Basic Principles of Life and Health Insurance and Annuities Part 1

Basic Principles of Life and Health Insurance and Annuities TYPES OF INSURANCE COMPANIES Commercial Insurers (also known as private insurance companies ) are in the business of selling insurance for a profit. Commercial insurers offer many lines of insurance. Some sell primarily life insurance and annuities, while other sell accident and health insurance, or property and casualty insurance. An insurance company selling more than one line of insurance is known as a Multi-line insurer. Commercial insurance is divided into two main groups: stock and mutual insurers. Stock Companies are organized and incorporated under state laws for the purpose of making a profit for its stockholders (shareholders). Traditionally, stock insurers are called nonparticipating insurers because policyholders do not participate in receiving dividends or electing the board of directors, unless they are also a stockholder of the company. When declared, stock dividends are paid to stockholders. In a stock company, the directors and officers are responsible to the stockholders. Transformation of a stock insurer into a mutual insurer is termed mutualization, and the reverse is termed demutualization. Dividends from a stock insurer subject to taxation because they are considered profit. Mutual Companies are owned by their policyholders. Mutual insurers are known as Participating Insurers because policyholders PARTICIPATE in receiving dividends and electing the board of directors. When declared, mutual company dividends are paid to the policyholders. Dividends from a mutual insurer are not subject to taxation because the dividends are considered to be a return of premium. The only exception is if the policyowner chooses to let the dividends sit and collect interest. In this case, only the accumulated interest would be taxable. If a company operates as both a PARTICIPATING and NONPARTICIPATING insurer they are known as a MIXED insurer. DIVIDENDS can NEVER be guaranteed regardless of the type of company offering them. Strong Assessment Mutual Companies are classified by the way the charge premium. 1. A pure assessment mutual company operates based on loss-sharing by group members. No premium is payable in advance. Instead, each member is assessed an individual portion of losses that occur. 2. An advance premium assessment mutual, charges a premium at the beginning of the policy period. If the original premiums exceed the operating expenses and losses, the surplus is returned to the policyholders as dividends. However, if total premiums are not enough to meet losses, additional assessments are levied against the members. Normally, the amount of assessment that may be levied is limited either by state law or simply as a provision in the insurer’s by-laws. Fraternal benefit societies are special types of mutual companies, nonprofit religious, ethnic or charitable organizations that provide insurance solely to their members. Fraternal must be formed for reasons other than obtaining insurance. An example of fraternal societies is Knights of Columbus. Risk retention groups are mutual companies formed by a group of people in the same industry or profession. Examples would be pharmacists, dentists, and engineers. 2 Service Providers offer benefits to subscribers in return for the payment of a premium. These services are packaged into various plans, and those who purchase the plans are known as subscribers. Examples of service providers are Health Maintenance Organizations (HMO) and Preferred Provider Organizations (PPO). Reciprocal insurers are unincorporated groups of individual members that provide insurance for other members through indemnity contracts. Each member acts as both insurer and insured and are managed by Attorney in Fact. Reinsurers make arrangements with other insurance companies to transfer a portion of their risk to the reinsurer. The company transferring the risk is called the Ceding Company and the company assuming the risk is the Reinsurer. Captive Insurer is an insurer established and owned by the parent company to insure the parent company’s loss exposure. Home Service Insurers (also known as industrial insurance), is sold by home service or debit life insurance companies. Face amounts are small; usually $1,000 to $2,000 and premiums are paid weekly. Government Insurance: Federal and state government are also insurers. They provide social insurance programs, to protect against universal risks by redistributing income to help people who cannot afford the cost of incurring such losses themselves. These programs have far reaching effects and millions of people depend on them. Types of Government Insurance include: • • • • • Social Security (Old Age Survivor Disability Insurance OASDI – Provides income benefits for the elderly (retirement), survivors of those who died young (young child of a deceased parent), and those qualifying for federal disability. Medicare - Health insurance to CARE for the elderly Medicaid - Health insurance to AID the financially needy. S.G.L.I. and V.G.L.I (Serviceman’s or Veteran’s Group Life Insurance: life insurance for active and retired members of the military) Tri-Care (health insurance for members of the military and