percentage of premiums, some agencies receive a

contingent commission, which is based on the premium volume and profitability level of the
agency’s business with that insurer. The insurer compares the premiums received for
policies sold by the agency with the losses incurred under those policies to determine
whether the agency’s business has earned a profit. If the business sold by the agency attains
a certain volume of premium and level of profitability, the company shares a portion of the
profit with the agency.
Contingent commissions encourage agencies to sell only policies that will be profitable for
the insurer. Agencies that practice careful selection can earn sizable contingent commission
as a result. An independent agency is typically eligible to receive a contingent commission
annually from each insurer for which the agency’s business has been profitable.
Insurers that use the exclusive agency or direct writing system may offer higher sales
commissions, rather than contingent commissions, for agents whose sales generate a given
level of profit. Alternatively, these companies sometimes offer bonuses or other forms of
compensation to agents whose business is profitable.
ADVERTISING

An independent agency uses advertising to attract customers to the agency; therefore local
advertising often stresses the agency rather than the various insurers it represents. On the
other hand, many insurers marketing through the independent agency system use national
advertising programs intended to enhance the company image. With many products
including insurance, name brands tend to be most readily accepted by customers.
Accordingly, insurers design advertising symbols and slogans to increase their public

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

recognition. Independent agents sometimes identify with national symbols or repeat

slogans from national advertising campaigns in their local advertisements. At other times,
their ads focus on the agency itself—its quality of service, reputation, personnel and their
qualifications, range of services, or similar theme that may attract an insurance buyer.

In the exclusive agency system, advertising programs emphasize the names of both the
insurer and the agent. Sometimes an insurer’s advertisement lists every agent in the area
with a photo of each. Advertising for direct writing insures tends to emphasize the company
itself rather than individual producers or office locations.

Because they do not have producers, insurers using direct response marketing must use
other ways to attract new customers. Some insurers using the direct response system
advertise heavily—an activity that can be quite costly. Others, working from an established
customer base, have traditionally relied successfully on free word-of-mouth advertising.

In addition to the traditional types of advertising—television, radio, magazines, newspapers,

and direct mail—insurers and agents of all types use the Internet for advertising. Nearly all
insurers and agents have Web sites that provide information about their company or
agency and its products and services.

Producers’ Trade Associations

Trade associations serve their members through activities such as education, political
lobbying, research, and advertising. The advertising programs are intended to create a
favorable image of association members as a group and to make the public familiar with the
logos and other association symbols.

Independent Agent’s Trade Associations

Most independent agents are members of the Independent Insurance Agents & Brokers of
America (IIABA), the National Association of Professional Insurance Agents (PIA), or both.
The IIABA is often called the "Big I" because of the prominent letter "I" in its advertising
logo. (In some states, IIABA and PIA have consolidated to form one state insurance agents’
association).
Agent’s and Broker’s Trade Association

The Council of Insurance Agents and Brokers (CIAB) include independent agents and brokers
associated with large agencies or brokerage firms that primarily handle commercial
insurance.

Managing General Agent’s Association

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Many managing general agents are members of the American Association of Managing
General Agents (AAMGA), which like agents’ and broker’s associations, also provides various
services to its members.

MARKETING MANAGEMENT

All insurers need some means of managing the activities of producers. This includes systems
to supervise and motive producers, and to provide them with insurance products they can
sell. Marketing management also involves monitoring agency sales and underwriting results
to ensure that both the company’s and the agency’s sales and profit objectives are met.

Producer Supervision

Although selling insurance is essentially a one-on-one activity that often occurs away from
the producer’s office and the insurer’s home office, insurers do supervise their producers.
An insurer using independent agents typically employs marketing representatives who visit
the independent agents representing the company. The role of the marketing
representative is to develop and maintain a sound working relationship with the insurer’s
agents and to motivate the agents produce a satisfactory volume of profitable business for
the insurer. Marketing representatives also have the responsibility of finding and
"appointing" (entering into agency contracts with) new independent agents who can
potentially produce profitable business for the company. Some marketing representatives
operate from their homes and spend most of their time travelling among agencies in their
marketing territories, maintaining a close personal contract with the insurer’s agents.

Other insurers have production underwriters, who spend most of their time inside the
insurer’s office but also travel to maintain rapport with agents and to meet with clients in
special situations. Insurers using the direct writing system may use an agency manager or
district manager to supervise a group of producers, directing their activities rather closely.

Depending on how an insurer is structured, producer supervision and support can be

provided from either the insurer’s home office or a branch or regional office. Small insurers,
or those doing business in a limited geographic area, may have only one office. When this is
the case, producers interact directly with personnel in the home office.

Insurers conducting business nationally or over a widespread geographic area usually find it
beneficial to establish field offices close to producer’s offices, and producers usually work
closely with a local field office rather the home office. A small field office, perhaps with only
one marketing manager or marketing representative, may be called a service office. A large

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

office, containing management personnel, underwriters, and claim representatives may be

called a branch or regional office.

Producer Motivation

Insurers also need to motivate their producers to sell the types of insurance the companies
want sold. Some producer motivation results from personal relationships and
encouragement by marketing representatives, regional managers, and other people
working in field offices. Other motivation comes from marketing programs developed in the
home office.

The financial incentives that producers receive for selling can affect their sales performance.
The insurer’s marketing department considers this motivational effect when recommending
salaries, bonuses, or commissions to be paid to producers.

Some insurers may also develop sales contests to encourage specific production activities,
such as selling a particular type of policy or reaching a particular level of sales activity. Sales
contests can lead to awards or special recognition.

Product Management and Development

Insurance production is most successful when producers have a desirable product to sell at
a competitive price. The insurer’s marketing department—usually at the home office level—
strives to give producers the products and pricing they need. The home office marketing
department bases many of its decisions on information provided by producers and by other
insurer personnel in the field. An insurer’s product management involves maintaining an
ongoing relationship with producers.

People involved with sales are often the first to identify a need could be addressed by either
a new policy or modification of an existing policy. Those involved in marketing are acutely
aware of what the competition is doing in regard to product management and
development. The response to new product development by competitors is often critical to
satisfying changing market demands.

The home office marketing department cooperates with other departments to determine
what coverage do the insurer’s insurance policies should provide what price to charge, and
what other services the insurer should offer. Decisions in those matters are based partly on
claim costs for the particular insurer or for the industry as a whole and on information
about the coverages, prices, and services of competing insurers.

PRODUCER REGULATION

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

State insurance departments regulate both insurer and producer activities. Producer
regulation occurs primarily through agent and broker licensing laws and other state laws
dealing with insurance, such as unfair trade practices laws.

Licensing Laws

To function legally as an insurance agent, a producer must be licensed by the state or states
in which he or she wants to sell insurance. Producers’ licensing laws vary by state and
change periodically. Some states have several different licenses, including licenses for
agents, brokers, and solicitors. The exact titles and the authority that goes with the licenses
vary somewhat by state. Generally, insurance agents are defined legally as representatives
of the insurer(s) for which they sell insurance. Brokers, as stated previously, are
representatives of the insurance purchasers rather than of the insurers.

Some states, such as California, have separate licenses for solicitors, who work for and are
representatives of agents or brokers, often as office employees, but have less authority than
agents. Generally, solicitors can solicit prospects but cannot bind insurance coverage. In
other states, such office employees who solicit insurance must secure an agent’s license;
they are often called customer service representatives (CSRs) or customer service agents
(CSAs).

To obtain a state agent’s license, a candidate must meet several requirements. Usually, the
candidate must pass an examination and meet other qualifications of the state insurance
department to receive a state insurance license. These examinations typically deal with
insurance principles, insurance coverages, and insurance laws and regulations. Some states
mandate a certain number of hours of classroom study before a candidate can take a
license examination. In some states, completing a recognized professional designation
program allows the candidate to waive the classroom and examination requirements for
licensing. Once a state agent’s license has been issued, the agent must seek to be appointed
by one or more insurers before the agent can sell insurance.

Producer’s licenses generally have a specified term, such as one or two years, and can be
renewed by paying a fee specified by the state. Most states also impose a continuing
education requirement, requiring that producers periodically complete a specified number
of hours of educational study related to the insurance business. Producers in those states
must provide evidence that they have completed approved continuing education courses
before the state will renew their licenses.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Licensed producers are required to adhere to all laws regulating insurance sales in the state
or states in which they conduct business. The state can suspend or revoke licenses under
certain circumstances, such as engaging in unfair trade practices.

Unfair Trade Practices Laws

Many states have adopted unfair trade practices laws that specify certain prohibited
business practices. These laws are not specifically limited to the activities of insurance
producers; underwriters, claim representatives, and others could also be guilty of
misconduct in these areas. Although they vary by state, these laws typically prohibit various
unfair trade practices, such as the following:
 Misrepresentation and false advertising
 Tie-in sales
 Rebating
 Other deceptive practices

Misrepresentation and False Advertising

It is an unfair trade practice for insurance agents or other insurance personnel to make,
issue, or circulate information that does any of the following:

 Misrepresents the benefits, advantages, conditions, or terms of any insurance policy

 Misrepresents the dividends to be received on any insurance policy
 Make false or misleading statements about dividends previously paid on any insurance
policy
 Uses a name or title of insurance policies that misrepresents the true nature of the
policies

It is also considered an unfair trade practice to make untrue, deceptive, or misleading

advertisements, announcements, or statements about insurance or about any person in the
insurance business.

Tie-In Sales

It is an unfair trade practice for a producer to require that the purchase of insurance be
"tied" to some other sale or financial arrangement—a practice referred to as a tie-in sale. It
is also an unfair trade practice for a lender to require that a borrower purchase insurance
from the lender or from any insurer or producer recommended by the lender. Each
transaction must stand on its own. For example, assume that Richard, a salesman with a car
dealership, also holds an insurance agent’s license with XYZ Insurer. If Julia purchases a car

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

from Richard, Richard cannot require that Julia purchase insurance on the car from XYZ
Insurer. Julia is free to purchase insurance from any company or agency she chooses. If
Richard told Julia that the loan on her new car would be denied unless she purchases a
policy from XYZ, Richard would be guilty of an unfair trade practice because he would be
requiring a tie-in sale—tying the sale of insurance to the financing of the car.

Rebating

The prohibition of rebating means that producers are not allowed to pay a portion of the
premium or give any commission to a policyholder. This prohibition also means that
producers are not permitted to offer to do other business with the policyholder in exchange
for the purchase of a policy.

Most states have enacted anti-rebating laws. The rationale behind anti-rebating laws is that
the practice is unfair to customers who do not get a rebate. Further, some feel that rebating
undermines the principles of insurance pricing regulations that most states enforce.
Insurance regulators in many states pay close attention to rates not only to make sure that
rates are adequate to protect the insurer from financial failure. Some feel that rebating
allows insurance customers to pay a rate that is below that needed to safely maintain the
insurer’s solvency.

However, rebating is permitted in at least one state, California, under limited circumstances.
Proposition 103, which were passed by California voters in 1988, repealed the law that
prohibited insurance agents from rebating part of their commission to clients. As a result,
rebates may now be made to California insureds, unless specifically prohibited by sections
of the state’s Insurance Code. California’s civil rights laws impose further restrictions by
prohibiting insurance producers from offering rebates, or varying the size of rebates, if the
practice unfairly discriminates among individuals.

Opponents of anti-rebating laws in other states continue to argue that such laws inhibit
competition in the insurance marketplace. These laws may be challenged further in the
future.

Other Deceptive Practices

Unfair trade practices laws also prohibit other practices of insurers that are deceptive or
unfair to applicants and insureds. For example, these laws prohibit an insurer and its
producers from making false statements about the financial condition of another insurer.
For example, an agent for one insurer cannot mislead his client by saying that another
insurer has a poor financial rating in the hope of discouraging the client from purchasing
insurance from the competing insurer.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

It is also an unfair trade practice to put false information on an insurance application to

earn a commission from the insurance sale. Occasionally, some information may cause the
insurer to reject the application, which would deny the producer a commission. Producers
are required to be honest in the information they enter on application forms. Both insurers
and policyholders count on insurance transactions being conducted in utmost good faith .

SUMMARY

Insurance marketing is the process of identifying potential customers and then creating,
promoting, selling, and delivering the insurance products and services they need. Although
there are many aspect of this process, the initial contact between an insurer and its
policyholders is typically through an agent or another type of producer. Therefore, a major
marketing concern is the insurer’s relationship with its producers.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The legal relationship of agency empowers the insurance producer—the agent—to act on
behalf of the insurer—the principal. Normally, insurers make very specific agency contracts
with their producers. An agent owes specific duties, such as loyalty and obedience, to the
principal in acting for the principal’s benefit; and the principal owes certain duties to the
agent, such as compensation for services. The principal is legally bound by any acts of the
agent that are within the agent’s authority. The agent’s authority includes the express
authority stated in the agency contract, the implied authority that is not expressly granted,
and the apparent authority a third party many reasonably expect the agent to have.

The specific relationship an insurer has with its producers reflects the type of marketing the
insurer uses to sell its products. Insurance marketing systems include the independent
agency system, the exclusive agency system, and the direct writing system. Independent
agents are in business for themselves, they usually represent several different insurers, and
they own their expiration lists. Exclusive agents represent only one insurer and adhere to
the insurer’s programs and procedures, even though they are also in business for
themselves. The sales representatives of direct writing insurers are the insurer’s own
employees. Beyond these three marketing systems, insurers and producers also use
alternative distribution channels, including direct response, Internet, call centers, group
marketing, and financial institutions.

The compensation of insurance producers includes commissions and salaries. The sales
commissions paid to agents and brokers are a percentage of the insurance premiums they
produce. Sales commissions are often supplemented by contingent commissions, which
reflect the volume and profitability of that business for the insurer. The sales
representatives of direct writing insurers receive a salary, which may be supplemented by
bonus reflecting sales performance.

Advertising, another aspect of insurance marketing, reflects the marketing system used.
Insurers relying on independent agents usually advertise to promote the company image,
while independent agents try to attract local customers to their offices. Joint advertising
campaigns are often used to serve the needs of both the agent and the insurer. Exclusive
agency companies tend to emphasize both the company name and the local service. Direct
writing insurers advertise primarily to promote the company’s name and products with the
public. Insurers using alternative distribution channels rely heavily on advertising to bring
customers to them.

An insurer’s marketing management activities include producer supervision, producer

motivation, and product management and development. Insurers motivate producers
through personal contact and through incentive programs developed in the home office.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Through product management and development activities, insurers provide producers with
the products needed to produce business for the insurer.

State regulators oversee the marketing activities of insurers and their producers. Insurance
producers must meet specific requirements to obtain and maintain a license in the state or
states in which they transact business. States prohibit unfair trade practices such as
misrepresentation and false advertising, tie-in-sales, rebating, and other deceptive
practices.

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Underwriting Chapter 5

Underwriting is the process of selecting insureds, pricing coverage, determining insurance

policy terms and conditions, and then monitoring the underwriting decisions made. To a

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

large extent, an insurer’s success in achieving its goals depends on the effectiveness of its
underwriting.

Insures themselves, rather than their employees, are sometimes called underwriters.
However, the term underwrites is usually reserved for an insurer employee who evaluate
applicants for insurance, selects those that are acceptable to the insurer, prices coverage,
and determines policy terms and conditions.

UNDERWRITING ACTIVITIES

Underwriting consists of the following activities:

 Selecting insureds
 Pricing coverage
 Determining policy terms and conditions
 Monitoring underwriting decisions

The first three activities are not performed in sequence but occur simultaneously. The last
activity, monitoring underwriting decisions, is ongoing. Underwriters try to select insureds
to whom the insurer can offer insurance coverage under reasonable conditions. Of course,
the price charged for coverage must be high enough to enable the insurer to pay claims and
to provide the insurer with a reasonable profit.

Selecting Insureds
Insurers must carefully screen applicants to determine which ones to insure. If insurers do
not properly select policyholders and price coverages, some insureds might be able to
purchase insurance at prices that do not adequately reflect their loss exposures.
Underwriters, producers, and underwriting managers all participate in selecting
policyholders.

Most insurers receive more insurance applications than they accept. An insurer cannot
accept all applicants for the following two basis reasons:

1. The insurer can succeed only if it selects applicants who, as a group, present loss
exposures that are proportionate to the premiums that will be collected. In other
words, insurers try to avoid adverse selection.

2. An insurer’s ability to provide insurance is limited by its capacity to write new

policies.

Adverse Selection Considerations

Insurers expect to pay claims. Without claims, insurance would be unnecessary. However,
insurers try to select applicants who are not likely to have covered losses greater than the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

insurer anticipated in its insurance rates. On the other hand, people with the greatest
probability of loss are often more likely to purchase insurance, a situation called adverse
selection. Poor underwriting results might occur if too many of the applicants accepted for
insurance are those most likely to incur serious losses. Underwriters minimize adverse
selection by screening applicants to avoid those who present loss potentials not adequately
reflected in the insurance rates.

An extreme of adverse selection involves a burning building. No insurer would knowingly

write fire insurance to cover a building that is already burning, but the owner of an
uninsured building that is on fire would probably be glad to purchase fire insurance on the
building.

Adverse selection is particularly prevalent with some kinds of insurance. For example,
owners of property next to a river are more likely to purchase flood insurance than are
those who own property on a hilltop with no flood exposure.

Capacity Considerations

Capacity refers to the amount of business an insurer is able to write and is often measured
by comparing the insurer’s written premiums to its policyholder’s surplus (the insurer’s total
admitted assets minus its total liabilities). An insurer must have adequate policyholder’s
surplus to increase the volume of insurance it writes.

Insurers often impose voluntary capacity constraints that are more conservative than those
used by regulators. This restriction on capacity provides a cushion to allow for variability in
the insurer’s underwriting and investment results.

An insurer’s capacity limits its ability to write new business. Selling new policies creates
insurer expenses, such as producers’ commissions, that reduce the policyholder’s surplus in
the short term. Reduced policyholders surplus leads to reduced capacity. Yet, in the long
term, if the new policies generate premiums that exceed losses and expenses, the new
policies will increase the policyholder’s surplus. Barring serious underwriting or investment
losses, an insurer can increase its capacity through steady, orderly growth in sales of
policies that contribute to the insurer’s profits. Planned growth is generally one of the goals
of an insurer.

Insurers attempt to protect their available capacity in the following three primary ways:

1. By maintaining a spread of risk

2. By optimizing use of available resources
3. By securing reinsurance

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The first way insurers protect available capacity is by maintaining a spread of risk. Because
every insurer has limited capacity, insurers must allocate their available capacity. Insurers
prefer to spread their available capacity. Insurers prefer to spread their risk among various
types of insurance and different geographic areas. Consequently, insurers reduce the
chances that overall underwriting results will be adversely affected by a large number of
losses in one type of insurance or one territory. For example, a tornado might require an
insurer to pay extensive property claims in one community, but these claims would be
balanced against premiums from other communities that do not experience a tornado in
the same year, as well as premiums from other communities that do not experience a
tornado in the same year, as well as premiums from other types of insurance the insurer
writes.

Insurers also allocate capacity by setting limitations on the amount of insurance they write
for any one insured. Generally, limitation is more restrictive for some types of business than
for others, depending on the exposures presented. For example, an insurer might place a
lower limit on the maximum amount of fire insurance it will provide on a rural home with
no fire hydrants nearby and no fire department within ten miles than on a home located
within a city with excellent public fire protection.

The second way insurers protect their capacity is by optimizing the use of available
resources. In additional to its financial resources, every insurer depends on other resources.
Among these are physical resources, which include offices and equipment, and human
resources, which include underwriters, claim representatives, producers, and service
personnel.

Underwriting and servicing some kinds of insurance require special skills or experience.
Consequently, some insurers do not offer those types of insurance. For example, an insurer
might avoid applications for insurance on farms if it does not have personnel experienced in
handling farm business. Without appropriate underwriting expertise, an insurer will be
unable to recognize unusual loss exposure in a farm operation and price coverage
accordingly. Without experienced farm claim representatives, it can be very difficult and
expensive to settle such claims. Conversely, another insurer might have personnel capable
of handling farm business, and that insurer might want to use its available capacity to
increase the amount of insurance it writes for farmers.

The third way insurers protect their available capacity is by securing reinsurance. In
reinsurance, the reinsurer receives a portion of the premiums from the primary insurer’s
policies and assumes some of the financial consequences of loss exposures on those
policies. The primary insurer usually retains a portion of the premiums, pays the insured

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

losses, and is then reimbursed by the reinsurer for the portion of losses for which the
reinsurer is contractually responsible. If reinsurance is readily available, insurers can
increase the number of new policies they write by transferring some of the premium and
financial consequences of loss exposures to reinsurers. Thus, securing reinsurance can
affect an insurer’s capacity to write business.

Pricing Coverage

The underwriting pricing goal is to charge a premium that is commensurate with the loss
exposure. In other words, each insured’s premium should be set at a level that is adequate
to enable the total premiums paid by a large group of similar insureds to pay the losses and
expenses of that group and to allow the insurer to achieve a reasonable profit. Basically,
pricing insurance involves classifying the applicant by category of loss exposure and then
determining a premium by applying an appropriate rate to the applicant’s exposure units.

Premium Determination

As discussed in previous chapters, the rate is the price of insurance charged per exposure
unit, and an exposure unit is a unit measure of loss potential used in rating insurance. The
exposure unit used depends on the type of insurance, as follows:-

Types of Insurance Exposure Unit

Workers’ compensation Each $100 of payroll
Property insurance Each $100 of insurance
Auto liability insurance Each car month insured (one car insured for one year would
be 12 exposure units)

The premium is determined by multiplying the rate by the number of exposure units. For
example, the premium for property insurance with a limit of $250,000 at a rate of $0.40 per
$100 of insurance is $1,000, calculated as follows:

Premium = $250,000/$100= 2,500 x $0.40 per unit = $1,000

The premium is the total amount of money an insured an insured pays the insurer for a
particular policy of coverage for a stated period. For example, an insurer may charge a
premium of $750 to provide a one – year property insurance policy with a $500 deductible
for a $200,000 brick home located in Anytown, U.S.A. The same insurer may charge $750 to
provide identical coverage on a $160,000 brick home located five miles outside Anytown.
While the total premium would be the same in both cases, the rate per $100 of insurance is
different, probably reflecting a difference in fire protection in the two locations.

Of course, accurately predicting what losses a particular insured will have during a given
policy period is difficult. An excellent driver may have several auto accidents in a year
because of a streak of bad luck. A careless driver may get through the same year without

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

any accidents. However, according to the law of large numbers, prediction becomes more
accurate as the number of similar insureds increasing. Although one excellent driver may
have a worse year than one careless driver, it is highly unlikely that a group of one hundred
cautious drivers will have more insured losses than a group of one hundred careless drivers.
Each group of drivers should be charged a premium commensurate with their loss
exposures. Therefore, drivers, with good driving records are generally charged less than
those with poor driving records.

In determining the appropriate premium to charge for coverage, insurers use either class
rates or individual rates, which are discussed next.

Class Rates

Class rates are common in property and liability insurance. Personal insurance and
commercial insurance often involve large numbers of insureds with similar loss exposures
grouped into rating classes. Each insured in a given rating class has approximately the same
exposures to loss and would therefore be charged approximately the same rate for
insurance coverage. Class rates are sometimes called manual rates because they have
traditionally been published in rating manuals – loose-leaf binders used by underwriters,
raters, and producers in pricing individual policies. Most insurers have replaced rating
manuals with computerized rating systems based on class rates formerly published in rating
manuals. The rating of most personal insurance and a growing amount of commercial
insurance is computerized. Class rates are based on the loss statistics of the large number of
insureds that constitute a rating class. In many different situations, the use of class rate
provides a uniform approach to pricing coverage for similar insureds.

Many insureds within a rating class have loss characteristics that may not be fully reflected
in class rates. Merit rating plans modify class rates to reflect these loss characteristics. A
merit rating plan serves the following two purposes:

1. It enables the insurer to fine-tune the class rate to reflect certain identifiable
characteristics of a given insured

2. It encourages loss control activity by rewarding safety - conscious insureds with a

lower rate than that for those who do not practice loss control

The following examples illustrate the use of merit rating plans:

 Safe Driver insurance plans. In personal auto insurance, insurers use safe driver
insurance plans (rating plans in which premiums are based on the insured’s driving
record) to lower the premiums for drivers with a history of accident-free driving and no
major traffic convictions.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Premium discounts. In homeowners insurance, insurers typically provide premium

discounts for insureds whose homes have fire alarms or burglar alarms.
 Experience rating. In commercial insurance, insurers often use experience rating. In this
type of rating, premiums are increased for insureds whose loss experience has been
worse than average, and premiums are decreased for insureds whose loss experience
has been better than average.
 Schedule rating. In commercial insurance, schedule ratting allows an underwriter to
consult a schedule of credits or debits based on criteria that are not reflected in the
class rate, and then modify the rate by the applicable credits. An example of such a
characteristic is the attitude of the insured’s management toward loss control. If the
insured’s management encourages loss control activities, the insurer could apply a
schedule credit to the property insurance rate. Schedule debits or credits are expressed
as percentage increase or decreases from the class rate.

Individual Rates

Class rates are not suitable for some types of insurance. For example, an underwriter would
not be able to use a rating manual or rating system to determine the rate for fire insurance
on a factory building that has an unusual construction and is occupied for a unique purpose.
An individual rate, or a specific rate, would be used in such a situation, and it is developed
only after a detailed inspection of the structure and its contents. Each individual rate
reflects the building’s unique characteristics, such as its construction (for example, brick or
frame), its occupancy (for example, warehouse or manufacturing), public and private fire
protection (such as distance to the fire department and existence of a sprinkler system),
and external exposures (for example, proximity to other buildings or to brush that could
spread a fire to the building).
The pricing of insurance coverage for one-of-a-kind exposures must often be based
primarily on an underwriter’s experience and judgment. An underwriter may examine rates
for comparable exposures to determine appropriate rates before arriving at the premium
that will actually be charged for the unique exposure. A judgment rate, which is a type of
individual rate, is not arbitrary but is based on the underwriter’s experience in covering
unique exposures for which there is no established rate. Judgment rating is often used in
rating ocean marine insurance covering many types of cargo being transported to ports
worldwide.
Determining Policy Terms and Conditions

Selection and pricing are intertwined with a third underwriting activity – determining policy
terms and conditions. The insurer must decide exactly what types of coverage it will provide
to each applicant and then charge a premium appropriate to that coverage.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

In addition to developing loss costs, insurance advisory organizations develop policy forms
using standard insurance wording. These policy forms, called standard form, can be used by
insurers that subscribe to (pay for) the services of the advisory organization. Because many
insurers use standard forms, the policy issued by one insurer is often identical to the policy
that would be issued by a competing insurer.

For each type of insurance it handles, an insurer needs to decide whether to use standard
forms developed by the advisory organizations or to develop its own policy language,
possibly providing coverages that differ in some ways from coverages provided by other
insurers. Some types of insurance, such as professional liability insurance, have no standard
form because many coverage differences exist among policies.

When advisory organizations develop insurance policies, they also develop rules specifying
what kinds of insureds will be eligible for certain policies. Insureds need to decide whether
they will adhere to these rules or modify them.

Monitoring Underwriting Decisions

Underwriters periodically monitor the hazards (conditions that increase the frequency or
severity of a loss), loss experience, and other conditions of specific insureds for significant
changes. Because underwriting decisions involve an assessment of loss potential, hazards
and other conditions must be reviewed periodically.

If an underwriter made loss control recommendations (such as installing fire extinguishers)

to a particular insureds, follow-up is necessary to ensure that the insured has implemented
the recommendations. An increase in hazards might change an acceptable insured into an
unacceptable one for the coverage and premium charged. For example, if an insured
converts a garage into a laboratory for producing toxic chemicals, the coverage and
premium would have to be changed to reflect the increase in hazard, or continued coverage
might be denied. Monitoring helps underwriters discover such changes and alter coverage
and premium as necessary. Monitoring also applies to underwriting decisions on an entire
book of business. A book of business, or a portfolio, is a group of policies with a common
characteristic, such as territory or type of coverage. A book of business can also refer to all
policies written by a particular insurer or agency.

Underwriters might also be responsible for maintaining the profitability of a book of

business by achieving written premium and loss ratio goals for that book. This is especially
true for insurers that underwrite policies, such as personal auto or homeowners
applications, through the use of computerized systems. Such systems screen the
applications using a scoring system that measures the acceptability of the loss exposures.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Underwriters then monitor the results for the entire book of the loss exposures.
Underwriters then monitor the results for the entire book of business to ensure that the
screening system is making selections that achieve the goals established for the book of
business. An underwriter can make recommendations to adjust the screening to achieve the
desired results.

UNDERWRITING MANAGEMENT

An insurer’s underwriting management has many responsibilities, including the following:

 Participating in the insurer’s overall management
 Arranging reinsurance
 Delegation underwriting authority
 Developing and enforcing underwriting guidelines
 Monitoring underwriting results

Only by constantly adjusting to a changing environment can an insurer meet its goals.
Insurers change underwriting rules and standards as business conditions change.
Underwriting management has the responsibility for implementing these changes.

Participating in Insurer Management

An insurer’ senior management team generally includes officers responsible for marketing,
product development, claims, finance, actuarial services, and other functions, as well as
underwriting. The head of an insurer’s underwriting department participates with other
members of the insurer’s goals, including annual written premium and loss ratio goals, and
plans to meet those goals. Decisions at this level might determine what type of marketing
system will be used, where offices will be located, what emphasis will be placed on personal
and commercial insurance, and so forth. Given senior management consensus on the
insurer’s broad goals and how its capacity should be allocated, underwriting management
must decide how underwriting activities can contribute to these goals. An insurer’s
underwriting management must then develop underwriting goals that complement or
support the company’s overall goals.

Arranging Reinsurance

Another aspect of underwriting management is arranging reinsurance. The two broad

categories of reinsurance are treaty reinsurance and facultative reinsurance.
Treaty reinsurance is an arrangement whereby a reinsurer agrees to automatically reinsure
a portion of all eligible insurance of the primary insurer. The treaty is a contract that defines
the eligible insurance. The primary insurer is required to reinsure, and the reinsurer must
accept, all business covered by the treaty. Policies are not selected individually.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Primary insurers and reinsurers periodically negotiate the reinsurance treaty. Before
entering into a treaty and agreeing on pricing, the reinsurer carefully evaluates the primary
insurer’s past performance and expected future underwriting results. Because the treaty is
based on all eligible insurance written by the primary insurer, the reinsurer is more
concerned with the group of insureds as a whole than with the individual accounts that
compose the group.

Facultative reinsurance is an arrangement whereby the primary insurer choose which

policies to submit to the reinsurer and the reinsurer can accept or reject any policies
submitted. It is not automatic but involves a separate transaction for each reinsured policy.
That is, the reinsurer evaluates each policy it asked to reinsure. Underwriters for the
primary insurer decide which policies to submit for reinsurance, and underwriters for the
reinsurer decide which policies to reinsure. Pricing, terms, and conditions of each policy are
individually negotiated.

Delegating Underwriting Authority

Underwriting management focuses on the entire group of insureds while underwriters who
usually work in field must deal with individual applications. Underwriting management must
determine how much underwriting authority to grant to those underwriters. Underwriting
authority establishes the types of decisions an underwriter can make without needing
approval from someone at a higher level. The amount of authority given to each
underwriter usually reflects the underwriter’s experience, responsibilities, and the types of
insurance handled.

With some insurers, underwriting authority is highly decentralized; that is, underwriting
management delegates extensive underwriting authority to personnel in the field offices.
Other insurers are highly centralized, with many or all final underwriting decisions being
made in the home office. For insurers with centralized authority, field offices serve as a
point of contact where insurer personnel gather information, accept application, and
provide policyholder services. Many insurers are neither completely centralized nor
completely decentralized; these insurers strive to maintain a balance between the
underwriting authority given to underwriters in field offices and the underwriting authority
reserved for home office underwriters.

Many insurers also grant some underwriting authority to the agents who represent the
company. Called front-line underwriters, these agents make the initial underwriting
decision about applications and then forward those applications that meet underwriting
guidelines to the company underwriter. Agents usually have the authority to accept
applications and bind coverage for the insurer if the applicant clearly meets the guidelines

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

and if the limit of insurance is within a predetermined amount. The extent of the authority
granted to an agent generally depends on the agent’s premium volume and loss experience
with the insurer.

Developing and Enforcing Underwriting Guidelines

Underwriting managements develops the guidelines that underwriters use in the

underwriting process. Companywide rules guide underwriters toward consistent decisions
that enable the insurer to meet its overall underwriting goals.

Underwriting guidelines and bulletins explain how underwriters should approach each
application. The guidelines list the factors that should be considered by the underwriter for
each type of insurance, the desirable and undesirable characteristics of applicants relative
to those factors, and the insurer’s overall attitude toward applicants that exhibit those
characteristics. Based on the guidelines, underwriters evaluate the applications they
receive, decide how to handle the applications, and act on those decisions.

Underwriting management activity does not end with the development of underwriting
guidelines. The guidelines must be clearly communicated to all underwriters, which may
require training programs. In addition, underwriting management must prepare and
distribute bulletins or guideline revisions whenever changes are made.

Monitoring Underwriting Results

Underwriting management must also monitor the underwriting results to see whether
underwriting guidelines have had the desired effect. Monitoring includes steps to ensure
that underwriters are following underwriting guidelines and that underwriting goals are
being met. If the guidelines are not followed, there is no evidence about whether they are
effective. Periodically, underwriting managements sends underwriting audit teams to visit
field offices to examine underwriting files, a process called an underwriting audit. If the
audit reveals that guidelines are being followed, it is then necessary to determine whether
they are having the desired results. For example, assume an insurer has broadened its
homeowners insurance policies by adding extra coverages, such as an additional theft limit
on jewelry, in an attempt to attract new customers. Monitoring would reveal the extent to
which insured losses increase because of the coverage addition, whether sales have
increased, and whether revenues from the increased sales more than offset the costs of
claims.

Many factors affect an insurer’s success. Constant monitoring of underwriting results

enables underwriting managements to adjust underwriting guidelines to accommodate
changing conditions, goals and results.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

MONITORING UNDERWRITING RESULTS

An underwriting decision must be made on every new insurance application, as well as on

renewal policies and on policy changes, such as adding a car or increasing policy limits. The
underwriting process consists of the following four steps:

1. Gathering underwriting information

2. Making the underwriting decision
3. Implementing the underwriting decision
4. Monitoring the underwriting decision

Traditionally, underwriting was a non-automated process that depended on human

judgment. Increasingly however, portions of the underwriting process, particularly in
personal insurance, are computerized. Computerized underwriting processes use software
that emulates the steps an underwriter would take. Computerized underwriting is most
common with high-volume types of insurance such as personal auto or homeowners
insurance. In this type of underwriting, the computer screens applications and accepts
those that clearly meet all criteria and rejects those that clearly do not. Questionable
applications are referred to an underwriter for evaluations.

Some insurers now use expert systems, also known as knowledge-based systems, to assist
underwriters in the underwriting process. These computerized systems are programmed to
emulate the underwriting decision-making process as it would be performed by “expert”
(usually senior) underwriters. The expert system asks for the information necessary to make
an underwriting decision, thereby ensuring that no information is overlooked. Although
expert under-writing systems are capable of making an underwriting decision (usually by
assigning a grade on a scale of one to ten or one to one hundred), most are used to
supplement an underwriter’s decision making, not to replace the underwriter.

