CHAPTER 22

LEARNING OBJECTIVES
After studying this chapter,
you will be able to:

* Explain the difference

between pure risk and
speculative risk.

^ List the five steps in the

risk-management decision
process.

J Distinguish uninsurable
risks from insurable risks.

^ Name the two main

government insurance
programs.

3 Explain how insurance

companies decide the amount
of income they need to
generate from premiums.

" Name four types of

business risks that are often
insured.

* Identify the two main

types of health-insurance
coverage.

D
** Describe the five main
forms of life insurance.
 Risk
Management
and Insurance

Liability Insurance: Go Naked or

Go Captive
What is it like when insurance costs skyrocket? "It was a definite shot in the

head," said ACMAT Executive Vice President Henry E. Nozko, Jr. ACMAT's
business is asbestos removal, and because of the hazards involved, the firm's
original insurer canceled the company's liability insurance. ACMAT was
forced to find new coverage, but the cost was now nine times what it had
been. According to new-job estimates, ACMAT could no longer pay for liabil-
ity insurance and realize a profit.
The insurance crisis of the past decade has forced many businesses to
look hard at self-insurance — to decide whether to go naked, to set up self-
insurance nest eggs, or to form their own captive insurance companies (that
is, set up an insurance company whose only — or major — customer is the
business itself)- Businesses choosing to go naked run the profound risk of
having to pay liability awards out of their current budgets. Considering that
RIKINF^ riACC lip awards have averaged over $1 million, how many suits would it take to force
a company into bankruptcy? Businesses choosing to set up nest eggs face
other problems. American Cyanamid Company's Lederle Laboratories lost
liability insurance and decided to self-insure with a liability reserve fund.
The result: The price of its DPT vaccine rose from $4.29 to $11.03 per dose.
Several years ago, Bruce Parker, general counsel for National Solid Wastes
Management Association (NSWMA), was asked his opinion on captive insur-
ing among MSWMA members. "It's the hula hoop of 1986," said Parker.
Self-insurance may be seen as falling into two groups: the risk-retention
group, which forms its own liabilitv insurance company, and the purchasing
group, whose members join together to purchase traditional liability insur-
ance at lower group rates. But the programs of various businesses and city
governments actually fall along a continuum. Hardee's Food Systems buys
catastrophe insurance for any losses over $2 million. Du Pont, on the other
hand, invested $20 million in the creation of two companies that insure not
onlv Du Pont but also 550 other businesses. Together with 50 other firms,
Control Data Corporation formed Corporate Officers & Directors Assurance.
And the business facing the ninefold increase in insurance rates? ACMAT
567
568 Part Seven: The Environment of Business

obtained reasonable rates for itself and for other construction firms by enter-
ing into a joint venture with two other companies and a publicly held in-
surer, by capitalizing a new insurance company.
For all the activity, self-insurance is not without worry. "When a com-
pany insures itself, it's not sharing the risk with anyone," said Marc Rosen-
berg, vice president for federal affairs at the Insurance Information Institute
in Washington. A recent Commerce Department study noted concern about
the potential undercapitalization of risk-retention groups and their inability
to pay claims if they go bankrupt. As for purchasing-group insurers, the study
noted concerns about states lacking the necessary information to protect in-
surance buyers from poor financial management and abusive business prac-
tices. And within the businesses themselves, self-insurers worry more about
safety. "Now that we are dealing with our own money the key to success is
. . .

loss prevention," says Francis X. Flaherty, mayor of Warwick, Rhode Island.

In fear of the lawsuits for which they are now directly responsible, self-insur-
ers install safety features on their products, track driving records of employ-
ees, and regularly test fire sprinkler systems. As part of their insurance pro-
Henry E. Nozko, Jr., execu- gram, some liquid-propane-gas distributors and dealers have inspectors
tive vice president of
hunting cigarette butts in their parking lots.
ACMAT, avoided a ninefold
Even though the prospect of self-insuring offers risks of its own, most
increase in liability insurance
self-insurers plan to continue. "The insurance companies have cast us to the
rates by self-insuring.
wolves more than once," says Robert Esenberg, risk manager for Virginia
Beach, Virginia. "We've got to get control over our own destiny." 1

Protection against Risk

Reasonable or not, risks are inescapable in business. Every business venture
is something of a gamble, because the possibility of loss is as real as the
prospects for profit. And even though managers do everything they can to
ensure that their businesses succeed, they cannot guard against every con-
ceivable form of risk. Consider the experience of Alpine Meadows, a ski resort
near Lake Tahoe. During a violent snowstorm, the resort closed down its 13
lifts and warned skiers to stay off the slopes. Ironically, an avalanche buried

the parking lot and ski-patrol building —

not the ski trails. The families of
damages Amount a court three victims sued Alpine Meadows for $10 million in damages, the amount
awards a plaintiff in a suc- the court awards a plaintiff in a successful lawsuit. Although the jury ruled
cessful lawsuit that the resort was not responsible, Alpine Meadows incurred legal fees of
$700,000 defending itself, and its liability premiums have doubled to
2
$800,000 per year.

Events like this represent one kind of risk that no business can predict or
Pure risk versus escape. Known as pure risk, it is the threat of a loss without the possibility of
speculative risk gain. In other words, a disaster such as an avalanche or a fire is costly for the
business it strikes, but the fact that no disaster occurs contributes nothing to
pure risk Risk that in- a firm's profit. It is pure risk that insurance primarily deals with. Speculative
volves the chance of loss risk, on the other hand, is the type of risk that offers the prospect of making a
only profit; it prompts people to go into business in the first place. Every business
speculative risk Risk that accepts the possibility of losing money in order to make money.
involves the chance of both To see the difference between speculative risk and pure risk, consider
loss and profit Sure-Grip International, a producer of roller skates and skateboards. When
Chapter 22: Risk Management and Insurance 569

roller skating became a sudden craze among teenagers in the late 1970s, the
24-year-old son of the company's president decided to make himself a pair of
skates, using an old pair of Adidas jogging shoes with wheels attached to the
soles.The resulting Joggers represented a real departure from the traditional
high-top boot styles. There was no guarantee that the public would prefer the
new skates, but the company was willing to take a chance. It took a specula-
tive risk in deciding to mass-produce the new style, and the risk paid off.
Within eight months, Sure-Grip became the leading manufacturer of outdoor
3
skates.
same lime, Sure-Grip was facing a variety of pure risks: Fires,
At the
floods, or earthquakes could have destroyed the factory; inventory might
have been stolen from the warehouse; or the company's delivery trucks
might have been involved in accidents, or someone might have been hurt by
defective skates. The company would not have benefited from any of these
events. At best, it could try to prevent a loss.

The process of reducing the threat of loss due to uncontrollable events is

Risk management called risk management. Those areas of risk in which a potential for loss
exists are called loss exposures, and they fall under four headings: (1) loss of
risk management Process property (due to destruction or theft of tangible or intangible assets); (2) loss
of evaluating and mini- of income (either through decreased revenues or through increased expenses
mizing the risks faced by a resulting from an accidental event); (3) legal liability to others, including
company employees; and (4) loss of the services of key personnel (through accidental
4
loss exposures Areas of injury or death).
risk in which a potential for One event may involve several kinds of losses. For example, in 1988 Ash-
loss exists land Oil Inc. had a storage tank collapse, spilling 1 million gallons of diesel
fuel oil into the Monongahela River, which then spread into the Ohio River.
As a result of this one accident, Ashland suffered property loss (because of
destruction of the tank, loss of the fuel, and damage to other Ashland equip-
ment and property), income loss (because of the increased expense of clean-
ing up the spill, which has already cost more than $4 million), and liability
loss (because of the damages claimed by property owners, by local busi-
3
nesses, and in class-action suits). Because of the innumerable situations in
which risk-management problems can arise, the process may be viewed as a
6
Making sure employees decision process made up of five steps.
have — and use —
protective clothing and
other safety devices is one 1 . Identify and analyze loss exposures
way companies can reduce
In order to understand the risk-management process more clearly, consider
risk.
just one of the many loss exposures that a manufacturer of stuffed toys must
face: the product-liability exposure. First, the manufacturer must identify
the ways in which a consumer (most can be injured by a stuffed
likely a child)
toy. Among numerous might choke on button eyes, get
possibilities, the child
sick from eating the stuffing, or have an allergic reaction to any material in
the tov. Second, the company must identify any possible flaws in the produc-
tion or marketing of the toys that might lead to one of these injuries; for
example, a child may have an allergic reaction to the toy if its materials are
not carefully tested for allergenic substances, if impurities enter the toy dur-
ing manufacture, or if the individual toys are not properly packaged (allow-
ing foreign substances to reach them). Third, the manufacturer must analyze
the possibilities in order to compute an expected value of product-liability
losses. Because it is often impossible to identify all the ways in which a
 570 Part Seven: The Environment of Business

product might cause injury or property damage and because it is often im-
possible to calculate an exact value for these losses, the risk-management
specialist must often be satisfied with rough estimates.

