Risk Management

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Table of Contents
Table of Contents 2
Preface 10
Course Goal 10
Chapter 1:Principles of Risk
Management 12
Learning Objectives 12
Topics 12
Introduction 12
1.1 Fundamentals 13
1.1.1 Meaning and Treatment of
Risk 13
1.1.2 Basic Risk Management
Assumptions and Techniques 13
Risk Avoidance 14
Risk Minimization 14
Risk Transfer 14
Risk Retention 14
The Role of Insurance in Risk
Management 15
 Rules of Risk
Management 15
1.2 Types of Risk 15
1.2.1 Pure and Speculative
Risk 15
Perils and Hazards 16
1.2.2 Major types of Pure
Risk 16
Loss of Income 16
Death and Disability 16
Catastrophic Losses 17
1.2.3 Major Types of Speculative
Risk 17
1.3 Personal Risk Tolerance and
Management 17
Assess Exposure to Financial
Risk 17
Identify Risk Management
Goals 18
Collect Information to Identify Risk
Exposures Facing the Client 18
 Analyze and Evaluate the
Information 18
Construct a Risk Management
Strategy 19
Implement the
Recommendations 19
Monitor the Recommendations for
Needed Changes 19
Property & Liability 19
Life 20
1.4 Principles of Insurance 20
1.4.1 Characteristics of
insurance 20
Underwriting 20
1.4.1.1 Requirements for an
Insurable Risk 21
Law of Large Numbers 21
Structure of Insurance
Policies 22
1.4.1.2 The Insurance
Contract 22
Insurable Interest 23
Change of Insurable
Interest 23
Principle of Indemnity 23
The Doctrine of Utmost Good
Faith 24
Duty of Disclosure 25
Subrogation 26
With an insurance contract, the
insurer makes an offer to provide
coverage for a given price
(premium). The applicant agrees to
coverage terms and pays the
required premium (offer and
acceptance). 26
Claims 26
Proximate Cause 27
Contract Terms and
Sections 28
Insurance Policy Sections 28
Exclusion Clauses 29
 Fraudulent Claims 30
Loss by Own Act 30
Measurement of the Loss 30
Underinsurance 31
Chapter Review 34
Discussion Questions 34
Review Questions 34
Chapter 2: Risk Exposures 36
Learning Outcomes 36
Topics 36
Introduction 36
2.1 Financial Obligations: Existing
and Potential 36
Types of Risk and Potential
Impact 36
2.2 Analysis and Evaluation of Risk
Exposures 38
Chapter Review 43
Discussion Questions 43
Review Questions 43
Chapter 3: Introduction to
Insurance 44
Learning Outcomes 44
Topics 44
Introduction 44
3.1 General insurance 45
Property Insurance 45
3.1.1 Homeowners 46
Section I 46
Section II 47
Additional Coverages 48
Covered Perils 48
How Much is Enough? 49
Replacement Cost
Calculation 49
Coinsurance Provision 50
Replacement Provisions 51
Factors Affecting the Cost of
Homeowners Coverage 52
General Exclusions 52
High-Value Property 53
 Other Homeowner’s
Products 54
3.1.2 Personal property 54
Personal Property
Exclusions 55
Personal Property
Endorsement 56
Inland Marine Insurance 56
Pair or Sets Settlement 57
3.1.3 Vehicles 57
Types of Policies 57
Who is Insured? 58
Cost of Insurance 59
3.2 Liability 60
Liability Terms 60
3.2.1 Personal Liability 61
Liability Exclusions 62
Medical Payments to Others 63
Umbrella Policy 64
Exclusions 64
3.2.2 Professional Liability 65
3.2.2.1 Malpractice and Errors and
Omissions 65
Malpractice 65
Occurrence versus Claims Made
Forms 65
Defense and settlement 66
Errors and Omissions
Insurance 66
3.3 Life Insurance 67
3.3.1 Term Life Insurance 67
3.3.2 Traditional – Whole Life and
Endowment 69
Cash Value (Permanent)
Insurance 69
Limited Pay Whole Life 70
3.3.3 Non-traditional – Universal,
adjustable, variable, variable
universal 71
Universal Life 71
Variable Life 74
Variable Universal Life 75
 Subaccounts versus Mutual
Funds 75
3.3.4 Joint Life Policies 75
Features & Provisions of
Individually-Owned Life
Insurance 76
Standard Provisions 76
Entire Contract Clause 77
Ownership Rights 77
Grace Period 77
Contestable Period 78
Misstatement of Age 78
Reinstatement 78
Nonforfeiture Options 78
Policy Loan 79
Beneficiary 80
Suicide/Aviation/War 80
Dividends 81
Conversion Clause 82