Inexperienced underwriters can use the expert system to determine why a certain grade
was assigned. The ability of the expert system to interact with the underwriter also makes
the system an excellent training tool.

Gathering Underwriting Information

Underwriters base their decisions about individual applications on a combination of

information and judgment. To make a decision, underwriters need adequate information to
analyze the potential losses each applicant represents. Underwriters derive information
from several sources, including the following:-

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Producers. In addition to completing and submitting applications, producers might

supply additional information not included on applications, such as a personal
evaluation of the applicant.

 Consumer investigation reports. Various independent reporting services investigate and

provide background information on prospective insureds. Insurance applications
generally inform the applicant that he or she may be investigated.

 Government records. Motor vehicle records (MVRs) are commonly use in underwriting
auto insurance. Underwriters can also seek underwriting information in court records
and public information relating to property ownership.

 Financial rating services. Firms such as Dun & Bradstreet (D&B) and Standard & Poor’s
provide data on the credit rating and financial stability of specific businesses. In personal
insurance, insurance credit reports are often used to examine an individual’s financial
history. Some insurers use insurance scoring, which is a statistical analysis of credit
report information that identifies the relative likelihood of an insurance loss based on
the actual loss experience of individuals with similar financial patterns.

 Inspection reports. Many insurers employ loss control representatives whose duties
include inspecting the premises and operations of insurance applicants and preparing
reports for underwriters.

 Field marketing personnel. Many insurers have marketing representatives or other

employees who spend much of their time in the field working with producers. These
field personnel can often provide additional insights regarding an applicant based on
personal observations.

 Claim files. After a policy has been issued, the insured may have claims. Significant
information about the insured may thus appear in the insurer’s claim files, and
additional information may be available from the claim representatives who handled
the claims.
 Production records. In evaluating applications, underwriters generally consider the track
record of the producer who submits the application. If the producer has consistently
generated profitable business, the underwriter may be willing to accept an applicant
that may not meet all of the underwriting standards.

 Premium audit reports. Rates for some kinds of commercial insurance are applied to
estimated payroll, sales, or some other exposure unit whose final measure is not

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

determined until the end of the policy year. Insurers employ premium auditors to obtain
the final figures from insureds’ accounting records to compute the final premium on
such policies. In addition to providing this exact information, a premium auditor can
provide other information about an insured, especially because the premium auditor
has probably visited the insured’s premises and seen the operations.

 Applicant’s or insured’s records. Underwriters can sometimes obtain information from

the applicant’s or insured’s records, including copies of appraisals of jewelry (for
valuation purposes) and bills of sale. For businesses, the annual report, which describes
the firm’s operations and future plans and includes its financial statements (balance
sheet and income statement), provides much useful underwriting information. Most
businesses now have Web sites that could also be a source of valuable information to an
underwriter.

Making the Underwriting Decision

As discussed earlier in this chapter, conditions that increase the frequency or severity of a
loss are called hazards. Examples of hazards include an untrained driver in regard to auto
insurance and the poor maintenance of fire extinguishers in regard to insurance on a
building. Once the underwriter has gathered the necessary information, he or she must
analyze the information to determine what hazards the applicant presents. To make an
underwriting decision, the underwriter must then evaluate underwriting options and
choose the best one.

Analyzing Hazards
An applicant with hazards that are greater than normal may not be acceptable as an
insured, unless the hazards can be eliminated, controlled, or offset by a substantially
increased premium. In contrast, an applicant presenting normal or less-than-normal hazards
is generally desirable from an underwriting standpoint. An underwriter must evaluate the
following four categories of hazards:

1. Moral hazards
2. Attitudinal (moral) hazards
3. Physical hazards
4. Legal hazards

Moral hazards are conditions that may lead a person to intentionally cause or exaggerate a
loss. The threat from a moral hazard is the possibility that the insured may intentionally
cause a loss or file a false claim. For example, an insured may intentionally cause fire or an
auto accident to collect a claim payment on a building or car and unjustly enrich himself or
herself. A moral hazard may be indicated by a weak financial condition (which could be

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

detected in a financial report) or questionable moral character (which could be indicated by

a police record).

One of the characteristics of an ideally insurable loss exposure is that losses be accidental.
Insurance is intended to deal with losses that are unexpected from the insured’s standpoint;
it is not feasible to insure against events within the insured’s control. The prudent
underwriter rejects applicants presenting a significant moral hazard.

Attitudinal hazards, also known as morale hazards, involve carelessness about, or

indifference to, potential loss on the part of an insured or applicant. Such hazards are more
subtle and thus more difficult to detect than are moral hazards. A particularly dangerous
attitudinal hazard is an insured’s attitude that “I don’t need to be careful because I have
insurance.” Evidence of an attitudinal hazard may be found in personality traits (some
people are naturally careless and therefore accident-prone regardless of insurance), poor
management (tolerance of dangerous conditions and practices), or past loss experience (a
history of losses caused by carelessness).

Moral hazards and morale hazards are often confused, which is why the term “attitudinal” is
more often used to refer to morale hazards. Someone who represents a moral hazard may,
for example, set a fire to collect an insurance settlement. Someone who represents a
morale (attitudinal) hazard may be careless in allowing smoking in hazardous areas or
permit combustible supplies to be piled in a furnace room.

In evaluating an application for property insurance on a building, the underwriter considers

possible physical hazards, such as those inherent in the building’s construction, occupancy,
protection, and external exposures.

Physical hazards are tangible characteristics of property, person, or operations that tend to
increase frequency or severity of loss. An office building located next to a restaurant
without adequate fire protection clearly represents a greater fire hazard than an office
building located next to a retail store with excellent fire protection.

Legal hazards are characteristics of the legal or regulatory environment that hamper an
insurer’s ability to collect a premium commensurate with the exposure to loss. Hazards in
the legal environment might include court decisions that interpret policy language in a way
unfavorable to insurers. For example, commercial liability policies at one time provided
coverage for pollution losses that were sudden or accidental, but court decisions applied
coverage in cases in which insurers thought the pollution was clearly not sudden or
accidental but gradual. Because of this legal hazard (courts mandating coverage broader

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

than insurers intended), insurers ceased to provide pollution liability coverage in many
cases or started charging an additional premium for pollution liability coverage.

The regulatory environment presents legal hazards when it forces underwriters to charge
premiums that are too low for the exposures or to provide coverages that are too broad.
Legal hazards are also presented when regulatory authorities unduly restrict insurers’ ability
to cancel or nonrenewal policies.

Evaluating Underwriting Options

In evaluating each application, an underwriter has the following three options:

1. Accept the application without modification

2. Reject the application
3. Accept the application with modification

The application may be so desirable that the underwriter will accept it with no changes.
Conversely, the application may be so undesirable that the underwriter will reject it. The
third option requires the greatest amount of underwriting creativity. Often an applicant that
is not acceptable for the insurance originally requested can become acceptable if some
aspect of coverage is changed or if methods to reduce the frequency or severity of loss are
implemented. Generally, the underwriter, producer, and applicant all want the insurance
policy to be issued. If the particular coverage requested cannot be provided, the
underwriter might be able to offer an alternative that satisfies all parties.

Frequently, a policy can be issued if the applicant agrees to implement loss control
measures. For example, an underwriter may agree to write property insurance for the
owner of a particular bookstore, provided the store owner installs and maintains an
appropriate fire alarm system.

Another possibility may be to modify the rate charged for the coverage. A producer may
have quoted auto insurance using the insurer’s preferred risk rate, a lower rate offered to
substantially better-than-average applicants. The underwriter may determine that the
applicant does not qualify as a preferred risk but would be acceptable for coverage at
standard class rates.
Coverage may also be modified – that is, the underwriter may offer terms and conditions
that are somewhat different from those that the applicant has requested. For example, an
underwriter may be asked to provide an auto policy, including coverage with a $100
deductible for an applicant who has had several claims for windshield damage. The
applicant may be a preferred risk except for this one coverage. The underwriter could offer
the desired coverage with a $500 deductible and thus avoid rejecting the application
acceptable through coverage modification.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Facultative reinsurance is a common underwriting alternative in cases in which an

otherwise acceptable application exceeds the limit in the underwriting guidelines. For
example, suppose an insurer is asked to provide $10 million of property insurance on
building, but the insurer’s acceptable limit on a single building is $500,000. After checking
with underwriting management, an underwriting may determine that facultative
reinsurance could be obtained to handle the remaining $9.5 million of coverage. By
arranging reinsurance in the amount in the amount of $9.5 million, the underwriter can
accept the application for the limit of $10 million requested by the applicant.

After carefully analyzing hazards and underwriting options, the best underwriting decision
for a particular application usually becomes obvious. Each alternative, such as following loss
control recommendations or accepting modified coverage, requires the agreement of the
applicant and may involve further negotiation. In such situations, the underwriter normally
contacts the producer to negotiate the modified terms, price, or conditions with the
applicant.

Implementing the Underwriting Decision

If the underwriting decision is within the underwriter’s authority and consistent with
underwriting guidelines, the underwriter can approve the policy and submit the file for
processing and policy issuance. This approach is typical with routine applications for auto
insurance, homeowners insurance, and small commercial accounts. In more complex cases,
the insurer must communicate the underwriter’s decision to the producer, along with a
quote showing the premium to be charged and the terms and conditions to be offered.
After the producer discusses this information with the applicant, and possibly compares it
with quotes from other insurers, the underwriter may be asked to issue the policy or may
learn that the applicant has decided to do business with another insurer.

To accept an application for coverage exceeding the underwriter’s authority, an underwriter

must seek a supervisor’s approval. The supervisor may simply approve or reject the
underwriter’s recommendation, or the entire application may be referred to a more
specialized or experienced senior underwriter.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Monitoring the Underwriting Decision

The underwriter’s job does not end when a policy is issued. The underwriter must also
monitor the results of the initial underwriting decision. Among other things, the
underwriter needs to reevaluate his or her underwriting decisions by considering claims
that develop from accounts that were accepted. The nature and number of losses in a given
period may indicate that some other underwriting action is required.

The fact that an insured has a serious loss or several losses does not necessarily indicate
that the underwriter made a bad decision. Conversely, a lack of serious losses on an account
does not necessarily mean that the underwriter made a good decision in accepting the
account. The lack of losses may have been a matter of chance. Despite these variations in
the loss experience of individual accounts, the entire group of accounts handled by an
underwriter is expected to meet the loss ratio goals established for that portfolio. Each
account contributes to the underwriter’s record in the long term.

If serious problems develop with an account, the underwriter may need to take corrective
action. Such action may include recommending additional loss control measures, modifying
the terms of coverage, canceling coverage (if permitted), or marking the policy for
nonrenewal at the end of present policy term.

During the policy term, the underwriter any also receive one or more requests for coverage
changes. Each request must be carefully considered and implemented as appropriate. Some
change presents no increased hazard, while others may increase the potential for losses.
For example, a change of vehicles on an automobile policy from a five-year-old sedan to a
newer model does not necessarily represent an increased hazard, but it may if, at the same
time, a young driver is added as an additional operator.

Finally, as the expiration date of a policy approaches, the underwriter may need to repeat
the underwriting process before agreeing to renew the policy for another term. Renewal
underwriting can generally be accomplished more quickly than underwriting new business
because the insured is already known, to some degree, and claim reports or loss control
reports may provide additional information. However, the underwriter must determine
whether my change in the exposures have occurred, and, if so, carefully go through the
underwriting process again.

Many insurers do not repeat the entire underwriting process for existing personal insurance
policies, such as auto and homeowners, at every renewal. Instead, they continue to renew
these policies until something triggers an underwriting review. Claims, requests for

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

coverage charges, or the passage of a certain amount of time may prompt the insurer to
repeat the underwriting process.

REGULATION OF UNDERWRITING ACTIVITIES

In the interest of protecting the public, every state regulates insurer’s underwriting
activities and places some constraints on the terms and conditions that insurers offer. Two
important examples of underwriting activity regulation are as follows:

1. Prohibition of unfair discrimination

2. Restrictions on cancellation and nonrenewal

Prohibition of Unfair Discrimination

The ability to discriminate fairly among applicants is one of the most important elements of
underwriting. However, state insurance regulations prohibit unfair discrimination in
insurance. This prohibition also applies to insurance underwriting activities. The challenge
lies in distinguishing between fair discrimination and unfair discrimination.

With the attention given to topics such as racial and sexual discrimination, it is easy to
forget that discrimination itself can be neutral word. Dictionary definitions of discrimination
include "The quality or power of finely distinguishing" and "The act or practice of
discriminating categorically rather than individually."

Teachers discriminate – that is, they finely, distinguish – when they assign different grades
to students with different levels of performance. Schools discriminate categorically when
they admit kindergarten students based on age rather than rating them individually on the
basis of physical or mental maturity.
Similarly, underwriting involves distinguishing among properties, business, and people and
grouping them into categories. An insurer’s ability to discriminate fairly is essential if
insureds are to be charged a premium commensurate with their loss exposures.

According to state insurance laws, unfair discrimination is prohibited as an unfair trade

practice. Examples of unfair discrimination include the following:

 Geographic location. Refusing to issue, canceling, or non-renewing coverage for an

applicant or an insured solely on the basis of geographic location. This prohibited
practice is sometimes called redlining – suggesting a bright red line on a map
surrounding a prohibited area.
 Gender or marital status. Refusing to issue, canceling, or non-renewing coverage for
an applicant or an insured solely on the basis of that person’s gender or marital
status.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Race. Refusing to issue, canceling, or non - renewing a policy solely because of the
applicant’s or the insured’s race.

These examples of unfair discrimination all include some kind of prejudice: judging, with no
further information, that property in a given area, persons of a particular gender or marital
status, or members of a certain race are likely to have unacceptable levels of losses. Further
information in each case may indicate that the applicant or insured does not meet the
insurer’s underwriting standards, regardless of address, gender, marital status, or race.
Therefore, if coverage is denied after objective underwriting criteria have been applied, it is
not likely that unfair discrimination has occurred.

Restrictions on Cancellation and Non-renewal

Most states require that insurers provide notification to the insured within a specified
period, such as thirty days, before a policy is to be concealed or non-renewed. This notice is
intended to give the insured an opportunity to replace the coverage. Generally, restrictions
of this kind help insurance to serve its purpose of providing protection for policyholders.
However, such restrictions also limit the speed with which an underwriter can stop
providing coverage for an insured that has become undesirable.

For example, after widely publicized claims involving allegations of child abuse caused
insurers to become concerned about the legal hazards of operating daycare centers, some
policies providing coverage to these centers were canceled or non-renewed. At the same
time, insurer capacity was severally restricted for other reasons as well, affecting many
kinds of insurance. Insurers canceled or non-renewed some policies in an attempt to
reallocate their available capacity. In response, several states enacted laws prohibiting
insurers from canceling insurance policies during the policy term and restricted insurers’
rights to non-renew policies. Even when such non-cancellation laws had not been passed,
underwriters became much more reluctant to exercise cancellation rights to avoid adverse
reaction that could lead to further regulatory restrictions on underwriting activities.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

SUMMARY

Underwriting is the process by which insurers evaluate applicants for insurance and those
currently insured in order to maintain a profitable book of business. Underwriting consists
of the following activities:

 Selecting those applicants who meet the company’s underwriting guidelines

 Pricing the coverage to charge a premium commensurate with the loss exposure.
 Determining the proper policy terms and conditions
 Monitoring underwriting decisions.

While underwriters are responsible for day-to-day decisions, they must refer to the
insurer’s underwriting guidelines. Underwriting management sets the insurer’s guidelines to
make optimal use of the company’s available capacity and avoid adverse selection. The role
of underwriting management involves various responsibilities, including the following:

 Participating in the overall management of the insurer in making broad business

decisions

 Arranging reinsurance, which can be either treaty reinsurance (on all eligible policies)
or facultative reinsurance (involving a separate transaction for each reinsured policy)
 Delegating underwriting authority, which establishes the types of decisions a
underwriter can make without receiving approval from someone at a higher level

 Developing and enforcing underwriting guidelines that reflect the company’s overall
underwriter objectives

 Monitoring the results of underwriting to see whether the underwriting guidelines

have had the desired effect

In making decisions, underwriters follow four steps in the underwriting process:

1. Gathering the necessary information from various sources to evaluate applicants

2. Making the underwriting decision, which includes analyzing hazards (which can be
moral, attitudinal physical, or legal), evaluating underwriting options (accepting or
rejecting the application or accepting it with modification), and choosing the best option

3. Implementing the underwriting decision

4. Monitoring the underwriting decision

In the interest of protecting the public, every state regulates insurers’ underwriting
activities by prohibiting unfair discrimination. In addition, most states require that insurers
provide notification to the insured within a specified period before a policy can be canceled
or non-renewed.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Claims Chapter 6

At 8.00 AM, Rajiv Gupta drove his two children to school, as he did each school day. Fifteen
minutes earlier, he dropped off his wife at the train station for her commute to work.
Leaving the school, he entered the expressway for the twenty minute ride to his office. As
he accelerated to merge into the highway traffic, he glanced over his shoulder to see if the
lane was clear. It was, and he pressed on the gas pedal. However, the car in front of him had
stopped in the merge lane, and Rajiv could not halt his car in time. He braced himself as his
car slammed into the rear bumper of the stopped vehicle.

Steam poured from under his crumpled hood as traffic backed up behind him. His back hurt,
but he was able to get out of the car and exchange insurance information with the other
driver, who was shaken but showed no visible injury. The police were summoned, and Rajiv
was cited for careless driving.

Rajiv had his car towed to a repair shop. That day he called his insurer. He learned that his
auto insurance policy will pay for the towing bill and for a rental car while his vehicle is
being repaired. His insurer will also pay to repair the damage to his car, less his $500
deductible, and will pay for the medical expenses he incurs from the accident. Because he
was cited and at-fault in the accident, Rajiv’s insurer will also pay for repairs to the other
vehicle.

Three months later, the other driver filed a lawsuit demanding $250,000 for pain and
suffering damages from the accident. Rajiv’s insurer advised him that they will defend
against this lawsuit, paying both the legal costs and any judgment up to his liability policy
limit.

Property-casualty incurred insurance claims and loss settlement expenses approach $300
billion per year in the United States. The responsibility for properly investigating, evaluating,
and settling the hundreds of thousands of claims submitted annually to insurers rests with
the people in claim departments.

Insurance is a promise. In return for the premium payment, the insurer promises to pay
those claims that are covered by the policy provisions. An insurance claim payment is the
fulfillment of the promise made by the insurer; this chapter discusses the people and the
processes that enable insurers to keep that promise.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

For insurance purposes, a claim is a demand by a person or business seeking to recover

from an insurer for a loss that may be covered by an insurance policy.

A claimant is anyone who submits a claim to an insurer. Insurance claim professionals

distinguish between first party and third party claimants. The first party is the insured. In
some cases, particularly in liability claims, the claimant is a third party who has suffered a
loss and who seeks to collect damages for that loss from an insured. This text uses the term
claimant to refer both to a third party claimant and to the insured who makes a claim.
The primary purpose of the claim handling process is to satisfy the insurer’s main obligation
under the insurance policy: to pay claims for covered losses. To fulfill this obligation, the
insurer’s claim representative must respond promptly once a claim is submitted. Claim
representatives (also called adjusters) verify coverage, determine the cause of loss and
amount of damages, and settle or otherwise conclude the claim.
The terms “claim adjusting" and "settlement” are often used when discussing claims. In a
narrow sense, a settlement is a payment that satisfies the insurer’s obligation to the
claimant. It is important to note that within the property casualty insurance industry, the
term is frequently used in a broader sense to refer to the process of negotiating the amount
of loss payment (if any), and closing the claim through payment or dental. This text uses the
term "claim handling" to refer to the entire series of events that begins with the report of
loss of the insurer and typically ends with payment (or denial of payment) to the claimant.

CLAIM HANDLING RESPONSIBILITY

If an insurer is handling claims, several different types of people can have claim handling
responsibility, depending on the circumstances. These include the following:
 Staff claim representatives (inside and outside)
 Independent adjusters
 Producers
 Public adjusters

In addition, an organization that has established a self-insurance plan must make provisions
to handle its own claims by using either an internal claim department or an outside
administrator.

Staff Claim Representatives of Insurers

A staff claim representative is an insurer employee who performs some or all of the
insurer’s claim handling activities. Most insurers have at least two kinds of staff claim
representatives: inside claim representatives, who work exclusively inside the office, and
outside claim representatives, who travel to the site of the loss and elsewhere to perform
claims investigations and evaluations.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Inside Claim Representatives

An inside claim representative is an insurer employee who handles claims that can be
settled, usually by phone or mail, from inside the insurer’s office. Some claim
representatives also use e-mail and Internet-based communication to settle claims. The role
of an inside claim representative is to gather information about a claim, verify coverage,
determine the cause of loss, determine liability and damages (for liability claims), and make
a timely settlement. Traditionally, the inside claim representative handled only relatively
simple and straightforward cases. However, the inside representative may also handle
complex claims by managing external independent claim adjusters. Often, the inside claim
representative gathers the initial claim information from the claimant, insured, or the
producer.
The inside claim representative communicates with the insured or claimant to obtain
information about how and when the loss occurred. If a third party is involved, the inside
claim representative may use a tape recorder to take statements about the loss from the
insured, the claimant, and any witnesses, after obtaining their permission to tape their
statements. In many cases, the claimant’s statement is taken first to get a record of the
claimant’s version of the occurrence.
For claims involving automobile accidents, the claim representative usually orders a police
report and compares this report with the statements of the insured, the claimant, and any
witnesses. The inside claim representative also requests repair estimates or assigns
appraisers to inspect damaged automobiles and to estimate repair costs. Some insurers
have drive-in claim facilities in which the claimant can obtain a damage appraisal and
receive claim payment. For simple cases, such as a broken window or a minor automobile
accident in which no one is injured, the inside claim representative can usually arrange for
the insured or claimant have or claimant to have repairs made or can otherwise settle the
claim without involving anyone else. Many claims, however, require an outside claim
representative or the services of an independent adjuster. Typically, the inside claim
representative coordinates the activities of the outside representative or independent
adjuster.

Outside Claim Representatives

An outside claim representative, also called a field claim representative, is an insurer

employee who handles claims that cannot be handled easily by phone, mail, or e-mail.
Outside claim representatives spend much of their time visiting the scene of a loss,
interviewing witnesses, evaluating damage, and meeting with insured’s, claimants, and
other persons involved in the claim.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

An outside claim representative is usually a member of the insurer’s staff located in a

branch office, regional office, or elsewhere, and is assigned to handle claims that occur in
the area served by that location. An insurer assigns an outside claim representative when it
is not practical to settle the claim by correspondence or when an inside claim representative
needs investigative assistance. For example, if a claim involves significant property damage,
an outside claim representative inspects the property to assess the damage. If a claim
involves bodily injury, an outside claim representative usually gathers information in person
by taking statements from the injured parties, inspecting the accident site, and interviewing
witnesses, physicians, and others.

Independent Adjusters

Insurers usually find it efficient to locate staff claim representatives only in those areas
where a significant number of policyholders may submit a large volume of claims. Generally,
it is inefficient for an insurer to have a staff of claim representative in an area where few
claims are filed. To handle claims in areas where they do not have large numbers of policy
representatives in an area where few claims are filed. To handle claims in areas where they
do not have large numbers of policyholders, insurers often hire independent adjusters.

Independent adjusters are claim representatives who offer claim handling services to
insurers for a fee. While some independent adjusters are self-employed, many work for any
of several large, national independent adjusting firms. These firms have offices located
throughout the U.S. and handle all types of claims.

Although a particular insurer may not have enough policyholders to set up its own staff of
claim representatives in a specific area, it is feasible for an independent adjusting firm to
open an office as long as there is enough claim activity within a reasonable distance from
the office. These firms offer their services to any insurer needing claim handling services in
that geographic area.

In some situations, an insurer may hire independent adjusters even if the insurer has staff
claim representatives in the area. A staff claim representative may work with an
independent adjuster when a claim involves a unique or complex situation and the staff
claim representative does not have sufficient expertise to handle the claim alone. Many
insurers, for example, use independent adjusters to handle claims involving business
income or ocean marine insurance. Independent adjusters offer the expertise for such
special claim handling needs of insurers.
Insurers may also need independent adjusters after a natural disaster, such as a
catastrophic hurricane. Because of the volume of claims generated by natural disasters,
insurers not only send staff claim representatives to work with insured’s and producers, but

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

also hire independent adjusters to assist in handling claims. Special considerations for
handling catastrophe claims are discussed later in this chapter.
Producers

In an independent or exclusive agency, the agency usually receives the first notification of a
claim. Depending on the office size, the agency may have one person, several people, or an
entire department responsible for handling claims.

Some agencies do little more than communicate the claim information to the insurer. Other
agencies take a more active role in the claim handling process. The producer immediately
sets up a claim file and collects information about the loss. For some claims, the producer
then monitors the claim handling process and the insured’s satisfaction with the insurer’s
claim service.

If the producer has settlement authority, the producer may actually settle claims.
Settlement authority is authority expressly given to a producer by an insurer to settle and
pay certain types of claims up to a specified limit. For example, an insurer may give a
producer settlement authority up to a certain limit (such as $1,000 or $2,500) per claim for
certain types of claims, such as homeowners or auto physical damage. This authority allows
the producer to settle claims and make payments on behalf of the insurer in such cases.

Insurers have found that allowing producers to handle small or routine claims results in
both expense savings and increased goodwill. Without the direct involvement of the insurer
on small claims, the claim can be handled more quickly and with less expense to the insurer.
Because agency personnel obtain the loss information, verify coverage, determine the
cause of loss, determine the amount of damages or extent of loss, and issue the claim
payment, delays and expenses involved in contacting the insurer’s claim staff are
eliminated. This reduction in claim handing expenses benefits both the producer and the
insurer because it contributes to a more competitively priced product.

To ensure that the insurer’s claim handling standards are met, staff claim representatives
perform quality control reviews on some or all of the claims settled by producers. The
insured benefits from the prompt claim payment, and the producer and the insurer also
benefit from the goodwill created. The producer can give personal service to the insured,
and both the insurer and the producer benefit from having a satisfied customer.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Public Adjusters

In some situation, insured may decide to hire a public adjuster to represent their interests in
the claim handling process. A public adjuster is a person hired by an insured to represent
the insured in handling a claim.
Often, an insured hires a public adjuster either because a claim is complex or because the
loss negotiations are not progressing satisfactorily. The public adjuster acts as an advocate
for the insured in negotiating the claim. The insured generally pays the public adjuster a
percentage of the settlement as compensation for this assistance.
The insured may also hire an attorney for the same purpose. Once the insurer has received
notice that the attorney or public adjuster will be representing the insured, the claim
representative must communicate directly with that party.

Claim Handling Under Self-Insurance Plans

Many organizations have self-insurance plans to cover part or all of their loss exposures. A
self-insurance plan is an arrangement in which an organization pays for its losses with its
own resources rather than by purchasing insurance. However many organizations with self-
insurance plans purchase insurance to pay losses that exceed a predetermined amount,
called retention. For example, a firm might self-insure all losses up to $2 million and then
purchase insurance to cover losses over $2 million.

Organizations with self-insurance plans must make provisions for handling claims. Options
for claim handling include using an internal claim department or a third party administrator.

Internal Claim Departments

If the organization is large enough, it may establish its own claim department. A smaller
organization may decide to hire one or two claim representatives to handle its claims. In
either case, the organization uses its own personnel to investigate and settle claims.
Regardless of the number of claim representatives an organization employee, the internal
claim staff should have skill and experience necessary to handle many different types of
claims. However, the employees of internal claim departments may have little or no
experience in handling certain types of complex cases, such as products liability claims or
workers’ compensation injuries. Furthermore, in workers’ compensation claims, a problem
could occur if the injured employee and the claim representative cannot agree on a
settlement. Because of the problems that can arise from the use of an internal claim
department, many organizations with self-insurance plans hire third party administrators to
handle the claims associated with self-insured loss exposures.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Third-Party Administrators

The growth of self-insurance has created a need for third-party administrators (TPAs), which
are organizations that contract to provide administrative services, including claim handling,
to other businesses, particularly to businesses that have self-insurance plans. Large
independent adjusting firms sometimes function as TPAs for self-insured’s and also provide
independent claim handling services to insurers. Many property-casualty insurers have
established subsidiary companies that serve as TPAs. When a self-insuring organization
hires a TPA, that organization generally purchases more than claim handling expertise. Most
TPAs offer claim recordkeeping and statistical analysis in addition to claim handling services.

CLAIM HANDLING PROCESS

Claim handling procedure can vary widely depending on the type of claim involved. A minor,
single-vehicle auto accident may require only verifying the coverage and loss details,
obtaining estimates of vehicle damage, and paying the claim. Little else is required as long
as the accident involves no bodily injuries and no other vehicles. Once the claim
representative verifies that coverage applies and determines the repair costs, the claim can
be settled.
An auto accident that involves two or more autos and injures several people can take
months or even years to settle. In such cases, different persons could provide conflicting
testimony about the accident, and difficult questions regarding legal responsibility could
arise. The claim representative may need the skills of a physician, a lawyer, an engineer, and
a police officer to understand all the issues involved.
Despite the unique challenge and variations from case to case, the same four activities are
involved in processing most claims (once the claim representative has acknowledged receipt
of the insured’s or claimant’s loss report) as follows:
1. Verifying coverage
2. Determining the cause of loss
3. Determining the amount of damages or extent of loss
4. Negotiating and settling (or denying) the claim
Although the claim handling process generally involves these four steps, the sequence and
the manner in which they are carried out varies by insurer and by the type of claim –
property or liability.

Property Insurance Claims

In property insurance claims, two parties are usually involved in the claim negotiation
process: the insured and the insurer. Claim representatives usually do not have to
determine who was at fault (unless the insured is suspected of an intentional act, such as

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

arson). When handling a property insurance claim, the claim representative rarely has to
consider unforeseen side effects manifesting months or years after the claim has occurred,
which is often the case when bodily injury is involved. Finally, valuing property is usually
easier than placing a dollar value on the income-earning ability or the life of a person who
has been disabled or killed in an accident.

Verifying Coverage
Once the insurer responds to the first report of the claim, the claim representative must
verify whether the claim is covered under the insured’s policy. If a question of coverage
exists and the insurer plans to continue its investigation, the insurer might send a
reservation of rights letter to the insured. A reservation of rights letter is a notice sent by
the insurer advising the insured that the insurer is proceeding with a claim investigation but
retains its right to deny coverage later. A reservation of rights letter serves two purposes: to
inform the insured that a coverage problem might exist and to protect the insurer so that it
can deny coverage later, if necessary.

Failure to reserve its rights while facts are gathered may prevent the insurer from denying
coverage later. Examples of claims that may require a reservation of rights letter include
occurrences that happened outside the policy period, intentional actions of the insured, and
situations involving more than one insurer when there is a question of which insurer must
pay first.
After receiving the initial report of a claim, the claim representative must gather further
information to verify coverage. The initial verification involves confirming that a valid policy
was in effect, determining that the date of the loss falls within the policy period, and
establishing whether the damaged property is insured under the policy. Often, the claim
representative uses a simple checklist to begin the verification process.

The claim representative must then determine whether the coverage provided by the policy
will pay any or all of the claim submitted. For a property insurance claim, the claim
representative must seek the answers to the following four questions to verify that the
claim is covered:
1. Does the insured have an insurable interest in the property?
2. Is the damaged property covered by the policy?
3. Is the cause of loss covered by the policy?
4. Does any additional coverage, endorsements, or coverage limitations apply?
The first question determines whether the person or organization making a claim for the
damaged property has an insurable interest in the property. In property insurance, an
insurable interest exists if a person or other entity would suffer a financial loss if the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

property were damaged. In most property insurance losses, the insured is the property
owner, so the question of insurable interest is easily answered.

However, others may also have an insurable interest in the property. For example, a
mortgagee (such as a bank that has provided a home mortgage loan) has an insurable
interest in real property to the extent of the outstanding mortgage. Under certain
circumstances, the mortgagee has rights to collect under an insurance policy if the
mortgaged property has been damaged or destroyed. The claim representative must
identify who has an insurable interest in the property so that payment can be made
according to the policy provisions.

The second question that the claim representative must answer is whether the damaged
property is covered by the policy. In the case of a damaged home or commercial building,
the answer may seem obvious. The answer, however, may not be as simple as it appears.
For example, insurance coverage on a building usually includes any item permanently
attached to the building and any outdoor equipment used to maintain the building.
Although the building may be clearly insured, would a room air conditioner attached to a
window frame be considered a part of the building? Would a tool shed connected to a
dwelling by a fence be considered a part of the dwelling? These are the types of questions
that the claim representative must answer according to the policy provisions.

The question of whether the damaged property is covered by the policy is equally important
for personal property. Most property insurance policies exclude losses to certain types of
property. For example, the homeowner’s policy generally does not cover losses to property
of tenants or to most motorized vehicles.

The third question the claim representative must answer is whether the cause of loss is
covered by the policy. Often, the cause of the loss, such as fire or lightning, is clearly
covered under the policy. Disputes between the insured and the insurer are not likely to
occur. However, disagreements may arise when the cause of loss is less obvious. Disputes
can occur, for example, if there is more than caused either by wind or by flooding. Disputes
may also arise about the meanings of terms used in the policy. In some cases, the insured
has the burden of providing whether coverage exists under a particular property insurance
policy. In other cases, the burden of establishing that the cause of loss is excluded rests with
the insurer. This burden of proof issue is discussed further in a later chapter.

The fourth question the claim representative must answer is whether any additional
coverage, endorsements, or coverage limitations apply. In many insurance policies,
additional coverages and limitations modify the basic coverage provided. For example,

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

under a homeowner’s policy, the definition of covered property does not include trees,
shrubs, plants, or lawns. However, these items can be covered under an additional
coverage, which specifically states that trees, shrubs, plants, and lawns are covered up to a
specific dollar amount if damaged by certain specified cause of loss.

The insured might also have purchased an additional coverage, selected one or more
optional policy coverages, or modified coverage through an endorsement (policy
amendment). Such changes to the basic policy can eliminate or modify exclusions or
limitations. The claim representative should recognize that such policy modifications might
apply and must consider them when determining whether a property claim is covered.

Insurance policies contain important limitations on coverage. Although a homeowners

policy covers most types of personal property, certain types of property, such as jewelry
and furs and covered for only a specified dollar amount when the loss is due to theft.
Similarly, homeowner’s policy does not cover losses caused by vandalism if the dwelling has
been vacant for more than thirty consecutive days. Such policy limitations are important in
verifying coverage.

The claim representative must also check the policy to see whether a deductible applies to
the loss, which would reduce the amount of the loss payment. For an especially large
deductible or a small loss, application of the deductible may indicate that no payment can
be made. Before determining whether a given loss is covered, the claim representative
must confirm that the loss occurred during the time period and within the territory
described in the policy.

During the investigation, the claim representative should consider whether the final cost of
the claim can be reduced by subrogation (recovering a claim payment from the party
responsible for the loss) or salvage (the rights of the insurer to recover and sell or otherwise
dispose of insured property on which the insurer has paid a total loss). Subrogation and
salvage are discussed in detail later in this chapter.

