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Chapter 2

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FIN 512
Giulio Iacobelli

Chapter 2: Backdrop to Insurance and Insurance Law May 3 , 2012. Introduction: - Since insurance policies are contracts,theyfallunder contract law and wewilllookatthe elementsof contract law - Tort law appliesto private individualsfor wrongsdonetothembyother peopleand itaffects insurance companies asmany potentialwrongscan becovered byan insurance contract (thisleadsto negligence) Insurance: A Brief History: - The medievalera saw the establishment of guilds: groupsofindividuals withcommon goals - Merchant Guilds: those involved in long-distance commerce and localwholesaletrade - Craft Guilds: were those in particulartrades,suchasbakers,brewers,and butchers - Guilds of manufacturers: those whomadedurablegoods,suchastextiles,militaryequipment,and metal ware, andthese were guildswhosold skills and servicessuchasclerks,teamsters,and entertainers - With these poolsof groups,reimbursement duetolossescame fromapooltowhichallmembers contributed - First actualinsurance policy wassigned inGenoa,Italy,in2347 o Underwriter: individualssigned their namesand,under thename,theamount ofrisk they were willing to assume o Mortality Tables:tables that showdeathrate byageusingstatisticallaws ofmortality and the principle of compound interest - The first stock insurancecompanies,insurance companieswithshareholders,wereset upinEngland in 1720and in the USin 1735 - Reserves: fundsset aside for a specialpurpose tomeet unexpectedlyhighlosses - Reinsurance:more than one insurance companycoveringapolicytospread therisk amongseveral insurance companies - The first stock insurancecompany forCanadawasset upinOntariocalledTheCanadaLifeAssurance Company - The WorkersCompensation Act of 1897Britainrequired employerstoinsuretheir employeesagainst accidents at work whichlead to different typesofinsurances(ex:travelinsurance) Basic Characteristicsof Insurance: 1. Pooling or sharing of losses. Pooling iscombining onesrisk exposurewithotherswhohavesimilar riskstodistributethe risk among the group.Thispresupposesthatfuturelossesofthegroupcan bepredicted with some degree of accuracy. 2. Losses must be fortuitous. The losses must be accidental,notdeliberate. 3. Transfer of pure risks. Only pure risk istransferred fromtheinsured totheinsurer. 4. Indemnification of losses. Insurersagree to indemnify insuredsfor losses. To indemnify meansto restore alossinwholeor inpart by payment,repair,orreplacement without the insured making a profitfromtheloss. The remedy of rescission(fromrescinding toannual,repeal,cancel)meanstheinsurance willput the injured partyback intotheposition theinsurance would havebeen in hadthere been no loss. Benefitsand Costs to Society - Benefits: o Indemnification for loss. Theinsured doesnothavetobear thefinancialconsequencesfor major insurable losses. o Less worry and fear. Because peopleareinsured,theydonot havetoworry about and prepare for major losses. o Source of investment funds. Insurance companieshavelargereservesoffundstopayout future losses.These fundsare major source ofinvestment fundsfor theinvestment community. o Loss prevention. Insurance companies playan activerolein developingprogramsto minimize losses.These programsincludefireprevention,preventingtheft and arson,and reducingwork- related disabilities. o Enhancement of credit. Becausepeoplehaveinsurancecoveragefor majorlossexposures, they can more easily obtain credit.In fact,ahomeowner cannotget aresidentialmortgage from a financial institution without showingproofofinsurance coverage. - Costs: o Cost of doing business. Insurancepremiumsincreasecostsfortheinsured.In addition tothe pure premium,the premiumshavetocover thecostsofinsurance operationsand profits.On the other hand,insurance companiesalsoprovidejobstothousandsofemployees. o Fraudulent and Inflated Claims. Claimsfor lossesnotactuallyincurred increasesthecost to everyone whopaysinsurance premiums.Inflatedclaimsshowupasmalingeringafter an illness while collecting disability,claimingfor lossesafter afireor break-inthatdidnotactually happen,and asadditional legalcostsresultingfromlawsuitsthataremadebecausethe plaintiff knowsthe defendant isinsured. Insurable Risk:The basic requirements of an insurable risk areasfollows: 1. Large number of exposure units. Therehavetoenoughinsuredstobeable tohavealargeenough poolof subscribersto spread therisk amongthem. 