Common Disaster Clause 82
Settlement Options 82
 Common Riders 83
3.3.5 Amount of Insurance
Needed 83
Human Life Value (Income-Based)
Method 84
Needs-Based Method 85
Liabilities 85
Income Replacement 86
Capital Utilization 86
Capital Retention 86
Final Expenses 87
Education Funding 87
3.3.6 Annuities 89
Definitions 90
Immediate Annuities 91
Deferred Annuities 91
Fixed Annuities 92
Variable Annuities 93
Indexed Annuities 95
Settlement and Payout
Options 96
3.4 Health Insurance 97
Sources of Coverage 98
3.4.1 Types of Medical Expense
Insurance 98
3.4.2 Managed Healthcare
Plans 99
How Much and What Type of
Coverage is Appropriate? 101
Choosing Coverage 101
3.4.3 Long-Term Care 102
3.4.3.1 Common Features of LTC
Insurance Policies 103
Activities of Daily Living 103
Coverage Amount 103
Elimination Period 104
Benefit Period 104
Waiver of Premium 104
Respite Care 105
Additional Features 105
Common Riders 106
Inflation Rider 106
 Return of Premium Rider 106
Restoration of Benefits
Rider 106
Nonforfeiture Option
Riders 106
How Much and What Type of
Coverage is Appropriate? 106
Hybrid Policies 107
Is LTC Insurance Worth the
Money? 108
3.5 Disability: Personal 109
3.5.1 Common Features of Disability
Insurance 110
Sources of Coverage 111
Common Riders 112
Inflation Riders 112
Guaranteed Purchase
Option 112
Return of Premium 113
Partial Disability 113
Residual Disability 113
 3.5.1.1 Definition of
Disability 114
Presumptive Disability 115
Conversion 115
Other Common Provisions 116
Premiums and Benefits 116
How Much and What Type of
Coverage is Appropriate? 117
3.5.1.2 Common Continuation
Provisions 118
Policy Durability (Renewal
Provisions) 118
3.6 Business-related 119
3.6.1 Key person 119
Life Insurance 119
3.6.2 Disability: Business 120
3.6.3 Business Overhead
Expense 121
3.6.4 Business Liability and Board
Member Cover 122
Chapter Review 125
 Discussion Questions 125
Review Questions 127
Chapter 4: Insurance Company and
Advisor Selection 132
Learning Outcomes 132
Topics 132
Introduction 132
4.1 Company and Advisor (Agent)
Selection and Due Diligence 133
4.1.1 Company Evaluation and
Selection 133
Using the Information 134
NAIC Criteria 135
4.1.2 Intermediary Selection and
Responsibilities 137
Competence and Inclination to
Service 138
Experience, Training, Education
and Specialization 138
Reputation 139
 Steps to Avoid
Misunderstandings 139
4.1.3 Choosing an Insurance
Policy 140
Choosing the Right Policy 140
4.2 Legal and Financial
Characteristics of Insurance Parties
Involved in an Insurance
Contract 143
4.2.1 Insurance company 143
4.2.2 Policyowner 144
4.2.3 Beneficiary 145
4.2.4 Insured 145
4.3 Regulation and
Compliance 145
Summary 146
Chapter Review 150
Discussion Questions 150
Review Questions 150
Chapter 5: Strategic
Solutions 152
Learning Outcomes 152
Topics 152
Introduction 152
Assess Exposure to Financial
Risk 154
5.1.1 Risk Review and Evaluation:
Property and Liability 155
5.1.2 Risk Review and Evaluation:
Life 157
Faber Case 158
5.2 Risk Management Tools Being
Used to Address Risk
Exposures 161
Prioritizing Risk Management
Needs 163
5.4 Risk Management
Optimization 165
5.4.1 Risk Management
Audit 165
5.4.2 Implement the Chosen
Approaches 166
 Advantages and
Disadvantages 167
5.4.3 The Road Map 168
Summary 169
Chapter Review 176
Discussion Questions 176
Review Questions 176
Chapter Review Answers 177
Chapter 1 Review Answers 177
Chapter 2 Review Answers 180
Chapter 3 Review Answers 181
Chapter 4 Review Answers 194
Chapter 5 Review Answers 196
Appendix 1: Provision for
Dependents 199
Needs Analysis 199
Present Value of an Annuity
Calculation 200
Distinction Between an Ordinary
Annuity and an Annuity-
due 201
 Calculating the Value of an Annuity
Due 202
Present Value of an
Annuity 202
Putting it All Together 202
Life Insurance for a Non-Income
Earner 204
Effect of Inflation on the Life
Insurance Payout 204
Preface
Most financial advice is about gain.