Determining the Cause of Loss

As discussed the cause of loss must be known to verify coverage. For a property insurance
claim, investigation often involves visiting the loss site to inspect the damaged property.
Whether it is real property, such as a house or an office building, or personal property, such
as household furnishings or business inventory, the claim representative must inspect the
property (except for smaller claims handled by inside adjusters) to determine the cause of
the loss and to assess the damage. For some losses, the cause is obvious; in others, the
cause is harder to determine.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The claim representative may also need to interview and take statements from any
witnesses to the loss to better understand how and why the loss occurred. When a building
is totally destroyed, the best information about how the loss occurred often comes from
witnesses. This information can help determine the cause of loss, which could be especially
important in situations in which someone other than the insured may be responsible.

Determining the Amount of Damages or Extent of Loss

Another fundamental aspect of a claim, particularly with regard to real property, is the
physical condition of the property before the loss occurred. This information is difficult to
obtain when a building has been completely destroyed. The claim representative must
consult with the insured, examine the building remains, study pictures that may be
available, and examine blue-prints showing the building’s dimensions.

For personal property, the most important information is what property was damaged or
destroyed. Creating an inventory of damaged personal property can be an arduous task for
some losses, such as serious fire losses. However, for the claim representative to determine
the value of the loss, a detailed inventory is essential and specific information must be
gathered. When the loss involves a business, historical valuation information often appears
in the company’s financial records. In addition, if a business income loss is involved, the
financial records are useful in determining the proper valuation of the lost income.

For claim representatives, the valuation of loss can be most difficult aspect of settling
property insurance claims. In order to indemnify the insured according to the policy
provisions, the claim representative must be able to answer the following two questions:

1. How does the policy specify that the property be valued?

2. Based on that specification, what is the value of the damaged property?

All property insurance policies include a valuation provision that specifies how to value
covered property at the time of the loss. The most common property valuation methods are
as follows:

 Actual cash value

 Replacement cost
 Agreed value

Actual cash value (ACV) is the cost to replace the property minus an allowance for the
property’s depreciation. (Depreciation is the allowance for physical wear and tear or
technological or economic obsolescence). For example, assume a fire completely destroys a
new television and a four-year-old sofa. The television had a replacement cost of $600 (its

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

cost when it was purchased a week earlier), and the sofa would cost $800 to replace with a
comparable (of like kind and quality) new sofa. (A sofa that is four years old probably
cannot be replaced with exactly the same sofa because styles change. Therefore, the sofa’s
replacement cost would be the cost of a new sofa comparable to the one that was
destroyed.) Under these circumstances, an ACV settlement includes $600 for the television
because it has not yet had time to depreciate. For the sofa, however, the claim
representative has to place a value on the used property.

The claim representative must determine the extent of depreciation that should be
considered. This determination is usually made by estimating the property’s expected useful
life. If, under normal circumstances, a sofa might be used for ten years and it is now four
years old, a good estimate of depreciation from normal wear and tear is 40 percent.
Therefore, with a replacement cost of $800 and depreciation estimated at 40 percent, the
ACV for the damaged sofa is $480. A payment of $480 would indemnify the insured for the
loss of the four-year-old sofa. Certain types of property, such as computers, become
obsolete after a certain amount of time, so obsolescence must also be estimated.

Another valuation method specified in some property insurance policies allows for valuation
on a replacement cost basis. An item’s replacement cost is the cost to repair or replace the
property using new material of like kind and quality with no deduction for depreciation. In
this case, deduction for depreciation is not a part of the valuation, and the insured in the
previous example would be paid $800 for the four-year-old sofa. Generally, a loss valued on
the replacement cost basis is paid only after the property has been replaced. The insurer
may pay the claim first on an ACV basis, and the insured then has 180 days to provide notice
of the replacement cost.

Still another method for valuing property losses is agreed value, which is used to insure
property that is difficult to value, such as fine arts, antiques, and collections. Under the
agreed value method, the insurer and the insured agree, at the time the policy is written, on
the maximum amount that will be paid in the event of a total loss. This agreed value is often
based on an appraisal, and that amount is stated in the policy declarations. If a total loss to
the property occurs, the insurer will pay the agreed value, regardless of the property’s exact
value at the time of the loss.

In commercial insurance, there are various agreed value options for property insurance
policies. In some policies, the term agreed value has a different meaning and relates to the
amount of insurance that the insured must carry to avoid a penalty for underinsurance.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Once the claim representative has verified coverage and identified the valuation method
specified in the policy, the valuation process begins. Claim representatives must use
guidelines to determine both replacement cost and ACV. Personal property and real
property present different valuation problems.

If the exact style and brand of the damaged personal property are available for purchase,
obtaining the replacement cost is simple. If the particular item is no longer available, the
claim representative identifies the closest substitute in style and quality and uses that
substitute’s value as the replacement cost.

For actual cash value, however, depreciation must be estimated. While claim
representatives have attempted to develop straightforward methods, such as the useful life
procedure described in the case of the damaged sofa, these procedures do not fit every
circumstance. For example, if a sofa has an expected life of ten years, the claim
representative makes a reasonable estimate in considering the four-year-old sofa to be 40
percent depreciated. But what if the sofa is fifteen years old? Is the sofa considered
worthless? The fifteen-year-old sofa has some value as long it is functional, so the
depreciation procedure must make allowance for that fact. The claim representative may
have guidelines stating that property still being used is no more than 75 percent
depreciated, no matter how old it is. While such guidelines may be developed to treat most
cases, it is impossible to anticipate every situation the claim representative may encounter.
Therefore, the claim representative must use good judgment to determine depreciation.

The replacement cost of real property can usually be determined by using three factors as
follows:

1. Square footage of the property

2. Type and quality of construction
3. Construction cost per square foot.

The first factor is the square footage of the property. If the building has been badly
damaged, its area can be determined from the original blueprints or by measuring the
remains.

The second factor is the type and quality of construction. A one-family frame house with
standard trim and fixtures costs far less to replace than the same size house built of stone
with high-quality woodworking, skylights, and other features. The quality of the house or
building is more apparent if part of the structure has escaped damage. Pictures of the house
or building can be useful, particularly if the structure has been totally destroyed.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The final factor affecting replacement cost is the construction cost per square foot currently
charged for the style and quality of the destroyed building. Contractors who do business in
the general location of the damaged building can quote costs per square foot in various
quality-of-construction categories, such as $65 per square foot for standard quality, $75 per
square foot for medium quality, and $90 per square foot for superior quality. Multiplying
the square footage by the appropriate cost per square foot yields the building’s
replacement cost.

If the building is only partially damaged, the claim representative usually prepares a repair
estimate or obtains repair estimates from one or more contractors. Replacing the property
when a partial loss has occurred involves restoring the property to its previous state as
closely as possible.

Some policies specify that the ACV method should be used to measure loss to real property.
For policies specifying ACV valuation, claim representatives estimate depreciation of real
property using methods similar to those used for estimating depreciation of personal
property. Other policies state that the insured can collect the replacement cost of damaged
real property under certain circumstances. Often, however, these policies provide for
immediate payment of the ACV of the property, and payment of the remainder of the
replacement cost is made when actual repair or replacement is completed. Either type of
policy requires a claim representative to calculate the ACV of damaged real property.

Negotiating and Settling the Claim

After verifying coverage, determining the cause of loss, and determining the amount of
damage or extent of loss, the claim representative must settle the claim. This step usually
requires that the claim representative and the insured discuss the details of the loss and the
valuation of the damage to agree on an amount for the insurer to pay to settle the loss. The
negotiation phase of claim handling can be relatively simple, as in the case of the fire-
damaged television in a previous example. However, it may be complicated because of a
large number of damaged items, property of high value, or disagreement between the
insured and the claim representative regarding the value or circumstances of the loss.
Whenever possible, questions of coverage, valuation, and other matters, should be
discussed and resolved as they arise. In addition, investigation and valuation often continue
while the negotiation is in progress.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Subrogation and Salvage Rights

After the claim representative and the insured agree on the amount of the settlement, two
other factors can affect the insurer’s cost for property claims: subrogation and salvage
rights.

Subrogation is the insurer’s right to recover payment from a third party that is legally
responsible for having caused the loss. When an insurer pays an insured for a loss, the
insurer assumes the insured’s right to collect damages from a third party responsible for the
loss. Subrogation often applies in claims involving auto accidents. Once the insurer pays the
insured for the repair or replacement of the damaged auto, the policy provides that any
rights to collect from another party responsible for the damage to the auto belong to the
insurer (up to the amount the insurer paid the insured for the claim). Subrogation prevents
an insured from collecting from both the insurer and the party at fault for the same loss.

The claim representative investigates whether another party involved in the accident is
legally responsible for the damage paid by the insurer. If another party is responsible, the
insurer can attempt to collect the repair or replacement cost from that person or that
person’s insurer. Formal legal proceeding may be necessary to determine who is legally
responsible for the damage.

Salvage rights are the insurer’s rights to recover and sell or otherwise dispose of insured
property on which the insurer has paid a total loss or a constructive total loss. A
constructive total loss exists when a vehicle (or other property) cannot be repaired for less
than its actual cash value minus the anticipated salvage value. For example, if an auto
damaged in an accident cannot be repaired for less than its ACV minus the anticipated
salvage value, the auto is considered to be a constructive total loss. In this case, the insurer
pays the auto’s ACV to the insured (or finds an auto similar to the insured’s auto before it
was damaged).

Although the settlement with the insured is paid as a total loss, the insurer might be able to
collect some salvage value for the damaged auto. Depending on the actual condition of the
vehicle, an auto salvage dealer may be willing to pay for the auto to obtain scrap metal and
undamaged parts that can be resold as used parts. In this way, the salvage value can offset
some of the insurer’s claim cost.

For example, assume the ACV of the insured’s car at the time of an accident is $10,000 and
the repairs will cost $9,000. If the car could be sold for $1,500 to a salvage dealer, the
insurer would consider the car a constructive total loss because it would cost more for the
insurer to pay the repair cost than to pay the insured the ACV of $10,000 and then sell the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

salvage for $1,500. ($10,000 ACV – $1,500 salvage value = $8,500, which is less than the
$9,000 cost of repairing the car.)

Liability Insurance Claims

Liability claim adjusting is different from property claims adjusting because determining
liability may be difficult. First, the claimant is a third party who has been injured or whose
property has been damaged by the insured. The claimant may perceive the claim
representative as an adversary, and this perception could cause the claimant to act in a
hostile or unfriendly manner.

Second, a liability claim may involve bodily injury. It is not always easy to determine the
amount of the loss in property damage liability claims, and determining the amount of loss
is more difficult and complex when the loss involves bodily injury or death.

Liability claim settlement sometimes involves a claim for damage that the insured has
allegedly caused to the property of others. The process for handling property damage
liability claims resembles the claim handling process for property insurance claims, with the
added difficulty of determining whether the insured is legally responsible for the property
damage that has occurred. The following discussion concentrates on the issue of legal
responsibility, which is central to the liability claim handling process.

Verifying Coverage

As in a property claim, the claim representative must gather information to verify coverage.
The process includes checking that a valid policy was in effect, determining that the date of
the loss falls within the policy period, and discovering whether any additional coverages,
endorsements, or coverage limitations apply. In handling a liability claim, the key difference
from a property claim is that the claim representative must determine if the insured is
legally responsible for the loss; if not, coverage does not apply.

Determining the Cause of Loss

After receiving the first report of injury or damage and verifying coverage, the claim
representative must gather detailed information relating to the liability claim. The question
of how much damage occurred may be secondary because the amount of the loss is
relevant only if the loss is covered under the insured’s policy and if the insured is legally
responsible for the loss. Therefore, the claim representative must first determine how and
why the loss occurred and whether the insured appears to be responsible.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

In investigating a liability claim, the claim representative often inspects the scene of the
occurrence or accident. This inspection is particularly usefully if a traumatic event has
occurred, such as an auto accident, a building collapse, or a fire. By studying the scene and
interviewing the insured, the claimant, and any witnesses, the claim representative
attempts to reconstruct the events that led to the loss. This reconstruction helps to
determine, as closely as possible, how the loss occurred and who is responsible. Additional
details are needed to determine the extent of the bodily injury or property damage. At this
point, the claim representative collects enough information to help determine whether the
liability policy covers the loss and, if so, whether the insured may be legally responsible.

As soon as possible, the claim representative speaks directly with the injured party or the
injured party’s legal representative to hear that side of the story and to assess what bodily
injury or property damage has been sustained. Many times the events surrounding an
accident are difficult to reconstruct, so the claim representative often receives different
interpretations from the injured party and the insured as to how the loss occurred. The
claim representative also gathers reports from any available witnesses.

The injured party has the option of suing the insured, and the ensuing legal process could
end in a legal decision determining who is responsible and to what extent. Because of the
time, expense, and uncertainty involved in a lawsuit, insurers often prefer to settle claims
out of court. If the claim does go to court, the insurer is obligated to provide and pay for the
insured’s defense for a covered claim (until the insurer has paid the full policy limit for the
occurrence involved).

Liability policies usually cover the insured’s liability arising from certain specified activities,
such as owning or using an automobile or operating a business, subject to certain
exclusions. Coverage depends on whether the activity leading to the claim is within the
scope of the policy’s coverage and whether any exclusions in the policy apply to the specific
case. Based on the information gathered, the claim representative must determine whether
coverage applies.

If the claim representative’s investigation finds that no coverage applies, the insurer will
deny the claim. For example, if the policy excludes injury intended by the insured and the
insured purposely injures someone with a baseball bat, there would be no coverage unless
the insured has evidence that the injury was careless but not intentional. In that case, the
claim representative would need to investigate further to determine whether the injury was
indeed intentional on the insured’s part. If coverage does exist, the valuation aspect of
liability claims settlement then becomes very important.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Valuation

Damages are money claimed by, or a monetary award to, a party who has suffered bodily
injury or property damage for which another party is legally responsible. When bodily injury
occurs, determining the amount of damages often depends on medical records and the
reports and opinions of physicians. Properly evaluating medical information is important in
determining the amount of damages and is a distinguishing factor in the loss settlement
process for bodily injury liability claims. This aspect of bodily injury claims requires
experience and skill.

Legal liability cases may involve the following types of damages:

 Compensatory damages (which include both special damage and general damages)
 Punitive damages

Compensatory damage is intended to compensate a victim for harm actually suffered.

Compensatory damages include special damages and general damages.

Specific, out-of-pocket expenses are called special damages. In bodily injury cases, these
damages usually include hospital expenses, doctor and miscellaneous medical expenses,
ambulance charges, prescriptions, and lost wages for time spent away from the job during
recovery. Because they are specific and identifiable, special damages are easier to calculate
than general damages.

General damages are compensatory damages awarded for losses that do not have a specific
economic value. Examples of general damages include compensation for any of the
following: paid and suffering; disfigurement; loss of limbs, sight, or hearing; and loss of the
ability to bear children. Because these losses do not involve specific and measurable
expenses, estimating their dollar value requires considerable expertise. For the claim
representative, the best guide is usually to analyze past cases similar to the case currently
under investigation. For the purpose, the claim representative may use any of the following
tools to estimate the bodily injury valuation of specific damages: supervisor’s guidance,
roundtable discussion with other claim representatives, or computer software.

There is usually no direct relationship between the amount of general damages and the
amount of special damages. In some cases, such as when a claimant loses an eye, the
amount of special damages may be relatively low, but the general damages may be quite
high because of the pain and suffering involved and the change in the claimant’s quality of
life. In other cases, such as for whiplash injuries, general damages may be minimal, but

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

special damages may be considerable because the claimant requires physical therapy or
other medical treatment.

In recent years, courts have often made large awards for general damages, particularly for
traumatic incidents like automobile accidents. Claim representatives must be aware of the
awards for damages made in their jurisdictions, because these awards provide a guideline
for negotiating with the injured party.

When a court finds the defendant’s conduct particularly malicious or outrageous, it might
award punitive damages. The purpose of punitive damages is to punish the wrongdoer and
to deter others from committing similar wrongs. In some states, the insurer’s payment of an
award of punitive damages is not permitted because such payment by an insurer would not
punish the insured. Some policies expressly exclude the payment of punitive damages.

Negotiating and Settling the Claim

While the awards for damages described previously may result court decisions, a large
percentage of liability cases are settled out of court through negotiations between the claim
representative and the claimant or the claimant’s attorney. In most instances, neither party
wishes to become involved in a formal legal action with the accompanying costs and delays.
When negotiations do not result in a settlement, however, the claimant has the option of
suing for the alleged damages. The court then decides who is responsible and determines
the value of the bodily injury or property damage. Even after the claimant initiates a
lawsuit, however, the claim negotiation process usually continues. Many out-of-courts
settlements have resulted after some or all of the courtroom testimony has been given.
Negotiating with the claimant while simultaneously preparing for proceedings in court
requires a great deal of skill, patience, and understanding on the part of the claim
representative.

SPECIAL CONSIDERATIONS FOR CATASTROPHE CLAIMS

Although this chapter focuses on the day-to-day process of handling claims, the volume of
claim handling activity reaches crisis proportions following catastrophic losses, as from a
hurricane or a terrorist attack. For each insurer faced with a significant number of losses
resulting from catastrophe, activity originates from the following two sources:

1. Processing the increased number of property claims

2. Dealing with the increased scrutiny of the claim handing processes when media
attention turns toward the victims

For these reasons, property insurers subject to catastrophic losses should prepare well in
advance to handle the large number of losses should a catastrophic event occur.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Processing the Increased Number of Property Claims

After a catastrophe, policyholders and regulators expect an insurer to settle losses quickly,
regardless of the volume of claims or any disruptions to the insurer’s own resources. As
noted previously effective catastrophe response requires careful preparation. Contingency
plans that are detailed and communicated throughout the organization serve the following
purposes:
 Identifying weakness, bottlenecks, and potential difficulties
 Permitting staff to clearly understand their roles and responsibilities during a crisis in
advance, so that they can react productively and not emotionally
 Keeping the organization free to focus on handling claims without reallocating
essential resources to resolve problems for which it was unprepared

Dealing With Claim Handling Scrutiny

The human tragedy that follows a catastrophe cannot be overstated, but the relief delivered
through the insurers’ efficient claim handling can help enormously. Insurers can initiate
certain activities to ensure that catastrophe losses are handled promptly, despite the huge
volume of claims. These include the following modifications to normal operations:
 Developing and using abbreviated claim handling procedures to speed processing
 Temporarily increasing claim settlement authority to producers for the duration of
the catastrophe response
 Temporarily transferring claim settlement authority to preselected independent
adjusting firms
 Bringing in catastrophe teams of claim representatives from other regions
 Making advance payments of policyholders for expenses such as additional living
expenses
 Immediately settling all questions of property valuation in favor of the policyholder
 Suspending all but the most essential recordkeeping
 Reallocating available employees in critical work areas.

In addition, claimants are under enormous stress following a catastrophe. After claimants
restore their lives to as normal as possible, claim payment by an insurer may be the only
step remaining until they can begin repairing their homes and businesses. At this point,
claimants may become aggressive in their pursuit of a settlement. Claim staff should be
trained in dealing with aggressiveness without resorting to antagonistic responses. Media
attention can easily be diverted to the plight of claimants with insurers painted in the role
of the enemy. Such negative media can escalate aggressive behavior by other claimants
who may perceive the need to assert their rights.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Finally, claim departments should prepare to assist claimants with problems that occur
outside of normal claim-related issues. For example, some claim settlement checks for
property losses are made both to the policyholders and their mortgagees. Mortgagees may
withhold their signatures until they have evidence that repairs to the secured property have
been completed. However, in post-catastrophe areas, repairs may require payment in
advance. A staff person in the claim department who can help policyholders handle these
unusual problems can free claim representatives to settle other claims.

LOSS RESERVES
Claim representatives play a vital role in establishing an insurer’s loss reserves. As stated
previously, loss reserves are funds held by the insurer to pay claims for losses that have
occurred but have not yet been settled. Loss reserves are the largest and most important
obligation of property-casualty insurers.

Loss reserves are liabilities in the accounting sense because they are shown on an insurer’s
financial statements as sums that the insurer owes to others. They represent an estimate of
the amount of claim payments the insurer will make in the future.

After the claim representative receives notice of a loss, obtains initial information, and
verifies coverage, a loss reserve for that claim is established. (Loss reserves assigned to
individual claims are often called case reserves.) Assume, for example, that an insured had a
minor auto accident in which the insured’s car hit a guardrail on a foggy night and that no
injuries or other cars were involved. After obtaining initial information concerning the
accident, verifying coverage, and receiving written estimates of the cost to repair the
insured’s car, the claim representative establishes a case reserve of $1,500. (Many insurers
establish an initial case reserve as soon as a claim is reported, using an average amount for
that type of claim and later adjusting the reserve based on the claim representative’s
findings.) This figure is probably a very accurate estimate because a single-car collision loss
is relatively easy to evaluate. Two weeks later, the repairs are made to the insured’s car,
and the insurer issues a check for $1,500. Once the loss is paid, the reserve is reduced to
zero because no future loss payment is expected. Therefore, the $1, 500 claim paid by the
insurer equals the initial case reserve.

Conversely, complex claims are often difficult to estimate, especially liability claims.
Assume, for example, that an insured was involved in a serious auto accident and that two
persons in the other car were hospitalized with severe injuries. The cause of the accident is
not immediately clear because of conflicting testimony of witnesses, and it is difficult to
determine whether the insured is responsible for the accident. What case reserve should be
established? The amount eventually paid because of this accident could range from almost

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

nothing (if the insured is not found to be legally responsible) to hundreds of thousands of
dollars (if the insured is responsible and the injured victims die or are permanently
disabled). The eventual payment on this particular claim, which may not be made for
several years, can vary significantly from the original reserve.

Calculating case reserves is always an estimate–no one knows exactly how much the insurer
will pay in the future for an individual claim or all claims for a particular period. Claim
representatives generally estimate case reserves for individual claims based on their
knowledge and experience. For inclusion on the insurer’s financial statements, and for rate
development, actuaries calculate an insurer’s overall loss reserves. Actuaries use case
reserve totals as a starting point in determining the overall loss reserves. No system of
estimating overall loss reserves can be accurate unless the underlying reserves on individual
claims are reasonably accurate. A claim representative who properly estimates a case
reserve for a given claim provides a valuable service to the insurer, who in turn is better
able to report appropriate loss reserves to regulators, investors, and others.

The process of setting case reserves varies by insurer. Often, the claim representative’s
input, based on an analysis of the many factors associated with a particular claim, is
combined with the knowledge and experience of a claim supervisor or manager. Reserving
is not a one-time activity for any particular claim; the case reserve must be regularly
evaluated as new information becomes available.

UNFAIR CLAIM PRACTIES LAWS

Throughout the claim handling process, the claim representative must remember that a loss
often produces strong emotions. The claim representative is dealing with an insured or a
claimant who has been through a trying, if not traumatic, experience. Good interpersonal
and communication skills are vital. Although dealing with persons in such circumstances can
be a challenge, the claim representative may find it rewarding to help people through a
difficult time.

The claim representative must treat all parties fairly by promptly paying valid claims
according to the policy provisions and by denying claims for which no coverage applies.
Failure to pay a claim that is covered by an insurance policy hurts the person who is denied
a fair settlement. On the other hand, paying a claim that is not covered penalizes the insurer
and all of the insurer’s policyholders. If an insurer pays claims that are not covered by a
particular insurance policy, the ultimate cost will be shared by all of the insurer’s
policyholders, who will eventually pay higher premiums. It is important to policyholders
that insurers neither overpay nor underpay claims.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Most claim representatives strive to treat insureds and claimants as fairly as possible while
adhering to policy terms and state regulations. It is difficult to gain the expertise to
understand complex policy conditions and to determine the value of the loss. Also, the
claim handling process requires sound interpersonal skills to manage a situation that may
involve stress and disagreements.

Because of problems that have occurred in the claim process, most states have enacted
unfair claim practices laws, which specify claim practices that are illegal. The prohibited
claim practices usually include the following:

 Misrepresentation of material facts or insurance policy provisions relating to

coverage at issue in a claim
 Failure to acknowledge and promptly respond to communications about claims
arising under insurance policies
 Actions that compel an insured to sue to recover amounts due under insurance
policies by offering amounts that are substantially lower than the amounts
ultimately recovered in legal actions brought by such insureds
 Refusal to pay claims without first conducting a reasonable investigation based on all
available information

Insurance regulators usually learn of unfair claim practices when they receive complaints
from insured’s and claimants. Claim representatives must be able to justify their actions and
provide proper documentation when asked to do so by state insurance regulators. Some
complaints are frivolous, often occurring because the claimant is annoyed that the policy
does not cover a loss. On the other hand, some complaints are valid, and regulators may
take action when a serious complaint occurs or when several complaints, especially of a
similar nature, are registered against a claim representative or insurer. The claim
representative or insurer must justify the practices that are under scrutiny or face a
reprimand, fine, license suspension, substantial legal judgment, or some other legal penalty.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

SUMMARY
When an insurer sells a policy, it promises to pay claims covered by that policy. The purpose
of the claim handling process is to fulfill that promise. A claim representative is the key
person responsible for interacting with the claimant and handling claims.

Depending on the circumstances, the following different types of claim representative may
handle claims, including:

 Staff claims representatives, who are insurer employees and include inside claim
representatives and outside (field) claim representatives.
 Independent adjusters, who are claim representatives who offer claim handling
services to insurers for a fee
 Producers, who often have claim settlement authority to settle certain small claims
 Public adjusters, who are hired by and represent the insured in the claim handling
process

Self-insurance also requires claims handling services. The self-insuring organization may use
its own personnel to settle claims, or it may use the services of a third-party administrator.

Regardless of who handles claims, the claim handling process involves the following same
four activities:

1. Verifying coverage
2. Determining the cause of loss
3. Determining the amount of damages or extent of loss
4. Negotiating and settling (or denying) the claim

For property claims, investigation usually includes inspecting the damaged property to
determine the cause of loss and to assess the damage. The investigation also involves
verifying coverage to determine whether an insurable interest exists, whether the policy
covers the damaged property, whether the policy covers the cause of loss involved, and
whether any additional coverage’s endorsements, or limitations apply. The procedure for
valuing the loss depends on whether the policy specifies actual case value, replacement
cost, agreed value, or some other method for valuing losses.

In liability claims, the claim representative’s investigation focuses on whether the activity
leading to liability comes within the scope of the policy and whether the insured could be
legally responsible for the loss. The valuation of bodily injury loss involves examining
medical records and physicians’ reports. If the case goes to court, the total liability loss can
result in compensatory damages (which include special damages and general damages) and,

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

sometimes, punitive damages. Often, however, it is in the best interest of all parties to
negotiate a settlement out of court rather than to incur the expense and delay of legal
proceedings.

Claim representatives deal with many day-to-day claim situations, but occasionally face
claims that result from a catastrophic event. Such catastrophe claims present a dramatic
short-term increase in the number of claims which must be handled. The increased volume
presents a new set of challenges to the claim representative and draws greater scrutiny on
the claim handling process.

In addition to having a key role in fulfilling the promise contained in the insurance contract,
claim representatives also play an important role in establishing an insurer’s loss reserves. A
case reserve for a particular claim is the best estimate of the amount the insurer will
eventually have to pay for that claim.

Many states have passed laws prohibiting unfair claim practices. Regulators also monitor
complaints from insured’s and claimants. A number of valid complaints about a particular
insurer or claim representative could lead to a reprimand, a fine, license suspension,
substantial legal judgment, or some other legal penalty.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Insurance Contracts Chapter 7

Purchasing insurance differs from buying groceries, clothes, or other tangible goods. A car
buyer, for example, can examine and even test drive a car before buying it. Although
warranties and promises of reliable service may influence the decision to buy, the primary
consideration is the car itself. The car’s physical characteristics are readily apparent at the
time of the sale. The buyer cannot blame the dealer if the car is too small or the wrong
color. Insurance, in contrast, is not something a person can test before buying. The essence
of insurance is the insurer’s promise that it will pay claims in the future for losses that are
covered under the policy.

The evidence of this promise is the insurance contract, or policy. The policy defines in detail
the rights and duties of both parties to the contract: the insured and the insurer. A
particular insurance policy meets a buyer’s needs only if the terms of the policy obligate the
insurer to provide the protection desired. Although it is possible to evaluate a car with a
test drive, evaluating an insurance policy requires an analysis of its terms.

This chapter provides a foundation for such an analysis. The chapter first discusses contracts
in general and then describes the special characteristics of insurance contracts, their
content, and their structure. It concludes with a description of several conditions that are
common to most property and liability insurance policies.

ELEMENTS OF A CONTRACT
An insurance contract, called a policy, is an agreement between the insurer and the insured.
An insurance policy must meet the same requirements as any other valid contract, which is
a legally enforceable agreement between two or more parties.

If a dispute arises between the parties to a contract, a court will enforce only valid
contracts. The validity of a contract depends on the following four essential elements:

1. Agreement (offer and acceptance)

2. Competent parties
3. Legal purpose
4. Consideration

If a court cannot confirm the presence of all four elements, it will not enforce the contract.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Agreement (Offer and Acceptance)

One essential element of a contract is that the parties to the contract must be in
agreement. One party must make a legitimate offer and another party must accept the
offer. In legal terms, there must be “mutual assent.”

In the case of insurance, the process of achieving mutual assent generally begins when
someone who wants to purchase insurance completes an insurance application – an offer to
buy insurance. The details on the application describe the exposures to be insured and
indicate the coverage the applicant requests.

In an uncomplicated case, an insurer underwriter (or an agent, acting on behalf of an

insurer) accepts the application and agrees to provide the coverage requested at a premium
acceptable to both the insurer and the applicant. The premium is the payment by an
insured to an insurer in exchange for insurance coverage. At this point, agreement exists;
the insurer has accepted the applicant’s offer to buy insurance.

In a more complicated case, the underwriter may not be willing to meet all the requests of
the applicant. One of the underwriter’s options is to accept the application with
modification. The underwriter may be willing to provide coverage, but only on somewhat
different terms. For example, the underwriter may insist on a higher deductible than the
applicant had requested. When the underwriter communicates the proposed modifications
to the applicant, these modifications constitute a counteroffer. Several offers and
counteroffers may be made before both parties agree to an exact set of terms. If the other
essential elements of a contract exist, the mutual assent of the insurer and the applicant
forms a contract.
To be enforceable, the agreement cannot be the result of duress, coercion, fraud, or a
mistake. If either party to the contract can prove any of these circumstances, a court could
declare the contract to be void.

Competent Parties

For the contract to be enforceable, all parties must be legally competent. In other words,
each party must have the legal capacity to make the agreement binding. Individuals are
generally considered to be competent and able to enter into legally enforceable contracts,
unless they are one or more of the following.

 Insane or otherwise mentally incompetent

 Under the influence of drugs or alcohol
 Minors (persons not yet of legal age)

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

However, minors are sometimes considered competent to purchase auto insurance,

especially when auto insurance qualifies as a necessity. State laws vary in regard to issues
involving minors.

Another aspect of legal capacity is that, in most states, an insurer must be licensed to do
business in the state. If an insurer mistakenly writes a policy in a state where that insurer is
not licensed, the insured might later argue that the contract is not valid and demand the
return of the premium. This demand would be based on the fact that the insurer did not
have the legal capacity to make the agreement.

Legal Purpose

An enforceable contract must also have a legal purpose. The courts may consider a contract
to be illegal if its purpose is against the law or against public policy (as defined by the
courts). For example, an agreement to pay a bribe to a government official in exchange for
receiving a government job would not be enforced by the courts because such activities are
against public policy.

Although most insurance policies do not involve a question of legality, certain situations do
exist that may invalidate an insurance policy. Courts will refuse to enforce any insurance
policy that is illegal or that tends to injure the public welfare. Insurance contracts must
involve a legal subject matter. Property insurance on illegally owned or possessed goods is
invalid. For example, property insurance covering illegal drugs would be illegal and
therefore unenforceable. If fireworks are illegal in a particular state, then an insurance
policy covering fireworks would be illegal in that state. In addition, no insurance contract
will remain valid if the wrongful conduct of the insured causes the operation of the contract
to violate public policy. Thus, arson by an insured would render a property insurance policy
unenforceable and would preclude recovery by the insured under the policy for a building
the insured intentionally burned.

Consideration

Consideration is something of value given by each party to a contract. For example, when
an auto is purchased, the buyer gives money (consideration) to the seller who, in turn,
provides the car (which is also consideration).

Some contracts do not involve the exchange of one tangible item for another, but instead
involve performance. For example, an author may sign a contract agreeing to write a book
in exchange for payment by the publisher.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Performance can also involve a promise to perform some act in the future that is dependent
on a certain event occurring. In the case of an insurance contract, the insurer’s
consideration is its promise to pay a claim in the future if a covered loss occurs. If no loss
occurs, the insurer is still fulfilling its promise to provide financial protection even though it
does not pay a claim. In insurance contracts, the following two types of consideration are
involved:

 The insured’s consideration is the payment of (or the promise to pay) the premium.
 The insurer’s consideration is its promise to pay claim for covered losses.

SPECIAL CHARACTERISTICS OF INSURANCE CONTRACTS

In addition to having the four essential elements of all contracts, insurance contracts have
certain special characteristics. An insurance policy is all of the following:

 A conditional contract
 A contract involving fortuitous events and the exchange of unequal amounts
 A contract of utmost good faith
 A contract of adhesion
 A contract of indemnity
 A nontransferable contract

Conditional Contract
An insurance policy is a conditional contract because the parties have to perform only under
certain conditions. Whether the insurer pays a claim depends on whether a covered loss
has occurred. In addition, the insured must fulfill certain duties before a claim is paid, such
as giving prompt notice to the insurer after a loss has occurred.

A covered loss might not occur during a particular policy period, but that fact does not
mean the insurance policy for that period has been worthless. In buying an insurance policy,
the insured acquires a valuable promise – the promise of the insurer to make payments if a
covered loss occurs. The promise exists, even if the insurer’s performance is not required
during the policy period.

Contract Involving Fortuitous Events and the Exchange of Unequal

Amounts
While noninsurance contracts involve an exchange of money for a certain event, such as the
provision of goods or services, insurance contracts involve an exchange of money for
protection upon the occurrence of uncertain, or fortuitous, events. Insurance contracts
involve an exchange of unequal amounts. Often, there are few or no losses and the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

premium paid by the insured for a particular policy is more than the amount paid by the
insurer to, or on behalf of, the insured. If a large loss occurs, however, the insurer’s claim
payment might be much more than the premium paid by the insured. It is the possibility
that the insurer’s obligation might be much greater than the insured’s that makes the
insurance transaction a fair trade.

For example, assume an insurer charges a $1,000 annual premium to provide auto physical
damage coverage on a car valued at $20,000. The following three situations may occur:

1. If the car is not damaged while the policy is in force, the insurer pays nothing.
2. If the car is partially damaged, the insurer pays the cost of repairs, after subtracting a
deductible.
3. If the car is a total loss, the insurer pays $20,000 (minus any deductible).

Unless, by chance, the insurer’s obligations in a minor accident total exactly $1,000,
unequal amounts are involved in all three of these cases. However, it does not follow that
insureds who have no losses – or only very minor losses – do not get their money’s worth or
that insureds involved in major accidents profit from the insurance.