their family) Self-Insurers retain risks and must have a large number of similar risks and enough capital to pay claims. However, they may save money if the loss experience is lower than the expected costs. Self-insurers are not a method of transferring risk, rather self-insurers establish their own self-funded plan to cover potential losses. A Self-funded plan is a plan in which an employer pays insurance benefits from a fund derived from the employer’s current revenues Lloyd’s of London is not an insurance company. Members of the association form syndicates to underwrite and issue insurance- like coverage. This is a group of investors who share in unusual risk. HOW INSURANCE IS SOLD Distribution Systems are the ways insurance products are marketed and sold to the public. Insurance can be purchased through licensed insurance producers, who are either agents or brokers, or through a number of other ways. Agents are either captive/career agents or independent agents. Captive agents work for only one insurer. Independent agents work for themselves or for several insurers non- exclusively. Career Agency System: With the career agency system commercial insurers establish offices in certain locations. Career agents are recruited to work at these locations. A general agent hires and trains new producers and supervises 3 a number of other producers. All producers under the career agency system are captive agents and employees of the insurer. Personal Producing General Agency System: With the personal producing general agency (PPGA) system, agents work for an independent agency selling policies from several insurance companies. Unlike the career agency system, agents are not employees of the insurance company. Instead, they work for the PPGA. Furthermore, personal producing general agents primarily sell insurance, instead of recruiting and training new agents as in the career agency system. Independent Agency System (American Agency System): Independent agents represent a number of insurance companies under separate contractual agreements. They may also work for themselves or under other insurance agents. Independent insurance agents have control and ownership over their clients’ accounts. This means they may place clients’ business with a different insurer when policies are up for renewal. Independent insurance agents earn commissions on the sales they make and overrides on sales made by agents they manage. Managerial System: With the managerial system, branch offices are established in several locations. Instead of a general agent running the agency, a salaried branch manager is employed by the insurer. The branch manager supervises agents working out of that branch office. The insurer pays the branch manager’s salary and pays him a bonus based on the amount and type of insurance sold and number of new agents hired. Mass Marketing: Another way to sell insurance is through mass marketing methods. Direct selling (or direct mail) is a mass marketing method where agents are not used. Instead, policies are marketed and sold through television and radio advertisements, print sources found in newspapers and magazines, by mail, in vending machines, and over the internet. INDUSTRY OVERSIGHT AND REGULATION The insurance industry is primarily regulated on a state-by-state basis with minimal federal oversight. The primary purpose of this regulation is to promote public welfare and provide consumer protection and ensure fair trade practices, contracts and prices. Key historical events that have shaped the current regulation include: • 1869 Paul v. Virginia: the U.S. Supreme Court ruled that insurance transactions crossing state lines are not interstate commerce. • 1905 The Armstrong Investigation Act gave the authority to the states to regulate insurance. • 1944 United States v. South-Eastern Underwriters Association ruled that insurance transactions crossing state lines are interstate commerce and are subject to federal regulation. Thus, many federal laws were conflicting with existing state laws. However, this decision did not affect the power of states to regulate insurance. • 1945 The McCarran Ferguson Act states that while the federal government has authority to regulate the insurance industry, it would not exercise its right if the insurance industry was regulated effectively and adequately on the state level. Under the McCarran-Ferguson Act, the minimum penalty of a producer who has obtained personal information about a client without having a legitimate reason to do so is a fine of$10,000. • 1970 Fair Credit Reporting Act: provides individuals privacy protection and fair and accurate credit reporting. 