Advisors help people gain financially,
reach goals, achieve objectives, and live
dreams. This course, however, has a
different focus. Rather than being about
gain, it considers the potential for loss.
An important aspect of financial advice
includes recognizing the possibility that
things may not go as the client desires.
Broadly speaking, this type of guidance
is known as risk management, and in
some ways, it is one of the most
important aspects of financial advice.
Adequate and consistent cash flow and
sufficient assets are essential elements
of financial success. Think about it.
While some goals do not require
funding, most do require money for
clients to achieve their goals and have
financial freedom. As a result, financial
objectives include making payments
from current income, and allocating
financial assets, like savings accounts
and investments, for goal achievement.
The underlying assumption is that cash
flows will continue, and assets will
remain available and, hopefully,
increase.
What happens to financial goals when
cash flows stop or assets are depleted
or destroyed? In many cases hopes for
goal achievement end, or must be
modified. This is one reason why we
sometimes refer to Maslow’s Hierarchy
of Needs in the context of financial
advice (McLeod, 2014). The lower levels
of Maslow’s Hierarchy refer to
psychological and physiological safety
or security needs. The concept is,
before an individual can address higher-
level needs, he or she must first meet
those at the foundational levels. The
same concept applies to financial
advice. An individual must first address
financial security needs before moving
to higher-level needs, such as saving for
retirement. This is one reason why
financial (cash-flow) management is so
important.
Risk management is one of the primary
financial security needs. While risk
management has broad application,
when we focus on individuals or
businesses, it is primarily concerned
with protecting against the financial
impact of loss: assets (i.e., property),
income, health, and life. We must also
address legal liability, as it represents a
potentially significant financial concern,
and can result in loss of income and
assets. This course will consider several
risk management techniques, and
appropriate application of risk transfer
(i.e., insurance) will be a primary focus.
It’s unusual to find a client who does not
have some form of insurance. In fact,
insurance (i.e., risk transfer) is usually
the primary risk management tool
people use. A client may have existing
insurance coverage, but is it the right
type of policy with the right amount of
coverage? Further, if the coverage is not
right, are there implications resulting
from making policy changes? This
course will emphasize examining
insurance coverage characteristics, and
how policies can be used to address an
individual’s risk management concerns.
Course Goal
The material in this course covers risk
management and insurance. Upon
completion of this course, you should
have a good understanding of risk
management need areas and ways to
address them. You should be able to
evaluate existing insurance coverage
and how it addresses the client’s risk
management needs. Finally, you should
be able to develop various strategies to
protect the client’s financial wellbeing
through appropriate risk management.
Chapter 1:Principles of Risk
Management
Learning Objectives
Upon completion of this section,
students should be able to:
1-1 Identify the types of risk clients
potentially face (including pure versus
speculative)
1-2 Describe principles of insurance
Topics
1.1 Fundamentals
1.1.1 Meaning and treatment of risk
1.1.2 Basic risk management
assumptions and techniques
1.2 Types of risk
1.2.1 Pure and speculative risk
1.2.2 Major types of pure risk
1.2.3 Major types of speculative risk
1.2.4 Perils and hazards
1.3 Personal risk tolerance and
management
1.4 Principles of insurance
1.4.1 Characteristics of insurance
 1.4.1.1 Requirements for an
insurable risk
1.4.1.2 The insurance contract
Introduction
As mentioned in the preface,
psychologists have suggested that a
fundamental need of all people is to
satisfy physiological essentials. Some of
the foundational areas of concern are
having food, protection from the
elements, and maintaining security (e.g.,
protection from criminals, illness, and
other threats). Once basic survival and
security needs are met, people feel
psychologically and physiologically
secure enough to focus on other areas,
such as financial goals.
Similarly, the financial advice process
has foundational aspects that should be
addressed prior to concentrating on
more advanced needs. Personal risk
management is just such a foundational
area that should be addressed because
it helps to provide security, a safety net
so to speak, so people can focus more
on their long-term goals.