The premium for a particular policy should reflect the insured’s share of estimated losses
that the insurer must pay. Many insureds have no losses, but some have very large losses.
The policy premium reflects the insured’s proportionate share of the total amount the
insurer expects to pay to honor its agreements with all insureds having similar policies.

Contract of Utmost Good Faith

Because insurance involves a promise, it requires complete honesty and disclosure of all
relevant facts from both parties. For this reason, insurance contracts are considered
contracts of utmost good faith. Both parties to an insurance contract – the insurer and the
insured – are expected to be ethical in their dealings with each other.

The insured has a right to rely on the insurer to fulfill its promises. Therefore, the insurer is
expected to treat the insured with utmost good faith. An insurer that acts in bad faith, such
as denying coverage for a claim that is clearly covered, could face serious penalties under
the law.
The insurer also has a right to expect that the insured will act in good faith. An insurance
buyer who intentionally conceals certain information or misrepresents certain facts does
not act in good faith. Because an insurance contract requires utmost good faith from both
parties, an insurer could be released from a contract because of concealment or
misrepresentation by the insured.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Concealment
Concealment is an intentional failure to disclose a material fact. Courts have held that the
insurer must prove two things to establish that concealment has occurred. First, it must
establish that the failure to disclose information was intentional, which is often difficult. The
insurer must usually show that the insured knew that the information should have been
given and then intentionally withheld it.

Second, the insurer must establish that the information withheld was a material fact –
information that would affect an insurer’s underwriting or claim settlement decision. In the
case of an auto insurance applicant, for example, material facts include how the applicant’s
autos are used, who drives them, and the ages and driving records of the drivers. If an
insured intentionally conceals the material fact that a sixteen-year-old son lives in the
household and is the principal driver of one of the cars, that concealment could void the
policy.

Insurers carefully design applications for insurance to include questions regarding facts
material to the underwriting process. The application includes questions on specific subjects
to which the applicant must respond. These questions are designed to encourage the
applicant to reveal all pertinent information.

Misrepresentation
In normal usage, a misrepresentation is a false statement. In the insurance context, a
misrepresentation is a false statement of a material fact on which the insurer relies. The
insurer does not have to prove that the misrepresentation is intentional.

For example, an applicant for auto insurance is assumed to have had two speeding tickets
during the eighteen months immediately before submitting the application for insurance.
When asked if any driving violations have occurred within the past three years (a question
found on most auto insurance application forms), an applicant giving either of the following
answers would be making a misrepresentation:

 “I remember having one speeding ticket about two years ago.”

 “I’ve never been cited for a moving violation-only a few parking tickets.”

The first response provides incorrect information, and this false statement may or may not
be intentional. The false statement made in the second response is probably intentional.
The direct question posed in the application requires a full and honest response from the
applicant because the insurer relies on the information. Anything less is a
misrepresentation, whether intentional or not.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

As with concealment, if a material fact is misrepresented, the insurer could choose to void
the policy because of the violation of utmost good faith.

Contract of Adhesion
The wording in insurance contracts is usually drafted by the insurer (or an insurance
advisory organization), enabling the insurer to use preprinted forms for many different
insureds. Because the insurer determines the exact wording of the policy, the insured has
little choice but to “take it or leave it.” That is, the insured must adhere to the contract
drafted by the insurer. Therefore, insurance policies are considered to be contracts of
adhesion, which means one party (the insured) must adhere to the agreement as written by
the other party (the insurer). This characteristic significantly influences the enforcement of
insurance policies.

If a dispute arises between the insurer and the insured about the meaning of certain words
or phrases in the policy, the insured and the insurer are not on an equal basis. The insurer
either drafted the policy or used standard forms of its own choice; in contrast, the insured
did not have any say in the policy wording. For that reason, if the policy wording is
ambiguous, a court will generally apply the interpretation that favors the insured.

Contract of Indemnity
The purpose of insurance is to indemnify an insured who suffers a loss. To indemnify is to
restore a party who has had a loss to the same financial position that party held before the
loss occurred. Most property and liability insurance policies are contracts of indemnity.
With a contract of indemnity, the insurer agrees, in the event of a covered loss, to pay an
amount directly related to the amount of the loss.

Property insurance generally pays the amount necessary to repair covered property that
has been damaged or to replace it with similar property. The policy specifies the method for
determining the amount of the loss. For example, most auto policies, both personal and
commercial, specify that vehicles are to be valued at their actual cash value (ACV) at the
time of a loss. If a covered accident occurs that causes a covered vehicle to be a total loss,
the insurer will normally pay the ACV of the vehicle, less any applicable deductible.

Liability insurance generally pays to a third-party claimant, on behalf of the insured, any
amounts (up to the policy limit) that the insured becomes legally obligated to pay as
damages because of a covered liability claim, as well as the legal costs associated with that
claim. For example, if an insured with a liability limit of $300,000 is ordered by a court to
pay $100,000 for bodily injury incurred by the claimant in a covered accident, the insurer
will pay $100,000 to the claimant and will also pay the cost to defend the insured in court.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

A contract of indemnity does not necessarily pay the full amount necessary to restore an
insured who has suffered a covered loss to the same financial position. However, the
amount the insurer pays is directly related to the amount of the insured’s loss. Most policies
contain a policy limit that specifies the maximum amount the insurer will pay for a single
claim. Many policies also contain limitations and other provisions that could reduce the
amount of recovery. For example, a homeowners policy is not designed to cover large
amounts of cash. Therefore, most homeowners policies contain a special limit, such as
$200, for any covered loss to money owned by the insured. If a covered fire destroys $1,000
in cash belonging to the insured, the homeowners insure will pay only $200 for the money
that was destroyed.

According to the principle of indemnity, the insured should not profit from a covered loss.
That is, insurance should provide a benefit no greater than the loss suffered by the insured.
Insurance policies usually include certain provisions that reinforce the principle of
indemnity. For example, policies generally contain an other insurance provision to prevent
an insured from receiving full payment from two different insurance policies for the same
claim. Insurance contracts usually protect the insurer’s subrogation rights, as discussed
earlier. Other insurance provisions and subrogation provisions clarify that the insured
cannot collect more than the amount of the loss. For example, following an auto accident in
which the insurer compensates its insured when the other driver is at fault, the subrogation
provision stipulates that the insured’s right to recover damages from the responsible party
is transferred (subrogated) to the insurer. The insured cannot collect from both the insurer
and the responsible party.

Another factor enforcing the principle of indemnity is that a person usually cannot buy
insurance unless that person is in a position to suffer a financial loss. In other words, the
insured must have an insurable interest in the subject of the insurance. For example,
property insurance contracts cover losses only to the extent of the insured’s insurable
interest in the property. This restriction prevents an insured from collecting more from the
insurance than the amount of the loss he or she suffered. A person cannot buy life
insurance on the life of a stranger, hoping to gain if the stranger dies. Insurers normally sell
life insurance when there is a reasonable expectation of a financial loss from the death of
the insured person, such as the loss of an insured’s future income that the insured’s
dependents would face. Insurable interest is not an issue in liability insurance because a
liability claim against an insured results in a financial loss if the insured is legally responsible.
Even if the insured is not responsible, the insured could incur defense costs.

Some insurance contracts are not contracts of indemnity but valued policies. When a
specified loss occurs, a valued policy pays a stated amount, regardless of the actual value of

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

the loss. For example, a fine arts policy may specify that it will pay $250,000 for loss of a
particular painting or sculpture. The actual market value of the painting or sculpture may be
much smaller or much greater than $250,000, but the policy will pay $250,000 in either
case. In most valued policies, the insurer and the insured agree on a limit that approximates
the current market value of the insured property.

Nontransferable Contract
The identities of the persons or organizations insured are important to the insurer, which
has the right to select those applicants with whom it is willing to enter into contractual
agreements. After an insurance policy is in effect, an insured may not freely transfer the
policy to some other party (a practice called “assignment”). If such a transfer were allowed
to take place, the insurer would be legally bound to a contract with a party it may not wish
to insure. Most insurance policies contain a provision that requires the insurer’s written
permission before an insured can transfer a policy to another party.

Traditionally, insurance textbooks used language stating that “insurance is a personal

contract” to indicate its nontransferable nature, and cited clauses in property policies to
illustrate the principle. The policy language does differ between typical property and liability
policies, but in both types, the intention is to prohibit the insured from transferring the
policy to another party without the insurer’s consent.

CONTENT OF INSURANCE POLICIES

Insurance policies must be drafted carefully. The parties must agree on how to handle many
situations that could arise even if these situations are not likely to occur. Familiarity with
both the general content and structure of insurance policies helps in analyzing the terms of
a particular policy.

An insurance policy specifically describes the coverage it provides. Because no insurance

policy can cover every possibility, the policy must describe its limitations, restrictions, and
exclusions as clearly as possible. For example, most insurance policies do not cover losses
caused by acts of war or nuclear contamination. If the insurer does not intend to cover such
losses, the policy must clearly state that fact. The only way to determine the coverage
provided by a particular policy is to examine its provisions, which are generally included in
the following categories:

 Declarations
 Definitions
 Insuring agreements
 Exclusions

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Conditions
 Miscellaneous provisions

Declarations
An insurance policy must first identify the parties to the contract. Information such as the
name and location of the insurer and the name and address of the insured is usually shown
of the first page of the policy. This information page is often called the declarations page,
although it can be more than one page; it is also known simply as the declarations or the
dec. As its name implies, a declarations page declares important information about the
specific policy of which it is a part. The name of the insurer is almost always preprinted on
the declarations page and the name and address of the insured are entered when the policy
is issued. Exhibit 7-1 shows a sample declarations page of a personal auto policy.

Insurance policies usually provide coverage for a specified period. The inception date of the
policy is stated in the declarations. The expiration date may also appear in the declarations,
or the policy period may be clarified elsewhere in the policy, usually as part of the
conditions.

The insurance policy must describe the consideration involved. As stated previously, the
insured’s consideration is the premium, and the insurer’s consideration is its promise to pay
if a covered loss occurs. The premium amount is usually shown in the policy declarations.
Other statements regarding when the premium should be paid, to whom it should be paid,
and the consequences if it is not paid may appear elsewhere in the policy.

The declarations also show the policy limit (or limits). A limit is the maximum amount of
coverage the insurer will pay for a given type of loss. In some situations, however the
insurer may ultimately pay an amount greater than a policy limit. For example, under some
liability policies, defense costs may be paid in addition to the amount of damages. Some
property policies include additional coverages, such as debris removal, may be paid in
addition to a policy limit.
In addition, the declarations usually include any information that specifically describes the
covered property or locations, specific coverages, deductibles, policy forms, endorsements,
and other important details about the insured, the subject of the insurance, and the
coverages provided by the policy.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

EXHIBIT 7-1

Sample Declarations Page of a Personal Auto Policy

Insured
Insured Vehicles
Vehicles and
and
Schedule
Schedule of
of Coverages
Coverages
In
Inaddition,
addition,thethe declarations
declarations
Insurer
Insurer and
and Policyholder
Policyholder usually
usually include
includeany
any information
information
The
Thename
nameofofthe
theinsurer
insurerisis almost
almost that
thatspecifically
specifically describes
describes thethe
always
alwayspreprinted
preprinted ononthe
the covered
covered property
property ororlocations,
locations,
declarations
declarationspage
page andandthe
thenamename specific
specificcoverages,
coverages,deductibles,
deductibles,
and
andaddress
addressofofthe
theinsured
insured are are policy
policy forms,
forms,endorsements,
endorsements,and and
entered
enteredwhen
whenthe
thepolicy
policy isis issued.
issued. other
otherimportant
importantdetails
detailsabout
aboutthe
the
insured,
insured,thethe subject
subjectof ofthe
the
insurance,
insurance,and andthe
thecoverages
coverages
provided
providedby by the
the policy.
policy.

Policy
Policy Period
Period
Insurance
Insurancepolicies
policiesusually
usually provide
provide
coverage
coveragefor foraa specified
specified period.
period.
The
Premium
Premium
Theinception
inceptiondate
dateofofthe
thepolicy
policy isis
stated
statedin inthe
the declarations.
declarations.TheThe The
Theinsurance
insurance policy
policymust
must
expiration
expirationdatedatemay
mayalso
alsoappear
appearin in describe
describethe theconsideration
consideration
the
thedeclarations,
declarations,or orthe
the policy
policy involved.
involved.The Theinsured's
insured's
period
periodmaymaybe be clarified
clarified elsewhere
elsewhere consideration
considerationisisthethepremium,
premium,
in
inthe
thepolicy,
policy,usually
usually asaspart
partof
ofthe
the and
and the
the insurer's
insurer's consideration
considerationisis
conditions.
conditions. its
its promise
promiseto topay
pay ififaa covered
covered
loss
lossoccurs.
occurs.TheThe premium
premium
amount
amountisisusually
usually shown
shown in in the
the
policy
policy declarations.
declarations.Other Other
statements
statementsregarding
regardingwhen whenthe the
Limits
Limits of
of Insurance
Insurance premium
premiumshouldshouldbebe paid,
paid,toto
The
Thedeclarations
declarations also also show
showthe the whom
whomititshould
should bebepaid,
paid,and
andthethe
policy
policylimit
limit(or
(orlimits).
limits).AAlimit
limitisisthe
the consequences
consequences ififititisis not
notpaid
paid
maximum
maximumamountamountof ofcoverage
coverage may
may appear
appearelsewhere
elsewhere in in the
the
the
theinsurer
insurerwill
willpaypayfor
foraagiven
given policy.
policy.
type
typeof
ofloss.
loss.InIn some
somesituations,
situations,
however,
however,the the insurer
insurermay
may
ultimately
ultimatelypaypay an anamount
amountgreater
greater
than
thanaapolicy
policylimit.
limit.For
Forexample,
example,
under
undersome
some liability
liabilitypolicies,
policies,
defense
defensecosts
costsmay may bebepaid
paidin in
addition
additionto tothe
theamount
amountof of
damages.
damages.Some Some property
property policies
policies
include
includeadditional
additionalcoverages,
coverages,
such
suchasasdebris
debrisremoval,
removal,which
which
may
maybebepaid
paidin inaddition
additiontotoaa
policy
policylimit.
limit.

Definitions
Because insurance policies often contain technical terms that are used in a precise way,
most policies define words that have a specific meaning with regard to the coverage
provided. The terms may be defined in a separate section of the policy or where they first
appear in the policy. If a policy definition differs from normal usage for a term, the
definition in the policy prevails. Unless the contract provides specific definitions, the in
words in insurance policies and other contracts are generally interpreted according to their

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

ordinary meanings or dictionary definitions. If ambiguity exists, the words could be

interpreted by the courts.

Insurance policies sometimes distinguish defined terms by placing quotation marks around
the terms or by printing them in boldface type each time they appear in the policy. Exhibit
7-2 shows the definitions section of a typical homeowners policy.

Insuring Agreements
An insurance policy contains at least one insuring agreement, which is a specific statement
indicating that the insurer will, under certain circumstances, make a payment or provide a
service. For example, the Personal Auto Policy developed by Insurance Services Office (ISO)
contains a separate insuring agreement for each of the four coverages provided by the
policy: liability, medical payments, uninsured motorists, and coverage for damage to the
insured’s auto.

A typical insuring agreement in the ISO Personal Auto Policy for Part D – Coverage for
Damage to Your Auto would read, in part, as follows:

We will pay for direct and accidental loss to “your covered auto” or any “non-owned
auto,” including their equipment, minus any applicable deductible shown in the
Declarations.

The words enclosed in quotation marks in this insuring agreement are defined in the
definitions section of the policy.

Exclusions
The exclusions in an insurance policy describe what the insurer does not cover. Although
the insuring agreement makes a broad promise to provide coverage, the exclusions
eliminate coverage for specified loss exposures. No insurance policy can reasonably cover
all possible losses. Insurance policies contain exclusions for several reasons as follows:

 To eliminate duplicate coverage. Some losses are best covered by one type of
insurance and are thus excluded by other types of policies. For example, most motor
vehicle exposures are excluded from homeowners policies because they should be
covered under automobile insurance policies.
 To assist in managing moral hazards. Moral hazards are conditions that may lead
some people to exaggerate losses or intentionally cause them to collect insurance
proceeds. Most policies exclude losses expected or intended by the insured. For

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

example, coverage is excluded when an insured commits arson for the purpose of
collecting the insurance proceeds.
 To avoid insuring other losses that are deliberate. Some liability losses are within the
control of the insured. Many policies exclude coverage for bodily injury or property
damage intentionally caused by the insured. The motivation may be different than
the profit incentive that is common with moral hazards. For example, a person may
deliberately back his truck into his neighbor’s car door out of anger or spite. As with
moral hazards, most policies exclude losses that are deliberate.
 To assist in managing attitudinal (morale) hazards. Attitudinal hazards, also called
morale hazards, exist when the frequency or severity of loss is increased because a
person is not as careful as he or she could be. Some exclusions help manage morale
hazards by making the insureds themselves bear the losses that might easily have
been avoided. For instance, the ISO homeowners policy excludes losses caused by
the insured’s neglect to use reasonable means to protect property at the time of loss
or afterwards.
 To avoid covering losses that are not economically feasible to insure. Some losses
cannot reasonably be private insurers. For example, war and nuclear events involve
a potential for catastrophic losses that are not economically feasible for one insurer
to cover.
 To eliminate coverage that most insureds do not need. For example, the average
homeowner does not own a private airplane or need coverage for destruction of
aircraft. Accordingly, the homeowners policy excludes aircraft.
 To eliminate coverage for exposures that require special handling by the insurer. For
example, most commercial property policies exclude coverage for steam boiler
explosions because boilers require special inspections and coverage that many
insurers do not have the expertise to handle. Also, such coverage may be obtained
under a policy designed for that purpose.
 To keep premiums reasonable. For example, auto insurance policies exclude
coverage for wear and tear of the auto. If auto insurers were to provide coverage for
all regular maintenance of insured autos, premiums would probably become
unreasonable because of the large number of expected losses.

Many exclusions, including the previous examples, fit into more than one of the preceding
categories. Any exclusion can serve more than one purpose. To a certain extent, all
exclusions fit the last purpose of keeping premiums reasonable. Logically, it would require a
higher premium to pay for the additional losses that may be covered whenever a policy is
broadened by eliminating exclusion.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Although exclusions often appear in a separate section or sections labeled “Exclusions,”

they can also appear in various places throughout the policy. The term “exclusion” can
accurately apply to any policy provision whose function is to eliminate coverage for
specified loss exposures – whether or not the provision is labeled as exclusion. For example,
in the ISO homeowners policies, exclusions appear in various parts of the policy, labeled in
different ways, including the following:

 “Property Not Covered,” which lists specific types of uninsured property

 “Section I – Perils Insured Against,” which lists both covered causes of loss and specific
causes of loss that are not covered
 “Section I – Exclusions ,” which specially lists exclusions that apply to covered property

Conditions
Insurance policies contain several conditions relating to the coverage provided. A policy
condition is any provision that qualifies an otherwise enforceable promise of the insurer.
The insured must generally comply with these conditions if coverage is to apply to a loss.
Some of the more common conditions included in insurance policies are discussed later in
this chapter.

Miscellaneous Provisions
Insurance policies often contain provisions that do not qualify as one of the policy
components described previously. These miscellaneous provisions sometimes deal with the
relationship between the insured and the insurer, or they may help to establish procedures
for carrying out the terms of the contract. However, actions by the insured that differ from
the procedures in the miscellaneous provisions normally do not affect the insurer’s duty to
provide coverage.

Some miscellaneous provisions are unique to particular types of insurers. For example, a
policy issued by a mutual insurer is likely to describe the right of each insured to vote in the
election of the board of directors.

STANDARD FORMS AND MANUSCRIPT POLICIES

Although insurance contracts, like all other contracts, represent freely negotiated
agreement between the parties, most insurance policies are made up of standard,
preprinted forms. The parties do not normally negotiate all the terms of the contract each
time someone purchases an insurance policy. Only in a special situation, usually involving a
large amount of insurance, might such negotiation happen. When it does, the result is a
manuscript policy or manuscript endorsement, specifically drafted according to terms
negotiated between a specific insured (or group of insureds) and an insurer.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

As mentioned earlier, insurance advisory organization such as ISO and the American
Association of Insurance Services (AAIS) develop industry wide standardized forms for any
different types of insurance, and many insurers use these standard forms for any insured
accepted for a particular coverage. Similarly, an insurer may develop its own forms that
meet the coverage needs of most insureds. A standard policy form has no specific reference
to the insured’s name, address, policy limits, premiums, and so forth. Instead, the standard
form is attached to a declarations page that contains all of the specific information relating
to the insured.

The use of standard forms has many advantages for insurers and is an efficient way to
provide contracts to thousands of insureds. Not only do standard forms save considerable
time and expense in issuing the policy, but they also promote consistency in the insurer’s
operations. When a prospective insured applies for a specific insurance policy, the
underwriter knows the scope of the coverage provided by that policy, including the
applicable restrictions and exclusions. If the underwriter had to develop a manuscript policy
for each individual case, underwriting efficiency and consistency would be seriously
hampered. With standard forms, the underwriter can choose from among applicants for the
same coverage and can determine appropriate premiums on a consistent basis. Similarly,
claim representatives know the extent of coverage provided by standard forms and can
more quickly and easily decide whether the policy covers a particular loss.

Standard policies benefit insureds and insurers. For informed buyers, often in commercial
insurance, selecting an insurer requires comparing differences in policy provisions and
language if the various insurers do not use the same standard form. In addition, if a loss is
covered by two or more insurers, the likelihood of claim disputes is reduced if all insurers
involved have provided coverage under the same standard form.

Standardized wording also leads to a more consistent interpretation of insurance policies.

When disagreements arise between the insured and the insurer concerning the
interpretation of a particular insurance contract, a court ruling may be necessary to
determine the appropriate legal interpretation of the contested policy language. If the
identical language appears in many other policies of the same type, the insurer knows how
the court is likely to interpret this language in the future and can properly underwrite and
price the policy based on that interpretation. If the language were constantly changing or
were different for each insured, more disputes would occur, and there would be no
standard legal interpretation on which the insurer and the insured could rely.

After the policy wording has been drafted by the insurer or advisory organization and
approved by state regulators, the insurer prints thousands of copies of each standardized

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

form, or stores the forms electronically. When insurance is purchased, the appropriate
documents are combined with the declarations to create the policy for that particular
insured. The documents can be combined in many different ways to create policies that
meet the needs of many different insureds.

STRUCTURE OF INSURANCE POLICIES

Insurers use two approaches when structuring an insurance policy, whether manuscript or
standardized. A policy’s structure can be either self-contained or modular, as discussed
next.

Self-Contained Policies
A self-contained policy is a single document that contains all the agreements between the
insurer and the insured; it forms a complete policy by itself. One example of a self-
contained policy is the ISO Personal Auto Policy. A widely used auto insurance policy, the
ISO Personal Auto Policy includes both property and liability insurance coverage in a single
document.

The cover of a Personal Auto Policy may be a multicolor “wrapper” or “jacket” containing
the name and logo of the insurer. Like the wrappers on most products, the purpose of the
cover is to enhance the appearance of the product, to highlight the provider’s name, and to
protect the contents.

Inside the cover of a Personal Auto Policy is the declarations page. Although the preprinted
Personal Auto Policy form is the same for all insureds, the declarations page and any
attached endorsements personalize it for a particular insured. As described earlier, the
policy contains a broad insuring agreement and separate insuring agreements that relate
specifically to the four coverages provided. Exclusions and conditions that relate to each
coverage are also presented. The Personal Auto Policy contains a definitions section that
defines certain terms as they are used in the policy. The policy also includes a section that
states the duties of the insured after a loss occurs. A separate General Provisions section
provides conditions that apply to the policy as a whole.

The Personal Auto Policy, with the declarations page added to the standard form, is a
complete contract of insurance. However, it is often modified by the addition of one or
more endorsements. An endorsement is a document that amends an insurance policy. It
may add coverage – such as coverage for towing and labor on a car that breaks down. Or,
an endorsement may modify the policy in some way to conform to the requirements of the
state where the insured lives. For example, an endorsement may change the termination
provision in the policy by placing some state-specific restrictions on cancellation of the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

policy by the insurer. An endorsement may also deal with a change in the insured’s loss
exposures, such as the purchase of an additional car.

Modular Policies
Modular policies combine coverage forms and other documents to tailor a policy to the
insured’s needs. Commercial package policies (CPPs), for example, are modular policies.

CPPs can provide many different coverages to businesses and other organizations. Unlike
the Personal Auto Policy, which contains four coverages in one form, a CPP combines
different forms, depending on the coverages a particular insured purchases. Modular
policies offer a combination of coverages, some of which may not be purchased by a given
insured. An insured elects coverages by having a limit and premium shown in the
declarations, and declines other coverages by leaving the limit and premium blank.

The components that can be used to compile a CPP are illustrated in Exhibit 7-3.

Under ISO’s program, all CPPs must contain common policy declarations and Common
Policy Conditions. The common policy declarations contain information that applies to the
entire policy, such as the name and address of the insured, the policy period, and the
coverage (s) for which a premium has been or will be paid. The Common Policy Conditions
form contains standard provisions that apply to all CPPs, regardless of the coverages
included. The remaining components of a CPP vary depending on the insured’s desired
coverages. In most cases, a separate declarations page is included for each coverage
provided in the CPP. As illustrated in Exhibit 7-3, a CPP can be used to provide many types
of coverage that a business may need. Unlike a self-contained policy such as the Personal
Auto Policy, however, a CPP includes several different documents. For example, if a
business owner wanted to purchase property and general liability insurance, the CPP would
include the following documents:

 Common policy declarations

 Common policy conditions
 Commercial property declarations
 One or more commercial property coverage forms
 Commercial property conditions
 One or more causes of loss forms
 Commercial general liability declarations
 Commercial general liability coverage from
If the business owner wanted other coverages, such as coverage for autos used in the
business, additional documents would be added to the CPP.

EXHIBIT 7-3

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Components of the ISO Commercial Package Policy (CPP)

CONDITIONS COMMONLY FOUND IN PROPERTY AND

LIABILITY INSURANCE POLICIES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

An insurance policy describes the coverage the insurer provides and also stipulates the
conditions under which the coverage is provided. These conditions provide the rules for the
relationship between the insurer and the insured. Without such rules, insurers would find it
difficult to operate efficiently. Some conditions relate to a specific coverage and appear only
in policies providing that coverage. Other conditions typically appear in most property and
liability insurance policies. Similarly, some conditions appear in both personal and
commercial insurance policies, while others are in only one or the other type of policy.
Conditions common to most property and liability insurance policies, both personal and
commercial, address the following matters:

 Cancellation
 Policy changes
 Duties of the insured after a loss
 Assignment
 Subrogation

The descriptions of policy in this section are based on policies developed by ISO. Polices
developed by other advisory organizations, such as AAIS, and by individual insurers may
have different names for these conditions, or the provisions themselves may differ from
those presented here.

Cancellation
Cancellation occurs when either the insurer or the insured terminates a policy during the
policy term. The cancellation provision states the procedures that must be followed when
cancellation is initiated by the insured or by the insurer. This provision also states any
limitations on the rights of either party to cancel the policy midterm and explains how any
premium refunds will be computed.

Cancellation by the Insured

The insured may usually cancel the policy at any time. To do this, the insured may either
return the policy to the insurer or provide the insurer with advance written notice of the
date the policy is to be cancelled.

Written notice eliminates the possibility of a dispute over a verbal cancellation request.
Suppose, for example, an insured were permitted to request that an insurer cancel
insurance on a given building as of six months earlier and return the premium for those six
months. The insurer would have been obligated to pay a claim if the building had been
damaged during that six-month period because there was a policy in force. Now that the
time has passed and no loss has occurred, the insurer has a right to keep the premium for
that period during which would have been paid if they had occurred.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Cancellation by the Insurer

The insurer may also cancel most insurance policies. However, the procedures described in
the policy provide the insured with some safeguards, such as a given number of days’
written notice before the cancellation takes effect. Many policies also prohibit the insurer
from canceling, except for certain stated reasons. State law may require a longer
notification period or limit the reasons for which an insurer may cancel. If the law is more
favorable to the insured than are the policy provisions, the law prevails.

When a policy is cancelled, the insured may be entitled to a refund. If the insurer cancels
the policy, the return premium is calculated on a pro rata basis and is called a pro rata
refund. For example, if the insurer cancels a one-year policy and the cancellation is effective
exactly six months after the policy’s inception date, the insurer will return to the insured a
pro rata refund of exactly half the premium.

Some policies state that if the insured requests the cancellation, the premium refund will be
less than pro rata and is called a short rate refund. For example, the insurer may return only
45 percent of the premium on a policy that is canceled at exactly the halfway point of the
policy term. This cancellation penalty (also known as a short rate charge) reflects the fact
that the insurer incurred some expense in issuing the policy and will not be able to keep the
full premium. The short rate refund also discourages insurance buyers from canceling their
insurance before the end of the policy period.

Policy Changes
Many policies contain a Policy Changes condition stating that the written insurance policy
contains all the agreements between the insurer and the insured and that the terms of the
policy can be changed only by a written endorsement issued by the insurer. Other policies
state that changes to the policy are valid if the insurer agrees to the change in writing.

Some insurers revise their policies fairly frequently, perhaps to clarify policy language or to
broaden or restrict coverage. If a revision broadens coverage with no additional premium
charge to insureds, the liberalization clause makes it clear that the revision automatically
applies to all similar policies in force at the time of the revision. The liberalization clause is a
benefit to insurers as well as insureds because it precludes the need for such a change to be
endorsed on every similar policy already in force.

Duties of the Insured After a Loss

If a covered loss is to be paid, the insurer must be informed that the loss occurred.
Therefore, under property and liability insurance, the insured must immediately notify the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

insurer of the loss; most policies state that notice be given “promptly” or “as soon as is
practical”. Insureds also are required to cooperate with the insurer and to perform certain
other duties in settling a loss. The type of cooperation and the duties required depend on
the type of coverage. For example, property insurance policies generally require that the
insured prepare an inventory of damaged and undamaged property and protect the
property from further damage. Liability insurance policies usually require that the insured
promptly forward all papers regarding a claim or suit to the insurer. Other specific duties of
the insured are determined by the type of coverage provided and by the wording of the
policy.

Assignment
As discussed, an insurance policy is a personal contract between the insurer and the
insured. Insurers select their insureds carefully. The selection process would be bypassed if
an insured were permitted to transfer the insurance coverage to some other person. The
other person might be someone with whom the insurer would prefer not to do business.

The assignment provision, which is sometimes labeled “Transfer of Your Rights and Duties
Under This Policy,” makes it clear that assignment of the policy to another party is not
permitted without the written consent of the insurer. For example, a homeowner cannot
transfer his or her homeowners policy to a new owner when the house is sold unless the
insurer agrees, in writing, to the transfer, which is seldom the case. Insurers rarely agree to
such policy transfers because they want the right to underwrite the policy again based on
the loss exposures presented by the new owner.

The assignment provision could present a problem when an insured dies, because coverage
would cease at the time of death. Property that is now part of the insured’s estate could be
damaged or destroyed, or liability claims could be brought against the estate. Because of
this problem, insurance policies usually state that the rights and responsibilities of an
insured who has died pass to the insured’s legal representative (such as the executor of an
insured’s estate)

Subrogation
Most property and liability insurance policies contain a subrogation provision. This provision
is sometimes labeled “Our Right to Recover Payment” or “Transfer or Rights of Recovery
Against Others to Us.” Insurance practitioners, however, often use the term subrogation
even when that word is not used in the policy.
When the insurer pays an insured for a loss, the insurer assumes the insured’s right to
collect damages from any other person responsible for the loss. As discussed in an earlier
chapter, the insurer is subrogated to the insured’s rights of recovery, and the insurer’s

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

process of recovering is called subrogation. In short, subrogation shifts the ultimate cost of
a loss to the party responsible for causing the loss.

For example, if Michael drives his car too fast for the existing road conditions and slides off
the road into Joanne’s building. Joanne would have a right to recover damages from
Michael. However, Joanne may also file a claim with the insurer providing her property
coverage, and her insurer would pay for the damage to her building. After paying the
property insurance claim, Joanne’s insurer has the right of subrogation against Michael. In
this example, Joanne has no further right of recovery if she has been fully indemnified for
her loss. If she could also recover from Michael, the principle of indemnity would be
violated. Joanne’s insurer now has any rights of recovery Joanne had before the insurer paid
for the loss, including the right to file a claim against Michael. If Michael has liability
insurance, his insurer is obligated to defend him and to pay damages on his behalf.

However, if Joanne has not been fully indemnified, she could recover the portion of her loss
that her insurer did not cover. For example, if Joanne had a deductible of $1,000 on her
property insurance policy, she could recover the $1,000 from Michael that her insurer
deducted from its payment to her. Usually, insurers will help insureds recover deductibles
as part of the subrogation process.

Most subrogation provisions require that the insured do nothing after a loss to impair the
insurer’s subrogation rights. Therefore, in the previous example, Joanne may not tell
Michael, “Don’t worry about the damage-you won’t have to pay anything because my
property insurance will cover it. “ If Joanne were to make such a statement, her property
insurer could refuse to pay for the loss because Joanne has no authority to waive the
insurer’s rights.

Some insurance policies, however, permit an insured to waive rights of recovery before a
loss. For example, in a property lease that states the tenant will not be held responsible for
accidental damage to property owned by the insured, the insurer will have no right to
recover from the tenant if the tenant accidentally causes a fire that damages the insured’s
property.

SUMMARY
When someone buys an insurance policy, the value he or she receives is the insurer’s
binding promise to pay for specified kinds of losses. The promise is binding because the

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

policy is a contract that can be enforced in a court of law. To be legally valid, a contract
must have certain essential elements as follows:-
 If must represent an agreement between the parties.
 Each party must be legally competent to make the agreement.
 The purpose of the agreement must be legal.
 Each party must give some form of consideration to the other party.

Although all of the rules of contract law apply to insurance policies, certain special
characteristics distinguish insurance policies from other contracts. An insurance policy is all
of the following:-
 A conditional contract
 A contract involving fortuitous events and the exchange of unequal amounts
 A contract of utmost good faith
 A contract of adhesion
 A contract of indemnity
 A nontransferable contract

All insurance policies contain certain components, and the insured should review the
provision in each of these components to determine the coverage provided. Most policies
include the following:-
 Declarations page
 Definitions
 One or more insuring agreements
 Exclusions
 Conditions
 Miscellaneous provisions

In general, insurance policies consist of standard forms to which only the specific details
regarding a particular insured must be added. Occasionally, a manuscript policy is drafted
according to terms specially negotiated between the insured and the insurer.
An insurance policy can be either self-contained or modular. A self-contained policy (such as
a Personal Auto Policy) is a single document that, when combined with a declarations page,
forms a complete policy. A modular policy (such as a Commercial Package Policy) comprises
several different documents, none of which forms a complete contract by itself.

Insurance policies stipulate certain conditions under which the policy is issued. The insured
accepts those conditions as part of the transaction. Typical conditions address the
following:-
 Cancellation
 Policy changes
 Duties of the insured after a loss
 Assignment

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Subrogation

This chapter provides a basis for studying the material in the next two chapters, which cover
property and liability loss exposures and specific provisions in policies that insure many of
these exposures.