2. Formulate alternatives
Once loss exposures have been identified and analyzed, a company must
consider the techniques available to deal with the problems.

risk-control techniques
Methods of minimizing
losses
risk control One way to formulate alternatives is through risk-control tech-
niques, or by minimizing the losses that strike an organization. The ap-
proaches to risk control include risk avoidance, loss prevention, and loss
reduction.
Risk avoidance means eliminating the chance of a particular type of loss.
With rare exception, this approach is extremely difficult. The stuffed-toy
manufacturer could avoid being sued for a child's allergic reaction by not
making stuffed toys. Of course, the company would also be out of business.
Loss prevention means reducing (but not totally eliminating) the chance
of a given loss.The toy manufacturer might reduce the risk of children hav-
ing allergic reactions to the stuffed toys by testing the materials in the toys
before production, by controlling impurities during manufacture, or by care-
fully packaging each toy to guard against foreign substances. Steps typically
taken for other loss exposures include installing overhead sprinklers to pre-
vent extensive damage from fire, putting safety locks on doors to prevent
theft, and checking equipment to prevent accidents.
Loss reduction means reducing the severity of the losses that do occur. By
adhering to all government regulations, the toy company can avoid the addi-
tion of punitive damages to any damages the company may have to pay an
injured consumer. Also, by maintaining good relations with consumers
whose children do have allergic reactions and by paying their medical
expenses, the toy company can reduce the size of the claims they may have
to pay.

risk-financing techniques risk financing Another way to formulate alternatives is through risk-financ-
Paying to restore losses ing techniques, or paying (at the least possible cost) to restore losses that do
occur despite the organization's risk-control efforts. There are two ap-
proaches to risk financing: risk retention and risk transfer.
Risk retention is paying losses with funds that originate within the orga-
nization. Many companies draw on current revenues or set aside a "contin-
gency fund" to cover unexpected losses. For example, a huge corporation
with 100 factories might put aside a certain sum each year to cover possible
fire losses. If the factory should burn down, the company would probably
have enough money on hand to rebuild or to replace it. Setting aside money
on a regular basis could be cheaper than purchasing insurance on each of 100
factories; moreover, the company could earn interest on the reserved cash.
self-insurance Arrange- This sort of self-insurance, like Lederle Laboratories' liability reserve fund,
ment whereby a company has become more common in the last few years because of big increases in
insures itself by accumulat- the cost of some forms of outside insurance. There is a difference, however,
ing funds to pay for any between setting aside self-insurance funds and "going naked" (having no
losses, rather than buying
reserve funds). In a small company, it is virtually impossible to set aside
insurance from another
enough money to cover catastrophes. If disaster strikes, companies that can-
company
not afford insurance may have to borrow funds to cover the losses, or they
could be forced out of business.

.
Chapter 22: Risk Management and Insurance 571

Risk transfer is paying losses with funds that originate outside the organi-
insurance Written contract zation. By purchasing insurance, companies transfer the risk of loss to an
that transfers to an insurer insurance firm, which agrees to pay for certain types of losses. In exchange,
the financial responsibility the insurance firm collects a fee known as a premium. Proper risk manage-
for any losses ment nearly always requires a combination of at least one risk-control tech-
premium Fee that the in- nique and at least one risk-financing technique.
sured pays the insurer for
coverage against losses
3. Select the best alternative
Risk-management techniques should be chosen on the basis of their contri-
bution to the total value of the organization, and this can best be measured
through the organization's net cash flows. The stuffed-toy manufacturer
must decide whether testing materials, controlling impurities during manu-
facture, or individual packaging would best fit the company's cash flow; the
company may choose all three. The company must also decide whether pur-
chasing conventional liability insurance or establishing some form of self-
insurance would have the least impact on, and the best coverage for, the
company. In the end, the best choice may be a combination of several
options.

k. Implement the chosen technique(s)

Implementation requires two types of decisions: (1) technical decisions, or
choosing what action should be taken, and (2) managerial decisions, or
choosing how and by whom this action should be taken.

5. Monitor the results

This final step provides the necessary control for determining whether the
original choice of techniques was correct and, if so, whether conditions have
changed so that a change of techniques is now called for. Effective monitor-
ing has three aspects: (1) setting standards for defining acceptable perfor-
mance, (2) comparing actual results with these standards, and (3) correcting
any step in the process to comply more fully with the standards.

In riskmanagement, it is useful to distinguish between insurable and unin-

Insurable and surable risks (see Exhibit 22.1). Outside insurers are not eager to promise
uninsurable risks that they will pay for losses unless there is some reasonable expectation that
they won't have to. Most (but not all) pure risks are insurable; in general,
speculative risks are not insurable.

Uninsurable risks
uninsurable risk Risk that An uninsurable risk is one that few, if any, insurance companies will agree to
few, if any, insurance com- cover. possible to purchase disaster insurance against such calamities as
It is
panies will assume because floods (available from the federal government), hurricanes, tornadoes, and
of the difficulty of calculat- earthquakes. But there is no way to buy insurance against more prolonged
ing the probability of loss
disruptions such as the drought that scorched much of the Midwest in the
summer of 1988, devastating crops and crippling many farm-related busi-
nesses. Because "drought" was not a named peril on most private insurance
policies in the region, farmers had to seek federal assistance.
572 Part Seven: The Environment of Business

EXHIBIT 22.1 Insurable / Uninsurable

Insurable and Property risks: Uncertainty surrounding the Market risks: Factors that may result in loss of
occurrence of loss from perils that property or income, such as
Uninsurable Risks cause 1. Price changes, seasonal or cyclical

Insurance companies gener- 1. Direct loss of property 2. Consumer indifference

2. Indirect loss of property 3. Style changes
ally consider pure risks Personal Uncertainty surrounding the
risks: 4. Competition offered by a better product
insurable. However, they occurrence of loss due to Political risks: Uncertainty surrounding the
view speculative risks as 1 Premature death
. occurrence of
2. Physical disability 1. Overthrow of the government or war
uninsurable. (Some pure
3. Old age 2. Restrictions imposed on free trade
risks such as flood and Legal liability risks: Uncertainty surrounding the 3.Unreasonable or punitive taxation
strike are also considered occurrence of loss arising out of 4. Restrictions on free exchange or currencies
uninsurable.) 1. Use of automobiles Production risks: Uncertainties surrounding the
2. Occupancy of buildings occurrence of
3. Employment 1. Failure of machinery to function economically

4. Manufacture of products 2. Failure to solve technical problems

5. Professional misconduct 3. Exhaustion of raw-material resources
4. Strikes, absenteeism, labor unrest
Personal risks: Uncertainty surrounding the
occurrence of
1. Unemployment
2. Poverty from factors such as divorce, lack of
education or opportunity, loss of health from
military service

7Z

Other risks that insurers are reluctant or unwilling to consider include

potential government actions and general economic conditions. Such uncer-
tainties as changes in the law and economic fluctuations are beyond the
realm of insurance.
Sometimes uninsurable risks become insurable when enough data be-
come available to permit accurate estimation of future losses. Insurers were
reluctant to cover passengers on airplanes in the early years of this century.
But decades of experience have made these risks predictable. Similarly, com-
panies can now buy insurance against the prospect of a foreign country seiz-
ing their overseas factories, mines, or offices.