4 Insurance companies are required to notify applicants if a credit check will be made on them. Under the Fair Credit Reporting Act, the maximum penalty of a producer who has obtained Consumer Information Reports under false pretenses is a fine of $5,000. • 1999 Gramm-Leach-Bliley Act (Financial Services Modernization Act): This law repealed the Glass-Steagall Act; this allows Banks, Retail Brokerages and Insurance companies to enter each other’s line of business. • 2001 USA PATRIOT ACT (Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act): as it relates to the insurance industry, is designed to detect and deter terrorists and their funding by imposing anti-money laundering requirements on brokerage firms and financial institutions. • 2003 National Do Not Call Registry: Insurance calls are not exempt from the do not call registry. • 2010 Patient Protection and Affordable Care Act (PPACA): often shortened to the Affordable Care Act (ACA), represents one of the most significant regulatory overhauls and expansions of coverage in U.S.history. The National Association of Insurance Commissioners (NAIC) is an organization composed of insurance commissioners from all 50 states, the District of Columbia and the 4 US territories. They are responsible for recommending appropriate laws and regulations. They are responsible for the creation of the Advertising Code and the Unfair Trade Practices Act, and the Medicare Supplement Insurance Minimum Standards Model Act. The NAIC has four broad objectives: 1. 2. 3. 4. To encourage uniformity in state insurance laws and regulations To assist in the administration of those laws and regulations by promoting efficiency To protect the interest of policyowners and consumers To preserve state regulation of the insurance business Advertising Code: the code specifies certain words and phrases that are considered misleading and are not to be used in advertising of any kind. Unfair Trade Practices Act: gives chief financial officer the power to investigate insurance companies and producers to impose penalties. In addition to that, the act gives officers the authority to seek a court injunction to restrain insurers from using any methods believed to be unfair. NAIFA (National Association of Insurance and Financial Advisors) and NAHU (National Association of Health Underwriters): Members of these organizations are life and health agents dedicated to supporting the industry and advancing the quality of service provided by insurance professionals. These organizations created a Code of Ethics detailing the expectations of agents in their duties toward clients. To sell insurance, each state requires high level of professionalism and ethics. Some of these standards and ethics are: • • Selling to needs: agents must first determine the consumers’ needs then determine which policy fits their needs best. Suitability of recommended products: an ethical agent must be able to assess the correlation between a recommended product and the consumer’s needs. 5 • • • • • Full and accurate disclosure: an ethical agent must inform consumers of the benefits and limitations of recommended products. Recommendations must be accurate, complete and clear. Documentation: an ethical agent must document each client’s meeting and transaction. Client Services: an ethical agent must know that a sale does not mark the end of the relationship, but rather the beginning of the relationship. Therefore, routine follow-up calls are recommended. Buyer’s Guide: each state requires agents to deliver a buyer’s guide to consumers that explain various types of life insurance products and other information on the recommended policy, such as premiums, dividends, and benefit amounts. Policy Summary: help consumers evaluate the suitability of the recommended product. Reserves: are the accounting measurement of an insurer’s future obligations to its policyholders. They are classified as liabilities on the insurance company’s accounting statements since they must be settled at a future date. Reserves are set aside by an insurance company and designated for the payment of future claims. Liquidity: An insurer’s ability to make unpredictable payouts to policyowners Guaranty Associations are established by all states to support insurers and protect consumers in case an insurer becomes insolvent. State life and health guaranty associations provide a safety net for all member life, health, and annuities insurers in a particular state. Guaranty associations protect insureds in the event of insurer insolvency, or inability to pay claims up to a certain limit. Independent Rating Services are credit rating agencies that rate or “grade” the financial strength and stability of insurers based on claims, reserves, and company profits. The nationally recognized statistical rating organizations that rate insurers are A. M. Best, Moody’s, Standard and Poor’s, and Fitch Ratings. Each rating service has its own rating system, but most use an A to F letter grading scheme. 6 Nature of Insurance HAZARDS, PERILS, and RISK Hazard: A condition or situation that creates or increases a chance of loss. For example, icy roads, driving while intoxicated, improperly stored toxic waste. Types of Hazards include: • Physical – Poor health, overweight, blind. • Moral – Dishonesty, drugs, alcohol abuse. • Morale – Careless attitude – reckless driving, jumping off a cliff, stealing, racing motorcycles, carefree, careless lifestyle. This attitude causes an indifference to loss. Loss: is the unintentional decrease in the value of an asset due to a peril. Peril: an immediate, specific event which causes loss, such as an earthquake or tornado. Perils can also be referred to as the accident itself. Risk: the potential for loss Speculative Risk: is a risk that presents both the chance for loss or gain. Gambling is an example. Speculative risks are not insurable. Pure