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Property Loss Exposures

& Policy Provisions Chapter 8

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Everything seemed normal When Mr. Brown closed the supermarket for the night.
Therefore, he was shocked when he was later awakened by a telephone call from someone
exclaiming, "Get down to the shopping center. Your store in on fire!”

The fire apparently started in the store’s storage area. A problem in an electrical fixture may
have caused some sparks that ignited trash in a nearby bin. Paper goods, bags of charcoal,
and other combustible material in the storage area were apparently ablaze long before the
fire was visible from outside the building. The fire spread rapidly through the store’s
sprawling open spaces.

A few months after the fire, Mr. Brown cut the ribbon for the store’s grand reopening sale,
and it was soon business as usual. Thanks to his property insurance, Mr. Brown was in
almost the same financial condition as he was before the fire. The building had been rebuilt,
and the food, freezers, and other contents had been replaced. Business income insurance
also reimbursed Mr. Brown for the income lost while the store was closed, as well as for the
extra expenses he incurred because of the fire.

It was not by chance that Mr. Brown’s insurance enabled him to reopen quickly because he
had planned ahead. With the help of his insurance agent, he had identified his property loss
exposures and made sure that he was insured against the financial consequences of
damage from fire and other cause. Mr. Brown had to identify the various items of property
that could be lost or damaged, and he had to determine what could occur to cause loss or
damage. In addition, he had to estimate the amount that he could potentially lose. Having
done these things well, he was aware of his property loss exposures and had taken steps to
properly insure the property.

This chapter illustrates how Mr. Brown was able to successfully handle the consequences of
the fire by exploring the various aspects of property loss exposures and then describing
important property insurance policy provisions that cover those loss exposures.

PROPERTY LOSS EXPOSURES

Three important aspects of property loss exposures are as follows:

1. Types of property – The types of property that may be exposed to loss,

damage, or destruction.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2. Cause of loss – The causes of loss that may result in property being lost,
damaged, or destroyed.
3. Financial consequences – The financial consequences that may result from a
property loss

These aspects are important because they create the framework for the contract. They
describe (1) what is covered, (2) what cause of loss are covered, and (3) how much will be
paid to cover the losses.

In addition to describing these aspects of property loss exposures, this section discusses the
parties that may be affected when property is lost, damaged, or destroyed.

Types of Property

Property is any item with value. Individuals, families, and business own and use property,
depend on it as a source of income or services, and rely on its value. Property can decline in
value – or even become worthless – if it is lost, damaged, or destroyed. Different kinds of
property have different qualities that affect the owner’s or user’s exposure to loss.

Two basic types of property are real property and personal property. Insurance
practitioners further divide these types of property into the following categories:

 Building
 Personal property (contents) contained in buildings
 Money and securities
 Motor vehicles and trailers
 Property in transit
 Ships and their cargoes
 Boilers and machinery

These categories overlap to some extent. For example, motor vehicles, when carried on
trucks, can be property in transit. When motor vehicles are on ships for long distance trips,
they are waterborne cargo. These categories are listed separately here because they
represent types of property for which specific forms of insurance have been developed.

Buildings
Buildings are more than bricks and mortar. Most buildings also include plumbing, wiring,
and heating and air conditioning equipment, which can lead to leaks, electrical fires, and
explosions. Most buildings also contain basic portable equipment – fire extinguishers, snow
shovels, lawn mowers, and so forth – required to service the building and surrounding land.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Under most insurance policies, such equipment is considered part of the building. A high-
rise building usually has elevators and may have specially designed portable platforms,
hoists, and tracks for use by window washers. This equipment is also considered to be part
of the building. Property that is permanently attached to the structure, such as wall-to-wall
carpeting, built-in appliances, or paneling, is generally considered part of the building as
well.

Personal Property (Contents) Contained in Buildings

The contents of a typical home include personal property such as furniture, clothing,
electronic equipment, jewelry, paintings, and other personal possessions. The contents of a
commercial building may include the following:

 Furniture, such as the desks in an office or file cabinets in Mr. Brown’s store
 Machinery and equipment, such as the cash registers in Mr. Brown’s supermarkets.
 Stock, such as the groceries in Mr. Brown’s store or the raw materials and completed
products in the inventory of a shoe factory. A shoe factory’s stock includes leather
(raw materials), partly finished shoes (goods in process), and shoes (finished goods)

Although most policies use the term "personal property" to refer to the contents of a
building, many insurance practitioners and policyholders use the term "contents" as a
matter of convenience and common practice. Property insurance policies refer to personal
property, rather than contents, because the property is often covered even when it is not
literally contained in the building. When the contents of a commercial building are involved,
policies generally use the term "business personal property."

Money and Securities

For insurance purposes, money and securities are separate from other types of contents
because their characteristics present special problems. Money is currency, coins, bank
notes, and sometimes traveler’s checks, credits card slips, and money orders held for sale to
the public. Securities are written instruments representing either money or other property,
such as stocks and bonds. Money and securities are highly susceptible to loss by theft. Cash
is particularly difficult to trace, because it can be readily spent. In contrast, other types of
property must be sold for cash before the thief can make a profit. Money and securities are
also lightweight, easily concealed, and easy to transport.

Besides being susceptible to theft, money and securities can be quickly destroyed by fire.
Unless Mr. Brown made a bank deposit every night when the store closed, he probably lost
a considerably amount of currency and checks during the fire in his store.

Motor Vehicles and Trailers

The primary purpose of most vehicles is to move people or property, and this movement
exposes vehicles to several causes of loss. Vehicles may be grouped by vehicle type, by

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

operator type, by typical usage, or by a combination of these types. No matter what types
are used, some vehicles (such as snowmobiles or utility vehicles) fit into more than one
category, depending on the purpose for which they are owned and used. However, the
following categories are useful in identifying property loss exposures:

 Autos and other highway vehicles

 Mobile equipment
 Recreation vehicles

In insurance terminology, the term auto has a broad meaning. It includes motorized
vehicles, such as cars, trucks, trailers, and buses, designed for road use but can also include
such diverse vehicles as fire engines, ambulances, motorcycles, and camping trailers. Mobile
equipment includes tractors, bull-dozers, road graders, front-end loaders, forklifts,
backhoes, and power shovels, and the equipment attached to them. Mobile equipment may
be damaged in a highway collision, but the most frequent exposures to loss involve off-road
situations. Recreational vehicles include a wide range of vehicles used for sports and
recreational activities, such as dune buggies, all - terrain vehicles, and dirt bikes. Most
snowmobiles also fall into this category. In some cases, the owners of recreational vehicles
face exposures to loss both on and off the road.

Property in Transit
A great deal of property is transported by truck, but property is also moved in cars, buses,
trains, airplanes, and ships. When a conveyance containing cargo overturns or is involved in
a collision, the cargo can also be damaged. In addition, cargo can be destroyed without
damage to the transporting vehicle. Liquids can leak out of a truck, fragile articles can be
jostled during transit, and perishables can melt or spoil in a conveyance with a defective
refrigeration system.

When property is damaged or lost in transit, it must be replaced. Delays often result,
because replacement property may have to be shipped from the place of the original
shipment. The property owner may also incur expense to move the damaged property.

Ships and Their Cargoes

Ships and their cargoes are exposed to special perils not encountered in other means of
transit. For example, a ship can sink for a variety of reasons, resulting in a total loss of its
cargo. Even more than other property, ocean cargoes fluctuate in value according to their
location. If the ship cannot reach its intended destination and the cargo must be sold in a
different port, the price received for the cargo might be less than the price expected at the
original destination.

Boilers and Machinery

Boilers and machinery include any of the following:

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Steam boilers (large water tanks heated by burning gas, oil, or coal to produce steam for
heating or to produce power)
 Unfired pressure vessels, such as air tanks
 Refrigerating and air conditioning systems
 Mechanical equipment, such as compressors and turbines
 Production equipment
 Electrical equipment

Boilers and machinery share the following two characteristics:

1. They are susceptible to explosion or breakdown that can result in serious losses to
the unit and to persons and property nearby.
2. They are less likely to have explosions or breakdowns if they are periodically
inspected and property maintained.

Many buildings use steam boilers to provide heat. Refineries and steel mills often use
boilers to provide power for factory process. Machinery, such as transformers and other
electrical apparatus, is found in most factories and power stations.
Causes of Loss to Property

A cause of loss (or peril) is the actual means by which property is damaged or destroyed and
includes fire, lightening, windstorm, hail, and theft. Most causes of loss adversely affect
property and leave it in an altered state. A fire can change a building to a heap of rubble. A
collision can change a car to twisted scrap. Some causes of loss do not alter the property
itself, but they do affect a person’s ability to possess or use the property. For example,
property lost or stolen can still be usable, but not by its rightful owner.

Many property insurance policies list the covered causes of loss. Such policies are
commonly known as named perils policies because they "name" or list the covered perils.
Usually, these policies also list the causes of loss that are excluded from coverage. Other
policies cover all causes of loss except losses caused by a peril specifically excluded. These
policies are known by several different terms, including special form or open perils policies.
This text uses the term special form policies.

Perils and Hazards

The terms "peril" and "hazards" are often confused.

As stated earlier, a peril is a cause of loss. Fire, theft, collision, and flood are examples of
perils that cause property losses. (Many property insurance policies use the term cause of
loss instead of peril. This text uses these terms interchangeably.)

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

A hazard is anything that increases the frequency of a loss or the severity of a loss.
Examples include the following:

 Careless smoking practices are a fire hazard because they increase the frequency of
fires.
 Paint cans and oily rags are fire hazards because they enable a fire to spread and cause
severe damage.
 Keeping large amounts of money in a cash register overnight is a theft hazard affecting
both the frequency of loss and the severity of loss. This practice would attract thieves if
they became aware it. The amount that would be stolen – the severity of the loss – is
also affected by the amount of cash in the register.
Burden of Proof
An important difference between named perils and special form coverage involves the
burden of proof, as follows:

 With a named perils policy, for coverage to apply, the insured must prove that the loss
was caused by a covered cause of loss.
 With a special form policy, if a loss to covered property occurs, it is initially assumed
that coverage applies. However, coverage may be denied if the insurer can prove that
the loss was caused by an excluded cause of loss.

In the first case, the burden of proof is on the insured; in the second, it is on the insurer.

By shifting the burden of proof, a special form policy can prove an important advantage to
the insured who suffers a property loss by an unknown cause. For example, suppose that
after a flood strikes the community, the insured’s wrought iron patio furniture is missing.
Assume also that the patio furniture is clearly covered property. It is possible that the
furniture was swept away in the flood, but it is also possible that the furniture was stolen
following the flood. If a named perils policy covered theft but not flood, the insured would
have to prove that the property had been stolen. Under a special form policy, the insurer
would have to pay the claim (even if the policy excluded flood losses) unless the insurer
could prove that the property was swept away in the flood.

Financial Consequences of Property Losses

The loss of or damage to property can have adverse financial consequences such as reduced
property value, lost income, or extra expenses.

Reduced Property Value

When a property loss occurs, the property is reduced in value. The reduction in value can be
measured in different ways, sometimes with differing results. If the property can be

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

repaired or restored, the reduction in value can be measured by the cost of the repair or
the restoration. Property that must be replaced has no remaining worth, unless some
salvageable items can be sold. Consider the following examples:

 A fence worth $7,000 was damaged by a car, and the fence owner has to pay $2,000 to
have the damage repaired. The fence owner has incurred a partial loss that reduced the
fence’s value by $2,000.
 A camera worth $400 is run over by a truck. The camera owner has incurred a total loss
that reduced the camera’s value by $400.

If property is lost, is stolen, or otherwise disappears, its value to the owner is reduced just
as though it had been destroyed and retained no salvage value. A further reduction in value
might occur if repaired property is worth less than it would be if it had never been
damaged. This is true for items such as fine painting and other art objects. Many collectibles
are valuable largely because they are in mint or original condition. An object that has been
repaired after damage from a tear, scratch, or fire is no longer in that unspoiled condition
and its value will decline. The owner faces loss in the form of the cost to repair the object,
as well as a reduction in value because of the altered condition.

Property may have different values, depending on the method by which the value is
determined. The most common valuation measures used in insurance policies, as discussed
earlier in this text, are replacement cost and actual cash value (ACV). In certain situations,
however, other valuation measures, such as agreed value, are used.

Lost Income
When property is damaged, income may be lost because the property cannot be used until
it is repaired, restored, or replaced. In the supermarket fire example earlier in this chapter,
Mr. Brown temporarily lost the income from his store because the building and its contents
were damaged by fire.

Determining the amount of business income that may be lost following a property loss
requires estimating the future level of activity of an organization and doing a "what if"
analysis. The "what if" analysis would include such questions as; "What if the business could
not operate for six months because it would take six months to rebuild after a fire? How
much net income would be lost?”This analysis involves projecting the organization’s net
income (revenue minus expense, including taxes) in normal circumstances. Those projected
amounts are compared to expected post-loss net income for the same period to determine
the income lost. This analysis requires comparing what the business might have expected its
revenue and expenses to have been compared to what they actually were after the loss.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The following example shows expected revenue expenses compared to those experienced
after the fire. The post-loss amounts might be a "what if" in order to determine the amount
of business income insurance needed, or the actual amounts following a loss. In either case,
the lost income for the time period is simply the expected net income less the post-loss net
income: $ 90,000 minus ($30,000) = $120,000.

Expected (Normal Operations) Post-Loss

Revenue $150,000 $0
Expenses $ 60,000 $ 30,000
Net Income $ 90,000 $ 30,000

The owner of rental property would face a similar situation because rental income would be
lost if the property were damaged and temporarily could not be rented. The owner would
probably continue to incur some expenses, such as mortgage payments and taxes, but
would not receive the rent that helped to pay those expenses.

Extra Expenses
Determining the extent of a property loss exposure involves considering the extra expense
required in the event of the loss of property. When property is damaged, the property itself
declines in value, and the owner or other affected party suffers a corresponding loss. In
addition, the owner or other user of that property may incur extra expenses to acquire a
temporary substitute or to temporarily maintain the property in usable condition. Consider
the following examples:

 When a family’s house is damaged, the family may have to live in a hotel temporarily at
considerably greater expense than living at home.
 When a newspaper’s printing presses are damaged, the newspaper may spend extra
money to have the newspaper printed on another company’s presses.
 When a car is damaged in a collision, the owner may rent an auto until the car’s damage
has been repaired.
 When a bank building is damaged, the bank may hire additional security guards until the
building can be made secure.

Because so many variables are involved, it is difficult to estimate the extra expenses that
might be required to stay in business following damage to business property or to keep a
family together and maintain its standard of living after a home is damaged.

Parties Affected by Property Losses

Parties that may be affected by a property loss include the following:

 Property owners
 Secured lenders of money to the property owner
 Property users
 Property holders

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Property Owners
The party most affected when property is lost, damaged, or destroyed is usually the owner
of the property. If the property has some value, the owner of the property incurs a financial
loss to repair or replace the property. In the supermarket fire example, Mr. Brown incurred
a considerable financial loss because he had to rebuild his store and restock the shelves.

Secured Lenders
When money is borrowed to finance the purchase of a car, the lender usually acquires some
conditional rights to the car, such as the right to repossess the car if the car’s owner (the
borrower) fails to make loan payments. This right gives the lender security. Such a lender is
therefore called a secured lender or a secured creditor. When a person or business borrows
money to buy a home or a building and the property serves as security for the loan, the
secured lender is called a mortgagee (or mortgage holder), and the borrower is called a
mortgagor.

When a property is used to secure a loan, both the property owner and the lender are
exposed to loss. If, for example, Mr. Brown had a mortgage on his supermarket building, the
mortgagee would lose the security for the mortgage loan when the building burned.
Similarly, if a financed car is destroyed in an accident and the owner has no money to repay
the loan, there would be no car for the lender to repossess. Property insurance policies
generally protect the secured lender’s interest in the financed property by naming the
lender on the insurance policy and by giving the lender certain rights under the policy.

Property Users
Some events result in losses to end users (such as consumers or resellers) of the damaged
property, even though they do not own the property. Consider the following example: a fish
store buys fresh shellfish from the only supplier within 200 miles. About one-third of the
fish store’s retail sales are shellfish. If fire or another peril were to destroy the supplier’s
processing facility, the fish store would not be able to sell fresh shellfish, and would incur a
financial loss.

Property Holders
Some parties are responsible for safekeeping property they do not own. Dry cleaners, T.V.
repair shops, common carriers, and many other businesses temporarily hold property
belonging to others. A person or business in possession of property entrusted to them by
others is called a bailee. To estimate their property loss exposures, such businesses have to
consider not only their owned property, but also the property held for others.

PROPERTY INSURANCE POLICY PROVISIONS

A property insurance policy indemnifies an insured who suffers a financial loss because
property has been lost, stolen, damaged, or destroyed. The policy must specify exactly

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

which property loss exposures are covered – that is, the types and locations of property,
causes of loss, and financial consequences that are covered. Policies must also identify the
parties that are covered and how the value of insured property will be determined.

This section examines common characteristics of policies that provide property insurance
and focuses on explaining general features rather than describing the content of specific
policies. The following aspects of property insurance policies are discussed next:

 Covered property and locations

 Covered causes of loss
 Causes of loss often excluded
 Covered financial consequences
 Covered parties
 Amounts of recovery

Covered Property and Locations

An insurance policy specifies what property is covered and where it is covered. Covered
property is often described broadly and then refined through a series of limitations and
exclusions. Locations of property are often defined by geographical boundaries. For
example, a typical personal auto insurance policy covers collision damage to an auto
described in the declarations, provided the collision occurs in the United States, its
territories and possessions, Puerto Rico, or Canada. When coverage is provided worldwide,
such as personal property covered by a homeowners policy, some limitations are placed on
the value of the property that will be covered when it is permanently kept at another
location, such as at a secondary residence.

Many types of property insurance are designed primarily to cover buildings and personal
property. The identification of a covered building is generally clear because its location is
fixed. However, stating the location of covered property might not be as straightforward.
One challenge lies in describing precisely what is and what is not covered under the
insurance policy. Another challenge lies in the fact that personal property and, in some
instances, buildings do not necessarily remain at a fixed location. Portions of a building may
be removed from the premises for repair or storage. For example, screen windows may be
removed from the building and placed in storage during the winter while storm windows
are being used. Furniture may be located inside buildings as well as on outdoor patios and
decks. Items usually kept in a building may be temporarily located in a car or truck.

A property insurance policy for covering personal property that moves from place to place is
often called a floater because it provides coverage that floats, or moves, with property as it
changes location. Examples of items that could be covered by a floater include jewelry, furs,
cameras, and other types of property owned by individuals and families; property

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

transported on trucks or other conveyances covered by a transportation policy; and

earthmovers and other construction equipment owned by contractors. Policies covering
movable property may have territorial limits, or they may provide coverage anywhere in the
world.

Commercial package policies now typically include coverage for movable property and
homeowners policies usually provide worldwide coverage for many types of moveable
property. The homeowners policy may, however, be endorsed with one or more floaters
that add covered perils and increase coverage limits for items jewelry and furs.

The following types of covered property are discussed next:

 Dwellings, buildings, and other structures

 Personal property
 Property other than the insured’s building and contents

Dwellings, Buildings, and other Structures

Some property insurance policies stipulate that they cover only the building(s) at the
specific location(s) listed in the declarations. These policies also define exactly what
property qualifies as part of the building and is therefore covered by insurance.

In personal insurance, a residential structure is generally called a dwelling and is usually

covered under a homeowners policy. A typical policy on a dwelling covers the residence
premises, which is defined as the location shown in the policy declarations. Usually, the
policy definition of residence premises also includes other structures attached to the
dwelling, and materials and supplies located on or next to the dwelling used to construct,
alter, or repair the residence premises. The coverage for the residence premises does not
apply to land.

Structures attached to the dwelling include an attached garage or carport. A free standing,
detached garage is not part of the dwelling. A separate insuring agreement for other
structures covers such detached items. Whether the garage is part of the dwelling or
qualifies as another structure is important to know because different policy limits (dollar
amounts of insurance) apply for the dwelling and for other structures. When determining
how much insurance the insured should purchase to adequately insure real property, it is
necessary to know whether the garage is considered part of the dwelling or a separate
structure.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

In commercial insurance, a permanent structure with walls and a roof is usually called a
building. Other outdoor structures such as carports, antenna towers, and swimming pools
may not be buildings, but they also can be insured.

A typical commercial property policy covers the building or structure described in the
declarations. The policy definition of building may include additions that are either
completed or under construction as well as materials and supplies used for constructing the
additions. Permanently installed fixtures, machinery, and equipment are also included as
part of the building. Thus, items such as a pipe organ in a church or equipment installed in a
manufacturing plant would be considered part of the insured building. The building
coverage of a commercial property policy also includes other items, such as fire
extinguishing equipment, outdoor furniture, wall-to-wall carpeting, and refrigerators.

Personal Property
The second type of covered property found in property insurance policies is personal
property. Although buildings and personal property can be insured by the same policy, they
are usually treated as separate coverage items. For example, when a building sustains
damage by fire or some other peril, the personal property in that building is often damaged.
Likewise, a fire that starts in a wastebasket, for example, may spread and damage the
building.

Because personal property can be moved more easily than buildings, it is exposed to
additional perils. In addition, property such as valuable papers, computer programs,
accounts receivable records, fine arts, stamp collections, money, and securities are loss
exposures that require special handling.

The personal property coverage of a homeowners policy typically covers personal property
owned or used by an insured while the property is anywhere in the world. The homeowners
insuring agreement for personal property is a very broad statement of coverage, but such
broad coverage is restricted by number of exclusions and limitations.

It is important to note that exclusions and limitations are not the same thing. While
exclusions eliminate all coverage for excluded property or cause of loss, limitations place a
specific dollar limit on specific property that is covered.

At stated earlier, commercial property insurance policies usually refer to the contents of
buildings as business personal property, which includes personal property of the insured
located in or on the building described in the declarations. Business personal property also
includes personal property located outside (or in a vehicle) within 100 feet of the described
premises.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The usual 100-foot limitation in commercial policies is far more restrictive than the
worldwide coverage of most homeowners policies. Commercial property policies often
include an additional coverage (known as a coverage extension) that provides a certain
limit, such as $10,000, of coverage for property off-premises; this extension, however,
applies only to losses that occur in the specified policy territory, which is typically the U.S.
and Canada.

The definition of “your business personal property" in commercial property policies makes
it clear that coverage for business personal property applies to such items as furniture,
machinery, equipment, and stock that are not part of the building.

Property Other Than the Insured’s Buildings and Contents

Property insurance policies usually clarify coverage by listing property not covered. Policies
that cover buildings and personal property typically show autos in such a listing because
autos are more appropriately covered under auto insurance policies. Some policies exclude
money and securities because these items should be insured under crime insurance
policies.

The declarations page of an auto insurance policy, either personal or commercial, describes
the specific autos that are covered, including the vehicle identification number (VIN) unique
to each vehicle. The declarations also state where each vehicle is normally kept (or garaged)
because this information is necessary to establish the appropriate premium. However, the
location where coverage applies is not limited to the garage but includes any location in the
specified coverage territory.

Most auto insurance policies do not cover personal property while transported in autos, but
some provide a minimal amount of coverage for personal effects. Such personal property
owned by individuals or families can be covered by homeowners policies. When businesses
need coverage, business personal property in transit can be covered by a transportation
policy.

As noted previously, property insurance policies often provide coverage for property that is
owned by someone other than the insured. Homeowners policies provide coverage for the
personal property of others, such as guests or employees, while the property is in the
insured’s home. Commercial property policies generally include limited coverage for the
personal effects of officers, partners, and employees as well as to the personal property of
others while it is in the care, custody, or control of the insured. The personal auto policy
provides coverage for damage to a borrowed auto if the owner of the borrowed auto does
not have physical damage coverage.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

As discussed earlier, some property insurance policies cover personal property that does
not remain at fixed location. For example, homeowners policies cover personal property of
the insured while it is anywhere in the world. Auto insurance policies provide coverage
while the insured’s auto is in the U.S., its territories and possessions, Puerto Rico, or
Canada. Commercial property insurance policies are more restrictive; they provide coverage
for the insured’s business personal property while it is in the insured building or within 100
feet of the building. Commercial policies also provide limited coverage for property away
from the insured premises under certain circumstances. Many floaters provide coverage for
movable property anywhere in the world.

Covered Causes of Loss

Most property insurance policies cover many causes of loss, including fire and crime. Losses
from earthquake and flood can be covered by special types of policies or endorsements.
Most property insurance policies group several causes of loss and offer coverage for them in
one policy form. Insureds can obtain the coverage they need by selecting among the form
covering various causes of loss.

Personal and commercial property insurance policies on buildings and personal property
are available with three different levels of coverage as follows:

1. Basic form coverage. The lowest-cost version that provides coverage for
approximately a dozen named perils.
2. Broad form coverage. A higher-cost version of coverage that adds several perils to
those covered by basic coverage.
3. Special form (open perils) coverage. The highest-cost version that covers all causes
of loss that are not specifically excluded. Special form coverage covers all the perils
of broad form coverage, as well as other perils.

Most homeowners policies provide either or special form coverage. Homeowners policies
providing basic form coverage are not available in most states.

Basic Form Coverage

Property insurance policies define many cause of loss in detail; however, precise definitions
vary by policy. The following causes of loss are discussed in this section:

 Fire and lightning  Windstorm

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Hail  Aircraft
 Vehicle damage  Riot and civil commotion
 Explosion  Smoke
 Vandalism  Sprinkler leakage
 Sinkhole collapse  Volcanic action

These causes of loss are generally included in both personal and commercial policies that
provide basic form coverage.

Fire is one of the most serious causes of loss, but not every fire causes a loss. A gas fire in a
kitchen oven, an oil fire in a furnace, and a wood fire in a fireplace serve a specific purpose
and cause no loss- unless they blaze out of control.

The term friendly fire refers to a fire that remains in its intended place. Such a fire is
generally not intended to be covered by a named peril property insurance policy but is
covered under a special form policy.

A fire that leaves its intended place is called a hostile fire and is generally covered by both
named peril and special form property insurance. If a person’s wig accidentally fell into a
fireplace and was burned, many property insurance policies would not cover the loss
because the fire did not leave its intended place. However, if sparks flying from the fireplace
set the house on fire, a hostile fire would have occurred and the damage would be covered.
Some fires originate from another peril, such as lightning, which might strike a house and
set in on fire. It is standard practice that policies covering fire also cover loss caused by
lightning.

In property policies, damage caused by fire includes damage resulting from conditions
accompanying the fire (such as heat and smoke) and events that can be linked to the fire in
an unbroken chain of causation (such as collapse resulting from the fire or water damage
caused by firefighters). When these conditions occur because of a fire, the fire is considered
the proximate cause of the entire loss because it was the event that set in motion the chain
of events contributing to the loss. It does not matter that the fire itself was caused by some
other peril, such as an earthquake. If property insurance covers loss from fire but not from
earthquake, damage from fire would be covered even if the fire resulted directly from the
earthquake. The insurance policy would cover the portion of the loss caused by the fire but
not be portion caused exclusively by the earthquake.

Like fire, a windstorm can cause serious damage to buildings and their contents, as well as
to other property. Windstorms including hurricanes and tornadoes but are not confined to
those disturbances. Less severe storms are also considered windstorms.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Water damage due to flood, waves, or spray sometimes accompanies a windstorm. Many
insurance policies cover windstorm damage but not water damage, unless wind causes an
opening in the structure through which water enters. When a loss occurs, it is not always
easy to distinguish the damage done by wind from the damage done by water.

Hail consists of ice particles created by freezing atmospheric conditions. Hailstones the size
of marbles, golf balls, or baseballs can cause substantial damage to autos, buildings, and
other property. Aluminum siding and metal roofs are susceptible to dimpling caused by hail.
Small hail that is not capable of damaging most property can cause serious crop damage by
knocking kernels out of standing grain or by destroying blossoms on fruit trees, for example.

Aircraft damage occurs when all or part of an airplane or satellite strikes property on the
ground. Although such incidents are rare, the damage can be severe. For example, if debris
from an airplane crash damages a home, the homeowner could collect from his or her
homeowners insurer for the damage to the house. (The insurer could then subrogate
against the airline and thus attempt to recover its payment to the homeowner).

Damage caused by a motor vehicle to some other kind of property is called vehicle damage.
When a car runs into a house, the house suffers vehicle damage and the car suffers collision
damage. The homeowner could submit a claim for the vehicle damage to his or her
homeowners insurer, and the insurer could in turn subrogate against the driver and try to
recover an amount equal to its payment to his homeowner.

While legal distinctions may exist between riot and civil commotion, both terms refer to
similar kinds of unruly mob behavior, and insurance covering riot invariably covers civil
commotion. Although losses from these perils do not occur very often, they can be quite
large. For example, insured losses from the 1992 riots in Los Angeles totaled almost $800
million.

An explosion is a violent expansion or bursting accompanied by noise. An explosion may

result from the ignition of gases, dust, or other explosive materials. Such explosions are
often followed by fire. Explosions can also occur when a pressurized object bursts, such as a
tank containing compressed air. An explosion can destroy an entire building.

The sudden or accidental release of large amounts of smoke can cause considerable
damage to walls and other objects. When damaging smoke comes from a fire, the fire is
generally considered to be the proximate cause of the loss. However, the sudden
malfunction of an oil-burning furnace may result in the discharge of grimy, sooty smoke. In

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

that case, the resulting damage is not caused by fire but by a peril independent of fire.
Property insurance policies that cover loss from fire typically include smoke as a covered
cause of loss as well. However, coverage for smoke damage does not include smoke
produced by many industrial operations.

Certain kinds of property are particularly susceptible to smoke damage. In a clothing or

grocery store, a relatively small amount of smoke can cause considerable damage. Clothes
must be cleaned to remove the smell and may be permanently stained. Foods such as fresh
vegetables may be total loss. Other property - such as a stack of plumbing pipes - may be
essentially undamaged by a large volume of smoke.

Willful and malicious damage to or destruction of property is called vandalism. Vandalism

losses are not accidental; they are intentionally caused, usually by an unknown person or
persons. However, because they are not intentionally caused by the insured, they can be
covered in insurance policies. Examples of vandalism include graffiti spray painted onto
building walls and defacement of statues or other objects of art. Some insurance policies
refer to vandalism and malicious mischief; others simply use the term vandalism. The
meaning is largely the same in either case.

Many commercial and institutional buildings, as well as some private residences, are
equipped with automatic sprinkler systems. An automatic sprinkler system is designed to
discharge water (or a chemical or gas) when a fire occurs, thus extinguishing or containing
the fire. When a fire sets off a sprinkler, the fire is considered the proximate cause of any
water damage from the operation of the sprinkler. However, an automatic sprinkler system
may discharge accidentally. The system’s pipes can freeze and burst, or a buildup of heat
from some cause other than fire can cause the system to discharge. Maintenance workers
may accidentally bang a ladder against a sprinkler head and cause it to discharge. The peril
of sprinkler leakage includes such accidental discharges. Compared to fire, sprinkler leakage
is not usually a serious threat to a building. The vulnerability of a building’s contents could
be another matter, however. With some occupancies, such as dealers in paper products,
sprinkler leakage losses can be devastating.

The action of underground water on limestone or similar rock formations can create empty
spaces underground. A sinkhole collapse occurs when land suddenly sinks or collapses into
one of these empty spaces. This problem occurs most often in Florida, but other states are
also susceptible to sinkhole losses. Sinkhole collapse is a covered cause of loss under the
basic form of commercial property policies. For personal property policies such as
homeowners, the coverage is not automatic and must be added by endorsement.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Sinkhole problems also exist in states such as Pennsylvania and West Virginia because of
underground mining. The mine subsidence peril is present when the ground surface sinks as
underground open spaces, caused by mining operations, are gradually filled in by rock and
earth from above. Typically, mine subsidence is not a covered cause of loss under the basic
form for either commercial or personal property policies but can be added by endorsement.

In the U.S., losses caused by volcanic action occur primarily in the Pacific coastal states,
Alaska, and Hawaii. Volcanic action encompasses loss involving lava flow, ash, dust,
particulate matter, airborne volcanic blast, or airborne shock waves resulting from the
eruption of volcano.
When Mount St. Helens erupted in 1980, many policies did not specifically provide or
exclude coverage for volcanic action but did cover the peril of explosion. There was
considerable debate over whether a volcanic eruption constitutes an explosion. Insureds,
seeing explosion as a covered cause of loss and noting no policy definition of the term,
requested coverage for damage from the eruption. The outcome was that many losses were
treated as explosion losses, and claims were paid. Now, most property insurance policies
specifically include coverage for volcanic action, but some specifically exclude such
coverage.

Broad Form Coverage

While property insurance policies that cover basic form cause of loss cover the perils
discussed previously, other property insurance policies add coverage against the following
additional causes of loss that are commonly referred to as broad form coverage or broad
form perils:

 Falling objects. Trees or other objects may fall onto a building.

 Weight of snow, ice, or sleet. The weight of accumulations of any of these may damage
or destroy buildings and their contents.
 Sudden and accidental water damage. Sudden leaks may, for example, damage carpets,
floors, or ceilings.

Special Form (Open Perils) Coverage

As noted, property insurance policies that cover all causes of loss that are not specifically
excluded are called special form coverage or open perils. Special form coverage policies
were once described as "all - risks" but this term is now less commonly used, because it may
be misinterpreted to mean that no causes of loss are excluded.

Collapse

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Although collapse is usually not listed as either a basic or a broad form peril, many property
insurance policies provide an additional coverage for loss or damage involving collapse of all
or part of a building, but only if the collapse is caused by one or more of the basic or broad
causes of loss described previously. Other covered causes of collapse are hidden decay;
hidden damage by insects or vermin; weight of people or contents; weight of rain that
collects on a roof; and use of defective material or methods in construction, remodeling, or
renovation if the collapse occurs during the construction, remodeling or renovation.

Crime Perils
Coverage for various crime perils can be included in insurance policies. The definitions of
these causes of loss for insurance purposes may differ somewhat from the usual definitions
of these terms. For example, burglary is the taking of property from inside a building by
someone who unlawfully enters or exits the building. The definition of burglary in insurance
policies includes breaking out of a building because thieves may hide inside a building
before it is closed for the night and make a forcible exit after stealing some of the contents.
Robbery is the taking of property from a person by someone who has caused or threatened
to cause the person harm through use of intimidation or force. Theft is a general term
meaning any act of stealing. It includes robbery, burglary, and other forms of stealing. Some
insurance policies cover the peril of theft, but others cover only a specific type of theft, such
as burglary or robbery.

Auto Physical Damage

Insurance policies that provide auto physical damage coverage offer the following types of
coverage:

 Collision. Covers damage to a motor vehicle caused by its impact with another vehicle or
object or by the vehicle’s overturn.
 Other than collision (also called comprehensive). Covers losses caused by fire, theft,
vandalism, falling objects, flood, and various other perils.
 Specified causes of loss. Used primarily in commercial auto policies, this is a named
perils alternative that is less expensive than comprehensive because fewer causes of
loss are covered.