2. Accidental and unintentional loss. Thelosses havetobefortuitous,thatis,theycant havehappened deliberately.(Thisiswhy self-employed peopleinCanadadonot payemployment insurance premiums-self-employed people are theonlyoneswhocould lay themselvesoff,either outrightor throughbeing unable tofind enoughwork) 3. Determinable and measureable loss. Ifthesize ofthelosscannotbepredicted,thereisabasisfor determining the appropriate premium. 4. No catastrophic loss. Private companiescannotinsurecatastrophiclosses. 5. Calculable chance of loss. The insurer mustbeabletocalculate thechance ofloss. 6. Economically feasible premium. Thepremiumhastobeaffordable Principlesof Insurance: 5 basic principlesthatarereflected inallinsurancecontracts: 1. Principle of Indemnity: statesthat theinsured should notprofitfromthecovered loss but should be restoredto approximately the same financialposition thatexisted prior totheloss.Therearesome exceptionsto thisprinciple: a) In a valued policy,the insured and insurer agreeonthevalue ofsomething,likeapieceof jewelry or a painting,and thatistheamount thatispaidifitislost ordamaged. b) Replacement cost insurance onahomeand contentswillreplace thelost ordamaged item with a new one, not one that reflectsthedepreciated orused value. c) Life insurance policies pay theface value,whichisbased ontheamount purchased at the inception of the policy. While wecan calculate thepresent value ofanindividualsexpected future earnings,there isno waytocalculate theintrinsicvalue ofahuman life. - A person can buy as much life insurance asheor sheisprepared topayfor. 2. Insurable Interest: the insured must havesomekind offinancialinvestment inwhatever or whoever is insured.The person who takes out thepolicymustlosefinanciallyifaloss occurs,ormust incur some other kind of harm if thelosstakes place. Thisrequirement existsforseveralreasons: a) To prevent gambling. Without this, someonemightthink youareaterribledriver ofyour very expensive car and be willing tobet thecost ofafewyearscar insurance premiumsthatyouwill have a serious accident. b) To reduce moral hazard. Without this, someone might first takeout an insurance policyon your life and then murder you tocollect the proceeds. c) Must be able to measure the loss. Theinsurance company hastoknowthatthereisalimiton what it might have to pay out for anygiven lossexposure.Otherwise,ifsomeone isapoor driver,each person in a group offriendscould takeout acar insurance policyonthecar and just sit back and wait to collect. - In property insurancethe insurable interesthastoexist atthetimeoftheloss whilein life insurance, it must exist at the timethe policy istaken out,notat thedate ofdeath. 3. Reasonable Expectations: the insured isentitled tothecoverageheorshereasonableexpectsthe policy to provide,and,to be effective,exclusions,or qualificationsmust be conspicuous,plain,and clear. 4. Subrogation: the insurer (the second party totheinsurance contract)willpaytheinsured (the first party) for a losscaused by a third party andthe insurer isentitled torecover thelossfromanegligent third party (the third party isnegligent bydefinitionbyvirtueofhavingcaused theloss).Thegoal of thisprinciple is: a) Preventthe insured collectingtwice-once fromtheinsurance companyand once fromthe negligent third party b) Hold the guilty person responsiblefortheloss c) Hold down insurancerates-iftheinsurance companywhopaysfor thelosscan recover some its cost from a third party,it doesnothavetoreflect thisamount initspremiums - There are 5 corollariesto thisprinciple: 1. The insurer can recoveronly the amount paid out,notmore. 2. The insured cannot impair the insurersrightsby,for instance,makingadealwiththethird party. 3. The insurer can waive itsrightstorecover-itisnotobligated torecover itsloss. 4. Thisprinciple doesnot apply to lifeinsurance and most individualhealthinsurance contracts. 5. The insurer cannot subrogate itsown insureds-itcannotpayaninsuredslossesand then goafter the same insuredto re
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