Insurable risks
insurable risk Risk tor An insurable risk —
one that an insurance company wil cover — generally
which an acceptable prob- meets the following requirements:
ability of loss may be calcu-
lated and that an insurance The peril insured against must not be under the control of the insured. This
company might therefore be means that insurers do not pay for losses that are intentionally caused by
willing to cover the insured, caused at the insured's direction, or caused with the insured's
collusion. For example, a fire-insurance policy excludes loss caused by the
insured's own arson. It does, however, include loss caused by an employee's
arson.
Losses must be calculable, and the cost of insuring must be economically feasi-
ble. To operate profitably, insurance companies must have data on the fre-

quency and severity of losses caused by a given peril. If this information

covers a long period of time and is based on a large number of cases, insur-
ance companies can usually predict accurately how many losses will occur
in the future. For example, the number of people who will die each year in
the United States has been calculated with great precision, and insurance
companies use this information to set policyholders' life-insurance
premiums.
 Risk Management and Insurance 573

Earthquakes are insurable
risks, unlike prolonged dis-
asters such as drought.
claims Demands for pay-
ment by an insurance com-
pany due to some loss by
the insured
deductible Amount of loss
that must be paid by the
insured before the insurer
will pay for the rest
There must be a large number of similar cases subject to the same peril. The
more cases there are in a given category, the more likely it is that future
experience will reflect insurance-company predictions. Insurance compa-
nies are therefore more willing to issue insurance for risks that many busi-
nesses or individuals lace. For example, fire is a common danger that threat-
ens virtually all buildings, so insurance for loss by fire is easy to come by.
But the possibility that John McEnroe will fracture his serving arm and
miss several lucrative tennis matches is an unusual risk because there is
only one John McEnroe. Most insurance companies would not consider issu-
ing this sort of insurance.
The peril must be unlikely to affect all insured simultaneously. Unless an insur-
ance company spreads its coverage over large geographic areas or a broad
population base, a single disaster might force it to pay out on all its policies
at once.
The possible loss must be financially serious to the insured. An insurance com-
pany could not afford the paperwork involved in handling numerous small
claims (demands by the insured that the insurance company pay for a loss)
of a few dollars each (nor would a business be likely to insure such a small
loss). As a result, many policies have a clause specifying that the insurance
company will pay only that part of a loss greater than an amount stated in
the policy. This amount, the deductible, represents small losses that the
insured has agreed to absorb. Your health insurer, for example, may require
you to pay up to $100 of your physician's fees, and the company that insures
your car may require you to pay the first $200 of any needed repairs.

The Insurance Industry

In its simplest form, the idea of insurance is probably as old as humankind.
Since the days of the cave dweller, groups of people have banded together to
help one another in times of trouble. They have stored food in years of plenty
so that they would have something to draw on during years of famine. If their
neighbor's house burned, they helped rebuild it, with the tacit understanding
that the favor would be returned if they were ever in need. Over the years, the
informal cooperation between neighbors gradually became institutionalized.
Mutual-aid societies were formed, and dues were collected from the mem-
bers for use in emergencies. Ultimately, modern insurance companies
emerged, with professional management.

Private insurance companies are businesses. The product they sell is finan-
Basic insurance cial protection. To succeed, they must cover their costs, which include pay-
concepts ments to cover the losses of policyholders as well as sales and administrative
expenses, dividends, and taxes.
In order to decide how much income they need to generate from premi-

actuaries Persons em-

ums, insurance companies must predict the amount they will probably have
ployed by an insurance to pay in claims over a given period. The amount of the premium for a spe-

company to compute ex- cific type of risk is based mainly on the probability of loss. For example,

pected losses and calculate because fire is a greater risk for wooden buildings than for brick ones, insur-
the cost of premiums ance premiums tend to be higher for wooden structures. The people who
figure out how many deaths, illnesses, fires, accidents, natural disasters, and
underwriters Insurance
company employees who so on are likely to occur over the course of a year are called actuaries; they
decide which risks to insure, develop "actuarial tables" of probabilities for various occurrences that can
for how much, and for what be used to calculate premiums. Underwriters, insurers, then decide which
premiums. risks to insure and under what terms.
574 Part Seven: The Environment of Business

EXHIBIT 22.2 /
$400 $400 $400 $400 $400 $400 $400 $400 $400 $400
How Law of Large
Che
Numbers Works $400 $400 $400 $400 $400 $400 $400 $400 $400
$400 $400 $400
An insurance company cov-
ers the cost of a policyhold- $400 $400 $400 $400 $400 $400 $400 $400 $400 $400 $400 $400
er's loss out of the premi-
ums paid by a large pool of $400 $400 $400 $400 $400 $400 $400 $400
policyholders. Thus, if 100
policyholders pay $400 each $400 $400 $400 $400 $400 $400 $400 $400
Fire-insurance pool
to insure against fire dam- $40,000
$400 $400 $400 $400 $400 $400 $400 $400
age, the insurance company
can afford to compensate
one policyholder who actu-
ally suffers fire damage with
$400 $400 $400 $400
<^r\ V
$400 $400 $400

$40,000. $400 $400 $400 $400 $400 $400 $400 $40o\ $400 $400 $400

/
$400

>
$400

$400
$400

$400
$400

$400
$400

$400
$400

$400
$400

$400
$400

$400
$400

$400
«
$400
$400

$400
$400

<L

law of large numbers
Principle that the larger the
group on which probabilities
are calculated, the more
accurate the predictive value
In calculating probabilities, actuaries rely on the law oflarge numbers —
that is, more accurate the predic-
the larger the pool of insured parties, the
tions of probable loss. Insurance companies don't count on making a profit
on any particular policy, nor do they count on paying for a single policyhold-
er's losses out of the premium paid by that particular policyholder. Rather,
each insurance company pays for a loss by drawing money out of the pool of
premiums it has received from all its policyholders (see Exhibit 22.2). In this
way, the insurance company redistributes the cost of losses from a single
individual to a large number of policyholders.

When most people think of insurance, they think of private insurance the —
Insurance kind purchased from an insurance company. But actually, the largest single
providers source of insurance in the United States is the government, which accounts
for about 47 percent of the total insurance premiums collected for all types of
7
coverage combined.

Government insurance programs

Most government insurance programs are designed to protect people from
loss of income, either because they have reached retirement age or because
they have lost their job or become disabled. Unlike private insurance, which
is voluntarily chosen by the insured, government-sponsored programs are

compulsory. The largest of the public insurance programs is Social Security,

which was created by the federal government during the Great Depression of
the 1930s. Officially known as Old-Age, Survivors, Disability, and Health
Insurance, this program covers 9 out of 10 workers.
The basic purpose of the Social Security program is to provide a mini-
mum level of income for retirees, their survivors, and their dependents, as
well as for the permanently disabled. The program also provides hospital
and medical payments —
known as Medicare —
for people age 65 and over.
Chapter 22: Risk Management and Insurance
575

Social Security benefits vary, depending on how long a worker has

contrib-
uted to the svstem. In 1988, 38.4 million people received Social Security
"
11
benefits. The program is funded by a tax paid by workers and their employ-
ers. In most cases, these taxes are automatically deducted from
each pay-
check. Currently, there are three workers for every beneficiary, but by the
year 2000, the ratio of workers to retirees will be 2 to 9
1

The Social Security Act of 1935 also provided for federal and state coop-
eration to insure workers against unemployment. The cost is borne by em-
ployers. A worker who becomes unemployed for reasons not related to per-
formance is entitled to collect benefits. The amount of the benefit is usually

tied to the employee's total earnings during the previous year, but both the
amount and the length of time the benefit is available vary from state to
state.

Private insurance companies

There are about 5,000 private insurance companies in the United States,
stock company Profit- most of which are either stock or mutual companies. 10 A stock company is a
making insurance company profit-making corporation with shareholders who expect to receive divi-
owned by shareholders dends on their investment in the company. A mutual company is a nonprofit
mutual company Non- cooperative owned by the policyholders; any excess income is returned to the
profit insurance company policyholders, either in the form of dividends or as a reduction in their insur-
owned by the policyholders ance premiums. In terms of premium volume, stock companies dominate the
property and liability insurance industry; mutual companies dominate the
medical and life insurance industry. In addition, a handful of companies take
on unusual risks, such as insuring racehorses, athletes, and movie stars. The
most famous of these is Lloyd's of London, an association of individuals who
issue insurance on a cooperative basis.
Recently, a number of organizations have been created by groups of in-
surance buyers who are looking for better coverage and more affordable pre-
miums than they can get through traditional insurance companies. ACMAT
overcame its ninefold rate increase by entering such a venture with other
companies. Another venture is the ACE Insurance Company, which is jointly
funded by 33 major American corporations, including IBM, General Electric,
Ford Motor Company, and Chase Manhattan. In the event of a major prob-
lem, a participating company would exhaust its own insurance coverage and
then turn to ACE for additional coverage of up to $100 million. 11

Historically, the private insurance business has gone through cycles of profit
Insurance-industry and loss keyed to ups and downs in the financial markets. When interest rates
problems are high, the insurance companies make extra money in the form of invest-
ment income. When interest rates fall, this form of income diminishes, and
the companies must rely more heavily on income from premiums.
The cycle has been particularly volatile among stock companies that spe-
cialize in property insurance. When interest rates soared to over 20 percent
in 1979, these companies launched an all-out campaign to attract new poli-
cyholders, hoping to invest the premiums at high interest rates. Many com-
panies were so eager to obtain business that they slashed their premium
rates and took on poor risks. When interest rates fell, these firms found them-
selves in trouble, paying out more in claims than they were taking in. In
1987, insurance companies issuing policies against casualty reported losing
12
$9.6 billion on premium income of $189 billion.
576 Part Seven: The Environment of Business

Average award
$1,500

$1,400

$1,300

$1,200

« $1,100
I
§ $1,000
I
« $900

$800

$700

$600

$500

$400
1$ '81 '82 '83 '84 '85 '86 '87

EXHIBIT 22.3
Lawsuits Related to
Products
The size of the average Many insurers contend that their problems are aggravated by the trend
award for damages in toward more lawsuits and higher awards for damages. (Exhibit 22.3 shows
product-liability lawsuits has the trends in lawsuits related to products causing damage, injury, or death.)
increased in recent years To settle these suits, insurers are having to pay out far more than they had
along with the number of anticipated when they set their premium rates. In an effort to "get well," the
awards of $1 million or insurers arenow boosting premiums or refusing to write policies for types of
more. insurance in which future claims may be unpredictable. The insurance crisis
has created dilemmas for many companies, including ACMAT and Lederle
Laboratories, discussed at the beginning of the chapter.