Risk: is the only insurable risk and present a potential for loss only, such as injury, illness, and death. ELEMENTS OF INSURABLE RISK o o o o o o Loss must be due to chance – Causeless, outside the insured’s control. Loss must be definite and measurable – Time, place, amount, and whenpayable. Loss must be predictable – Statistically able to estimate the average frequency and severity. Loss cannot be catastrophic – Must be reasonable, 1 trillion-dollar policy is not reasonable. Loss exposure to be insured must be large – Ideally, common enough that the insurer can pool many homogeneous, or similar, exposure units (law of large numbers). Loss must be randomly selected – Fair proportion of good and poor risks (adverse selection). Law of Large Numbers: The larger the amount of exposures that are combined into a group, the more certainty there is to the amount of loss incurred in any given period. The Law of Large Numbers allows: • • Prediction of individual and group losses based on past experience An increased degree of accuracy in predicting losses in large groups Homogeneous exposure units are similar objects of insurance that are exposed to the same group of perils. For example, insuring a large number of homes in the same geographical area against hail damage. Adverse Selection: Insurers must minimize adverse selection, which is defined as the tendency for poorer than average risks to seek out insurance. For example, a person who takes 12 prescriptions is a poor risk. If an insurer cannot compensate poor risks with better than average risks, then its loss experience will increase and its ability to pay claims may be compromised. Risk Management: is the process of analyzing exposures that create risk and designing programs to handle them. 7 Treatment of Risk – how people deal with risk • • • • • Avoidance – Avoid the risk all together. For example, you can avoid the risk of getting injured in a car accident by never leaving the house. Reduction – Take precautions; minimizing severity of a potential loss. For example, you can reduce the risk of getting injured in a car accident by taking public transportation. Retention (Self Insure) – accepting a risk and confronting it if it occurs. For example, you would retain the risk of getting injured in a car accident by driving without insurance. Transfer (Transference) – Make someone else responsible for a loss. For example, buying auto insurance transfers the cost associated with a car accident from the driver to the insurance company. Buying Insurance is the best way to transfer risk. Risk Pooling (Loss sharing): When a large group of people spread a risk for a small certain cost. It transfers risk from an individual to a group. An example of Risk sharing would be, doctors pooling their money to cover malpractice exposures Reinsurance: Insurers deal with catastrophic loss through reinsurance, which is defined as a contractual arrangement that transfers exposure from one insurer to another insurer. Principle of Indemnity involves making an insured whole by restoring them to the same condition as before a loss. ECONOMIC BASIS OF INSURANCE Human Life Value Approach: A method of determining the financial value of a person’s life based on computing the current value of a person’s future earnings for a certain period of time. For example, if the main income earner of the family makes $50,000 a year and the family would like to make sure they are protected for 10 years in the event something happens to the main income earner. $50,000 (current income) X 10 years (protection) = $500,000 insurance policy. Needs Based Value Approach: A method of determining a person’s financial value based on the amount of money needed for current and future expenses. These expenses include final expenses, spouse’s income, mortgage, college education, retirement, charity donations, etc. For example, a family would like to ensure they can take care of 5 years of annual expenses if something were to happen to the main income earner, and they have an average of $60,000 worth of expenses per year. $60,000 (expenses) X 5 years (protection) = $300,000 insurance policy. 8 Legal Concepts of the Insurance Contract Insurance policies are legal contracts where a promise of benefits is exchanged for valuable consideration (Premiums). Contracts of insurance are binding and enforceable. All parties are subject to specific legal requirements. • Life insurance: the insurance company agrees to pay a predetermined amount – the face amount (or benefit), in exchange for the insured’s consideration (premium). Health insurance: the insurance company agrees to pay a percentage of the insured’s medical bills (or benefit) in exchange for consideration (premiums). • ELEMENTS OF THE CONTRACT Four elements must be present in every contract to be valid and legally enforceable. These elements include: 1. Consideration: Consideration is something of value that each interested party gives to each other. The insured provides consideration with payment of premium. The insurer provides consideration by promising to pay the insurance benefit. The applicant says, “PLEASE CONSIDER me for insurance. Here's my initial premium, my completed application, as well as how much and how often I agree to pay.” 2. Legal Purpose: An insurance contract must be legal and not in opposition of public policy. If an insurance contract has insurable interest and the insured has provided written consent, it has legal purpose. Without legal effect, the contract would be null and void. Said differently, the contract cannot be for an illegal purpose. 