The reason for this is obvious when you
put it in context of a client’s situation.
For example, let’s imagine a client who
has done a great job saving for
retirement and other investment
objectives (long-term goals), but has not
adequately managed risk exposures.
When an event occurs for which there is
no insurance or risk management
preparation in place to cover against the
loss, savings and investments must be
redirected to pay for the damage. The
result may be complete loss of
necessary money for retirement or other
funding needs.
This chapter will provide an overview of
risk management and insurance for
individuals and business owners.
Insurance is not the only risk
management tool, but it is one of the
major ones. As such, this chapter will
introduce and discuss types of
insurance, policies and characteristics.
Prior to that, it will be important to
understand the nature of risk and risk
management terminology.
1.1 Fundamentals
1.1.1 Meaning and Treatment of Risk
Risk is the possibility of loss. It
represents the uncertainty around
whether a loss will occur, and perhaps
when and how. People experience low-
level risks daily. Is the food in the
refrigerator safe to eat? Will I get to
work safely and on time? Will a tree
branch fall on me or will I step into a
hole and twist my ankle? Many
questions, all of which represent a level
of risk-taking. People often also
experience additional, more substantive
levels of risk. Will I be harmed in a car
accident? Will I outlive my retirement
income? Will I become disabled and
unable to maintain my current lifestyle?
Will my house suffer harm or will
someone break in and take my goods?
Will I be the target of a lawsuit alleging
misconduct or simply seeking to prove
liability?
Each of the preceding is one of many
significant risk events that people
regularly experience. When considering
whether a person will experience a loss
of some kind, it’s likely the better
question is not “whether” but “when”.
Will the individual experience a loss in
the near future? If a loss is likely, the
person will want to act to avoid or at
least minimize the related financial
exposure. On the other hand, if a given
loss is unlikely to happen soon, but if it
were to happen, the loss potential would
be financially catastrophic, the individual
should not ignore that potential, and
take protective action.
Life often presents difficult situations.
Whether it’s an illness leading to loss of
work, significant damage to a home, a
recreational accident, or a car crash,
each can cause financial loss. Some
risks of loss can be addressed without
insurance, but others are best
addressed by transferring the risk to an
insurer. Risks may be relatively simple
or complex. Regardless of the nature,
risk management begins with an
identification of the types of and
potential exposures to risk.
1.1.2 Basic Risk Management
Assumptions and Techniques
Risk management is the process of
addressing concerns related to
both insurable and uninsurable risks. It
is the identification, analysis, and control
of unacceptable risks. Identifying a
client’s tolerance for risk is part of the
data gathering process. By asking the
client insightful questions you will
determine to what degree the client is
comfortable with various risks. Clients
aren’t always consistent in their attitudes
toward risk. For instance, you may find a
client who is an avid mountain biker and
comfortable taking physical risks, but
has low risk tolerance with financial
matters.
Once a risk is identified, the techniques
used to manage that risk include risk
avoidance, risk minimization, risk
transfer and risk retention. Some risk
management techniques are almost
automatic. People make many small
decisions in less time than it took to
read this section. However, other
decisions require more careful thought
and deliberation.
Risk Avoidance
Risk avoidance is not doing things that
expose one to risk. For example, if
someone wants to avoid the risk of
death due to hitting a tree while skiing at
50 kilometers per hour, they can choose
to not ski. However, risk avoidance is
not always feasible. As an example, if
someone wished to avoid the risk of
dying in a car accident, giving up driving
may not be a reasonable solution if
alternative means of transportation are
not available or practical.
Risk Minimization
Risk minimization or reduction is
employing strategies to reduce the
likelihood or the severity of loss caused
by a particular risk. Skiing within your
ability and wearing appropriate
protective gear is an example. Wearing
a seat belt while driving and ensuring
the brakes work are also examples of
risk minimization.
Risk Transfer
Risk transfer occurs when one individual
or entity takes on the risk for the benefit
of another. When buying a lift ticket at a
ski resort, the ticket or receipt states that
the skier assumes all risks inherent to
skiing, up to and including death. This is
an example of the resort transferring the
risk of skiing to the skier. Buying car
insurance effectively transfers the risk of
damaging one’s car or someone else’s
car or person to an insurance company.
Insurance is the most common method
of risk transfer.
