Chapter 7

Chapter 7
Insurance as a Risk Transfer Mechanism

Outline
• What is it?
• Steps to Implement
• Step One: Beginning the Process
• Step Two: Choosing an Intermediary
• Step Three: Binders of Insurance
• Step Four: Receiving and Reviewing Policies
• Advantages
• Disadvantages
• Chapter Summary
Dr. James Kallman, ARM 7-1

©2009 The National Underwriter Company
Chapter 7
What is it?
• Insurance is a transfer of the financing of risk
• One party agrees to indemnify another for the financial

consequences of the other party’s loss
• An exchange of a known, small amount (the premium) for an

•uncertain,(accidental or foretuitus loss),
• potentially catastrophic future amount (the loss)
• Insurance combines a large number of homogeneous,
independent exposure units into a pool
• The losses of a few are shared by the many. Low frequency
over all insureds.
• The law of large numbers enables actuaries to predict an
expected outcome, loss distributions, and calculate premiums
and reserves.
Chapter 7
Steps to Implement
1. Identify the exposures
2. Choose an Intermediary
3. Get Binders of Insurance
4. Receiving and Reviewing Policies

Chapter 7
Step One: Beginning the Process
• Use a risk exposure survey (and other tools) to identify exposures
e.g., Property, Liability, Human Resources, Net
Income
• Interview intermediaries (producer, agent, broker) to solicit

insurance proposals
• Give intermediary a broker-of-record letter
• Mid-term broker-of-record letters may cause the underwriter to

cancel, re-underwrite, and re-write coverages
• Broker-of-record letters may restrict brokers to specified carriers

– this enables multiple brokers to go to the market and market an
account without approaching the same insurers
Chapter 7
Step Two: Choosing an Intermediary
• Types of Intermediaries
• independent agents
• exclusive agents
• employee agents
• direct-writers
• brokers
• surplus lines brokers
• Independent Agents
• An independent business person
• Represents multiple insurers
• Agent owns the expirations
• Agent’s legal duty is to insurer
• Agent may have binding authority
• Agent usually compensated by commission
Chapter 7
• Exclusive agent
• An independent business person
• Represents only one insurer
• Agent might not own the expirations
• Agent’s legal duty is to insurer
• Agent may have binding authority
• Agent usually compensated by commission
• Employee agent
• Licensed agents
• Employees of an insurer
• Agent does not own expirations
• Agents are compensated by salary

Chapter 7
• Direct-writer agent
• Licensed agents
• Employees of an insurer
• Agents solicit by mail, telephone, or internet
• Agent does not own expirations
• Agents are compensated by salary
• Brokers
• Represents the insured
• Usually used for large commercial accounts
• May have a service agreement and be
compensated by service fees and/or commissions

Chapter 7
• Surplus Lines agent
• Licensed with non-admitted insurers
• Not subject to rate and form regulations
• Not protected by state guarantee funds
• Can write custom (manuscript) coverages
• Write coverage for non-standard exposures
• Agent paid a commission

Chapter 7
Step Three: Binders of Insurance
• Factors in choosing coverage:
• Level of service
• Insurance coverage
• Policy exclusions
• Insurer’s financial condition
• Rate credits
• Total premium
• Intermediary issues binder of temporary coverage
• Names of insured, insurer, and intermediary
• Policy forms that apply
• Effective and expiration date (30 days)
• Exposures covered
• Limits of insurance
• May be an ACORD form
• Special coverage must be clearly indicated on the
binder

Chapter 7
Step Three: Binders of Insurance
Supplement
• Additional documents provided by insurer

• Evidence of insurance
• Certificate of insurance
• Supplied at time of binding coverage or to verify

renewal or as snapshot of coverage
• These documents do not provide insurance coverage

Chapter 7
Step Four: Receiving and Reviewing Policies
• Receiving the policy
• The policy is the contract
– it overrides any binders, oral agreements, or applications
• Discrepancies should be immediately addressed
•Contract of adhesion
• Standard contracts are offered as take-it-or-leave-it
• Courts may rule any ambiguous conditions in favor of the
personal lines consumer
• Commercial consumers are expected to read their policies and
may not be protected by this precedent
• Many conditions are established by state statutes
• Insurance contracts are matters of public policy

Chapter 7
• Reviewing the Insurance Policy
• Read the policy forms and attachments
• Check to be sure all policy forms are appropriate
• Are the right exposures covered?
• For the desired perils?
• At the desired limits?
• Declarations Page
• The information page (may be an ISO form)
• Named insured
• Mailing address
• Insured locations
• Forms and endorsements
• Policy period (inception and expiration – 12:01 a.m.)
• Intermediary’s name and address
• Insurer and address
• Premium

Chapter 7
Supplement
• Declarations Page may also indicate:

• State-specific taxes and fees
• How to contact regulators to log a complaint
• Audit or inspection intervals