3. Offer and Acceptance: An offer is made when the applicant submits an application and initial premium for insurance to the insurance company. The offer is accepted by the insurer after it has been approved by the insurance company’s underwriter and a policy is issued. If no money is given, the applicant is making an invitation. On the other hand, if an offer is answered by a counteroffer, the first offer is void. 4. Competent Parties: All parties must be of legal competence, meaning they must be of legal age, mentally capable of understanding the terms, and not influenced by drugs or alcohol. SPECIAL FEATURES OF INSURANCE CONTRACTS Contract of Adhesion: Because an insurance contract has been prepared by an insurance company with no negotiation, it is considered a contract of adhesion. In a contract of adhesion there is only one author – the insurance company. Insurance carriers are also responsible for assembling the policy forms for insureds. If there is an ambiguity in the contract, the courts always favor the insured over the insurer. Under a contract of adhesion, the terms must be accepted or rejected in full. The customer must adhere to the insurer’s contract without any input of their own. Aleatory Contract: Insurance contracts are aleatory, which means there is an unequal exchange. The premiums paid by the applicant is small in relation to the amount that will be paid by the insurance company in the event of a loss. For example, Tory paid one month’s premium of $50, when she died one month later, her beneficiary received the whole $50,000 face value of Tory’s policy. • • • Consideration may be unequal The outcome depends on chance or uncertain event A legal bet is considered an aleatory contract 9 Unilateral Contract: One sided agreement, where only the insurer is legally bound. In an insurance contract, only the insurance company is legally bound to do anything (pay claims). Uni=one lateral=side, one side - the insurance company is legally bound. The insured does not make a promise to pay premiums, however, if premiums are not paid the insurer has the right to cancel the contract. Personal Contract: Most insurance contracts are personal contracts between the insurance company and the insured individual and are not transferable to another person without the insurer's consent. Life insurance is an exception to this standard as the owner of the policy has no bearing on the insurer’s assumed risk. Therefore, people who own life insurance are called policyowners rather than policyholders and may transfer or assign ownership by notifying the company. Conditional Contract: Insurance contracts are conditional because certain conditions must be met by all parties in the contract. Hence, benefits depend on the occurrence of an event covered by contract. This is needed when a loss occurs for the contract to be legally enforceable. Valued vs. Indemnity: Life insurance contracts are valued contracts, which means it will pay a stated amount. Health insurance contracts are indemnity contracts and will only reimburse the actual cost of the loss (pay medical bills, etc.). The Principle of Indemnity is to restore the insured to the same financial condition as that which existed prior to the loss. You cannot profit from an indemnity contract. Utmost Good Faith: Implies that there will be no attempt by either party to misrepresent, conceal or commit fraud as it pertains to insurance policies. Insurance applicants are required to make full, fair, and honest disclosure of the risk to the agent and insurer. Agents and insurers are required to accurately explain the policy’s features, benefits, advantages, and possible disadvantages to an applicant. Warranties: Statements made by the applicant guaranteed to be true (name, DOB) becomes part of the contract and if found to be untrue, can be ground for revoking the contract. Representations: Statements made by the applicant believed to be true (height, weight) are not part of the contract and need to be true only to the extent that they are material and related to the risk. Concealment: Withholding of information or facts by the applicant (smoker, diabetes). Insurable Interest: Requires that an individual have a valid concern for the continuation of the life or well-being of the person insured. Without insurable interest, an insurance contract is not legally enforceable and would be considered a wagering contract. Insurable interest only needs to exist at the time of the application (the inception of the contract). For example, spouses would typically have insurable interest on each other’s life childhood friends typically would not have insurable interest on each other’s life. An employer may have insurable interest on a key employee’s life. Reasonable Expectations: A concept which states that the insured is entitled to coverage under a policy that a sensible and prudent person would expect it to provide. Reinforces the rule that ambiguities in insurance contracts should be interpreted in favor of the policyholder. Stranger-Originated Life Insurance: In Stranger-Originated Life Insurance, or STOLI, a consumer purchases a life insurance policy with the agreement that a third-party agent/broker or investor will purchase the consumer’s policy and receive the proceeds as a profit upon the consumer’s death. This differs from a standard insurance policy because a 3rd party OWNER will be the one benefiting from the death of the insured. STOLI policies are typically illegal as they violate insurable interest requirements. 