Risk Retention
Risk retention may be intentional or
unintentional. To illustrate, an individual
with no life insurance might decide that
the risks associated with skiing are
worth it and does not take steps to
avoid, minimize, or transfer the risk. It
may also be the case that this same
individual doesn’t understand the risks
of skiing and assumes them
unintentionally. Likewise, individuals
who drive without car insurance are
retaining the property and liability risks
associated with driving. More typically,
people choose to retain risk when the
potential for loss is unlikely or the cost of
a loss is small. One of your functions as
an advisor is to help clients make
proactive choices about retaining risk so
they do not retain a risk because they
were unaware of their exposure to it. For
example, clients may be unaware that
insurance exists to replace a portion of
their income if they become sick or
injured and cannot work. Or they may
believe that the odds of such an event
happening are so small that protecting
against it is not worth the cost. You can
educate clients so they can make
informed decisions.
To demonstrate how these risk
management techniques can work
together, let’s look at two examples. If
Cho does not want her daughter to go
mountain climbing, because of potential
injury, Cho is practicing risk avoidance.
Her daughter An, however, wants to
mountain climb, but would reduce
potential risk by using a guide and
wearing protective clothing. The risk is
the same: injury to An. Cho believes that
if An does not climb the mountain, she
can’t get hurt. An thinks that by working
with an experienced guide, wearing
protective clothing, and keeping fit, she
will reduce the possibility and potential
severity of injury (risk minimization).
An example of risk transfer would be a
young couple, Aden and Jena,
purchasing life insurance. In doing so
they transfer their risk of not being able
to provide financial support for their
children to the insurer. In the event of
their deaths, the couple’s insurer would
pay a death benefit to the children (most
likely to a guardian or administrator for
the children’s benefit) to help cover the
financial loss.
The Role of Insurance in Risk
Management
Insurance is an excellent tool to use
when the likelihood of loss is significant
and/or when the cost of a loss is
substantial and that risk can be
transferred for a premium that is
relatively affordable. Although insurance
is a common solution for managing risk
never assume that insurance is the only
solution for managing risk. Risk
avoidance, risk minimization, or risk
retention may be appropriate for a
client’s unique exposure to a specific
risk. Additionally, there are other
financial tools besides insurance, such
as an emergency fund, that can help
manage the risk of loss.
However, as a practical matter,
insurance is commonly used to manage
risk. One reason for this is because it is
not practical or desirable for most
people to avoid most risks and live a
satisfying life. Living an active and
satisfying life usually means taking
calculated risks. Insurance is often
available to protect against the resulting
exposure to financial losses. Prior to
insurance, an individual or family
suffered individually for the losses—
some people would be lucky and others
would not. Insurance allows the loss to
be spread across society, so the
comparatively small amounts of money
spent on insurance by many people
reduces individual financial impact.
Insurance is used to protect against
many pure risks because it is relatively
inexpensive compared to the potential
losses against which it protects.
Rules of Risk Management
Looking up and down a street before
crossing to make sure no cars are
coming is risk reduction. Risk avoidance
would be making the decision not to
cross the street. Risk retention would be
to simply cross the street, and allow
events to occur naturally.
What about other risk management
decisions? Are there rules to use when
you are unsure how to proceed? The
following rules provide some guidance:
1. Consider the odds
2. Don’t risk a lot for a little
3. Don’t risk more than you can
afford to lose
When considering the odds, a person
understands that when a financial loss is
very likely, insuring such a risk may not
make sense. Why? The way insurance
usually operates, insurers base
premiums, in large measure, on the
likelihood of a loss occurring. This
means that a high-probability risk will
cost quite a bit—perhaps as much as
the financial loss—to insure.
A person who does not want to risk a lot
for a little would compare the cost of
insuring against a possible loss with the
potential amount of financial loss. As an
example, a person who decides not to
insure against a catastrophic loss to his
or her home would be risking a lot (loss
of the home) for a little (the insurance
premium). This could also be a
reasonable example of not risking more
than you can afford to lose.
1.2 Types of Risk
1.2.1 Pure and Speculative Risk
A speculative risk has the potential for
either a gain or a loss. Gambling is an
example of speculative risk. As opposed
to speculative risk, pure risk only allows
for either a loss or no loss. No insurance
will cover speculative risk, while
coverage is often available for pure
risks. As such, we will be addressing
various forms of pure risk as it applies to
risk management.
Perils and Hazards
Losses (i.e., risks) are caused by perils.
Perils such as hail and fire can cause
property damage and cancer can lead to
disability or death. Perils may be
specifically named in an insurance
policy to identify what is covered as well
as what is not covered.