Types of Business Insurance

Ifyou were starting a business, what type of insurance would you need? To
some extent, the answer to that question would depend on the type of busi-
ness you were in. In general, however, you would probably want to cover
your property against losses and protect assets such as cash and securities
from loss due to natural or human causes. In the discussion of risk manage-
ment, four types of loss exposure are listed: loss of property, liability, loss of
income, and loss of services of key personnel. Businesses can purchase insur-
ance to cover each of these four areas. Exhibit 22.4 lists some of the more
widely purchased types of business insurance available.

. , Property can be lost through a variety of causes, including accidental dam-

OSS OT properly and theft. Property can also be lost through employee
a g e natura } di sas ter,
dishonesty and nonperformance.
Chapter 22: Risk Management and Insurance 577

EXHIBIT 22.4
Business Risks and
Loss of property
Protection Due to destruction Fire insurance
Disaster insurance
Marine insurance
Due to dishonesty or Fidelity bonding
nonperformance Surety bonding
Credit life insurance
Crime insurance
Liability Comprehensive general liability insurance
Automobile liability insurance
Workers' compensation insurance
Umbrella liability insurance
Professional liability insurance

Loss of income Business-interruption insurance

Extra-expense insurance
Contingent business-interruption insurance

Loss of key personnel Key-man insurance

Loss due to destruction or theft

When a cannery in California ships jars of pizza sauce by truck to New York,
the goods face unavoidable risks in transit. One wrong turn could cover a
whole with broken glass and sauce, which would represent a sizable
hillside
loss to the manufacturer. The canning factory itself is vulnerable to fire,
flood, and (especially in California) earthquake.
property insurance Insur- Property insurance covers the insured for physical damage to or destruc-
ance that provides coverage tion of property and also its loss by theft. This insurance comes in three
for physical damage to, or varieties: fire insurance, natural-disaster insurance,and marine insurance.
destruction of. property Despite name, marine insurance covers losses related to transportation on
its

water and on land. (In 1988 the Insurance Sendees Office [a trade association
of insurers] introduced a new property and liability insurance program for
commercial lines so that businesses may now purchase one or more of the
following: commercial property, commercial crime, commercial boiler and
machinery, commercial inland marine, commercial general liability, and
commercial auto.) 13
In purchasing property insurance, the buyer has a choice between two
options: replacement-cost coverage or depreciated-value coverage (actual
replacement cost Cost of cash value insured). Replacement cost coverage is more expensive but pro-
replacing a lost or damaged vides more protection because it entitles the policyholder to buy new prop-
item with a new one ertv to replace the old. Depreciated value coverage assumes that the property

depreciated value Value of that was lost or damaged was worth less than new property because the
something after it has been owner had used it for some period of time.
in use for a time, which is

less than its value when

new Loss due to dishonesty or nonperformance

fidelity bond Mechanism Dishonest employees and criminals outside the company pose vet another
that protectsemployers threat to business property and assets. There are various ways ot dealing
from dishonesty on the part with this problem. One is a fidelity bond, which protects the insured business
of employees against dishonest acts committed by employees, such as embezzlement, ior-
eerv, and theft.
578 Part Seven: The Environment of Business

surety bond Mechanism Another is a surety bond, a three-party contract in which one party
that protects companies agrees to be responsible to a second party for the obligations of a third party.
against losses incurred For example, in public construction projects, the law requires surety bonds
through nonperformance of that guarantee the performance of every contract. The insurance company
a contract
would pay damages for any uncompleted or incompetent work of its in-
sured — a construction company, let's say — that had been awarded a con-
tract by a municipality. Similar bonds are required for municipal contracts
for garbage collection and snow removal as well as for elected officials, who
must be insured against untrustworthiness while in office. Surety bonds are
also commonly used in the private sector. Railroads, for example, permit
shippers to defer payment of freight charges with the filing of a bond; corpo-
14
credit life insurance Cov- rations reissue lost or destroyed securities if there is a satisfactory bond.
erage that guarantees repay- Another form of insurance against loss due to nonperformance is credit
ment of a loan or an life insurance, which guarantees repayment of the amount due on a loan or
installment contract if the an installment contract if the borrower dies. Yet another is crime insurance,
borrower dies which covers loss from theft of any kind, whether it is burglary (forcible entry
crime insurance Insurance into the premises) or robbery (taking property from another person by vio-
against loss from theft lence or the threat of violence).

All licensed drivers are aware that they may be held liable for substantial
Liability damages they cause an auto accident. Similarly, businesses are liable for
if

any injury they cause to a person or to the property of others. Liability insur-
liability insurance Insur- ance covers the insured for losses arising from injury to an individual, death
ance that covers losses aris- due to something the company does, and damage to the property of others.
ing either from injury to an
individual or from damage
to other people's property Types of liability insurance
What might make a company liable
sorts of accidents or corporate practices
for damages? The types of accidents that most commonly result in legal
action are injuries received on the company's property, injuries caused by
the company's products, injuries to the company's own employees, and inju-
ries from professional malpractice. Injuries received on the company's prop-
erty mayaffect employees or outsiders; for instance, an elevator accident
may involve either, whereas injury resulting from the collapse of metal
shelving in a warehouse is likely to affect employees only. Examples of inju-
ries caused by a company's products are food poisoning and choking on a
loose toy part. Malpractice includes bodily injury arising from treatment by
doctors and dentists and loss of assets due to mishandling by lawyers and
comprehensive general lia-
accountants. To accommodate these various forms of liability, the insurance
bility insurance Liability
industry has created various types of liability policies.
insurance that covers a wide
variety of losses, except cer- comprehensive general liability For basic coverage, most companies carry
tain losses specifically men- comprehensive general liability insurance, which automatically provides
tioned in the policy protection against all forms of liability not specifically excluded under the
product liability Com- terms of the policy. Most comprehensive general liability policies cover lia-
pany's responsibility for in-
bility for completed projects, the work of independent contractors, and any
juries or damages that result new operations added to the business. 15 In addition, these policies usually
from use of a product the include product liability coverage, which protects insured companies from
company manufactures or being threatened financially when someone claims that one of their products
distributes caused damage, injury, or death. (As noted in the discussion of property in-
Chapter 22: Risk Management and Insurance
no-fault insurance laws
Laws limiting lawsuits con-
nected with auto accidents
workers' compensation
insurance Insurance that
partially replaces lost in-
come, medical costs, and
rehabilitation expenses for
employees who are injured
on the job
umbrella policies Insur-
ance that provides busi-
nesses with coverage be-
yond what is provided by
other parts of a
liability
policy
579
surance, new policies were created in 1988 for property and liability
insurance.)
automobile liability Many companies also carry insurance that specifically
covers liability connected with any vehicles owned or operated by the com-
pany. In states having no-fault insurance laws, which limit lawsuits con-
nected with auto accidents, this form of coverage is less important.
workers' compensation Another form of liability coverage, workers' compen-
sation insurance, pays the medical bills of employees who are hurt or become
ill as a result of their work. It covers loss of income by occupationally injured
or diseased workers plus rehabilitation expenses for these workers, and it
provides death benefits to the survivors of any employee killed on the job. In
most cases, it covers both full- and part-time employees. Workers' compensa-
tion insurance is required by law throughout the United States. It can be
obtained through adequate self-insurance in some states, from state funds in
some states, and from a private insurer in most states.
An employee who is disabled temporarily receives weekly benefits, usu-
ally after a waiting period of a few days to two weeks, depending on the state.
If the injury is fatal, dependents receive weekly payments for a specified
period. In nearly all states, the weekly benefit rate for an injured worker is
normally two-thirds of the employee's weekly wage. The benefits received
under workers' compensation programs total about $20.5 billion per year. 16
Over the years the courts have interpreted workers' compensation laws
broadly, holding employers liable for injuries related even indirectly to an
employee's work. In one case, a worker in Rhode Island got angry, punched a
coffee machine, and permanently damaged an arm. The worker was awarded
$7,500 because the injury was "deemed to have met the requirements for a
compensable situation — arising out of and in the course of employment.
"' '
This type of insurance also protects businesses, however, by guarantee-
ing that no assets will be lost if the injured employee wins a lawsuit for
damages greater than those covered in the policy. The premiums vary from
state to state, depending on the hazards in particular lines of work. But the
premiums have more than doubled in recent years, for a variety of reasons:
Higher benefits are being paid as wages and living costs rise; the courts have
expanded the definition of "work-related injuries," as we have seen; and
lawsuits have opened up new areas of coverage. Work-related illness, espe-
ciallv lung ailments from chemicals and fibers encountered on the job, is an
area in which workers' compensation claims seem certain to grow.
To find less expensive alternatives, many businesses are turning to self-
insurance programs for workers' compensation coverage. Another way to
avoid paying high premiums is to cut down on the number of employee
claims by reducing injuries and job-related illnesses. With that aim in mind,
many companies are examining their safety programs more closely.
umbrella liability insurance Umbrella policies are designed to give extra
protection above and beyond that provided under other liability policies.
Because of the unknowns associated with this type of coverage, many insur-
ance companies have recently raised their rates for umbrella coverage by up
to 1,000 percent or have refused to issue this form of policy. As a result, some
insurance buyers such as Du Pont and ACMAT have set up their own insur-
ance companies to obtain additional coverage.
580 Part Seven: The Environment of Business