Like other property, cars and trucks are subject to fire, theft, vandalism, and other perils.
However, the most serious cause of loss to autos is collision. Insurance against collision
costs considerably more than insurance against all other perils combined. Collision coverage
is not included with either of the other coverages and must be purchased as a separate
coverage.

Causes of Loss Often Excluded

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Discussion to this point has focused on causes of loss covered by most property insurance
policies. Numerous other perils can also cause loss to property but are usually excluded
from insurance policies. In most instances, broad categories of exclusions can be matched
to those concepts of ideally insurable loss exposures, as described earlier. An ideally
insurable exposure has these characteristics: loss exposure involves pure, not speculative
risk; loss exposure is subject to accidental loss; loss exposure is subject to losses that are
definite in time and measurable; loss exposure is one of a large number of similar, but
independent, exposures; loss exposures such that losses are not catastrophic; and loss
exposure is economically feasible to insure.

Catastrophe Perils
Insurance functions best when many insured pay relatively small premiums to provide a
fund for paying large losses incurred by relatively few insureds. Some perils that affect a
great many people at the same time are generally considered to be uninsurable by insurers
because the resulting losses would be so widespread that the funds of the entire insurance
business might be inadequate to pay all of the claims.

For this reason, almost all property insurance policies exclude coverage for losses from
catastrophes such as war and nuclear hazard. However, there are policies that provide so-
called war risks coverage on oceangoing vessels and cargo. Insurance against losses to
property from nuclear hazard is available for nuclear power plants and transporters of
nuclear materials. Most property insurance policies also exclude property losses resulting
from governmental action, such as governmental seizure of property.

Most policies providing coverage on buildings and personal property at fixed locations
exclude coverage for earthquake and flood losses. An earthquake can be a catastrophe
affecting many different properties in the same geographic area at the same time. Also, the
extent of earthquake damage depends in part on the type of construction of the property. A
building that is susceptible to fire damage may be less susceptible to earthquake damage,
and vice versa. For these and other reasons, insurers prefer to handle earthquake coverage
separately, making a specific decision on each application for insurance.

Flood damage can also be catastrophic. However, floods can sometimes be predicted. For
property in low - lying areas near rivers, creeks, or streams, the question is not whether
floods will occur, but when. Insurers are generally not willing to provide coverage for a loss
that is certain to occur. However, flood insurance on buildings and personal property is
available through the National Flood Insurance Program sponsored by the federal
government. Auto insurance policies and other policies covering movable personal property
generally include coverage against flood losses.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Maintenance Perils
Property insurance policies also typically exclude loss from inherent vice and latent defect,
as well as wear and tear and other maintenance perils. Such losses are generally
uninsurable either because they are certain to occur, over time, or are avoidable through
regular maintenance and care. Maintenance perils that are excluded from most policies
include the following:

 Wear and tear

 Marring and scratching
 Rust
 Gradual seepage of water
 Damage by insects, birds, rodents, or other animals

These maintenance perils are usually not covered even in the broadest property insurance
policies. As stated earlier, insurance works well only for definite and accidental losses. Some
of these excluded perils (wear and tear, marring and scratching, or rust) involve the results
of ordinary use and aging rather than unexpected damage. Damage from the other perils
(water seepage, insects, or rodents) is preventable through proper care and maintenance.

Covered Financial Consequences

As discussed earlier in the chapter, property losses can lead to any or all of the following
financial consequences: reduction in property value, lost income, and extra expenses.
Property insurance policies must specify which financial consequences of a property loss are
covered and which are not.

Reduction in Property Value (Direct Loss)

A reduction in the value of property that results directly and often immediately from
damage to that property is often referred to as direct loss. If the property is not restored, it
is not worth as much after the loss as before. For example, the insuring agreement of the
Insurance Services Office, Inc. (ISO) commercial building and personal property coverage
form states that the insurer will pay for "any direct physical loss of or damage to Covered
Property at the premises described in the Declarations caused by or resulting from any
Covered Cause of Loss."

Time Element (Indirect) Loss

Lost income and extra expenses resulting from direct loss to property can also be insured.
Such losses are called time element losses or indirect losses. For example, the longer the
property is unusable, the greater the time element loss. If a building cannot be occupied for
six months, the financial loss for the insured is much more severe than if the building
cannot be occupied for only a few days.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Business income insurance protects a business from income lost because of a covered direct
loss to its building or personal property. Coverage is provided for the reduction in the
organization’s net income (business revenue less expenses and taxes) resulting from
damage by a covered cause of loss to the property at the insured’s location. By covering the
insured’s reduction in net income, business income insurance can put the business in the
same financial positions it would have been in if no direct loss had occurred.

Coverage for loss of income is also provided by homeowners policies. When a covered
cause of loss damages the part of the residence that the insured rents, or holds for rental,
to others, “fair rental value” coverage in the homeowners policy indemnified the insured for
the loss of rental income until the rented portion of the residence is restored to livable
condition.

In the case of a business income loss, extra expenses would include additional expenses
that reduce the length of the business interruption or enable a business to continue some
operations despite damage to its property. For example, Iris, an insurance agent, may rent
office space to conduct her business at a temporary location during the repairs to her office
building following a fire Iris’s rental expense would be covered as an extra expense, as
would any extra expenses (over and above her normal expenses) such as installing
telephone service and notifying her customers of the temporary location.

The additional living expense coverage in homeowners and other policies covering dwellings
is another example of extra expense coverage. If a direct loss to the dwelling makes the
dwelling uninhabitable, additional living expense coverage indemnifies the insured for the
additional expenses that are incurred so that household can maintains its normal standard
of living while the dwelling is being restored. Such expenses may include moving expenses
and the cost of renting an apartment or a hotel room.

Another example of coverage for extra expenses is the optional rental reimbursement
coverage available by endorsement to personal auto policies. This coverage pays up to a
certain amount per day toward the cost of renting a vehicle because the covered auto has
been damaged by collision or some other covered cause of loss.

Covered Parties
Although a property insurance policy is a contract between the insurer and the named
insured, the named insured is not always the only party that can recover in the event of an
insured loss. Depending on the policy terms and conditions, property insurance can protect
the insured and sometimes other parties that have an insurable interest in the property and
that suffer a financial loss because covered property is lost, damaged, or destroyed.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Person or organizations with an insurable interest in property can include property owners,
secured lenders, users of property, and other holders of property. Insurance policies are
written to cover these persons or organizations as follows:

 The owner of a building is the named insured on a property insurance policy covering
the building.
 A party that owns and occupies a building is the named insured on a policy covering
both building and personal property.
 The tenant of a building is the named insured on a property insurance policy covering
the tenant’s personal property in that building.
 A secured lender, although usually not a named insured, is listed by name in the
declarations (or in an endorsement) as a mortgagee or a loss payee.
 A bailee is the named insured on a bailee policy. The bailee policy covers property of
others that is in the bailee’s custody.

Named Insured(s)
The declarations page of a policy has a space labeled named insured(s). Only parties whose
names appear in the named insured space (or on an attached endorsement listing
“additional named insured’s”) are, in fact, named insureds. In personal insurance, the
named insured’s spouse usually receives the same coverage as the named insured, even if
the spouse is not named on the declarations page. Coverage for the spouse of a named
insured depends on the policy definition of named insured and generally requires that the
spouse live in the same household as the named insured. For example, a homeowners
policy states:

In this policy, "you" and "your" refer to the "named insured" shown in the Declarations
and the spouse if a resident of the same household

Therefore, if Larry Maple’s name is the only name that appears on the declarations page of
his homeowners policy as a named insured, the policy also provides coverage for his wife,
Susan, who lives in the house with Larry. The wording in the preprinted portion of the
policy, following the declarations page, does not refer to them as "Larry" and "Susan" but
uses the word "you" (or "your") to include both Larry and Susan.

The situation is somewhat different with commercial insurance because several different
individuals and businesses may be listed as named insureds. Thus, commercial insurance
policies often state that the first named insured is, in effect, the contact person. The first
named insured is responsible for paying premiums and has the right to receive any return
premiums and to cancel the policy. If the insurer decides to cancel or to not renew a policy,
the first named insured receives the notice of cancellation or nonrenewal.

Secured Lenders

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Although secured lenders are generally not named insureds on insurance policies covering
property for which they have loaned money, the insurable interests of such lenders are
protected when they are listed in the policy. Secured lenders include mortgagees (or
mortgage holders) and loss payees, as discussed next.

Until the loan is paid in full, the lender has an insurable interest in the property because
destruction of the property could cause a financial loss to the lender. To protect its interest
in real property, a lender usually requires the borrower to purchase property insurance
covering the building and to have the lender listed by name as mortgagee on the policy’s
declarations page.

The mortgagee has certain rights under the mortgage clause (or mortgage-holders clause),
which protects the insurable interest of the mortgagee, including the following:

 The insurer promises to pay covered claims to both the named insured and the
mortgagee as their interests appear (that is, to the extent of each party’s insurable
interest).
 The insurer promises to notify the mortgagee before any policy cancellation or
nonrenewal. This notice enables the mortgagee to replace the policy with other
insurance.
 If the insurer cancels the policy and neglects to inform the mortgagee, the mortgagee’s
interest is still protected, even if the named insured no longer has coverage.
 The mortgagee has the right to pay the premium to the insurer if the insured fails to pay
the premium so that the policy will remain in effect.
 In case of loss the mortgagee may file a claim if the insured does not.
 If a claim is denied because the insured did not comply with the terms of the policy, the
mortgagee may still collect under the policy. For example, a policyholder who commits
arson may be barred from compensation. However, the mortgagee may still be able to
receive payment for the claim up to its financial interest in the property (the value of
the outstanding loan).

While a mortgage clause is used in a policy covering real property, a loss payable clause is
used when a secured lender has an insurable interest in personal property. The secured
lender is listed as a loss payee. A loss payable clause provides that a loss will be paid to
both the insured and the loss payee as their interests appear. In addition, loss payee is
entitled to the same advance notice of cancellation or nonrenewal as is the named insured.
Therefore, to the extent of its insurable interest, a loss payee has the right to participate in
the recovery whenever any covered claim entitles the insured to payment. However, a loss
payee does not have any right to recover in cases in which the insured cannot recover. In
this regard, a loss payee does not have the same level of protection that a mortgagee has.

Other Parties Whose Property is Covered

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Many property insurance policies provide coverage to parties who are neither named
insureds nor secured lenders. The following examples illustrate this point:
 A homeowners policy can provide coverage for property owned by others who reside in
the named insured’s household – relatives of any age, and other persons (such as a
foster child) under the age of twenty-one.
 A homeowners policy can provide coverage for property belonging to guests, residence
employees, and others while it is in the named insured’s home.
 A commercial property policy providing coverage on the named insured’s personal
property can also provide limited coverage for (1) the personal effects of officers,
partners, or employees and (2) the personal property of others in the care, custody, or
control of the insured.
 A personal auto policy can provide coverage for collision damage if the named insured
borrows a car belonging to somebody else, the car-sustains collision damage, and the
owner of the borrowed car has no insurance.
The typical property policy provides that property of others is covered only if the named
insured submits a claim. In the previous examples, the other parties do not enter into the
insurance contract with the insurer, and they have no specific rights to collect under
someone else’s policy. However, the named insured can request that the insurer pay claim
of this type.

Amounts of Recovery

When covered property is damaged by a covered cause of loss, how much will an insurer
pay to a covered party with an insurable interest? That question must be clearly addressed
in any insurance policy providing property coverage. The answer depends on policy
provisions in the following categories:

 Policy limits
 Valuation provisions
 Settlement options
 Deductibles
 Insurance-to-value provisions
 “Other insurance” provision.

Policy Limits
When buying property insurance, the applicant usually requests a certain dollar amount of
coverage. If the insurer agrees to provide that amount of coverage, the policy limit is
established and the applicable policy limit is entered in the policy declarations. If a policy
provides more than one coverage, a separate limit may be shown for each coverage.

A policy limit has several roles. If tells the insured the maximum amount of money that can
be recovered from the insurer after a loss. By comparing the policy limit to the value that
may be lost, the insured can determine whether the amount of insurance is adequate.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The policy limit tells the insurer the maximum amount it may have to pay for a covered loss.
This limit is important, because insurers must keep track of their overall obligations in any
one geographic area. For example, a fire or windstorm that affected several insured
properties on one city block could have an unexpected effect on an insurer that relied on a
spread of risk.

The policy limit is also important to both the insurer and the insured because the premium
charged is directly related to the policy limit for most property insurance coverages. For
example, a building might be insured for a rate of $0.50 per $100 of coverage. If the policy
limit were $1 million, the corresponding premium for a one-year term would be $5,000. If
the policy limit were $1.5 million, the premium would be $ 7,500.

Valuation Provisions

Several approaches may be used to set a value on a single item. As previously discussed, the
two most common valuation approaches in property insurance policies are replacement
cost and actual cash value. A third approach, used for certain types of property, involves
agreed value.

Valuation provisions may create the impression that all insured losses are paid in money.
Actually, property insurance policies usually give the insurer a choice of different settlement
options.

Settlement Options

An insurer generally has the following three options to settle a loss:

1. Paying the value (as determined by the valuation provision) of the lost or damaged
property.
2. Paying the cost to repair or replace the property (if repair or replacement is
possible)
3. Repairing, rebuilding, or replacing the property with other property of like kind and
quality.

These options for settling property losses can often reduce the insurer’s costs of settling
claims without diminishing the insured’s actual indemnification. For example, the insurer
may choose the second option and pay the cost to repair a partially burned garage if the
cost of repair is less than an appraiser’s estimate of the garage’s decrease in value as a
result of the fire. The third option would allow an insurer to replace a stolen watch, for
example, with one of the same kind. An insurer may exercise that option because it can
obtain the watch at a price that is less than the retail value of the watch.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Deductibles

Property insurance policies usually contain a deductible provision, which states that a
portion of a covered loss will be subtracted (deducted) from the amount the insurer would
otherwise be obligated to pay. Property insurance deductibles serve several functions. They
encourage the insured to try to prevent losses because the insured will bear a part of any
loss. Shifting the cost of small claims to the insured also enables the insurer to reduce
premiums. Handling claims for small amounts often costs more than the dollar amount of
the claim. Thus, deductibles enable people to purchase coverage for serious losses at a
reasonable price without unnecessarily involving the insurer in small losses.

Insurance-to-Value Provisions

Many property insurance policies include insurance-to-value provisions, which encourage

insured’s to purchase an amount of insurance that is equal to, or close to, the value of the
covered property. Few losses are total. Unless all insureds purchase an amount of insurance
close to the full value of their property, some insureds will pay considerably less for what
usually provides the same recovery for a loss.

Assume, for example, that the grocer in the opening example, Mr. Brown, owns the
supermarket building, which is worth $2 million. He insures the building for $2 million.
Across town, Mr. Rodriguez owns a competing supermarket, and her building is worth $4
million. Ms. Rodriguez believes that the largest amount of loss she will suffer is $2 million so
she insures her building for that amount. If their policies do not contain insurance-to-value
provisions and each building suffers losses totaling $2 million. Mr. Brown and Ms. Rodriguez
will each receive $2 million from their insurers to pay for the damage.

Ms. Rodriguez took a chance that her loss would be no more than $2 million (a fairly safe
assumption in most cases) and paid much less for her coverage. This result is not only unfair
to other policyholders, but it could also result in the insurer receiving inadequate premiums
to cover losses. It is inequitable because Ms. Rodriguez pays the same premium as the
owner of a $2 million building who insurers it for $2 million dollar, yet she is much more
likely to sustain a $2 million dollar loss. (Two million dollars constitutes a partial loss on a $4
million building, but would be a total loss on the $2 million building. Most building property
losses are partial losses).
Insurers could solve this problem by charging a higher rate for those insureds who insure to
less than the property’s value. Because such a solution is complicated, however, it can be
used only in some rare cases. Consequently, insurers have encouraged their insureds to buy
insurance to value or to insure to a high percentage of the property’s value. The traditional
approach to encouraging insurance to value is to include a coinsurance provision in the
policy. A coinsurance provision states that if the property is underinsured, the amount that

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

an insurer will pay for a covered loss is reduced. The insurer’s goal is to have property
insured to its full value.

"Other Insurance" Provisions

In some cases, more than one insurance policy provides coverage for the same item of
property. If two or more insurers paid in full for the same loss, the insured could profit from
the loss, violating the principle of indemnity. Most policies contain an "other insurance"
provision to deal with this problem. When more than one policy covers a loss, the amount
paid by each policy depends on the allocation procedure specified in the "other insurance"
provisions of the policies.

SUMMARY
Three important aspects of property loss exposures are (1) the types of property exposed to
loss, (2) potential causes of loss, and (3) financial consequences that may result from an
approval loss.
Types of property include the following:

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Buildings
 Personal property (contents) contained in buildings
 Money and securities
 Motor vehicles and trailers
 Property in transit
 Ships and their cargoes
 Boilers are machinery

These categories are useful for insurance purposes because they emphasize the
characteristics that affect property loss exposures.
Causes of loss, or perils, that can damage or destroy property, are sometimes listed in
insurance policies, called named perils policies. Other policies, called special form coverage
or open perils policies, provide coverage for any direct loss to property unless the loss is
covered by a peril that is specifically excluded by the policy.
The financial consequences of a property loss can include the following:

 Reduced property value

 Lost income because the property cannot be used
 Extra expenses

Parties other than the property owner who may affected by a property loss include secured
lenders, users of property, and other holders of property.

Property insurance policy provisions specify exactly which property loss exposures are
covered. These provisions specify covered property and locations, covered causes of loss,
excluded causes of loss, covered financial consequences, and the covered parties.

Policy limits stipulate the maximum amount the insurer will pay in the event of a loss. Policy
valuation provisions explain how the amount of a loss payment will be determined, that is,
according to replacement cost, actual cash value, or some other valuation method.
Settlement options provide insures with several ways to settle a loss. Property insurance
policies often specify a deductible to be subtracted from the amount of the loss payment.
Some policies also include an insurance-to-value provision that encourages insureds to
purchase insurance equal or close to the value of the property. When more than one policy
covers a loss, the amount paid by each policy depends on the allocation procedure specified
in the "other insurance" provisions of the policies.
REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Liability Loss Exposures

and Policy Provisions Chapter 9

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The day seemed like any other at the Atwell Insulation Company (AIC). Trucks entered and
left the plant, and the chemical processing operations ran at full capacity to keep up with
demand. The only unusual event in the day's schedule was a tour by chemical engineering
students who were impressed by the plant's efficiency.

However, disaster struck at 11:08 AM when the No.2 storage tank exploded. Minor
explosions had occurred before but had done little damage. Things turned out differently
this time.

Apparently the No.2 storage tank had been filled beyond its listed capacity, leaving
inadequate space for expansion as the temperature of the contents increased. A pressure
relief device failed to function, and the tank wall popped at a seam, causing the contents of
the tank to spread into the plant yard. A large amount of the contents also went into a drain
leading to a nearby river. Some of the fluid flowed into one of AIC's buildings, where a
furnace ignited it. The fire spread quickly and burned for two days. Fumes from the fire
injured thirty-five of AIC's employees, killed two other employees, and injured seven of the
visiting engineering students. Five more employees were injured in an auto accident as they
attempted to escape from the fire and fumes. The accident injured three occupants in
another vehicle and caused major damage to both cars.

The neighborhoods around the plant had to be evacuated, and some nearby businesses
were closed for two weeks. Over the next twelve months, a series of customer complaints
and claims led AIC to conclude that the spillage and fire had caused impurities in its
products from several production runs.

In addition to the losses that AIC suffered to its own property because of the explosion and
ensuing fire, AIC could suffer devastating financial consequences because of the harm
suffered by others. AIC could be legally liable to a number of persons and businesses,
suffering large liability losses as a result of the explosion and fire.

This accident will inevitably result in claims for monetary damages. These claims arise from
AIC's legal obligations to the people and the organizations that suffered bodily injury or
property damage caused by the explosion and its aftermath. The explosion could lead to at
least one court case, which might last for many months or even years. If the court rules
against AIC and the ruling is upheld despite any appeals made by AIC's attorneys, the
company will have no choice but to pay the amount awarded by the court. AIC's liability
losses may not be as obvious on the day after the explosion as its property losses, but the
financial consequences of AIC's legal liability could be much greater than the financial

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

consequences of its property losses. This chapter explores liability loss exposures, based on
the concept of legal liability, and the insurance policy provisions that deal with those
exposures.

LEGAL LIABILITY

The term legal liability refers to a person or an organization's status as legally responsible
for injury or damage suffered by another person or organization. An understanding of legal
liability is essential to recognizing liability loss exposures. Although complex legal questions
require the professional expertise of an attorney, knowledge of some fundamental legal
terms and concepts is essential for anyone dealing with liability loss exposures or liability
insurance.

Laws exist in a civilized society to enforce certain standards of conduct. Although laws
generally make the world safer and more secure, they also impose certain duties. Where
there are rights, there are also responsibilities. People must accept the constraints of the
law in order to enjoy its benefits. The law accomplishes its objectives by holding people
responsible for their actions.

Sources of Law

The legal system in the United States derives essentially from the following:

 The Constitution, which is the source of constitutional law

 Legislative bodies, which are the source of statutory law
 Court decisions, which are the source of common law

Constitutional Law

The supreme law in the U.S. is the Constitution, which specifies the structure of the federal
government and outlines the respective powers of its legislative, executive, and judicial
branches. The Constitution provides for a federal system of government in which powers
not specifically granted to the federal government are reserved for the individual states.
With its amendments, the Constitution also guarantees to all citizens certain fundamental
rights, such as freedom of speech, freedom of religion, freedom from unreasonable
searches and seizures, the right to a trial by jury, and the right to due process of law.
All other laws must conform to constitutional law, which is the Constitution itself and all the
decisions of the Supreme Court that involve the Constitution. The courts interpret the
Constitution to decide constitutional issues. If the U.S. Supreme Court decides that a
particular law conflicts with the Constitution, that law is invalidated. The Supreme Court is
the highest court of appeal, and lower courts must follow the Supreme Court's decision in
judging future cases involving the same issue.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Each state also has a constitution establishing the powers of the state government. Further,
each state has some type of Supreme Court to resolve legal conflicts in the state
government and to hear appeals on matters of state law. States must ultimately follow the
U.S. Constitution.

Statutory Law

National, state, and local legislatures enact laws, or statutes, to deal with perceived
problems. At the national level, Congress considers many newly proposed laws each year.
Any member of the U.S. Senate or House of Representatives may introduce a bill. After its
introduction, a bill may be referred to a committee for study or perhaps for hearings before
it is debated on the floor of the Senate or the House. If the bill receives a majority vote in
both the Senate and the House and the President signs it, the bill becomes law. State
legislatures also make new laws in similar fashion. Laws made by local governments are
often called ordinances. Collectively, these formal enactments of federal, state, or local
legislative bodies are referred to as statutory law.

Numerous federal, state, and local government agencies have regulatory powers derived
from authority granted by legislative bodies. Examples of such agencies include the Federal
Trade Commission, the Environmental Protection Agency, state public utility commissions,
and local zoning boards. These regulatory bodies issue detailed rules and regulations
covering a particular public concern or relating to a particular industry. They also render
decisions on the application of these rules and regulations in certain cases.

Common Law

In contrast to statutory law, common law has evolved in the courts. When the king's judges
began hearing disputes in medieval England, they had little basis for their decisions except
common sense and the prevailing notions of justice. Each decision, however, became a
precedent for similar cases in the future. Gradually, certain principles evolved overtime that
the judges applied consistently to all the cases they heard. These principles became known
as common law, or case law.

These common-law principles guided judges not only in England but also in the English
colonies in America. Thus, the English common law heavily influenced the U.S. Legal system.
When neither constitutional nor statutory law applies, judges still rely on precedents of
previous cases in reaching their decisions. In many areas, laws have been passed that
modify or replace common-law principles, but common law is still important in matters of
legal liability.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Criminal Law versus Civil Law

The U.S. legal system makes an important distinction between criminal law and civil law.
While criminal law cases generally receive more headlines, legal cases related to incurrence
usually involve civil law.

Criminal Law

Criminal law applies to wrongful acts that society deems so harmful to the public welfare
that the government takes the responsibility for prosecuting and punishing the wrongdoers.
To cite only a few examples, criminal laws prohibit murder, rape, robbery, arson, fraud,
theft, and driving while intoxicated. Such offenses are crimes (wrongs against society).

Crimes are punishable by fines, imprisonment, or, in some states, death. The government
uses its power to punish in order to enforce criminal laws. When a crime occurs, the police
investigate and, if sufficient evidence is found, criminal charges are brought on behalf of the
state against the accused wrongdoer. For example, if Jesse James were arrested for robbing
a bank, the case would go to court as "The State versus Jesse James." The district attorney
presenting the evidence against Jesse James would represent society as a whole, not just
the bank. If the jury were to find Jesse James guilty of the bank robbery, he would probably
go to jail. Such a punishment is intended to protect the public, to punish Jesse, and to deter
other people from committing the same crime.

Civil Law

Civil Law deals with the rights and responsibilities of citizens with respect to one another,
and applies to legal matters not governed by criminal law. Actions that are not necessarily
crimes can still cause considerable harm to other people. In the absence of laws, a dispute
between neighbors can turn into an endless feud. Civil law proceedings provide a forum for
hearing disputes between private parties an rendering a decision binding on all parties. This
procedure enables individuals to protect themselves against infringement of their rights by
others.

Civil law protects personal and property rights. If someone invades the privacy or property
of another person or harms another's reputation, the injured person may seek amends in
court. By protecting such personal and property rights, civil law contributes to the welfare
and safety of society.

Civil law also protects contract rights. People and businesses are more willing to make
agreements or contracts with one another when they know that those contracts are

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

enforceable. If two parties make a contract that one party does not honor, the other party
can ask the court to enforce compliance to the contract or to assess damages. Contract law
is the branch of civil law that deals with contracts and settles contract disputes. Such laws
promote commerce by making contracts more reliable.

Criminal and Civil Consequences of the Same Act

Criminal and civil law do not necessarily deal with entirely different matters. A particular act
can often have both criminal and civil law consequences. Consider, for example, the
following two incidents in the life of Karen Smith.

Because she is an entrepreneur who travels frequently, Karen usually has large amounts of
cash in her purse. Once when she was walking down the street, a stranger grabbed her
purse and ran off. The police later found the stranger. He still had some of the contents of
Karen's purse, but the purse and money were gone. The stranger was arrested, tried, and
convicted of the crime of robbery. Karen might also have started civil law proceedings
against the robber to recover her money, but that would have accomplished little because
the robber had no money and was going to jail.

Another time Karen was returning from a business trip when her car was broadsided by
another vehicle. Beyond the damage to her car, Karen's injuries required medical care
costing thousands of dollars; she missed two weeks of work, losing existing customers and
opportunities to secure new customers. Following the accident investigation, the other
driver was charged and convicted of driving while intoxicated. Karen's auto insurer paid
most of her medical and auto physical damage bills. However, Karen did bring a civil suit
against the other driver for her lost business opportunities, and the court ordered the other
driver to pay an amount equal to the income Karen had lost.

In each incident, both criminal and civil law proceedings were possible results. The differing
circumstances influenced the practical effectiveness of each type of legal action.

ELEMENTS OF LIABILITY LOSS EXPOSURE

A liability loss exposure involves the possibility of one party becoming legally responsible for
injury or harm to another party. This section examines the following elements of a liability
loss exposure:

 The legal basis of a claim by one party against another for damages.
 The potential financial consequences of liability loss exposures.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The Basis for Legal Liability

The most common bases for legal liability are torts, contracts, and statutes. Exhibit 9-1
illustrates the different aspects of civil law that can give an injured party the legal basis for
recovering damages from another party.

EXHIBIT 9-1

Legal Basis of a Liability Claim

A
A Legal
Legal right
right of
of recovery
recovery can
can be
be based
based on
on ::

Torts Contracts Statutes

Torts Contracts Statutes

Neglige
Neglige Intentional
Intentional Strict
Strict Liability Breach of No-
nce Torts Liability Assumed Workers’
nce Torts Liability Warranty Fault
Under Compensatio
Auto
Contract n Laws
Laws

Torts
A tort is any wrongful act, other than a crime or breach of contract, committed by one party
against another, Crimes differ from torts, because criminal law allows the state to prosecute
and civil law does not. The central concern of tort law, which deals with civil wrongs other
than breaches of contract, is determining responsibility for injury or damage. Although
largely modified or restated in statutes, tort law is still based mainly on common law.

A person who is legally responsible for an injury may be compelled to compensate the
victim only if there is some standard for assigning that responsibility.

Under tort law, an individual or organization can face a claim for legal liability on the basis
of any of the following:

 Negligence
 Intentional torts
 Strict liability

Exhibit 9-2 presents a summary of the types of torts that may give rise to a liability loss.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

EXHIBIT 9-2

Types of Torts

Negligence occurs when a person or an organization fails to exercise the level of care that a
reasonably prudent person would have exercised under similar circumstances. The greatest
number of liability cases arises from negligence. Tort law gives injured parties the right to
seek compensation if they can demonstrate that someone else's negligence led to their
injuries.
A liability judgment based on negligence requires proof of all four of the following
elements:-

1. A duty owed to another. The first element of negligence is that a person of an

organization must have a duty to act (or not to act) that constitutes a responsibility to
another party. For example, the driver of an automobile has a duty to operate the car
safely. In the AIC example, AIC had a duty to provide safe conditions at its plant.

2. A breach of that duty. In order for a person or an organization to be held negligent, a

breach of the duty owed to another party must occur. A breach of duty is the failure to
exercise a reasonable degree of care expected in a particular situation. In the tank
explosion example earlier in this chapter, the fact that a storage tank had been filled
beyond its listed capacity could indicate that AIC had failed to act reasonably and had
breached its duty to provide safe conditions. However, if no breach of duty can be
proved, no negligence can be found.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

3. Injury or damage. The third element of negligence requires that the claimant must
suffer definite injury or harm. Although a legal duty to act and a breach of that duty may
exist, no recovery can be made based on negligence unless someone suffers injury or
damage to property. For example, AIC could be accused of causing injury to the visiting
students by breaching its duty to provide safe conditions.

4. Unbroken chain of events between the breach of duty and the injury or damage. A
finding or negligence also requires that the breach of duty initiate an unbroken chain of
events leading to the injury. The breach of the duty must be the proximate cause of the
injury. In the AIC example, the injured students would have to prove that AIC's breach of
its duty to provide safe conditions was the proximate cause of their injuries.

A person or an organization whose conduct is proved to be negligent is generally

responsible for the consequences. This party is called the tortfeasor, the wrongdoer, or the
negligent party. All of these terms refer to a party who does something that a reasonable
person would not do (or fails to do something that a reasonable person would do) under
similar circumstances.

In addition to the person who actually commits the act, other persons or organizations may
be held responsible for the tortfeasor's action. This responsibility is called vicarious liability.
Vicarious liability often arises in business situations from the relationship between employer
and employee. An employee performing work - related activities is generally acting on
behalf of the employer. Therefore, the employer can be vicariously liable for the actions of
the employee. If, for example, an employee drives a customer to a meeting and negligently
causes an accident in which the customer is injured, both the employee and the employer
could be held liable for the customer's injuries. Responsibility would not shift from the
employee to the employer but rather could extend to include the employer.

An intentional tort is a deliberate act (other than breach of contract) that causes harm to
another person, regardless of whether the harm is intended. Assault and battery are
common examples of intentional torts. Assault is an intentional threat of bodily harm under
circumstances that create a fear of imminent harm. Battery is any unlawful and unprivileged
touching of another person. Assault and battery often happen together at approximately
the same time, but either can happen without the other.

Another common example of an intentional tort is defamation. Defamation is an intentional

false communication, either written or spoken, that damages another's reputation.
Defamation includes both slander and libel. Slander is a spoken, untrue statement about
another person. Libel most often occurs when someone prints and distributes an untrue,
statement about another person that damages the person's reputation. However, libel can

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

take place through any medium, such as radio, television, film, or the Internet. As a rule, the
law affords public figures less protection against libel and slander than ordinary persons
except when a false statement is also malicious. For defamation to occur, someone other
than the defamed person must read or hear the false statement. Moreover, true
statements, no matter how offensive they may be, are not defamation according to the law.

False arrest or detainment is any unlawful physical restraints of another's freedom. This
international tort presents a potential problem for retail stores. False arrest can occur when
a store employee detains a customer suspected of shoplifting. If it is later determined that
the customer had not stolen any merchandise, the determent is a false arrest that
inconveniences and embarrasses the customer.

Still another intentional tort is invasion of privacy, which is an encroachment on another

person's right to be left alone. Liability for invasion of privacy can arise from the
unauthorized release of confidential information, the illegal use of hidden microphones or
other surveillance equipment, an unauthorized search, or the public disclosure of private
facts.

Strict liability (or absolute liability) is the legal liability arising from inherently dangerous
activities or dangerously defective products that result in injury or harm to another,
regardless of how much care was used in the activity.

Although most liability cases arise from negligence and some arise from intentional torts,
liability under tort law is not entirely limited to cases of injury caused by negligent or
deliberate conduct. In situations involving inherently dangerous activities, tort law can give
an injured person a right of recovery without having to prove negligence or intent. Such
inherently dangerous activities can give rise to strict liability for any injury regardless of the
intent or the carefulness of the person held liable. The situation itself, rather than the
person's conduct, becomes the standard for determining liability.

For example, the owner of a wild animal is liable for any injury the animal inflicts, regardless
of the precautions the owner may have taken. Blasting operations present an exposure to
strict liability for businesses. The mere fact that the business conducts blasting operations is
enough to make the owners of the business liable for any injuries or damage that results.

Contracts
Contract law enables an injured party to seek recovery because another party has breached
a duty voluntarily accepted in a contract. As discussed, a contract is a legally enforceable
agreement between two or more parties. If one party fails to honor the contract, the other

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

may sue to enforce it. In such a case, it is the specific contract, rather than the law in
general, that the court interprets. Two areas to contract law important to insurance are
liability assumed under contract and breach of warranty, discussed next.

Parties to a contract sometimes find it convenient for one party to assume the financial
consequences of certain types of liability faced by the other. The party assuming the liability
may be closer to the scene, exercise more control over operations, or have the ability to
respond to claims more efficiently. For example, James Smith, the owner of a building, and
Jane Jones, a contractor, make a contract in which Jones accepts responsibility for certain
actions of Bob White, a subcontractor. If one of the specified actions of White injures a
customer, Bonita Brown, and Brown sues Smith, then Jones will pay any damage owed to
Brown because of White's specified action. Such arrangements, called hold - harmless
agreements, are common in construction and service businesses and obligate one party to
assume the financial consequences of legal liability for another party. They are called hold -
harmless agreements because they require one party to "hold harmless and indemnify" the
other party against liability arising from the activity (or product) that is specified in the
contract.

Businesses can transfer the financial consequences of certain types of liability to other
persons and organizations through contracts, but, as a matter of public policy, not all types
of liability can be transferred. Normally, one party cannot transfer its liability for gross
negligence, willful or wanton misconduct, or criminal actions to another party. The law of
contacts also governs claims arising from breach of warranty. Contracts for sales of goods
include warranties, or promises made by the seller. The law also implies certain warranties.
A seller warrants, for example, that an item is fit for a particular purpose. If Juanita buys the
hair conditioner recommended and sold by her beautician, she relies on the warranty that
the conditioner will be good for her hair. If the conditioner damages her hair instead, the
beautician (as well as the manufacturer) could be held liable for breach of warranty. The
buyer does not have to prove negligence on the part of the seller. The fact that the product
did not work shows that the contract was not fulfilled.