The term hazard is used to describe
those things that increase the chance of
loss by a peril. Physical hazards could
be snow-packed roads, driving while
impaired, or other conditions that
increase the chance for loss. Moral
hazards have to do with character flaws
in an individual that increase the
frequency or severity of a loss.
Examples include faking injuries to
collect an insurance claim or committing
murder in order to collect the life
insurance benefits. Morale hazards are
similar to moral hazards, but have to do
with carelessness or indifference to loss.
An example would be not locking your
car and leaving the keys in it because
it’s insured.
1.2.2 Major types of Pure Risk
Loss of Income
Losing your income is one of the most
common personal financial risks, and
losing a job is not the only way to lose
income. Sickness, injury, or even death
can all cause loss of income (with death
producing financial concerns for
dependents).
Death and Disability
The death of a wage earner, in addition
to causing emotional difficulties, can
produce serious financial harm for
dependents. Most people count on an
ongoing income stream as the funding
source for many financial necessities
and goals. Death terminates at least
some of that income stream, and can
create significant financial difficulties as
a result.
A disability occurs when sickness or an
injury is serious enough that it prevents
the individual from being able to work.
Thankfully, insurance—either from the
government, employer or purchased
privately—can help cover at least some
of the financial loss. Even a short-term
disability can cause financial distress,
while long-term disabilities can cause
serious lifestyle disruptions.
Catastrophic Losses
Everyone faces the potential of
experiencing a catastrophic financial
event. Medical expenses have the
potential to become financially
catastrophic, beyond critical care needs
that may cause financial distress.
Lengthy recovery or long-term care
situations also can strain financial
resources.
Natural catastrophes such as floods,
earthquakes, fire, volcanic eruptions,
and others can destroy property.
Thieves can break in and steal. Vandals
can destroy. Losses can quickly add up.
A risk management plan helps to keep
these events from becoming financial
catastrophes.
Negligence or recklessness can cause
harm to another person, along with
liability for the individual who caused the
resulting loss. Sometimes, the damages
can be significant and require great
financial resources to cover. Without
adequate insurance, a person can
deplete his or her assets completely if a
legal judgment is large enough.
Insurance can be a valuable risk
management tool. However, few, if any,
people have the financial wherewithal to
insure against every possibility of
financial loss, nor is this a wise risk
management approach. As a result,
people need to carefully contemplate
each insurance purchase. Individuals
should cover potential large losses first.
Then, if additional funds are available,
they should consider other options.
Small losses may be upsetting but often
do not cause significant financial harm.
Large losses, on the other hand, can be
financially devastating.
1.2.3 Major Types of Speculative Risk

1.3 Personal Risk Tolerance and

Management
Assess Exposure to Financial Risk
Due to the complexity of the risk
management process and potential
severity of the consequences, it is
important for advisors to develop a
focused and well-organized process for
consistently assessing and addressing
risk management issues. The use of a
set process and clearly defined
methodology reduces the likelihood of
being sidetracked or missing important
potential risks that may exist in a client’s
situation.
In the data gathering step you will
identify potential risks the client faces. In
your analysis, you will evaluate various
options for addressing these risks and
present your recommendations to the
client. If you sell insurance products,
you may personally help implement the
product solutions that will aid the client
with managing risk. If you are not able to
sell insurance, you can monitor the
implementation that takes place through
a third party. You are a vital part of the
process of assessing your clients’
exposure to risk.
Many risks can be managed with the
risk management techniques described
above. As previously mentioned, some
individuals have a higher tolerance for
risk-taking and retention than others.
Avoiding risky activities or taking
precautions to minimize the financial
impact of potential losses will help
clients reduce the likelihood of suffering
significant financial loss. Purchasing
appropriate insurance products to
transfer the risk to an insurance
company allows clients to exchange a
known premium that is relatively much
smaller than the potential for a
financially devastating loss. Clients may
also choose to retain some risks and the
financial consequences as a means of
managing risk.
The risk management process can be
shown in six steps:
1. Identify risk management goals
2. Collect information to identify
risk exposures facing the client
3. Analyze and evaluate the
information
4. Construct a risk management
strategy (i.e., determine
 appropriate risk treatment
methods)
5. Implement the
recommendations
6. Monitor the recommendations
for any needed changes
Let’s look at the steps a little more
closely.
Identify Risk Management Goals
First, learn what the client wants from
his or her risk management program.