Chapter 7
• Insurance Policy Coverage Parts
• Insuring Agreement
• Definitions
• Exclusions
• Conditions
• Attachments (endorsements or riders)
• Deductibles
• Insured retains and pays losses up to a limit;
insurer pays after that retention amount to the policy
limit.
• Enables lower premiums
• Qualified self-insured retention (SIR) for state approved workers’
compensation, excess, or umbrella liability policies
• Higher deductibles may yield lower premiums

Chapter 7
• Deductibles
• Types of deductibles:
• Flat – usually applied per each claim
• Straight - usually applied per occurrence
• Percentage - proportion of exposure value
• Policy Forms
• Bureau filed form – standard form (e.g., ISO)
• ISO promulgates insurance forms and rates for insurers to
file with state regulators
• Independently filed form – company designed forms filed with
state regulators

Chapter 7
• Surplus Lines Market (non-admitted market)

• A licensed insurer is admitted if the state regulator approves their forms, rate
filings, and financial strength and the insurer pays a premium tax to the state
guarantee fund.
• A non-admitted insurer is licensed to sell in the state
• Used for hard to place exposures
• Plans for high risk, rejected to obtain Insurance

•1. FAIR plans; 2. Health Plans (MNCHA); 3. Workers
Comp; 4. Auto Plan-Assigned risk plans.
• State Fair Access to Insurance Requirements
• For writing high risk people and property where
standard market insurers prefer not to write
Chapter 7
Advantages
+ Exchange of small known cost for potential large cost
+ May satisfy a contractual responsibility
+ May satisfy loan requirements
+ Insurer handles the loss settlement procedures
+ May satisfy statutory or regulatory requirements

Chapter 7
Disadvantages
– Opportunity costs – money used for insurance not invested in
business operations
– Not all losses may be covered – exclusions apply
– Intermediary fees must be paid
– Insurance contract terms may be challenging to interpret

Chapter 7
Chapter Summary
• What is insurance: a risk financing tool
• Steps to Implement
• Step One: Beginning the Process – identify exposures,
broker-of-record letters
• Step Two: Choosing an Intermediary – independent,
exclusive, employee, direct-writer, broker, surplus lines agent
• Step Three: Binders of Insurance – temporary coverage
• Step Four: Receiving and Reviewing Policies – contract of
adhesion, review the contract, declarations, coverage parts,
deductibles, policy forms, surplus lines policies, FAIR plan
• Advantages – exchanges uncertain large loss for a premium,
satisfies obligations, insurer settles claims
• Disadvantages – opportunity cost, exclusions, fees, terms

Risk Management and
Insurance Issues
Captives
Cost of Risk
IBNR
Self Insurance 87,104,215 WC 363
SIRs vs. Deductibles 16,21,83,86,104
Frequency: of deductibles and policy limits: per
occurrence vs. per claim.
Claims-made vs. Occurrence
Ceritficates of Insurance
Employees v. Independent contractors
Summary of RUMINCO Ltd. Limits
Limits within the RUMINCO program are generally in the
same range as the maximum payout prescribed by the
Minnesota Tort Cap statutes; buying more limit
effectively waives the Statute’s protection. $400,000 Each
Claim
$1.2 Million Each Occurrence
$600,000 Each Claim
$1 Million Each Claim
$3 Million Each Occurrence
$5 Million Aggregate
$1 Million Each Loss
$3 Million Aggregate
RUMINCO (extra- jurisdictional)
RUMINCO In-State
Your Benchmarked Cost of Risk
Divided by Revenue or Payroll
A cost of risk includes:
Retained loss costs
Insurance premiums
Risk control costs
Administrative costs
Cost-of-Risk benchmark studies are available from RIMS
Premiums
Uncovered Losses
Prevention Expenses
Administration
Total Direct Cost (TDC)
X4 to include Indirect Cost (IC)

Caveats to Cost of Risk Data:
Assumes the industry is at a desired equilibrium
Assumes risk financing strategy is to follow others
Cost of risk is only an average which does not recognize the risk involved which require
consideration of the following: Valuable information obtained
Time of the occurrence
Length or duration
Expected outcome (arithmetic mean)
Mode
Median
Standard deviation from the mean
Range
Coefficient of variation
Timing of recovery
-------------------------------------------------------------
How to expand to an ERM scope?
First recognize indirect cost with the multiple of 4 of direct costs.
Second, recognition of intangible costs including damage to reputation and interests o f
all stakeholders from a long term/strategic view, and add the recovery time, ability and
costs.