10 AGENT AUTHORITY A relationship in which one person is authorized to represent and act for another person or company is established through the law of agency. In applying the law of agency, the insurance company (insurer) is the principal. An agent or producer will always be deemed to represent the insurance company and not the applicant. Regarding the insurance contract, any knowledge of the agent is considered to be the knowledge of the insurance company (insurer). If the agent is working within the conditions of his/her contract, the insurance company is fully responsible. Authorized agent: a person who acts for another person or entity and has the power to bind the principal to contracts. Agents are granted authority by the insurer through the agency contract to transact insurance or adjust claims on their behalf. Some common tasks agents are authorized to perform include solicit applications, collect premiums, render services to prospects and describes the company’s insurance policies. Types of agent authority: • • • Express: Express authority is the explicit authority granted to the agent by the insurer as written in the agency contract. For example, solicit applications and collect premiums. Implied: The unwritten authority of a producer to perform incidental acts necessary to fulfill the purpose of the agency agreement (otherwise unwritten in the contract). For example, since you are authorized to solicit applications and collect premiums, it is implied that you are authorized to set appointments. Apparent: Apparent authority deals with the relationship between the insurer, the agent, and the customer. It is the appearance of authority based on the agent-insurer r elationship. Apparent authority is a situation in which the insurer gives the customer reasonable belief that an agent has the power and authority to bind the principal. For example, since you have all of the insurance application forms and business cards it is apparent to the customer that you are able to help them apply for insurance. OTHER LEGAL CONCEPTS Fiduciary Responsibility – Because the agent handles money of the insured and insurer, he/she has a fiduciary responsibility. A fiduciary is someone in a position of trust and confidence. With insurance, for example, it is illegal for agents to mix premiums collected from applicants with their own personal funds. This is called commingling. Fraud: Fraud is an intentional misrepresentation or concealment of material fact made by one party in order to cheat another party out of something that has economic value. An insurer may void an insurance policy if a misrepresentation on the application is proven to be material. Waiver: Waiver is the voluntarily giving up of a known right. For example, if an insurer chose to approve an application and issue a policy without requesting a medical exam, they cannot later request a medical exam to for that policy in the future. Estoppel: The legal process of preventing one party from reclaiming a right that was waived. Parol Evidence Rule: Rule that prevents parties in a contract from changing the meaning of a written contract by introducing oral or written evidence made prior to the formation of the contract but are not part of the contract. Subrogation is the right for an insurer to pursue a third party that caused an insurance loss to the insured. This is done as a means of recovering the amount of the claim paid to the insured for the loss. For example, if an insured driver’s car is totaled through the fault of another driver; the insurance carrier will reimburse the covered driver as described 11 in the policy and take legal action against the driver -at-fault in an attempt to recuperate the cost of that claim. Void and Voidable Contracts: A void contract is an agreement that does not have legal effect, and therefore is not a contract. Void contracts are not enforceable by either party. Unlike a void contract, a voidable contract is a valid, binding contract which can be voided at the request of a party with the right to reject. Cancellation: the voluntary act of terminating an insurance contract. Endorsement: a written form attached to an insurance policy that alters the policy’s coverage, terms, or conditions. Brokers: a broker or independent agent may represent a number of insurance companies under separate contractual agreements. Professional Liability Insurance (Errors and omissions): A professional liability for which producers can be sued for mistakes of putting a policy into effect. under the insurance, the insurer agrees to pay sums that the agent legally is obligated to pay for injuries resulting from professional services that he rendered or failed to render.