Then, define the objectives, often using
a formalized risk management policy.
This can provide guidance for the
advisor and the client as part of
evaluating recommendations (similar to
an investment policy statement [IPS]).
Evaluate all the client’s risk exposures
and provide guidance in meeting the
resulting risk management goals.
Collect Information to Identify Risk
Exposures Facing the Client
In an overall risk management program,
relevant information includes just about
everything you can learn about the
client. Potential sources of information
include policy checklists, legal
documents, risk analysis questionnaires,
and financial statements. This
information is necessary because all the
client’s assets and activities are
potential sources of risk exposure, and
an advisor needs to know the risks a
client faces to determine if those risks
are adequately covered. Reviewing
existing insurance policies allows the
advisor to analyze the coverage to see if
it is appropriate. You will also want to
view tax returns, investment statements,
wills, and trust documents.
Analyze and Evaluate the Information
The advisor should evaluate each of the
client’s assets and activities to look for
risk exposures, of which there are three
basic types.
1. Asset-related; that is, loss of
the asset itself, loss of use of the
asset, and other associated
losses
2. Liability-related; based
on contract law associated with
the asset or activity (e.g.,
acquisition of an asset resulting in
liability to a lender, a club
membership contract putting
certain responsibilities on the
client, etc.).
3. Liability-related; based on tort
law (i.e., liability for a loss
resulting from the use of an asset
or from an activity—a boating
 accident, practicing one’s
profession, etc.).
Construct a Risk Management Strategy
After analysis and evaluation, the
advisor can develop risk treatment
approaches for risk exposures and
select appropriate alternatives. When
the advisor and client accept
appropriate approaches, they should be
incorporated into the risk management
strategy.
Implement the Recommendations
Implementing recommendations may
require restructuring existing insurance
policies and risk management plans. It
may also mean purchasing new
insurance policies. Although the client
must ultimately decide whether he or
she will implement the strategy you
present, you will probably need to help
guide the implementation process by
recommending action steps.
Monitor the Recommendations for
Needed Changes
Monitor recommendations because
things change over time. The client’s
situation will change, as will various
options for meeting client needs. By
reviewing and updating
recommendations, you gain the
opportunity to identify new or previously-
missed risk exposures, obtain missing
information, and modify any previous
actions.
As you continue to gather data from the
client, it is likely that you will uncover
risks that require the client to act. When
you share your findings with the client,
you will learn how important addressing
these risks are to the client. You may
also find that the client is unaware of the
potential for loss and the extent of the
potential financial cost that would result.
Property (including liability) and life are
two primary risk areas.
Property & Liability
Many clients who do not have adequate
liability coverage are exposed to the
potentially devastating loss of their
savings and investments in addition to
having their wages garnished. Clients
also may not have their home
adequately insured either for the proper
value or against potential perils. For
example, a client with a home in an
earthquake prone area may not have
earth movement coverage on the
homeowner’s insurance policy.
Similarly, clients who live in coastal
areas should be protected against
potential flood and losses from wind
damage.
Another often overlooked risk is the
potential for loss of high-valued personal
property. Jewelry, collectibles, and other
such property that may be frequently
targeted by thieves should be properly
protected. While using security
measures like alarm systems and video
surveillance is an option to minimize this
risk, insurance can also be purchased to
transfer this risk.
Life
You probably will meet with clients who
do not fully understand the potential
financial loss that would result if they die
prematurely. The financial difficulties
that surviving family members will suffer
because of not adequately addressing
this risk can cause the loss of the family
home and a drastic change in lifestyle.
Insurance, as we have learned, is one of
the main risk management tools. In the
context of risk management terms,
purchasing insurance is risk transfer. In
some ways, insurance is simple – pay a
premium and transfer the risk of loss to
the insurer. However, as you begin to
explore insurance more closely, you find
it can be a complex financial instrument
capable of addressing many risk
management needs.
1.4 Principles of Insurance
1.4.1 Characteristics of insurance
Underwriting
Ocean marine insurance first emerged
as a precursor to its current form during
the 17th century (i.e., 1600s) in
England. To take advantage of this
insurance coverage, a ship owner would
make a list identifying the ship, where it
was headed, the cargo, and any
additional relevant information. Those
who wanted to participate would write
their names under the portion of the
cargo (or risk) they were willing to
accept. They would also include any
conditions that might apply to their
acceptance of the risk. This process—
writing one’s name under a given risk—
was called underwriting. In today’s
world, an insurance underwriter
essentially does the same thing: he or
she determines risks that are acceptable
to the insurer, and any related
conditions for accepting that risk.