professional liability insurance Doctors, lawyers, accountants, architects,

malpractice insurance In-
surance chat covers losses
arising from damages or in-
juries caused by the insured
in the course of performing
professional services for
clients
stockbrokers, and other professionals usually carry some form of malpractice
insurance. This type of coverage, which protects professionals from financial
ruin if they are sued by dissatisfied clients, is another form of insurance that
is becoming increasingly — and prohibitively —expensive. In 1986 small
accounting firms faced premium increases of 300 to 400 percent. And because
of the escalating costs of malpractice insurance, thousands of obstetricians
18
decided to stop delivering babies. Premiums were slightly lower in 1987,
19
and thev remained stable in 1988.

The liability-insurance crisis

Accountants and doctors are not the only ones with problems. Preschools,
chemical companies, medical-equipment manufacturers, drug companies,
and corporate board members are also facing huge rate increases.
Insurers argue that they are forced to raise rates because of the unpre-
dictability of future claims. They blame the legal system for embracing the
strict product liability concept of strict product liability, which extends the scope of liability to
Responsibility of businesses include even indirect involvement in loss, injury, or death regardless of ap-
for damages or injuries re- parent or actual fault. For example, some court decisions have held that
sulting from the use of their manufacturers of goods are liable for any damages the products cause. Other
products, whether or not court rulings have held that a manufacturer (1) must protect employees from
the companies are proven
diseases and injuries sustained during the manufacture of a product with
to have been negligent
dangerous elements such as asbestos-lined heat chambers, and (2) has a
"duty to warn" customers of those dangers. A company that provides ser-
vices rather than goods may also be sued for injury or damages.
Changes in the law have also made it easier to sue. More and more work-
ers and consumers are taking companies to court for injuries suffered on the
job or while using the company's products. This propensity to sue poses
problems not only for the companies and their insurers but ultimately for the
public as well. Although the liability insurance crisis has recently begun to
let up a bit, companies are still facing problems.

consequences of the crisis Companies that can't obtain adequate coverage at

a reasonable price are withdrawing from high-risk businesses —
to society's
detriment. For example, the threat of liability suits prompted seven out of
20
nine U.S. firms to stop making anesthesia equipment. Pharmaceutical
companies are cutting back on research and development of new drugs in the
wake of large settlements involving medicines. One company, Lederle Labo-
ratories, was sued 109 times in 1985 because of risks associated with its polio
and DPT vaccines. As a result, the company had trouble obtaining liability
coverage. It now relies on self-insurance, and the price of the product has
21
soared. Fifteen doses that cost $5.43 in 1981 now cost $165. 50. At that price,
parents might be tempted not to have their children vaccinated. But in many
states, the law savs a child can't enroll in school without DPT shots.

proposed solutions It's debatable who's at fault in the current liability-insur-

ance crisis. Businesses blame the insurance industry for being profit-hungry
and jacking up premium rates to unreasonable levels; the insurance industry
blames the legal system and points the finger at greedy lawyers; the lawyers
blame business for failing to design safer products and take better care of
employees.
Chapter 22: Risk Management and Insurance
Loss of income
business-interruption in-
surance Insurance that
covers losses resulting from
temporary business closings
extra-expense insurance
Covers the added expense
of operating the business
temporary facilities after
event such as a fire
contingent business-inter-
ruption insurance Protects
a business from losses due
to an interruption in the
delivery of supplies
LOSS Of key
personnel
key-man insurance Covers
loss of a key employee
581
Various solutions have been suggested, most of them involving govern-
ment action to limit damages in malpractice, negligence, and personal-
injury cases. On the federal level, Congress passed legislation in 1988 to pro-
tect federal employees from professional liability suits. And across the na-
tion, 33 states passed major tort reform legislation in 1986 and 1987. 22 In
1988, the California Supreme Court upheld the constitutionality of Proposi-
tion 51, an initiative passed by the voters in 1986. 23 The proposition was
intended to bring premium relief to businesses and local governments by
controlling the size of punitive-damage awards in liability cases, thus attack-
ing the concept of "joint and several liability," which permits a victim to sue
several parties for the same incident and to make the one with the most
money pay the bulk of the damages, regardless of how much that party was
at fault.
While the government struggles with legal reforms, the insurance indus-
try working out solutions of its own. In addition to raising premiums and
is
refusing to handle certain types of insurance, the industry is developing new
wrinkles in its policies. One common solution is to raise deductibles so that
the policyholder bears a larger share of the loss. Another approach lowers the
maximum amount the insurer will pay so that instead of getting, say, up to
$10 million in the event of pollution liability law suits, a company would be
covered up to only $8 million. Yet another approach is the so-called claims-
made policy, which provides protection only for claims made during the
period in which a policy is in effect. This sort of policy gets insurers off the
hook for claims made under policies issued 30 and 40 years ago that have
24
long since expired.
A fire in a supermarket chain's warehouse would result in property loss, but
that's only part of the story. Fires also disrupt the business, often costing the
company more than repairs or replacement of damaged stock. Expenses con-
tinue — salaries, interest payments, rent — but no new revenues are coming
in. Disruption also results in new expenses: leasing temporary space, paying
overtime to meet work schedules with a reduced capacity, or buying addi-
tional advertising to assure the public that the business still exists. A pro-
longed interruption of business could even cause bankruptcy.
in For this reason many companies carry insurance protection over and
an above coverage for mere loss of property. Available coverage includes busi-
ness-interruption insurance, which protects the insured when a fire or other
disaster causes a company to shut down temporarily; extra-expense insur-
ance, which pays the additional costs of maintaining operations in tempo-
rary quarters; and contingent business-interruption insurance, which pro-
tects against loss of business due to an interruption in the delivery of
essential supplies.
In businesses, just one executive or employee has expertise or experi-
some
ence thatis cruc [ a \ to t he company's operation. Key-man insurance can be
purchased by a company to protect itself against the financial impact of the
death of such a key employee. (This type of insurance is also discussed in the
section on life insurance.)
582 Part Seven: The Environment of Business

Types of Employee Insurance

Besides insuring their property and assets, most businesses buy coverage for
risks to employees. Disease and disability may cost employees huge sums of
money unless they are insured. In addition, death carries the threat of finan-
cial hardship for an employee's family. Unemployment caused by a slow-
down in business threatens even model workers with loss of income.
Federal law requires employers to pay half the cost of employees' Social
Security taxes and to help finance state unemployment insurance funds. All
50 states mandate workers' compensation, and a few states even require
employers to provide disability income insurance. But beyond these manda-
tory programs, most businesses also provide employees with substantial
additional coverage.
Generally, companies are interested in three kinds of employee protec-
tion: health insurance, life insurance, and pension plans (discussed in Chap-
ter 10). This protection is usually provided through group policies, which are
sold to the company by the insurer. In some cases, the employer pays for the
insurance in full; in other cases, employees pay part or all of the cost through
a payroll deduction plan.