Statutes
Statutory liability is legal liability imposed by a specific statute or law. Although common
law may cover a particular situation, statutory law may extend, restrict, or clarify the rights
of injured parties in that situation or similar ones. One reason for such legislation is to
ensure adequate compensation for injuries without lengthy disputes over who is at fault.
Examples of this kind of statutory liability involve no-fault auto laws and workers'
compensation laws. In these legal areas, a specific statute (rather than the common-law
principles of torts) gives one party the right of recovery from another or restricts that right
of recovery.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Automobile accidents are among the leading causes of injury in the U.S. Because of this fact,
state legislatures seek ways to improve the system for distributing the generally high costs
of these accidents. Specific statutes now modify many of the common-law principles of
negligence that apply to automobile accidents. Because these laws are enacted by state
legislatures, the provisions vary considerably by state.

In an effort to reduce the number of lawsuits resulting from auto accidents, some states
have enacted "no-fault" laws. These laws recognize the inevitability of auto accidents and
restrict or eliminate the right to sue the other party in an accident, except in the more
serious cases defined by the law. Victims with less serious injuries collect their out -of-
pocket expense from their own insurers without the need for expensive legal proceedings.

A similar concept of liability without regard to fault applies to workplace injuries. Each of
the fifty states has a worker's compensation statue. Such a statue eliminates an employee's
right to sue the employer for most work- related injuries and also imposes on the employer
automatic (strict) liability to pay specified benefits. In place of the right to sue for
negligence, workers' compensation laws create a system in which in which injured
employees receive benefits specified in these laws. As long as the injury is work - related,
the employer pays the specified benefits regardless of who is at fault. In the AIC case, the
worker's compensation law in AIC's state would require that AIC provide benefits (such as
medical, disability, and rehabilitation benefits) to the injured employees as well as death
benefits to the survivors of the employees who were killed.

Potential Financial Consequences of Liability Loss Exposures

A person must sustain definite harm for a liability loss to result in a valid claim. Returning to
the loss example involving AIC, the visiting engineering students can collect damages from
AIC only if they can prove that they actually suffered some harm as a result of the explosion.
Perhaps they had to be treated in the hospital emergency room, their clothing was ruined,
or they could not go to their jobs and thus lost a day's pay. To those who can show that
actual harm or injury was suffered because of AIC's negligence, the court may award
damages that AIC will have to pay. In addition, AIC may incur defense costs to defend itself
in court. In addition to damages and defense costs, AIC can suffer other financial
consequences, such as loss of reputation. Exhibit 9-3 shows the various types of damages
and defense costs that may have to be paid as the result of a liability claim.
EXHIBIT 9-3
Potential Financial Consequences of Liability Loss Exposures

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Potential
Potential Final
Final Consequences
Consequences

Damages Defense Costs Damage

Damageto
to
Damages Defense Costs Reputation
Reputation

Compensatory Punitive Other

Lawyer Fees
Damages Damages Expenses

General
Special Damages
Damages

Damages
As explained earlier in the chapter, compensatory damages are intended to compensate the
victim for the harm actually suffered. An award of compensatory damages is the amount of
money that has been judged to equal the victim's loss, and it is the amount the party
responsible for the loss will have to pay. Compensatory damages include both special
damages and general damages. In addition, the court could award punitive damages.

Defense Costs
In addition to the damages that may have to be paid because of liability for bodily injury or
property damage, the financial consequences of a liability loss may also include costs to
defend the alleged wrongdoer in court. These defense costs include not only the fees paid
to lawyers but also all the other expenses associated with defending a liability claim. Such
expenses can include investigation expenses, expert witness fees, premiums for necessary
bonds, and other expenses incurred to prepare for and conduct a trial. Even in the unlikely
event that all the possible lawsuits against AIC are ultimately found groundless, AIC and its
liability insurer will probably incur substantial defense costs.

Damage to Reputation
A third financial consequence of liability loss may be the loss of reputation-the overall
adverse effects of liability losses on the business. Such consequences are often difficult to
quantify, but they do exist. For example, in 2000 a tire manufacturer recalled over six
million tires after they were alleged to be a factor in rollover crashes. In addition to
damages paid and defense costs for the lawsuits that followed, the manufacturer suffered a
damaged reputation and resultant loss of sales.

CATEGORIES OF LIABILITY LOSS EXPOSURES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Liability loss exposures exist whenever some activity or relationship can create liability to
others. Although the following list is far from exhaustive, liability can arise from any of the
following:

 Automobiles and other conveyances

 Premises
 Business operations
 Completed operations
 Products
 Advertising
 Pollution
 Liquor
 Professional activities

Automobiles and Other Conveyances

A significant liability loss exposure for almost all persons and businesses comes from the
ownership, maintenance, and use of automobiles. In the U.S., auto accidents produce the
greatest number of liability claims. Even people or businesses that do not own an auto can
be held vicariously liable for the operation of an auto by others. As shown in the AIC case,
AIC could be held liable for the auto accident caused by its employee fleeing the fire,
whether the employee was driving his own vehicles or one owned by AIC.

Liability loss exposures are also created by owning and operating other conveyances such as
watercraft, aircraft, or recreational vehicles.

Premises
Anyone who owns or occupies property has a premises liability loss exposure. If a visitor
slips on an icy front porch, the homeowner may be held liable for the injury. A business has
a similar loss exposure arising from its premises. As seen in the AIC case, the engineering
students were injured while on AIC's premises, and AIC will probably be held liable for their
injuries.

Business Operations
Business must be concerned not only about the condition of the premises but also about
their business operations. As AIC discovered, whatever activity the business performs has
the potential to go wrong and cause harm to someone else. Many business operations
occur away from the organizations' premises. A plumbing contractor, for example, may start
a fire in a customer’s house while soldering a copper pipe. Similarly, a roofing contractor
may drop debris from a ladder, injuring the customer's family members. In both case, the
customer will probably make a liability claim against the contractor.

Completed Operations

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Even after a plumber, an electrician, a painter or another contractor completes a job and
leaves the work site, a liability loss exposure remains. If faulty wiring or toxic paint leads to
an injury, the person or business who performed the work may be liable. Considerable time
could pass in the interim, but the person or business may still be held liable if faulty
workmanship created the condition that eventually caused the injury. If, for example, AIC
could prove that the explosion was caused by the negligence of the contractor who installed
the pressure relief device on the storage tank, the contractor may be liable for some or all
of the resulting damage and injury.

Products
Liability resulting from products that cause bodily injury or property damage is a significant
exposure for manufactures. This exposure begins with the design of the product and might
not cease until the product is properly disposed of by the ultimate consumer. Millions of
customers use or consume mass-produced products, foods, and pharmaceuticals. A
prescription drug may be dangerous, but the danger might not be known for several years,
when it is too late to help those who have taken the drug. AIC's customers complained of
impurities in its products; if these impurities caused injury to one or more of its customers,
AIC could be held liable for damages. If the manufacturer of the pressure relief device was
found to be negligent, the manufacturer might also incur some liability.

Advertising
Businesses often include pictures of people using their products in their advertisements. If a
local retailer cannot afford professional models, it might use pictures of people using its
products or shopping in its store. Unless the retailer obtains proper permission, publishing
the pictures could lead to a lawsuit alleging invasion of privacy. Using another company's
trademarked slogan or advertisement can also give rise to a liability claim.

Pollution
Many types of products pollute the environment when they are discarded. In addition, the
manufacturer of some products creates contaminants that, if not disposed of properly, can
cause environmental impairment, or pollution. If the explosion at AIC's plant polluted the
nearby river, AIC might have yet another liability loss. The Love Canal case in New York State
remains a good example of how industrial products or wastes can have serious detrimental
effects on the environment. Toxic wastes in the Love Canal area polluted the ground water
and made the surrounding community a dangerous place in which to live. Cleanup costs and
expenses to relocate persons living in the contaminated area can be enormous in such
cases.

Liquor
Serious dangers exist when people consume too much alcohol. Intoxicated persons can
pose a threat to themselves as well as to others. Providers of alcohol can be held
responsible for customers or guests who become intoxicated and injure someone while

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

driving drunk. Both the drunk driver and the person who served the alcohol can be held
legally liable. A business that sells or serves alcoholic beverages, therefore, has a significant
liability loss exposure.

Professional Activities
As explained earlier, negligence involves a failure to exercise the degree of care that is
reasonable under given circumstances. It is reasonable to expect that professionals with
special competence in a particular field or occupation will exercise great care in performing
their duties. Attorneys, physicians, architects, engineers, and other professionals are
considered experts in their field and are expected to perform accordingly. Professional
liability arises if injury or damage can be attributed to a professional's failure to exercise the
appropriate standard of care. For insurance professionals and others, this failure is
sometimes called errors and omissions (E & O). For medical professionals, it is often called
malpractice. For example, a physician who prescribes a drug but ignores the possible side
effects may be held liable for any resulting harm to the patient, because accepted medical
practice requires the doctor to consider possible side effects. When professionals make
errors, the injured party usually expects to be compensated.

LIABILITY INSURANCE POLICY PROVISIONS

Liability insurance covers losses resulting from bodily injury to others or damage to the
property of others for which the insured is legally liable and to which the coverage applies.
Because of differences between liability loss exposures and property loss exposures, liability
insurance differs from property insurance in several ways as follows:

 Property insurance claims usually involve only two parties - the insurer and the insured.
Liability insurance claims involve three parties - the insurer, the insured, and a third
party, who is the claimant who makes a claim against the insured for injury or damage
allegedly caused by the insured. Although the claimant is not a party to the insurance
contract, he or she is a party to the claim settlement.
 In property insurance, insurers typically pay claims to an insured when covered property
is damaged by a covered cause of loss during the policy period. In liability insurance,
insurers pay a third party on behalf of the insured against whom a claim has been made,
provided the claim is covered by the policy.
 Property insurance policies must clarify which property and clauses of loss the policy
covers. In contrast, liability insurance policies must indicate the activities and types of
injury or damage that are covered.

The insuring agreements of most liability insurance policies make essentially the same
broad promise: to pay damages (usually for bodily injury or property damage) for which an
insured becomes legally liable and to which the coverage applies. The insurer also promises
to pay related defense costs. In order to clarify the intent of the insuring agreement, which

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

is usually a relatively brief statement, the provisions of a liability insurance policy must
answer several questions, including the following:

 What parties are insured?

 What activities are covered?
 What types of injury or damage are covered?
 What loss exposures are excluded?
 What costs are covered in addition to damages and defense costs?
 What time period is covered?
 What factors affect the amount of claim payments?

Covered Parties

Liability insurance policies provide coverage for the named insured as well as others. A
liability policy generally gives the broadest protection to the named insured. Coverage for
others is generally based on their family or business relationship with the named insured.
Coverage for others is generally based on their family or business relationship with the
named insured. Therefore, liability insurance policy provisions must define the relationships
that determine coverage. For example, many policies provide the spouse of a named
insured with the same coverage that is provided to the named insured if they live in the
same household. If several named insureds are listed in the declarations of a commercial
liability policy, a policy provision usually stipulates that the first named insured is the
insured with whom the insurer has contact for payment of premiums, claim reporting and
claim payment, notices of cancellation or non renewal, or interim policy changes.

The extent of liability coverage provided to parties other than the named insured is
determined by their relationship to the named insured as well as by the circumstances. For
example, the liability coverage of a typical homeowners policy applies to the following:

 The named insured and the named insured's spouse, if the spouse is a resident in the
household.
 Relatives of the named insured or spouse, if the relatives reside in the household.
 Full - time students who were residents before moving out to attend school, if under
twenty-four and a relative or under twenty - one and in the care of an insured.
 Any person or organization legally responsible for animals or Watercraft owned by an
insured (except in business situations).
 Employees using a covered vehicle, such as a lawn tractor, and other people using a
covered vehicle on an insured location with the named insured's consent.

Commercial liability policies also cover the named insured and certain others, depending on
their relationship to the named insured. For example, a commercial general liability policy
(CGL policy) usually contains provisions that specify the relationships and circumstances
that determine who is insured under the policy. One provision clarifies who is insured when
the named insured is an individual, a partnership, or some other type of organization, such

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

as a corporation. Another provision defines others who may be covered because of their
business relationship to the named insured and the circumstances under which they are
covered. The parties who are insureds under this provision include the following:

 The named insured's employees and volunteer workers

 Real estate managers for the named insured.
 Persons responsible for the property of a named insured who has died.
 Any organization that is newly acquired or formed by the named insured for up to a
certain number of days after it is acquired or formed.

As these examples illustrate, both personal and commercial liability insurance policies
generally cover many individuals and organizations-including some that are not named in
the policy declarations.

Covered Activities

Under a liability policy, the insurer will pay damages only to those who suffer injury or
damage for which the insured is legally liable if the harm arose from a covered activity.

Just as property insurance policies use either a named perils or a special form coverage
approach to define covered causes of loss, liability insurance policies use two approaches to
define covered activities. Certain policies sate the specific activity or source of liability
covered. For example, an auto insurance liability policy states that it applies to claims that
result from covered auto accidents. In contrast, general liability insurance covers all
activities or sources of liability that are not specifically excluded.

A CGL policy is an example of general liability insurance. A general liability insurer agrees to
pay damages "to which this insurance applies." However, the extent of coverage depends
on the exclusions. That is, general liability policies essentially cover those claims that are not
excluded and specifically exclude coverage for claims that are better handled by other
liability insurance policies, such as automobile liability, workers' compensation, aircraft
liability, watercraft liability, and professional liability.
In additional to excluding losses covered by other types of liability policies, general liability
insurance policies contain exclusions dealing with difficult to insure exposures, losses
expected or intended by the insured, and loss exposures that would be too costly to insure.
For example, as with property insurance policies, nearly all liability policies exclude
coverage for losses arising from war and nuclear hazard.

Covered Types of Injury or Damage

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Liability policies typically cover claims for bodily injury and property damage for which the
insured is legally liable. Other types of injury may also be covered; for example, the CGL
policy also covers personal and advertising injury.

Bodily Injury

The standard CGL policy defines bodily injury as follows:

"Bodily injury" means bodily injury, sickness or disease sustained by a person, including
death resulting from any of these at any time.1

This definition indicates that, as used in the CGL policy, the term bodily injury also includes
some things in the everyday use of that term. Sickness and disease are often considered
forms of illness that do not involve injury. Death could be considered the severest form of
injury, but unless it is specified in the policy, there might be reason to question whether
coverage for claims for bodily injury liability includes coverage for death claims. Through the
bodily injury definition, the CGL policy clarifies that it covers claims for injury, sickness,
disease, and resulting death.

Property Damage

The definition of property damage in a typical CGL policy reads in part as follows:

"Property damage" means:

 Physical injury to tangible property, including all resulting loss of use of that
property; or
 Loss of use of tangible property that is not physically injured.

The definition of property damage also specified that data are not tangible property.

The definition of property damage in a typical homeowners policy is considerably briefer

and reads as follows:

"Property damage" means physical injury to, destruction of, or loss of use of tangible
property.2
Thus, according to both of these definitions, property damage includes both direct losses
and time element (or indirect) losses. For example, the fire at AIC's plant caused indirect
damage to the owners of surrounding businesses because they had to cease operations
temporarily. Although there was no actual directly physical damage to these surrounding
businesses, the business owners still lost the use of their property because of the explosion
of AIC. As for the auto accident, if the owner(s) of the other car temporarily lost use of their

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

car because of the accident, AIC might be liable not only for direct damage to the car but
also for a time element loss, such as the cost of a rental car until the car was repaired or
replaced.

Personal and Advertising Injury

In addition to bodily injury, harm can be inflicted in other ways, such as damage to one's
reputation. One may expect bodily injury and personal injury to mean the same thing. In f
act, attorneys tend to use the term personal injury when referring to bodily injuries.
However, when used in liability insurance policies, personal injury usually refers to a specific
group of intentional torts, including defamation (which includes libel and slander), false
arrest, and invasion of privacy. Any of these acts may cause harm to another person for
which the Tortfeasor may be held liable. For insurance purposes, intentional torts are
usually considered personal injury offenses and are either excluded from coverage or are
covered separately.
Some liability policies define personal injury in a way that includes not only the types of
offenses listed previously but also bodily injury. When that definition is used, personal
injury coverage is broader that bodily injury coverage. However, the more common
approach allows for separate coverage for bodily injury and personal injury, in which case
personal injury coverage supplements bodily injury coverage. For example, the CGL policy
includes personal injury coverage (combined with advertising injury) under a separate
insuring agreement.
Advertising injury which is covered by most CGL policies typically includes the following
types of offences:
 Libel and slander
 Publication of material that constituter on invasion of privacy
 Misappropriation of advertising ideas or business style.
 Infringement of copyright, trade dress, or slogan

The definitions of personal injury offenses and advertising injury offenses overlap
somewhat. Therefore, current versions of the CGL policy include both personal and
advertising injury in the same insuring agreement, so no coverage duplication results from
repeating that a certain type of claim is covered.

Coverage for personal injury liability, (but not advertising injury) also can be added by
endorsement to a homeowners policy.

Excluded Loss Exposures

No insurance policy can reasonably cover all loss exposures. Just as some types of injuries or
damages are typically excluded by liability insurance policies, some loss exposures are also

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

excluded. The exclusions in liability insurance policies generally fall into the following broad
categories.

 To avoid covering uninsurable losses. For example, war is an exclusion that appears
under many policies for both property and liability exposures. Losses from such
catastrophic events are not economically feasible to insure.
 To avoid insuring losses that could be prevented. Expected or intended injury exclusions
can be found under most broad liability coverages. In addition, losses resulting from the
possession of controlled substances, such as illegal drugs, are excluded by the liability
section of the homeowners policy. Such losses can be prevented by avoiding activity
that is prohibited by criminal and civil law.
 To eliminate duplicate coverage. For example, watercraft, liability and aircraft liability
are excluded under CGL policies and the liability section of homeowners policies. Such
exclusions eliminate duplicate coverage provided by the liability portion of the policies
specifically designed, to address these exposures.
 To eliminate coverage that most insureds do not need. For example, racing exclusive
appear under personal and commercial automobile policies. Most individuals and
organizations are not involved in racing vehicles. Therefore, the coverage is generally
excluded.
 To eliminate coverage for exposures that require special handling by the insurer. The
homeowners policy excludes coverage for professional services, such as coverages
required by physicians, architects, and lawyers. Providing appropriate liability coverage
to these professionals for their unique loss exposures would require specialized
coverage and underwriting.
 To keep premiums reasonable. For example, commercial liability policies generally
exclude all but limited exposures from pollution. Businesses with this type of exposure
must purchase specialty policies to cover catastrophic pollution exposures. If board
coverage were provided under all liability policies, the coverage would not be
affordable.

Covered Costs
Liability insurance policies typically cover the following two types of costs:
1. The damages that the insured is legally liable to pay.
2. The cost of defending the insured against the claim.

In addition, liability policies commonly cover incidental expenses (such as the cost of certain
required bonds or the insured's loss of earning while attending trials) under the policy's
supplementary payments provision. Finally, many liability policies cover medical payment
for injured persons, regardless of whenever the insured is legally liable.

Damages
The CGL policy contains a typical agreement to pay damages on behalf of the insured:

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

We agree to pay those some that the insured becomes legally obligated to pay as damages
because of "bodily injury" or "property damage" to which this insurance applies.

A person who has suffered bodily injury, property damage, or personal injury for which the
insured is allegedly responsible may make a claim for damages. The claim is often settled
out of court, and the insurer pays the claimant on behalf of the insured. If a case goes to
court, the claimant may be awarded two types of damages-compensatory damages and
punitive damages. These damages may or may not be covered by insurance.

Compensatory damages, intended to compensate the claimant for the injury or damage
suffered, are covered by liability insurance if the insured is liable for a covered loss. As
stated earlier, compensatory damages include both special damages and general damages.
A party who is held to be liable for another's injury may have to compensate the injured
party for special damages, such as hospital bills, physicians' fees, lost income, and
rehabilitation, expenses. In addition to these actual expenses, the liable party may be
required to pay general damages, such as pain and suffering, to compensate the victim for
the physical and mental suffering experienced because of the bodily injury. In the opening
example in this chapter, AIC's liability insurer may have to pay both special damages and
general damages if AIC is found liable for both types of compensatory damages because of
the explosion and fire.

Most liability insurance policies do not specifically state whether punitive damages, which
are intended to punish the insured for some outrageous conduct, are covered. Some states
do not permit insurers to pay punitive damages for their insureds because the punishment
is viewed as less effective if the responsible party does not personally pay the required
damages. On the other hand, insurers pay punitive damages if allowed by the state and not
excluded by the policy. Some people argue that punitive damages are as much a source of
unexpected financial loss as compensatory damages, and that the insured should be
entitled to insure against a judgment for punitive damages.

The damages that the insured is legally liable to pay can be determined in court, or can be
agreed on in an out-of court settlement. In practice, few liability claims are decided by the
courts. Most liability claims are settled before the claimant even files a lawsuit. Most are
settled privately between the claimant (or the claimant's lawyer) and the liability insurer (or
the insurer's lawyer) on behalf of its insured.

The claimant can decline to voluntarily settle a claim, in which case a lawsuit usually occurs,
and a court eventually decides the claim. Parties agree to settle claims when they believe a
proposed voluntary settlement is more attractive than a lawsuit and court verdict.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Generally out-of-court settlements are attractive to both sides for the following two
reasons:
1. Out-of-court settlements resolve cases quickly. Out-of-court settlements spare the
parties from significant financial and emotional costs.
2. Out-of-court settlements eliminate uncertainty about the outcome of a claim. Court
verdicts are unpredictable, and either party may do worse than expected. A claimant
or a defendant may bear substantial lawsuit costs and receive a court verdict less
favorable than an out-of-court settlement that was available months or years earlier.

An out-of-Court settlement is a voluntary agreement to drop a claim in exchange for an

agreed amount of money. Such settlements occur only after negotiation, by which one
party suggests a settlement amount and the other party accepts the amount, rejects it, or
suggests another amount. Settlement negotiations can conclude quickly or go on for
months, depending on the personalities and experience of the negotiators and on the
underlying facts of the claim. Proposed settlement amounts should be based on each
party's perception of what a likely court verdict would be. Therefore anything that would be
relevant in court should be relevant in settlement negotiations, including the nature of the
injuries or damages, the respective legal liability of the parties, and the quality of the
witnesses or evidences for each side.

Once negotiations have concluded with a settlement, the parties sign a release, which is a
written agreement in which the claimant agrees to drop his or her claim. The insured
through the insurer, promises to pay the agreed settlement to the claimant.

Insurers depend on our-of-court settlements. Claim costs would soar if insurers had to
resolve all liability claims through the courts. An ordinary automobile accident claim can
cost thousands of dollars in legal fees to prepare for trial and thousands more to put on
trial.
The court system and society in general favor out-of-court settlements. The courts would be
overwhelmed with cases and expenses if every legal issue had to go to court. Society
benefits when injured parties receive prompt compensation and when all parties put their
legal disputes behind them as quickly as possible.

Defense Costs
It is sometimes said that on insurer's duty to defend insured against liability claims is even
more important than its duty to pay damages. If the defense is successful, the court delivers
a judgment in favor of the defendant (that is the insured), and no damages are awarded. In
other cases, damages may be awarded, but an effective defense results in a lower award
than the award sought by the plaintiff (the claimant).

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Most liability insurance policies obligate the insurer to pay the costs of defending the
insured against any claim or lawsuit in which a claimant seeks damages that would be
covered by the policy. For example, the CGL insuring agreement specifics:
We will have the right and duty to defend the insured against any "suit" seeking (BI or PD)
damages.
Even if the claim seems to have no legitimate basis, as in the case of a fraudulent claim, the
insurer must defend the insured whenever the claimant's allegations (if proven) would be
covered under the policy. Often the defense can prove that the insured was not responsible
for the injury or damage alleged.

Defense costs are the insurer's responsibility. Some of these defense costs may be
specifically described in the policy; others are implicit. The duty to defend, for example,
implies that the insurer will retain the attorneys and pay their fees and expenses. Defense
costs may also include investigation, legal research, expert witness fees, and similar
incurred in preparing and presenting the case.

Supplementary Payments
Liability insurance policies typically include a supplementary payments section describing
various expenses that the insurer agrees to pay in addition to liability limits. The expenses
covered as supplementary payments usually include the following:
 All expenses incurred by the insurer such as investigating accidents, hiring external claim
adjusters, and paying fees for police reports.
 The cost, up to a specified limit, of bail bonds or other required bonds (persons involved
in auto accidents, for example, are sometimes required to post bail bonds)
 Expenses incurred by the insured at the insurer's request such as travel to attend a trial
or deposition.
 The insured's loss of earnings (up to specified amount per day) because of attendance at
hearings or trails at the insurer's request.
Other costs that relate to the claim, such as prejudgment or postjudgment interest, may
also be included in the list of supplementary payments.

Liability claims that go to trail often involve long delays between the time of injury or
damage and the time when a court awards a judgment to the claimant. The court award to
the plaintiff may include damages as well as prejudgment interest, which represents the
interest that may accrue on damages before a judgment has been rendered.
When an award for damages is successfully appealed to higher court, the plaintiff receives
no payment. If the higher court upholds the initial judgment, the plaintiff may also be
entitled to receive postjudgment interest as compensation for the money that would been
earned if the insurer had paid the claim at the time of the first judgment. Postjudgment

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

interest forces the insurer to bear the expense of the delay in payment caused by the
appeal.

Medical Payments
Some liability policies also provide medical payments coverage, which is sometimes offered
as an optional coverage the insured can purchase. Medical payments coverage pays
necessary medical expenses incurred within a specified period by a claimant for a covered
injury, regardless of whether the insured was at fault. Medical payments can help avoid
larger liability claims. If a homeowners policy includes $ 1,000 of medical payments
coverage, for example, a neighbor injured on the insured's property can receive emergency
medical treatment up to that amount without having to sue the insured to recover the cost.
Payment of this relatively modest amount reduces the possibility of a much more expensive
claim for damages. In some cases, such as in homeowners policies, this coverage is called
"medical payments to others" and does not cover injuries sustained by an insured or regular
residents of his or her household. In other cases, such as in personal auto policies, medical
payments coverage does cover an insured's injuries up to specified limit.

Covered Time Period

Personal auto insurance is usually written for a six-month term. Other types of liability
insurances are usually written for a one-year period, although other policy terms are also
possible.
A liability insurance policy states what must happen during the policy period to "trigger"
coverage. Depending on the types of policy coverage is usually triggered by either of the
following:
 Events that occur during the policy period ( in an occurrence basis policy)
 Claims made (submitted) during the policy period (in a claims-made policy)

Occurrence Basis Coverage

Bodily injury or property damage that occurs during the policy period triggers coverage
under a liability policy that provides occurrence basis coverage. In most situations, bodily
injury or property damage is apparent at the time of the accident or shortly thereafter.
Under a liability policy that provides occurrence basis coverage, if a covered accident occurs
during the policy period, the claim will be covered, regardless of when the claim is
submitted. For example, if the claimant was injured in an automobile accident caused by
the insured only a few hours before the policy period expired, the resulting claim would be
covered, despite the fact that it might be submitted after the policy expired.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

From the insured's standpoint, this coverage offers valuable protection for unknown and
unforeseen claims. For the insurer, however, occurrence basis coverage means that liability
claim may surface long after a policy has expired. This particular problem contributed to the
development of claims-made coverage.

Claims-Made Coverage
Although personal liability insurance policies and most commercial general liability
insurance policies are written on an occurrence basis, claims-made coverage is sometimes
used to insure businesses that face certain types of liability loss exposures, such as medical
malpractice, professional liability, and some especially hazardous products liability. Under a
liability policy that provides claims-made coverage, the insurer agrees to pay all claims that
are first made against the insured during the policy period (or before the end of an
extended period specified in the policy) if the covered event occurs on or after a specified
date (called a retroactive date) and before the end of the policy period.

In theory, the claims-made approach is ideal. An insured buys a series of claims-made

policies, and each succeeding policy becomes effective when the preceding one expires.
Unless coverage lapses, the insured will never be without coverage, because there is always
a current policy to provide coverage when a claim is presented.
In practice, the situation becomes more complicated. Most claims-made policies contain a
retroactive date, which is the date in a claims-made policy on or after which injury or
damage must occur in order to be covered. Claims due to injuries occurring before that
retroactive date are not covered even if the claim is made during the policy period.
Occurrence policies also do not cover claims arising from occurrences before the policy's
inception date. Therefore, an insured who replaces a claims-made policy either with an
occurrence policy or with a claims-made policy with a new retroactive date may face a gap
in coverage.

Because of periodic renewals and the possibility that the insured will shift coverage from
one insurer to another, maintaining continuous coverage without gaps is perhaps the
greatest difficulty with claims-made coverage. Thus, insurers producers, and insureds must
pay careful attention to the details of claims made policies.

Factor Affecting the Amount of Claims Payments

Even when a liability claim is covered, an insurer does not necessarily pay the full amount of
the judgment awarded to a claimant. The extent of the insurer's payment depends on the
following types of policy provisions:
 Policy limits
 Defense cost provisions
 "Other insurance" provisions

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Policy Limits
It is difficult to predict the dollar amount of liability insurance needed to cover an insured's
future claims. Legal obligations depend on uncertain future events in a changing legal
environment. Still, it is necessary for the insured and the insurer to agree on some dollar
amount of coverage. As with property insurance, policy limits helps an insurer measure the
extent of its obligation. Limits also provide options to the insured, who must decide not only
how much coverage is desirable but also how much is affordable. Liability insurance limits
are generally round number such as $100,000, $500,000 or $1 million.

Limits are expressed in different ways such as the following:

 An each person limit is the maximum amount an insurer will pay for injury to any one
person for a covered loss. If several persons are injured in a given occurrence, this limit
applies separately to each one.
 An each occurrence limit is the maximum amount an insurer will pay for all covered
losses from a single occurrence, regardless of the number of persons injured or the
number of parties claiming property damage. There may be several different covered
occurrences during one policy period.
 An aggregate limit is the maximum amount an insurer will pay for all covered losses
during the policy period.

Separate limits for bodily injury and property damage liability coverage are known as split
limits. For example, a personal policy may provide bodily injury liability coverage with a
$100,000 limit for each person and a $300,000 limit for each occurrence with a separate
limit of $50,000 for each occurrence for property damage liability coverage. A single limit
applies to any combination of bodily injury and property damage liability claims arising from
the same occurrence. For example, a $300,000 single limit cover a bodily injury loss up to
$300,000 a property damage liability loss up to $300,000 or any combination of bodily
injury and property damage arising from a single occurrence up to $300,000.

Examples of Split Limit and Single Limit

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Separate limits for bodily injury and A single limit applies to any combination of
property damage liability coverage are bodily injury and property damage liability
known as split limits. For example, a claims arising from the same occurrence.
personal auto policy may provide: For example,

Bodily injury liability coverage Bodily injury loss up to $300,000 for each
occurrence
• S100.000 limit for each person
Or property damage liability loss up to
• S300.000 limit for each occurrence
$300,000 for each occurrence
Property damage liability coverage
Or any combination of bodily injury and
• S 50,000 limit (or each occurrence property damage up to $300,000 for each
occurrence.

Defense Cost Provisions

Most liability policies place no dollar limit on the defense costs payable by the insurer. The
only limitation is that the insurer is not obligated to provide further defense once the entire
policy limit has been paid in settlement or judgment for damages.

Stated differently, defense costs are usually payable in addition to the policy limits, and
policy limits include only payment for damages. Practical limitations, however, tend to
restrict defense costs. For example, an insurer is not likely to spend $100,000 defending a
claim for $10,000 in damages. The insurer has a duty to defend, but also the right to settle
the claim. In this instance, the insurer is likely to choose settlement.

Some liability policies place defense costs within the overall policy limit. In such policies, for
example, if the policy limits is $10,000 and the insured has a covered claim involving
damages of $90,000 and defense costs of $30,000, the insurer would pay a total of
$100,000 for both the damages and the defense. The insured would be responsible for
paying the additional $20,000.

"Other Insurance" Provisions

In some cases, two or more policies may cover the same claim. Like property insurance
policies, liability insurance policies contain "other insurance" provisions to resolve this
problem and preserve the principle of indemnity. Several approaches can be used, and the
applicable approach depends on the wording of the particular policy and on the situation.

SUMMARY

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

This chapter discusses liability loss exposures and the liability policy provisions that deal
with those exposures. Liability loss exposures are based on the concept of legal liability. By
holding individuals and businesses responsible for their conduct, the legal system protects
the rights of individuals and businesses. The legal system in the U.S. derives essentially from
the following:
 The constitution, which is the source of constitutional law
 Legislative bodies, which are the source of statutory law
 Court decisions, which are the source of common law

The U.S. legal system makes an important distinction between criminal law and civil law.
Criminal law imposes penalties on those who commit wrongs against society. Civil law
provides means to settle disputes among individuals and to determine responsibility for
injuries or damage.
Liability loss exposures involve the following elements:
 The legal basis of a claim by one party against another for damages
 The potential financial consequences of liability loss exposures

Any of several legal principles can serve as the basis for holding one party responsible for
another's injury. Most liability cases rely on tort law, which allows an injured party to sue
for damages if the other party's negligence, intentional tort, or strict liability (from an
inherently dangerous activity) caused the injury or damage. Liability can also arise from a
breach of contract, which allows one party to seek relief in court form the other party to a
contract. Statutes, such as workers' compensation laws, also imposed liability on certain
parties when a legislative body has determined that it is in the interest of society to hold
those persons liable.

A liability loss occurs only if an insured causes another person to suffer definite harm. A
liability claim can lead to compensatory damages, consisting of special damages (for
medical expenses, lost income, and rehabilitation expenses) as well as general damages (for
pain and suffering). Many liability claims also lead to defense costs, including legal fees,
investigation expenses, and other expenses to defend the claim.

Many activities and situation can create liability to someone else. These include owning or
operating an automobile, owning or occupying property, conducting business operations,
manufacturing or selling products, advertising, polluting the environment, selling or
otherwise providing alcoholic beverages, and practicing a profession.

Liability insurance policies cover damages that the insured becomes legally obligated to pay
and that arise out of the activities covered by the policy. The following must be specified in
the provisions of liability insurance policies:

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Covered parties. A liability policy provides coverage to the named insured and to others.
The extent of liability coverage provided to parties other that the named insured is
determined by their relationship to the named insured as well as by circumstances
surrounding the claim.
 Covered activities. A liability policy must clear express the insurer's intent to cover
claims against the insured for which the insurer is legally obligated to pay damages. An
auto liability insurance policy states the specific activity or source of liability covered:
claims resulting from covered auto accidents. In contrast, general liability insurance
covers all activities or sources of liability that are not specifically excluded.
 Covered types of injury or damage. Liability policies most specify what types of injury or
damage is covered, such as bodily injury, property damage, personal injury, and
adverting injury. Liability most also specify what kinds of exposures are excluded.
 Covered costs. Typical policies cover damages that the insured is legally liable to pay and
the cost of defending the insured against the claim.
 Covered time period. Depending on the type of policy, coverage is usually triggered by
events that occur during the policy period (in an occurrence basis policy) or by claims
made during the policy period (in a claims-made policy).
 Factors affecting the amount of claim payments. The extent of the insurer's payment
depends on the policy provisions regarding policy limits, defense costs, and other
insurance.

