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Chapter 18

Chapter 18 BU353.docx

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Heather Graham

BU353 Chapter 18 – Commercial Insurance Contracts Week 8 Overview of Contracts and Markets -Commercial insurance contracts are broadly classified as either property-casualty or life-health- retirement contracts -The latter classification includes group life, medical, disability, annuity, and related pension contracts associated with employee benefit plan, as well as corporate-owned life insurance on key personnel and other employees Major Types of Commercial Property-Causality Insurance 1. First-party coverage for policyholders’ losses from property damage and associated loss of income 2. Liability and related coverages for injury or damage to third-parties 3. Multiple-peril contracts, which analogous to homeowners insurance cover both property and liability losses in a single contract 4. Surety bonds and financial guarantees -Businesses often retain substantial amounts of loss and/or rely on alternative risk transfer devices where the costs are not reflected in commercial lines insurance premiums -The largest two commercial lines of business are general liability which covers liability arising out of common business hazards, and commercial property -The major types of commercial property-casualty insurance contracts are subject to a large degree of standardization of coverage are legislation, general usage, and court decisions that require insurers to pay for losses that were not intended in the original wording, such as mold or asbestos losses -Separate policies and hundreds of endorsements are available to customize contracts, either by adding coverage for a higher premium, or deleting coverage for a premium reduction -Larger business buyers often negotiate customized terms of coverage to meet special needs -Highly customized contracts often are called manuscript policies -Policy standardization facilitates price and service comparisons among insurers by risk managers, brokers, and other commercial insurance buyers Designing and Negotiating Commercial Insurance Programs -Many medium-to-large businesses are relatively sophisticated in insurance maters and have employees or consultants devoted to risk management and insurance and/or are represented by knowledgeable brokers -Arranging a commercial insurance program typically begins with preliminary program specifications that outline the firm’s willingness to retain risk and general preference for coverages and terms -The broker than provides the specifications to insurers and solicits coverage proposals -The major criteria used to choose among competing proposals include: -The program’s expected cost, on a present value basis -Possible variation in the firm’s cost that arises because the firm retains ultimate responsibility for paying some losses through deductibles -The availability and scope of specialized coverages and endorsements -The types and quality of loss control, claim settlement, and other services provided by the insurer, and the insurer’s willingness and ability to accommodate special needs of the buyer with respect to the timing of premium payments, loss control, ad claim settlement -Any prior experience of the buyer with the insurer -The insurer’s reputation and financial strength -Business buyers and their brokers usually devote substantial effort to evaluating alternative proposals based on these criteria -The most important criterion is the expected cost of the program Deductibles and Self-Insured Retentions BU353 Chapter 18 – Commercial Insurance Contracts Week 8 -Exposure diagram – visually displays how the contract apportions losses between the insurer and the insured -The horizontal axis identifies the possible losses from the exposure, and the vertical axis identifies the amount of loss paid by the firm -Whenever the line describing a firm’s exposure to a loss has a positive slope, then the firm is retaining some of the risk -Per occurrence deductible – the firm pays up to the deductible amount on each loss that is covered -Aggregate deductible – the firm pays all losses during the policy period until the aggregate amount paid equals the aggregate deductible -Aggregate deductibles have the possibility of promoting moral hazard -Self-insured retention – the deductible amount that indicates losses below that point are self- insured or retained -The term “self-insured retention” often indicates that the insurer will only pay losses once they exceed the self-insured retention level -When the insurer pays losses and then bills the insured for the deductible amount, the insurer usually will require that the insured provide a letter of credit from a bank that guarantees that the insured will pay losses as promised Loss Sensitive Contracts -The premiums are paid by the insured depend on the losses that occur during the policy period -Loss sensitive contracts typically shift less risk to the insurer compared with traditional fixed premium insurance contracts -Typically involve greater retention than traditional, fixed-premium policies -To the extent that the insurer initially pays losses for the coverage period that eventually will be reimbursed by the policyholder, the insurer essentially provides a loan to the policyholder Experience-rated Policies -Base the premium for the coming period on the individual insured’s past loss experience -Not designed for the purpose of having the policyholder pay a large portion of the unexpected losses during the coverage period -Used because: -It reduces moral hazard -It formalizes how insurers will update their predictions of expected future losses based on the insured firm’s past losses Large Deductible Policies and Retrospectively Rated Policies -With large deductible policies, the policyholder essentially retains a large amount of the risk, but the insure temporarily finances the losses -A retrospectively rated policy has an up-front premium paid, but the size of the total premium ultimately paid by the policyholder, known as the retro premium depends on the magnitude of losses during the policy period -The policyholder must make an additional payment if the retro premium is greater than the up- front premium; the policyholder can receive a refund if the retro premium is lower than the up- front premium -The retro premium is subject to both a minimum and a maximum amount, both of which as defined when the policy is initiated -The policies must specify the timing of retro premium payments -Businesses choose these types of policies for tax reasons Related Loss Sensitive Plans -With an investment credit program, the insured pays the insurer an amount to cover loss payments up to the desired deductible amount and the insurer, after subtracting some of the BU353 Chapter 18 – Commercial Insurance Contracts Week 8 money for expenses, places the funds in a trust account Loss Portfolio Transfers -Loss portfolio transfer – pays the present value of expected claim payments in one lump sum -The insured firm can report the entire amount paid to the insurer as an expense in the year they are paid Policy Limits and Primary/Excess/Umbrella Policies -Excess policies – provide coverage if losses are in excess of some relatively large threshold, called the attachment point -Primary coverage – a policy that attaches immediately above the firm’s retention -Layering coverage – when firms purchase coverage in layers from different insurers -Layering helps to limit a particular insurer’s exposure to a single loss and to distribute losses across insurers, thereby providing greater diversification -Umbrella policy – covers liability losses from multiple exposures or perils -Structuring commerci
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