Today, employee health insurance is more complete than it was 10 or 15

Health insurance
years ago. Almost 75 percent of the population under 65 is covered by em-
ployer-provided health insurance, with the employer typically paying about
80 percent of the premiums. In 1987 corporations spent about $144 billion for
group health-insurance protection for more than 134 million workers and
25
their families, almost triple the amount spent in 1980 (see Exhibit 22. 5). In
fact, corporate spending on health care in 1987 surpassed after-tax corporate
26
profits, which were $140 billion.
There have traditionally been two main types of health insurance one —
covering medical expenses, the other guaranteeing income in the event of a
disabling illness or injury. That framework still exists, but today there tends
to be more coverage for "ordinary" care as well as for serious medical prob-
lems. Dental coverage, for example, is more widespread: Almost 95 million
people now have some form of dental insurance, compared with 18 million in
27
1975. As for group disability protection, benefits now last longer and pay-
ments are higher. Waiting periods are longer, however: Many policies do not
begin paying benefits until six months after the disability has occurred.

Medical coverage

hospitalization insurance Health insurance covers a variety of medical expenses. Although the types of
Health insurance that pays coverage available have increased in the last few years, the vast majority of
for most of the costs of a programs fall into five general areas:
hospital stay
Hospitalization insurance: Pays the major portion of the cost of a hospital
surgical and medical insur- stay.Coverage varies, but most policies pay all or part of the cost of a semi-
ance Insurance that pays private room and the total cost of drugs and services while the insured is in
for the costs of surgery and a hospital.
physicians' fees while a per- * Surgical and medical insurance: Pays the costs of surgery and of physicians'
son is hospitalized or recov- in-hospital care. Policies usually specify a maximum payment for each sur-
ering from hospitalization gical procedure covered.
Chapter 22: Risk Management and Insurance 583

major-medical insurance Major-medical insurance: Covers all the medical expenses that fall outside
Insurance that covers many the coverage limits of hospitalization insurance and surgical and medical
medical expenses not cov- insurance. Frequently, the insured must pay at least $100-$250 of her or his
ered by other health-insur- own medical costs per year. But a typical major-medical policy may pay 80
ance plans percent of all medical expenses up to $1 million; after the employee's own
co-payment in a given year has passed $1,500, most plans pick up 100 per-
28
cent of the rest.
dental and vision insur- Dental and vision insurance: Covers a fixed percentage of an employee's
ance insurance that covers expenses for eyeglasses, medically prescribed contact lenses, and various
a portion of the costs of forms of dental work. The best plans, however, have a "stop-loss" cutoff of
dental and eye care about $1,000, after which the insurance company pays the whole tab. 29
These programs are becoming increasingly popular.

It used to be that when from Clearwater, Florida, was offered medical cover-
an employee quit or was age by her husband's former employer at an individ-
fired, his or her health- ual rate of $430a month — only $19 less than her
insurance coverage was terminated. But not any entire monthly income from Social Security.
more. In 1986 a federal law went into effect repre- But while employees are reaping benefits from
senting a major development in employee benefits COBRA, employers are feeling COBRA'S "bite." Em-
and causing major concern for employers. The Consol- ployers complain that the cost of understanding and
idated Omnibus Budget Reconciliation Act of 1985 complying with COBRA is increasing the cost of ad-
(COBRA) requires companies with a least 20 employ- ministering employee benefit programs. Benefit man-
ees to continue offering group health plans to em- agers complain of being forced to spend more time
ployees who have been fired or laid off, to employees on COBRA and less on their own programs. Some
whose hours have been reduced, to employees who companies also fear that they may be forced to pay
have retired, and to the widowed or divorced spouses health benefits even during illegal strikes. But most of
of employees. all, employers object to the strict penalties imposed

The companies must make this medical coverage for not complying with COBRA.

available for as long as 18 months after the employee
leaves, and upon an employee's death or divorce, the
family has the right to buy health insurance at group
rates for as long as three years. Supporters believe
that COBRA will discourage companies from firing
certain employees, especially elderly and ill workers,
just to get them off the employer's insurance rolls.
A company refusing to comply can lose its tax
deduction for the cost of all employee medical insur-
ance. Then, without the tax deductions, the com-
pany's executives can be required to pay income tax
on the full amount the company pays for their insur-
ance premiums. Employers are also required to notify
all persons who qualify for continued coverage, and if

With health costs skyrocketing, being uninsured is
a fearful prospect. Thus, COBRA is a benefit for peo-
ple who would otherwise be uninsured either while
looking for new employment or after a spouse's
death. Former employees (or their spouses) must pay
the companies do not meet the notification require-
ments, they can be fined up to $100 per day. These
penalties are invoked whether the noncompliance is
intentional or inadvertent, which has enraged employ-
ers. Many would support a sliding scale for penalties,

their own premiums (the company's average cost of maintaining that such a method would more fairly re-
providing health coverage, plus a 2-percent charge to flect the degree of violation.

pay for paperwork costs). Even so, the opportunity to A 1987 poll of benefit managers revealed that for

get medical coverage at a group rate is invaluable to the second consecutive year, COBRA (and its associ-

many who would be unable to afford insurance at ated problems) was the most important health-care
individual rates (about twice the group rate). For ex- story.Numerous business groups are currently lobby-
ample, after her husband died, a 60-year-old widow ing to reform COBRA's regulations.
584 Part Seven: The Environment of Business

mental-health insurance Mental-health insurance: Pays for psychiatric care or psychological coun-
Insurance that covers the seling. After satisfying the deductible required by the policy, an employee
costs of psychiatric care or with a mental or nervous disorder is usually eligible for mental-health bene-
psychological counseling fits ranging from 50 to 80 percent of the cost of treatment. However, some

companies do not offer mental-health insurance. 30

the costs of medical care National expenditures on health care totaled

/ $558.7 billion in 1988 and are expected to reach $618.4 billion by 1989, in-
31
creasing 10-13 percent in the next five years. Much of the increase is due to
H 44
the spread of sophisticated procedures such as organ transplants, which are
extremely expensive.
As medical expenses climb, businesses have become less inclined to take
all responsibility for financing employee illness. But to help employees cope
with costs above and beyond the scope of traditional health-insurance poli-
cies, some employers have either included new types of policies in their in-
o * luu surance packages or offered their workers the option of paying for extra cov-

s »>* J erage through payroll deductions.

J
r ments were increasing by 14 percent a year. Given the magnitude of the
r
J expense, GM
/
'79 '81
/ /
EXHIBIT 22.5
Employer Spending on
Group Health Insurance
Employee health-insurance
plans are an increasingly
expensive part of the com-
pensation package as
health-insurance
skyrocket along with
health-care costs.
/
r cost-containment measures General Motors is one example of a company tak-
I ing a hard look at its costs for health insurance. GM's program covers over 2
f
million people and costs $2.3 billion a year. Between 1974 and 1983, pay-
management decided in 1985 to revamp its medical-insurance
program in cooperation with its insurer, Blue Cross. They now require pread-
'83 '85 '87 mission certification from the insurance company that a hospital procedure
32
is essential, and they demand a second opinion in surgical cases.
Many companies have also instituted worksite disease-prevention pro-
grams, referred to as "wellness programs" or "wellcare." Keeping employees
healthy reduces absenteeism and lowers health costs. Johnson & Johnson's
version of a wellness program is "Live for Life"; employees volunteer for
physical checkups to identify health risks, after which they participate in
free, professionally run workshops on stopping smoking, weight control, nu-
trition, stress reduction, and physical fitness. Other companies reward em-
ployees for staying well with cash incentives.
premiums
Some companies are also using health maintenance organizations
(HMOs), which are comprehensive, prepaid, group-practice medical plans in
which consumers pay a set fee and in return receive all their health care at
little or no additional cost. Unlike hospitals and doctors in private practice,

who charge on a fee-for-service basis, HMOs charge a fixed annual fee with
health maintenance organi- which they must cover all their expenses. Forced to operate within each
zations Prepaid medical year's "subscription income," they have a strong incentive to limit treatment
plans in which consumers and to avoid costly hospitalization. Yet a recent government-funded survey
pay a set fee in order to indicates that although cost escalation has been less for HMOplans than for
receive a range of medi-
full
conventional plans, savings offered by HMOs are slight, and a company's
cal care from a group of
medical practitioners
administrative costs go up when it offers HMO coverage in addition to con-
ventional medical insurance. Moreover, the HMOs have been losing money;
for example, Travelers' estimated pretax loss for 1988 was $100 million. Nev-
33
ertheless, HMOs now have close to 32 million members.
preferred-provider organi-
As an alternative to HMOs, some employers are opting for preferred-
zations Health-care provid-
ers offering reduced-rate
provider organizations (PPOs), health-care providers that contract with em-
contracts to groups that ployers, insurance companies, or other third-party payers to deliver health-
agree to obtain medical care care services to an employee group at a reduced fee. PPOs have several
through the providers' advantages over HMOs. For one thing, they are less expensive to set up be-
organization cause they use existing facilities. Furthermore, they give employees more
Chapter 22: Risk Management and Insurance 585

freedom of choice. In most companies, employees are not required to use

preferred providers, but they are offered incentives to do so: reduced deducti-
bles, lower co-payments, or "wellcare." PPOs not only save the employer-
money, they allow employers to control the quality and appropriateness of
sen ices provided. But critics point out that because of lack of cost-control
incentives, PPOs may be tempted to make up in quantity of services what
they lose in reduced fees. Other disadvantages cited are restrictions placed
on employees' choice of hospitals and doctors, and the possibilitv that em-
ployers may be grouped with hospitals and doctors in malpractice actions. 34

Disability coverage

Workers are protected from loss of income while disabled or partially dis-
disability income insurance abled by disability income insurance. The insured employee receives
Insurance that protects an monthly payments while disabled, usually after a specified waiting period.
individual against loss of
The payment and size of benefits normally depend on whether the disability
income while that individual
is partial or total, temporary or permanent. Disabled workers generally re-
is disabled as the result of
ceive 50 to 60 percent of their salary until retirement, offset by disability
an illness or accident
payments from Social Security. Some policies even provide partial payments
if an employee is able to return to work but unable to maintain the same pace

of career advancement or hours of labor per week.