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Managing Loss Exposures:

Risk Management Chapter 10

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Individuals and organizations face risk on a daily basis. Risk can have many meanings, but
for the purposes of this text, it simply means uncertainty concerning loss. For those risks
having the potential for substantial financial consequences, prudent persons and groups
practice risk management, often without realizing it. For example, a person who decides not
to take up skiing from fear of being injured is practicing the risk management technique of
avoidance. A person who decides to ski but chooses to wear a helmet while skiing, is
practicing the risk management technique of loss control. On the back of the lift ticket from
the ski resort is evidence of a form of noninsurance transfer, by which the skier agrees to
not hold the resort responsible for any injury incurred. A skier who does not have health
insurance against accidental injury is practicing the risk management technique of
retention. Someone who purchases an insurance policy to cover accidental injuries,
including skiing injuries, is handling the risk by purchasing insurance, thereby transferring
the risk to an insurer.

Insurance professionals focus on loss exposures when discussing risk. A loss exposure is any
condition or situation that presents the possibility of a loss. This chapter introduces risk
management as a formal process for handling loss exposures and covers some of the more
widely used risk management techniques. Informal risk management occurs each day in
everyone’s life and in every business.

Everything people or organizations do exposes them to possible accidental losses.

Whenever accidental losses occur, they can create serious financial consequences for the
individuals, households, or organizations that suffer the loss. Such losses can also prevent
persons or organizations from achieving their goals. Identifying and finding ways to deal
with these potential losses is what risk management is all about. Insurance, which cannot
prevent accidental losses, works best when it is part of a well-designed risk management
program tailored to the unique loss exposures of each insured.

THE RISK MANAGEMENT PROCESS

Risk management is essentially the process of managing exposures to accidental losses.
Whether those practicing risk management are company executives, individuals planning
for themselves or their families, or professionals working with clients, the primary goal of
risk management is the same-to minimize the adverse effects of loss exposures by reducing
the frequency and severity of losses. Risk management is not just a process used by large
corporations. Risk management concepts are also used, consciously or not, by small and
medium sized companies, communities, families, and individuals.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The risk management process needs specific attention in very household or organization,
regardless of its nature or its size. The person who performs the risk management function
differs, depending on the household or organization. The responsible person in an
organization may be an employee known as the risk manager, as the director of risk
management, or by some other title. In other organizations, risk management may be
performed by someone outside the firm-for example, a risk management consultant. An
insurance agent or broker (producer) can assist organizations with their risk management
process by helping them identify what loss exposures they have and by suggesting the types
and amounts of insurance they need; decisions should be made by the client, not by the
agent or broker (producer).

In a household, the person who performs risk management may be the primary wage
earner or the person who handles the household finances. In this chapter, the term risk
manager refers to anyone who is primarily responsible for risk management, regardless of
title or status within the organization or household. The term household refers to any
household unit, whether an individual, a traditional family, or individuals living together in a
single household. The term organization refers to a business or entity operating for-profit or
not-for profit. Risk management concepts are valid for all types of households and
organizations.

Risk managers in households or organizations are responsible for all six steps in the risk
management process. Those steps are as follows:

 Identifying loss exposures

 Analyzing loss exposures
 Examining the feasibility of risk management techniques
 Selecting the appropriate risk mismanagement techniques
 Implementing the selected risk management techniques
 Monitoring results and revising the risk management program

Step 1: Identifying Loss Exposures

Identifying loss exposures involves developing a thorough list of possible accidental losses
that can affect a particular household or organization. The key to identifying these loss
exposures is understanding how the household or Organization operates. The risk manager
can start with a physical inspection of the premises and then use other techniques, such as
loss exposure surveys, financial statement analysis, loss history analysis, flowcharts, and
interviews. Three of the more common techniques are examined next.
Physical Inspection
A family or an organization’s risk manager generally cannot gain a clear picture of possible
loss exposures by sitting at a desk away from the source or risk. The most straightforward

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

method of identifying loss exposures is to physically inspect all locations, operations,

maintenance routines, safety practices, work processes, and other activities. For example, a
risk manager in an industrial operation may observe that the guards have been removed
from machines or that boxes of parts are stacked high on a storage shelf, creating an
exposure for injury should the parts fall. Physical inspection alone may not be enough,
however, because the risk manager may not have sufficient knowledge of the household or
operations to identify all exposures or to ask others the right questions to uncover all loss
exposures.

Loss Exposure Surveys

Loss exposure surveys, or checklists, are documents listing potential loss exposures that
that a household or an organization may face. Independent risk management consultants,
as well as insurers, agents, and brokers, often design such surveys to be comprehensive
enough to apply to almost any household or organization. However, a given household or
organization is unlikely to face all of the loss exposures detailed in such surveys.

The risk manager usually discusses the items on the survey with managers, supervisors, and
other employees familiar with the organization’s exposures. If worded appropriately, the
survey can also help familiarize the risk manager with the organization’s operations. The
survey’s major weakness is that it may omit an important exposure, especially if the
organization has unique operations not included on a standard survey form. Therefore, risk
managers cannot depend solely on surveys. Rather, risk managers should use the survey as
a guide to develop a comprehensive picture of the organization’s operations, and loss
exposures.

Exhibit 10-1 presents a sample of questions frequently asked on loss exposure surveys for
organizations. Such surveys usually group similar exposures together, such as exposures
from manufacturing operations, from the sale of products, from the use of vehicles, and so
forth. Similar but less extensive surveys are available from insurers to help households
identify the loss exposures they face.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

EXHIBIT 10-1
Sample of Questions Frequently Asked on Loss Exposure Surveys

Yes No

1. Do you have a brochure or other written material that describes your business
operations or products?
2. Is your business confined to one industry?
3. Is your business confined to one product?
4. Do you own buildings?
5. Do you lease buildings from others?
6. Do you lease buildings to others?
7. Do you plan any new construction?
8. Are your fixed asset values established by certified property appraisers?
9. Do you own any vacant land?
10. Are any properties located in potential riot or civil disturbance areas?
11. Are any properties located in potential flood or earthquake areas?
12. Do your properties have security alarm systems? (Fire-sprinkler discharge,
burglary, smoke detection, and so forth)
13. Are there any unusual fire or explosion hazards in your business operation?
(Welding, painting, woodworking, steam boilers or pressurized machinery, and
so forth)
14. Do you take a physical count of inventory at least once a year?
15. Do you lease machinery or equipment other than automotive?
16. Do you stockpile inventory, either raw or finished?
17. Could you conveniently report inventory values on a monthly basis?
18. Do you buy, sell, or have custody of goods, or equipment of extremely high
value? (Radium, gold and so forth)
19. Do you use any raw stock, inventory, or equipment that requires substantial lead
time to reproduce ?
20. Do you export or import?

LOSS HISTORIES

Loss histories provide another method for identifying an organization’s loss exposures. Loss
histories deal with an organization’s past losses which can assist a risk management
professional in identifying that organization’s exposures to future accidental losses.

The quality of loss histories depends on whether they are complete, organized, consistent,
and relevant. For example, data quality is reduced whenever a loss is omitted; whenever
any item of information normally collected about losses (such as where or when they occur)
is omitted; whenever the conditions under which an organization operates or those
operations themselves change in some fundamental way; or whenever a new cause of loss
emerges. Past events or conditions that were not recorded, inaccurately recorded, or made
irrelevant by changing environments have little, if any, value for forecasting future events.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Step 2: Analyzing Loss Exposures

Analyzing loss exposures requires estimating how large the losses may be and how often
they may occur. Such an analysis helps to determine how losses may interfere with the
activities and objectives of the household or organization and what their financial effect
may be. To determine the financial effect of losses, a risk manager needs to measure both
the likely frequency and likely severity of those losses. This analysis enables the risk
manager to give priority to the most significant loss exposures.

Loss Frequency
Loss Frequency indicates how often a loss occurs in a particular period. Frequent losses
include abrasions and minor lacerations of employees at a manufacturing plant, minor auto
accidents with a large fleet of autos, and spoilage of produce at a supermarket. Other
losses, such as those caused by earthquakes, tornadoes, and hurricanes, occur much less
frequently.

Accurate measurement of loss frequency is important because the proper treatment of the
loss exposure often depends on how frequently the loss is expected to occur. If a particular
type of loss occurs frequently, or if its frequency has been increasing in recent years, the
risk manager may decide that procedures for controlling the loss are necessary.

Loss Severity
Loss severity is the monetary amount of damage that results from a loss. It is much easier to
gauge the potential severity of property losses than of liability losses. Most property losses
have a finite value. Whether the property is partially or completely destroyed, the severity
of the loss is usually calculable. Conversely, the severity of liability exposures is much harder
to calculate. For example, a paint manufacturer sells paint that produces toxic fumes when
used, the severity of the potential liability loss is almost unlimited.

Likewise, the severity of the property loss from an airplane crash may equal several million
dollars, a calculable amount. However, if an aircraft loaded with passengers crashes in a
densely populated metropolitan area, the potential severity of the liability loss is difficult, if
not impossible, to estimate accurately.

Properly estimating loss severity is also essential in treating the loss exposure. The potential
severity of losses is a major consideration in determining whether the household or
organization should insure a particular exposure or retain all or part of the financial
consequences of the loss.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Step 3: Examining the Feasibility of Risk Management Techniques

Once loss exposures have been identified and analyzed, the risk manager should examine all
possible techniques for handling the exposures. These techniques are grouped into two
broad categories-risk control and risk financing. Following is a discussion of some of the
more common risk management techniques under each of these categories.

Risk Control
Risk Control is a risk management technique that attempts to decrease the frequency or
severity of losses. Risk control techniques include the following:
 Avoidance
 Loss prevention
 Loss reduction
 Separation
 Duplication
Avoidance eliminates loss exposure and reduces the change of loss to zero. For example, a
manufacturer of sports equipment may decide not to sell football helmets to avoid the
possibility of large lawsuits from head injuries. Likewise, a family may decide not to
purchase a motor boat to avoid the potential property and liability exposures that
accompany boat ownership.

The advantage of avoidance as a risk control technique is that the probability of loss equals
zero-there is no doubt or uncertainty about the loss exposure because a loss is not possible.
Avoidance has the disadvantage of sometimes being impractical and is often difficult, if not
impossible, to accomplish. For example, suppose Priya is contemplating the purchase of her
first automobile, but she is worried about the exposures inherent in automobile ownership.
She may believe the chance of damage to the car is too great. Further, Priya may be
unwilling to assume the chance of liability imposed by law, or perhaps she cannot afford
automobile insurance. However, avoidance of these exposures may pose additional
problems for Priya. Does she need a car for commuting to work or for other activities? If so,
she will have to exchange the exposures of automobile ownership for the exposures
inherent in some other type of transportation. Renting or leasing a car may be more
expensive than auto ownership, and Priya would still be liable for any accidents she may
cause. Foregoing a car would mean traveling by public transportation, by bicycle, by
motorcycle, or on foot; any of these alternatives could prove more hazardous to Priya than
riding in her own car. Priya may decide that avoidance is not a feasible technique and would
thus choose to purchase a car and buy automobile insurance to cover her automobiles loss
exposures. Loss prevention seeks to lower the frequency of losses from a particular loss
exposure. Examples of loss prevention are commonplace and include the following:

 Keeping doors and windows locked to prevent burglaries

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

 Maintaining a regular program of vehicle maintenance to prevent accidents due to

faulty equipment

Loss reduction seeks to lower the severity of losses from a particular loss exposure.
Common loss reduction measures include the following:

 Installing a sprinkler system, which does not usually prevent fires, but can limit damage
should a fire occur
 Installing a restrictive money safe that a store clerk cannot open

Many insurers have a loss control department that includes risk management professionals
who attempt to reduce an insured’s frequency and severity of losses. Insured’s often use
loss control measures because the insurer has recommended them. Insurers direct much
loss control effort to commercial insurance accounts. The loss control programs
recommended by insurers are generally based on inspection reports prepared by the
insurers’ loss control representatives. An inspection report is one of the best sources of
underwriting information and it supplements the application.

When an underwriter receives an application for a commercial account, one of the

underwriter’s first tasks is often to request an inspection report from the insurer’s loss
control department. A loss control engineer or representative visits the applicant’s location
or locations to inspect the premises and operations and submits an inspection report.

An inspection report usually has the following two main objectives:

 To provide a thorough description of the applicant’s operation so that the underwriter

can make an accurate assessment when deciding whether to accept the application for
insurance.
 To provide an evaluation of the applicant’s current loss control measures and
recommend improvements in loss control efforts. The underwriter may require that the
applicant implement the loss control recommendations in order for the application to
be accepted.

Separation isolates loss exposures from one another to minimize the adverse effect of a
single loss. For example, an organization may store inventory in several warehouses for
valid business reasons, as well as for risk control. Another example of separation is using
several suppliers for raw material purchases. Using multiple suppliers may also enable the
organization to obtain competitive pricing.

Duplication uses backups, spares, or copies of critical property, information, or capabilities.

For example, an organization may make copies of key documents or information, which can
be stored at another location. Another example of duplication is maintaining an inventory
of spare parts for critical equipment. Risk control techniques are rarely used alone, and are

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

most often effective when used in conjunction with risk financing techniques discussed
next.

Risk Financing
Risk financing is an effective risk management technique that includes steps to pay for or
transfer the cost of losses. Risk financing techniques include the following:

 Retention
 Transfer (noninsurance transfer and insurance)

As a risk management technique, retention simply means that the household or

organization retains all or part of the financial consequences of loss exposure. The financial
consequences of any loss exposure that has not been avoided or transferred are invariably
retained.

Retention can be intentional or unintentional. After thoroughly analyzing the alternatives, a

risk manager may decide that retention is the best way to handle a given exposure, perhaps
because insurance is not available or is too expensive. For example, a risk manager may
decide that purchasing collision coverage on a fleet of older vehicles is not worth the
premium and may thus decide to retain the organization’s exposure by paying for any
collision losses from the company’s operating funds. Unintentional retention may result
from inadequate exposure identification and analysis or from incomplete evaluation of risk
management techniques. For example, a restaurant may not identify its liability exposure
for serving too much alcohol to a customer and therefore may fail to purchase liquor
liability insurance to cover this exposure.

Retention can be partial or total. Examples of partial retention are a $500 deductible on a
personal auto policy or a $ 10,000 per building deductible on a commercial property
insurance policy. An example of total retention would be husband and wife choosing not to
purchase flood insurance on their lake side home because they think it is too expensive.
They are therefore retaining their entire exposure to flood losses.

In the long run, retention is less expensive than insurance. While retention involves
absorbing the cost of losses, insurance premiums are used to cover losses and the insurer’s
overhead, taxes, expenses, and other costs of policy and claim handling.

Retention is usually used in combination with other risk management techniques,

particularly loss control and insurance. A deductible in a business auto policy is an example
of the combination of retention and insurance. If the risk manager also implements a driver

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

safety program to lower the frequency of corporate auto accidents, the combination of loss
control, retention, and insurance can handle the exposure economically.

Businesses often treat loss exposures by transferring the potential financial consequences
of loss to another party. When the other party is not an insurer, this method is called
noninsurance transfer. For example, the landlord of a commercial building may wish to
transfer the financial consequences of a liability exposure arising out of activities of a
tenant. The landlord accomplishes this transfer by having the tenant sign a hold-harmless
agreement. The agreement can be a separate contract but is usually a provision included in
the lease. A hold-harmless agreement states that one party (in this case, the tenant) agrees
to hold the other party (the landlord) harmless, or not legally responsible, for any liability
arising from the tenant’s use of the premises. Because a person can possibly sustain an
injury on the rented property, the landlord has transferred this liability exposure to the
tenant, who will be responsible for any such loss.

In addition to other techniques for handling loss exposures, households and small business
depend heavily on insurance, which is another transfer technique. Most medium-sized and
large businesses also rely on insurance as a major component of their risk management
programs, but they may be less dependent on insurance and employ other risk
management techniques more systematically than households and small businesses.

Even large businesses face loss exposures that they can handle most economically by
purchasing insurance. No viable alternative exists for highly unpredictable loss exposures
that could result in catastrophic financial consequences. Such businesses may use large
retention amounts (deductibles or self-insurance) and purchase insurance policies to
provide coverage above these amounts to protect them against large losses.

By working closely with the organization’s insurance producer, a risk manager can develop
an insurance program tailored to the company’s needs and coordinate the insurance
program with risk control and risk financing to form a complete risk management program.

Exhibit 10-2 summarizes the various risk management techniques, explains what each
technique does, and gives an example of each.

Step 4: Selecting the Appropriate Risk Management Techniques

If it were possible to predict accidental losses accurately, selecting risk management
techniques would be easy: prevent or avoid the losses that are most likely to happen and
buy insurance against the losses that cannot be prevented or avoided. However, because no
one can predict accidental losses with such accuracy, selecting risk management techniques

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

must be based on predictions of expected losses-where they are most likely to happen, how
often they are likely to occur, and how large they will probably be.

Businesses that are accustomed to reaching decisions based on expected profits or other
financial criteria will probably use these same financial standards to select the most
promising risk management techniques. Organizations that are less financially oriented are
more likely to apply informal guidelines in choosing risk management techniques. These
two types of decision making are discussed next.

Decisions Based on Financial Criteria

Financial management decisions are typically made with the objective of increasing profits
and/or operating efficiency. Risk management decisions can be based on the same
objectives. When an organization undertakes an activity to achieve profit goals or other
objectives, it also assumes the exposures to accidental loss that are inherent in that activity.
How the organization deals with those loss exposures affects the profits or output from the
activity. By forecasting how a particular risk management decision will affect profits or
output, an organization can choose the risk management technique that is likely to be the
most financially beneficial. For example, a corporation may analyze its financial position and
decide that it does not want any retained loss exposures to affect annual corporate earnings
by more than five cents per share of stock. If the corporation has one hundred million
shares outstanding, the risk management department can retain up to $5 million for all
exposures in a fiscal year. The risk management department makes its retention decisions
for the coming year based on this strategy of protecting corporate earnings.

Decisions Based on Informal Guidelines

Most households and small organizations follow less formal guidelines in selecting risk
management techniques. Four such guidelines are the following:

1. Do not retain more than you can afford to lose. Setting an upper limit on the proper
retention level is an important guideline. The amount that a household or
organization can afford to lose depends on its financial situation. For example, if a
family has only $500 in its savings account and has little remaining from each
paycheck, it probably cannot afford to carry a $1,000 deductible on either its
homeowners or personal automobile policies. Unless the family wishes to borrow
money to pay a deductible, the family will probably choose to carry whatever
minimum deductibles the insurer offers, despite the fact that the family could save
premium dollars by choosing a higher deductible. The family simply cannot afford to
sustain any loss greater than a few hundred dollars.
2. Do not retain large exposures to save a little premium. A risk manager should not
retain a loss exposure with high potential severity, such as auto liability, in order to
save a small amount of insurance premium. Depending on market conditions,

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

certain types of liability insurance coverage, such as some umbrella policies

(designed to cover large liability losses), can cost relatively little because the
potential frequency of large liability losses is low. However, such coverage can be
priced much higher given different market conditions. Exposures with the potential
of low frequency but high severity should generally be insured because they are
highly unpredictable. For example, the probability of a building suffering a total fire
loss is low because total fire losses happen infrequently; however, if a family’s
residence does burn to the ground, the severity of the loss would be great. One such
loss would cost the family many times a year’s insurance premium, so the family
should fully insure the residence.
3. Do not spend a lot of money for a little protection. Risk managers should spend
insurance dollars where they will do the most good. If the exposure is almost certain
to lead to a loss during the policy period, the insurer must charge a premium close
to the expected cost of the loss plus a portion of the insurer’s overhead, premium
taxes, and profit. It is better to retain exposures of this type because the household
or organization could absorb the cost of a loss almost as easily as the cost of the
insurance. For loss exposures with high frequency and low severity, retention and
loss control are usually the best alternatives. For example, a family may chose a
higher deductible on auto physical damage coverage and use that savings to buy
umbrella insurance to provide coverage for the infrequent but severe liability losses
exceeding their homeowners or auto policy liability limits.
4. Do not consider insurance a substitute for loss control. A risk manager may evaluate
a particular exposure, such as automobile collisions, and discover that the frequency
of accidents has been increasing in recent years. If the company has a $1,000
collision deductible for each accident, the risk manager may decide to take action to
reduce the organization’s total annual retention for auto accidents. One approach
may be to lower the deductible to $500 so that the company retains less of the loss
exposure on each accident. This step would not solve the real problem, however,
which is the increase in loss frequency. The insurance cost increases with the lower
deductible, and the loss frequency is likely to remain high. In this case, the risk
manager would be using the purchase of insurance in lieu of loss control.
A better option would be for the company to implement a loss control program to
prevent accidents from occurring. This program could include more careful
screening of company drivers, periodically reviewing drivers’ motor vehicle records,
training employees in safe driving practices, ensuring vehicle safety through regular
vehicle maintenance, and implementing other loss control activities to reduce the
frequency of collisions. If the program works and fewer accidents occur, the
organization’s overall retention from absorbing deductibles decreases, although the
cost of the loss control program must also be considered. Future insurance
premiums may be lower as well, because the insurer may offer a lower premium for
the improved accident record.
When insurance takes the place of loss control, the insured simply passes the cost of
absorbing additional losses to the insurer. It may be more economical to spend
dollars on a loss control program that will prevent and reduce losses and lower the
long-term cost of insurance and the risk management program.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Step 5: Implementing the Selected Risk Management Techniques

Implementing the risk management techniques that an organization has chosen requires
that the risk manager make decisions concerning the following:

 What should be done

 Who should be responsible
 How to communicate the risk management information
 How to allocate the costs of the risk management program

Deciding What Should Be Done

Once the risk manager has decided what risk management techniques to use, he or she
must implement them. For example, Helen, the risk manager of a supermarket, has decided
that the store needs a sprinkler system. She must now decide how much the supermarket
can afford to spend on the system, what kind of system should be installed, and which
contractor should install it. She might also need to check on the local water supply and
building permits and decide what is necessary to comply with local ordinances. Because the
executives of the store will certainly want to minimize customer disruption, Helen must
decide how to accomplish this objective. She must also consult with the store’s insurance
agent to make sure that appropriate property and liability coverages are in place during and
after the installation and that the insurer gives an insurance credit for the sprinkler system.
Helen must take into account these considerations and many others before deciding exactly
how to implement the loss control technique she has chosen.

Deciding Who Should Be Responsible

The risk manager usually does not have complete authority to implement risk management
techniques and must depend on others to implement the program based on the risk
manager’s advice. Larger organizations may have a written risk management statement and
a risk management manual outlining guidelines, procedures, and authority for
implementing risk management techniques. In smaller organizations and in households, the
person making risk management decisions is often the person implementing the program
because that person is the organization’s owner or the household’s primary wage earner.

Communicating Risk Management Information

A risk management program must include a communications plan. Risk management

departments of large organizations generally rely on a manual to inform others of how to
identify new exposures, what risk management techniques are currently in place, how to
report insurance claims, and other important information. Management and other
employees must communicate information to the risk manager so that the program can be
modified for new exposures and evaluated for effectiveness.
Allocating Costs of the Risk Management Program

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Determining how to allocate the costs of the risk management program is also important. In
large organizations the costs of loss control, retention, noninsurance transfers, and
insurance, as well as the expenses of the risk management department, must be spread
appropriately across all departments and locations.

In smaller organizations or within households, allocating costs is also feasible. For example,
an employee of a small business may be required to pay the deductible arising from damage
she caused to a company car, or a teenager may have to pay to fix a neighbor’s window that
he accidentally broke.

Step 6: Monitoring Results and Revising the Risk Management Program

Monitoring the risk management program is an ongoing activity that a risk manager must
carefully perform. Because the needs of all households and organizations change over time,
a risk management program should not be allowed to become outdated. Monitoring the
program ranges from handling routine matters, such as updating fleets, of vehicles by
replacing those less roadworthy, to making complex decisions concerning new activities to
initiate or avoid.

The household or organization should review its insurance program with its agent or broker
each year. Because decisions regarding insurance are usually associated with other risk
management techniques, any change in insurance will affect the other areas.

The last step in the risk management process is actually a return to the first. In order to
monitor and modify the risk management program, the risk manager must periodically
identify and analyze new and existing loss exposures and then reexamine, select, and
implement appropriate risk management techniques. Thus, the process of monitoring and
modifying the risk management program begins the risk management process once again.

BENEFITS OF RISK MANAGEMENT

Few businesses, individuals, or families are financially able to retain all their loss exposures
and must transfer much of the financial burden. Therefore, insurance is an essential part of
almost all sound risk management programs. However, insurance must be considered in its
proper role in a well-balanced program of risk management that also includes other risk
management techniques. Risk management has many advantages over merely buying
insurance. These advantages benefit businesses, individuals, families, society, and insurers,
as discussed next.

Benefits of Risk Management to Businesses

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Making insurance part of an overall risk management program instead of relying solely on
insurance provides many benefits to an organization, including the following:
 Improved access to affordable insurance because insurers often prefer to insure an
organization that practices risk management rather than one that relies solely on
insurance for protection against the financial consequences of accidental losses. An
insured who combines insurance with the risk management techniques of avoidance,
loss control, retention, and noninsurance transfer usually has fewer and smaller losses
than do other insured’s. Therefore, insurers are likely to generate better loss ratios and
underwriting results by insuring policyholders having sound risk management programs.
Consequently, such insured’s are often able to obtain broader coverage at lower
premiums than insured’s who do not practice risk management.
 Increased opportunities because uncertainty about future losses from new business
activities is diminished. The fear of uncertain future losses tends to make many business
owners and executives reluctant to undertake activities they consider too risky. This
reluctance deprives a business of the benefits that undertaking certain activities could
bring. A business having an effective risk management program is better prepared to
seek other opportunities that may increase its profits. For example, if a business is
confident in the way it has managed its present property and liability loss exposures, it
may be in a better position to consider a proposal to manufacture a new product or to
expand its present sales territory.
 Achievement of business goals through better management of large loss exposures. Risk
management makes it possible for a business to achieve its business and financial goals
in a cost-effective manner and can thus help improve profitability. The potential costs of
a loss exposure can be disruptive to a business, and risk management techniques can be
used to minimize the change that the business must absorb such a large loss. Profits can
be increased directly by reducing expenses. For example, a firm may reduce its
insurance costs because the risk manager chooses to retain a loss exposure instead of
insuring it.

Benefits of Risk Management to Individuals and Families

Like businesses, individuals and families benefit in the following ways from effective risk
management:
 Coping more effectively with financial disasters that may otherwise cause a greatly
reduced standard of living, personal bankruptcy, or family discord.
 Enjoying greater peace of mind from knowing that their loss exposures are under
control.
 Reducing expenses by handling loss exposures in the most economical fashion.
 Taking more chances and making more aggressive decisions on ventures with the
potential for profit, such as investing in the stock market, changing careers, or starting a
part-time business. Though this may seem inconsistent with the purpose of risk
management, many such decisions can have long term value when made with a full
knowledge of costs and potential benefits.
 Continuing activities following an accident or other loss, and thus reducing
inconvenience.
Benefits of Risk Management to Society

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

By helping themselves through effective risk management, businesses, individuals, and

families also benefit society in various ways as follows:

 Stimulating economic growth because fewer and less costly losses mean that more
funds are available for other uses, such as investment, which can spur economic growth.
 Reducing the number of persons dependent on society for support because businesses
and families plan for financial crises through risk management. For example, families
who buy flood insurance need less help from charitable agencies or the government for
federal flood relief after a flood event.
 Causing fewer disruptions in the economic and social environment because companies
and families are not subject to the big and sudden expense of bearing the cost of a loss.

Benefits of Risk Management to Insurers

From an insurer’s point of view, risk management is beneficial in many ways as follows:

 Creating a positive effect on an insurer’s underwriting results, loss ratio, and overall
profitability because insured’s who practice sound risk management tend to experience
fewer or less severe insured losses than those who do not.
 Providing more thoughtful consumers of insurance because those who practice risk
management are likely to combine insurance with other techniques for handling loss
exposures, and therefore may incur and submit fewer claims.
 Creating innovative products and competitive prices and services because professional
risk managers seek to get the most for their insurance dollars and are often willing to
pay higher premiums in exchange for greater insurance value. As a result, these risk
managers may encourage insurers to be more innovative and competitive in the
products and services they provide.
 Obtaining the respect and business of risk managers and business partners that have a
risk management program.

AN EXAMPLE OF A RISK MANAGEMENT PROGRAM

To show that a risk management program need not be complicated, this example applies
the risk management process to a family situation. Keep in mind, however, that risk
management programs for organizations can be more sophisticated. These programs
become more complex as organizations increase in size and their loss exposures become
more extensive and complicated.

A typical household faces many loss exposures, such as various property and liability
exposures from home and automobile ownership. For example, Tony and Maria Garcia both
work outside their home, and they have three school-aged children. The Garcia’s own two
automobiles and a home with a pool, have a modest savings account, and have invested in
the stock market. After attending a seminar at his company on risk management, Tony has

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

decided that the family should initiate a risk management program of its own.
Remembering the steps in the risk management process, Tony knows that the family must:

 Identify its loss exposures

 Analyze its loss exposures
 Examine the feasibility of risk management techniques
 Select risk management techniques appropriate for the family
 Implement the selected techniques
 Monitor and revise the family’s risk management program

Tony and Maria identified loss exposures by listing the exposures they could think of and
then inspecting their home, looking for other exposures they had not yet considered. For
example, when Tony spotted his son’s hockey stick, he realized that they have a liability
exposure arising from the children’s various athletic activities. His daughter’s saxophone in
her bedroom reminded Tony that the saxophone was not specifically insured and that they
did not have the funds readily available to replace it if it were stolen or damaged. As Tony
viewed their swimming pool full of neighborhood children, he realized that they needed
higher liability limits than their current homeowner’s policy provided. After physically
inspecting their home and property, Maria called their insurance agent and obtained a
household inventory form that they used to inventory their household contents and other
possessions to determine their property loss exposures. The agent also sent them a survey
form to complete, which they used to list potential liability exposures for the family. Maria
and Tony then analyzed all the loss exposures they had identified and attempted to
determine which ones could cause the most frequent or most severe losses.

After identifying and analyzing their property and liability exposures, the Garcia’s third step
was to examine risk management techniques. Tony knew from the seminar that the
possible techniques included avoidance, loss control, noninsurance transfer, and retention
as well as insurance. The Gracias had been thinking of buying a new home near the local
river, but Tony and Maria were concerned that the exposure to flooding was too great;
therefore, they decided not to buy the house, thus using avoidance to eliminate this
exposure. In an attempt to practice sound loss control, they installed deadbolt locks on all
their doors and locks on all their windows. They also installed smoke detectors in several
places in their home, and they are contemplating installing a burglar alarm system if they
can find one that is both effective and affordable.

Tony and Maria explored noninsurance transfer by considering leasing a car, but they found
that they would still be responsible for all liability connected with the use of the vehicle and
would therefore still have to purchase insurance, so they decided this was not a good risk
management technique.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

Because the Garcia’s do not have much disposable income after they pay they their
mortgage, car payments, and other household bills each month, they know that they must
rely heavily on insurance to cover their loss exposures. Although they cannot afford to
retain much of their exposure, they did raise the deductibles on both their homeowners
and personal auto policies from $250 to $500, thereby reducing the cost of their premiums.

They decided not to specifically insure their daughter’s saxophone because their
homeowner’s policy already covered it for fire, theft, lighting, and other causes of loss. They
also decided to apply the retention technique if their daughter simply lost or damaged the
saxophone; in other words, they would replace the saxophone from their personal funds,
make their daughter earn money to replace it, or not by a new one.

Further, they decided to purchase an umbrella policy to cover large liability losses such as
those that might arise from use of autos, the children’s sporting activities, or the poll
exposure. The increased deductibles and retention of the property loss exposures for the
saxophone were about all the retention Tony and Maria thought they could handle. Thus, as
in most households, insurance will play a dominant role in treating loss exposures for the
Garcia family.

By deciding not to purchase the house near the river, installing locks and smoke detectors,
purchasing umbrella insurance, and deciding to retain some exposures, the Garcia’s
effectively completed the third and fourth steps in the risk management process: selecting
and implementing their risk management techniques.

The last step in the Garcia’s’ risk management program was to periodically monitor and
modify their program. For a family, an annual review of the program is probably sufficient
unless the family’s circumstances change significantly. An ideal time for the Garcia’s to do
another physical inspection and inventory would be at the renewal of their homeowners
policy, or if either Tony or Maria changes jobs, receives a large bonus, has a salary increase,
or purchases any type of high-valued property. When Tony first began to monitor their risk
management program, he realized that they had neglected to consider their personal loss
exposures, such as death, illness, injury, or unemployment.
Tony and Maria immediately took steps to modify their risk management program to
include their human loss exposures and thus began the process of exposure identification
and analysis all over again.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

SUMMARY
Risk management is the process of making and implementing decisions to deal with loss
exposures. It involves identifying loss exposures and then applying various techniques to
eliminate, control, or finance those exposures.

Insurance is one of the fundamental techniques of risk management, but it is not the only
one. Risk management can enable a person, family, or business to handle loss exposures.
Risk management is the process of making and carrying out decisions to minimize the
adverse effects of accidental losses and involves the following steps:

1. Identifying loss exposures

2. Analyzing exposures
3. Examining the feasibility of risk management techniques
4. Selecting the appropriate risk management techniques
5. Implementing the selected risk management techniques
6. Monitoring results and revising the risk management program

A risk manager can conduct physical inspections to identify loss exposures and can also use
tools such as loss exposure surveys and loss history analysis. Analyzing loss exposures
includes measuring loss frequency (how often losses occur) and loss severity (the monetary
amount of losses).

After identifying and analyzing loss exposures, the risk manager must examine possible risk
management techniques to handle the loss exposures. These techniques include the
following:

Risk Control techniques:

 Avoidance
 Loss prevention
 Loss reduction
 Separation
 Duplication

Risk financing techniques:

 Retention
 Transfer (noninsurance transfer and insurance)

Selecting the most appropriate techniques involves making decisions based on financial
criteria as well as informal guidelines. Implementing the chosen techniques require making
decisions on what should be done, who should be responsible, how to communicate risk
management information, and how to allocate costs of the risk management program.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

The final step in the risk management process is actually a return to the first. To properly
monitor and revise the program, the risk manager must return to step one and once again
begin to identify new and existing loss exposures.

Risk management has many advantages over merely buying insurance. Although formal risk
management programs are used primarily by businesses, individuals and families can also
benefit from applying risk management to their loss exposures. While a risk management
program for a large business can be complex, a risk management program for a family can
be simple and is well worth the time and effort to implement.

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

REVIEW NOTES

2
Copyright of EXL Insurance Academy Internal
Property and Liability Insurance Principles EXL Insurance Academy

2
Copyright of EXL Insurance Academy Internal