Composition Of the Cost Of Risk Dollar Total Cost of Risk per
(Percent) $1,000 Of Revenue
U.S.-Based Respondents
20xx 20xx
Property Premiums 12.9 14.1

Retained Property Losses 4.9 5.7 Year Cost
Liability Premiums 16.8 19.1 Index
Retained Liability Losses 21.9 22.7 1989 $5.20
Workers’ Comp. Premiums 9.0 8.2 1990 $6.10
Retained Workers’ Comp. Losses 29.7 24.3 1991 $6.40
Risk Management Dept. Costs 2.8 3.0 1992 $8.30
Outside Services 2.0 2.9 1993 $7.70
Total Premiums 38.7 41.4 1994 $7.30
Total Retained Losses 56.5 52.7 1995 $6.49
Total Administrative Costs 4.8 5.9 1996 $5.70
Source: 1997 Cost of Risk Survey Source: 1997 Cost of Risk Survey

Cost of Risk as % of Revenue
(Excluding Risk Control)
Cost of Risk for Different Industries
Source: Towers Perrin and Risk and Insurance Management Society, Cost of Risk Survey, 1992, 23.
Industry 1990 1992
Transportation services 2.81 4.46

Health care 2.30 2.78
Construction 1.21 1.77
Primary metals; leather; stone — 1.25
Transportation equipment — 1.07
Metal products — 1.05
Average — 27 0.37 —
Lumber; furniture; packaging — 0.90
Printing and publishing — 0.84
Educational, nonprofit institutions 1.11 0.84
Retail trade — 0.80
Natural gas utility — 0.56
Personal and business services — 0.53
Real estate and security brokers — 0.47
Mining and energy — 0.47
Governmental 0.37 —
Telecommunications — 0.38
Chemicals; rubber; plastic — 0.35
Wholesale trade — 0.24
Electronic equipment — 0.15
Insurance — 0.07
Banking Dr. James Kallman, ARM 7-26
Cost Components 19 19
Insurance Premiums: $ 939,521 $1,030,925
Retained Losses:
1. Property $ 4,148 $ 4,738
1. General Liability 67,507 109,955
1. Workers’ Compensation 303,761 353,300
Risk Control 1 — —
Administration
1. ____________ 2 16,710 16,492
1. Self-insurance 3 40,000 40,000
Total Cost of Risk 1,371,647 1,555,410
Revenues 4
106,778,01 102,649,31
8 4
Cost of Risk as % of 1.28 % 1.52 %

Revenues
Value In Benchmarking Cost Of Risk
Three “C’s” Of Value—Calculating, Creating, Capturing
(Developed from “Gary Lilien & The Three C’s Of Value” Smeal College Of Business
Adm. Journal, Fall 1993, p.14)
CALCULATING VALUE: TAKE COST OF RISK AND BENCHMARKING FROM
MEASURING COST TO MEASURING VALUE, SO BUYING STRATEGIES ARE NOT
BASED ON LOWEST COST BUT INSTEAD ON BEST VALUE.
FOR EXAMPLE:
1 2 3 4 5
Lowest Highest Lowest Best Best Value
Premiu Loss Cost of Cost/Benef Quality
m Ratio Risk Ratio it Cost
$2 90% or $ Cost of Quality = Appropriate

million 80% Risk Outcomes ness
Claims Revenue Medical
Prems
Pt.
Satisfactio
n


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Chapter 7

Insurance as a Risk Transfer Mechanism

Dr. James Kallman, ARM 7-1

• One party agrees to indemnify another for the financial

• An exchange of a known, small amount (the premium) for an

3. Get Binders of Insurance

4. Receiving and Reviewing Policies

Dr. James Kallman, ARM 7-3

• Interview intermediaries (producer, agent, broker) to solicit

• Give intermediary a broker-of-record letter

• Mid-term broker-of-record letters may cause the underwriter to

• Broker-of-record letters may restrict brokers to specified carriers

Dr. James Kallman, ARM 7-6

Dr. James Kallman, ARM 7-7

Dr. James Kallman, ARM 7-8

Dr. James Kallman, ARM 7-9

• Additional documents provided by insurer

• Supplied at time of binding coverage or to verify

• These documents do not provide insurance coverage

Dr. James Kallman, ARM 7-10

Dr. James Kallman, ARM 7-11

Dr. James Kallman, ARM 7-12

• Declarations Page may also indicate:

Dr. James Kallman, ARM 7-13

Dr. James Kallman, ARM 7-14

Dr. James Kallman, ARM 7-15

• Surplus Lines Market (non-admitted market)

• Plans for high risk, rejected to obtain Insurance

+ May satisfy a contractual responsibility

+ May satisfy loan requirements

+ Insurer handles the loss settlement procedures

+ May satisfy statutory or regulatory requirements

Dr. James Kallman, ARM 7-17

– Not all losses may be covered – exclusions apply

– Intermediary fees must be paid

– Insurance contract terms may be challenging to interpret

Dr. James Kallman, ARM 7-18

Dr. James Kallman, ARM 7-19

Dr. James Kallman, ARM 7-23

Dr. James Kallman, ARM 7-24

Property Premiums 12.9 14.1

Dr. James Kallman, ARM 7-25

Industry 1990 1992

Transportation services 2.81 4.46

Insurance Premiums: $ 939,521 $1,030,925

Total Cost of Risk 1,371,647 1,555,410

Cost of Risk as % of 1.28 % 1.52 %

$2 90% or $ Cost of Quality = Appropriate

Dr. James Kallman, ARM 7-28

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