Life insurance is the closest thing there is to a universal employee benefit: It

Life insurance is offered to 96 percent of the employees in medium to large companies. 33 Of
the nearly $7.5 trillion worth of life insurance in force in the United States in
1987, over $4.1 trillion worth was bought by private individuals on behalf of
beneficiaries People their beneficiaries, who are paid by the insurance company if the individual
named in a life-insurance dies. Another $3 trillion was invested in group policies by employers for their
policy who are paid by the employees; typically, these policies guarantee payment of twice or three
insurer if the insured dies times an employee's annual salary to beneficiaries in case of death. More
than half of the remaining $400 billion in life insurance is made up of credit
lifeinsurance, required by many lending institutions to guarantee that a
mortgage or other large loan will be paid off in case of the borrower's
36
death.
term insurance Life insur- The most common type of life insurance provided by companies is term
ance that provides death insurance, which as the name implies, covers a person for a specific period of
benefits for a specified pe- time — the
term of the policy. If the insured does not die before the term
riod of years no value. Key-man insurance is a special form of term
expires, the policy has
insurance purchased by a company to protect itself against the loss of a key
employee. The beneficiary is the company, not the executive's survivors.
Term insurance may be written to cover various periods of time but generally
not past the age of 65. The most common terms range from 5 to 20 years, with
a renewal option. The older the insured, the higher the insurance premium.
Types of life insurance not usually provided by companies include whole
whole life insurance In- life, endowment, variable, and universal. Whole life insurance, which is more
surance that provides both expensive than term insurance, provides a combination of insurance and
death benefits and savings savings. The policy stays in force until the insured dies, provided that the
for the insured's lifetime, premiums are paid. In addition to paving death benefits, whole life insurance
provided that premiums are accumulates value, much as a savings account does. A whole-life policy-
paid
holder can take out a low-interest loan against the accumulated value or,
when it's time to retire, withdraw the accumulated value either in annual
payments or in one lump sum.
586 Part Seven: The Environment of Business

endowment insurance Life Endowment insurance is similar to whole life insurance in that it is a
insurance that guarantees form of savings as well as a form of insurance; however, endowment policies
death benefits for a speci- are written for a specific term. If the insured dies before the term expires, the
fied period of years, after insurance company pays the face value of the policy to the beneficiary. If the
which the face value of insured is still alive when the term expires, the insurance company pays the
the policy is paid to the
full face value at that time.
policyholder
Variable life insurance was developed in response to the soaring inflation
variable life insurance of the late 1970s and early 1980s. Like whole life insurance, it guarantees
Whole life insurance policy benefits until the death of the insured (as long as the policy remains in force),
that allows the policyholder
requires payment of a stable premium, and accumulates cash value. The
to decide how to invest the
difference is that the insured can decide how to invest the cash value,
cash value
whether in stocks, bonds, or money-market funds. If the insured's investment
decisions are good, the policy's cash value and death benefit will increase.
But if the investments do poorly, the cash value and death benefit may also
decrease — although usually not below a guaranteed minimum level.
universal insurance
life Universal life insurance is also a flexible policy, but it is better than
Combination of a term life variable life insurance for those who are not comfortable making their own
insurance policy and a sav- investment decisions. Premiums on a universal life insurance policy are used
ings plan with flexible inter- to fund, in essence, term insurance and a savings account. The interest that
and
est rates flexible
accumulates on the savings portion of the policy is pegged to current money-
premiums
market rates (but generally guaranteed to stay above a certain level). Pre-
mium payments may vary too, depending on the insured's preferences, as
long as they are big enough to fund the term-insurance portion of the policy.
Of course, cash value accumulates more slowly when interest rates or premi-
ums decline. This policy has proved to be popular with people taking out life
insurance in the past few years.

SUMMARY OF LEARNING OBJECTIVES

Explain the difference An uninsurable risk is one for predict the amount they will prob-
between pure risk and specu- which insurance generally is not ably have to pay in claims over a
lative risk. available— for example, losses due given period.
A pure risk involves only the poten- to economic and environmental
conditions, poor management, and Name four types of business
tial for loss, without any possibility
changes in government regulations. risks that are often insured.
of gain; a speculative risk is one

that accompanies the possibility of An insurable risk is a relatively Businesses run the risk of property
a profit. calculable one that an insurance loss, losses due to liability, income
company is willing to cover. loss, and loss of key personnel.
List the five steps in the
risk-management decision Name the two main govern- Identify the two main types
process. ment insurance programs. of health-insurance coverage.

The five steps include identifying The government's largest insurance Health insurance includes medical
and analyzing loss exposures, form- programs are Social Security and coverage (hospitalization insurance,
ulating alternatives, selecting the unemployment compensation. surgical and medical insurance,

best alternative, implementing the major-medical insurance, dental

Explain how insurance com- and vision insurance, and mental-
chosen techniques, and monitoring
panies decide the amount of health insurance) and disability
the results.
income they need to generate from coverage.
Distinguish uninsurable risks premiums.
from insurable risks. The insurance companies must
 .

Chapter 22: Risk Management and Insurance 587

p Describe the five main forms no-fault insurance laws (579)

of life insurance. preferred-provider organizations
Term life insurance provides death (584)
premium (571)
benefits for a specific time period. Risk-Management
Whole insurance pun ides both
life product liability (578)
Assessment: Balancing
savings and death benefits through- property insurance (577)
Public and Corporate
out the insured's life, as long as pure risk (568)
premiums are paid. Endowment replacement cost (577)
Interests
life insurance provides both savings risk-control techniques (570) Beyond assessing a particular
and death benefits for a specified risk-financing techniques (570) firm's potential loss of profits, risk
time period. Variable insurance
life
management grows vastly more
risk management (569)
is similar to whole life, except that
self-insurance (570) complex when assessing the pub-
it allows the policyholder to
speculative risk (568) lic's potential loss of health and
manage the investment portion of safety. Government agencies and
the policy. Universal life insurance
stock company (575)
commissions decide daily what is
is, in effect, a combination of term strict product liability (580)
safe and what is not. And in the
insurance and a savings account. surety bond (578)
case of dioxin, the Environmental
surgical and medical insurance
Protection Agency is living a
(582)
"nightmare" as it tries to reassess
term insurance (585)
the compound's carcinogenic
KEY TERMS umbrella policies (579) dangers.
underwriters (573)
actuaries (573) Dioxin is actually the name given
uninsurable risk (571)
more than 75 chemical variants
beneficiaries (585) universal life insurance (586)
occurring as impurities in many
business-interruption insurance variable life insurance (586)
herbicides and wood preservatives
(581) whole life insurance (585)
and as natural by-products of any
claims (573) workers' compensation insurance incomplete combustion process.
comprehensive general liability (579) Dioxins are found at incineration
insurance (578)
sites and municipal dumps, in the
contingent business-interruption
exhaust of cars and trucks, and
insurance (581)
REVIEW QUESTIONS even in the smoke from wood
credit life insurance (578)
stoves. It has been shown that high
crime insurance (578) doses of dioxin cause cancer and
damages 1 What are the four types of loss
(568) neurological damage in various
exposure?
deductible (573) animals. In humans, dioxin has
2. What is self-insurance, and why
dental and vision insurance (583) been associated with skin lesions,
is it becoming increasingly popular
depreciated value (577) birth defects, and miscarriages. So
among large corporations?
disability income insurance (585) what dosage can be considered
3. What are the five characteristics
safe?
endowment insurance (586) of insurable risks?
extra-expense insurance (581) 4. What is the difference between The EPA wants to increase the level

fidelity bond (577) workers' compensation insurance of dioxin it considers safe from
health maintenance organizations and disability income insurance? 0.006 picogram per day to more
(584) 5. What is the difference between a than 16 times that, or 0.1 picogram
hospitalization insurance (582) stock company and a mutual per day; thus begins the EPA's
company? "nightmare." Unable to determine
insurable risk (572)
6. What are the causes of the in- dioxin's cancer-causing mecha-
insurance (571)
surance industry's historical profit- nisms, and therefore unable to pre-
key-man insurance (581) what level will cease to
ability problems? dict at it
law of large numbers (574) have a toxic on humans, sci-
effect
7. What sorts of business insurance
liability insurance (578) entists must depend on mathemati-
are available to protect against the
lossexposures (569) four main types of business risks? cal models to assess the risks of
major-medical insurance (583) 8. How are the insurance compa- this compound. But what model
malpractice insurance (580) nies and the government respond- should be used, and what assump-
mental-health insurance (584) ing to the soaring costs of liability tions should be made once the

mutual company (575) insurance? model has been chosen? The pro-
588
jections of cancer cases in the pop-
ulation vary widely from one
model (and its associated assump-
tions) to the next. "Here we have a
clear case where, the more we
learn about dioxin, the harder it
becomes apply traditional risk
to
assessment approaches that rely
strongly on scientific inference,"
says William H. Farland, director
of the EPA's Health Environment
Review Division. "Yet we don't
have enough data to develop a new
model. So we're in a scientific
limbo."
It isnot clear why the EPA has
chosen to reassess the safety of di-
oxin, but critics suspect the agen-
cy's motivation. "This decision only
makes sense in a political context,"
says Ellen K. Silbergeld, a toxicolo-
gist with the Environmental De-
fense Fund and a member of the
Science Advisory Board. "It gets
them out of two main things they
don't want to do. One is cleaning
up Newark, New Jersey, and Times
Beach, Missouri. The other has to
do with regulating dioxin emissions
from municipal incinerators." It
has already cost the federal govern-
ment $33 million to buy out Times
Beach and relocate its residents.
Nevertheless, regulators insist that
risk estimates are important be-
cause they help provide perspec-
tive. The fear of dioxin is wide-
spread, especially among farmers
working with herbicides, Vietnam
veterans exposed to Agent Orange,
and the residents of neighborhoods
like the Love Canal area of Niagara
Falls in New York. Without per-
spective, regulators see the fear of
toxic risks leading to extraordinary
circumstances. Consider one exam-
ple from the liability-insurance
crisis.
In 1987, Monsanto Company was
found liable when a rail car spilled
one teaspoon of dioxin in Sturgeon,
Missouri. The trial lasted three
years and eight months. Tests re-
vealed no evidence of dioxin in the
blood of any of the 65 plaintiffs,
and the jury concluded that no ill
effectsfrom the spill were suffered
by them. Barbara Wetting was one
of the jurors. "We couldn't prove
that the dioxin caused these peo-
ple's illness," said Wetting, "but
they [the plaintiffs] did prove that
there was dioxin in the rail car,
and that Monsanto had known that
there was dioxin in the tank car."
The jury awarded the plaintiffs
$16.2 million in damages. Mon-
santo was punished, not for harm-
ing anyone but for knowing that
dioxin was being transported
through the town. Could this be the
sort of fear the regulators would
like to see put into perspective?
Risk assessment is necessary, even
desirable. But because we are un-
able to avoid the risks of our indus-
trial society, and because human
values must be as important as
entific data when making such
cisions, governmental risk assess-
ment will never be a simple task.
1. Are "toxic" accidents insurable
or uninsurable risks? Why?
2. How did strict liability affect the
Mo}isanto case in Sturgeon,
Missouri?
3. Are mathematical models an
fective tool for predicting the prob-
ability of events occurring? If
els can be "tweaked" into
predicting higher or lower safety
levels, are they dependable? What
about human values?
Circle K: Curbing
Health-Insurance Costs
Based on Lifestyle
Factors
Circle K Corporation wanted to cut
the costs of employee health insur-
ance, but a lack of planning and
foresight produced a policy that led
to public uproar in newspapers, on
radio, and on television.
Part Seven: The Environment of Business
The second largest chain of conve-
nience stores, Circle K operates
4,100 stores in 27 states and pays
health-insurance claims out of its
own budget (rather than purchas-
ing coverage from an insurance
company). In an effort to cut medi-
cal costs, Circle K adopted a new
policy. In addition to such changes
as extending the waiting period for
new employees to become eligible
for coverage and adding restric-
tions on elective surgery, coverage
was refused to employees who be-
came sick or injured as a result of
AIDS infection, alcohol or drug
abuse, or self-inflicted wounds. "We
felt we had to take certain steps to
help contain our medical costs, and
we felt that this was one thing we
could do," said Charles Shoemaker,
Circle K's vice president for human
resources. "There are certain life-
sci-
style decisions that we are just not
de-
going to assure the results of."
37
Shoemaker found that in 1987, Cir-
cle K
paid around $500,000 for
treatment of nine AIDS patients.
This was nearly 4 percent of its
medical-insurance budget, com-
pared to the 1 to 2 percent that
other employers spend for AIDS. In
ef-
explanation of this discrepancy,
Shoemaker pointed out that Circle
mod- K has about 26,000 employees and
an annual turnover rate of 170 per-
cent. "That means we have a
higher chance of hiring someone
with AIDS," said Shoemaker. Also,
many people hired by Circle K
have no health insurance or have
only minimal coverage. Shoemaker
contends that some applicants "are
shopping us for insurance
coverage."
Having received the "go-ahead"
from a large Phoenix law firm, Cir-
cle K proceeded to explain the new
policy in a letter sent to its em-
ployees at the end of 1987. At first,
there was no response at all. But
by August 1988, the storm broke.
Bryant Gumbel of the "Today"
show asked, "What is it you're try-
ing to police here — is it health or
Chapter 22: Risk Management and Insurance
morality?" Arizona activist Edward
Buck called the polio "corporate
irresponsibility at its worst" and
pointed out that the policy changes
were "vague and ambiguous." For
example, said Buck, it an employee
slipped and Fell in a bathtub, the
company could claim intoxication
and refuse coverage; or the plan
could "deny coverage of a person
who got lung cancer because they
chose to smoke cigarettes." Other
critics said the policy discrimi-
nated against homosexuals and vic-
tims of AIDS. Civil libertarians
questioned its legality, but Gay
Ann Williams, assistant to the di-
rector of the Arizona Department
of Insurance, said that because Cir-
cle K pays its own health-insurance
claims, challenging the new policy
under state laws was impossible.
However, commercial insurance
Locate a recent Wall Street Jour-
nal article that describes a com-
pany's experience with one of
the following risks:
Product liability
Professional liability
Casualty losses and other ex-
penses caused by fire or other
physical disaster
589
companies cannot include such a never meant to investigate how
clause in their policies because claimants contracted the disease.
state law "prohibits an insurance
company from underwriting on the On August 1 1 , the company an-
basis of lifestyle," continued nounced the suspension of the new
Williams. plan. Says Karl Eller, Circle K's
chairman and chief executive:
Circle K executives now believe "We've suspended the (new plan),
that the letter to employees could and I would imagine we'll keep it
have been better handled by toning suspended or figure some other
down the references to "personal way to accomplish cost control." 38
life-style decisions," by explaining
that the new policy would not af-
1. What types of employee insur-
ance are companies required by
fect the 8,000employees currently
covered, and by clarifying that the
law to provide?
policy would exclude only acci- 2. Is there any way Circle K might
dents —
not illnesses —
caused by have avoided the uproar and still
alcohol or drug abuse. Shoemaker cut costs?
said that employees unknowingly 3. Should employers be responsible
contracting AIDS from a blood for medical claims of an employee
transfusion or from a spouse would who has an automobile accident as
continue to be covered, yet other a result of driving while
company officials said that they intoxicated?
KEEPING CURRENT USING
THE WALL STREET JOURNAL
Losses caused by fraud, theft, company have done anything to
or employee dishonesty avoid or minimize the risk?
Workers' compensation 2. Was the company insured by an
outside company, self-insured (with
Employee medical coverage a reserve fund), or uninsured? Was
1. What was the company's experi- this coverage adequate?
ence? If the firm suffered a loss, was
3. What was the financial impact of
it the result of a pure risk (over
this experience on the company?
which it had no control) or a specu- What, any, major changes did it
if
lative risk (part of the anticipated
bring about in the company's busi-
risks of doing business)? Could the
ness practices?