The process of underwriting, then,
determines whether a risk is reasonable
to accept, at what price, and with what
conditions. Applications for insurance
coverage are sent to the insurer for
underwriting. Upon acceptance of a risk,
the insurer issues a policy and
completes the underwriting process.
Insurance companies do not accept all
risks. In fact, it would be foolish for them
to do so. The potential costs for certain
risks are greater than the insurer’s
ability to absorb, regardless of the
premium charged. Insurance companies
are in business to make a profit. The
chosen field is insurance, but the
object—or at least one object—is
making money. To be profitable,
insurers must be selective about risks
they are willing to assume.
In some situations it may be possible to
insure things that would seem to be
uninsurable. When a concert pianist
wants to insure her hands, or a singer
his voice, where can they turn? While it
is true that they almost certainly will not
be able to purchase true insurance to
cover their hands or voice, they do have
an option. This type of protection may
be available through Lloyd’s of London
or similar associations. Lloyd’s
associations have individuals and firms
evaluating each specific risk to
determine a premium based on the
estimated potential for loss. Normal
requirements for an insurer to accept a
risk do not necessarily apply; however,
most of these associations, and all
insurers, do follow certain requirements
when assessing acceptable risks.
1.4.1.1 Requirements for an Insurable
Risk
Insurers consider four factors before
accepting a risk:
1. The law of large numbers must
apply
2. The loss must be by chance
(i.e., accidental or fortuitous)
 3. The loss must be measurable
and able to be defined
4. The loss must not be
financially catastrophic
A catastrophic loss to an insurer is not
the same as a catastrophic loss to an
individual. Loss of a house might be
financially catastrophic to a family.
However, loss of one house would not
make much financial difference to an
insurer. On the other hand, the loss of
10,000 houses could definitely be
financially catastrophic for an insurer, to
the extent that the company might no
longer be viable as a business.
This is one of the reasons why it may
not be possible to purchase insurance to
cover a certain peril. If a business owner
wants purchase coverage against
robbery in a high-crime area, he or she
may be turned down; that, or the
coverage premium may be so high as to
be prohibitive. The insurer is effectively
telling the business owner that the odds
of a robbery are so high that the
remuneration cost would be too high. As
a result, the insurer might choose to
cover the peril, but charge an exorbitant
premium. More likely, the insurer will
determine not to extend coverage.
Law of Large Numbers
The law of large numbers is a
foundational insurance principle. The
idea is that with enough similar (i.e.,
homogeneous) risks or exposure units,
potential losses for the entire group
become somewhat predictable. No one
may be able to accurately predict when
one house might burn down. However,
an insurer that covers 20,000 houses
against loss by fire has the statistical
information to determine with
reasonable accuracy the potential
number of homes in that group that may
catch fire in a given period.
This knowledge can be applied to
assessing anticipated financial losses.
The insurer then uses the loss potential
as a base for determining appropriate
premiums to charge for coverage. The
procedure is a bit more involved than
this, but that’s the basic process for an
insurer to determine premiums (along
with administrative expenses, and
such). Underwriting will also look at
home construction quality, location, and
claims history for a given area, among
other factors.
To accurately determine premiums, an
insurer must have enough information to
measure potential financial losses.
Circumstances surrounding a loss
cannot be nebulous; it must be clear a
measurable loss actually occurred.
These two factors help insurers to
remain solvent. While it is tempting to
think that we don’t really care about an
insurer’s financial well-being, an
individual with insurance wants the
insurer to remain viable long enough to
pay any claims that may be filed. To do
this, the insurer must abide by the
preceding insurable risk requirements.
After underwriting completes its work
and accepts a risk, the insurer will issue
an insurance policy. The policy is a legal
contract with specific conditions to be
observed.
Structure of Insurance Policies
An insurance policy is an agreement
(generally a standard form contract)
between the insurer and the
policyowner, which determines the
claims the insurer is legally required to
pay. In exchange for an initial payment,
known as the premium or consideration,
the insurer promises to pay for losses
caused by perils covered under the
policy.
Insurance policies are called contracts
of adhesion because the insurer has the
power to draft the contract (therefore,
the insurer is “stuck” with and must
abide by contract terms), while the
potential policyholder only has the right
of refusal and he/she cannot counter the
offer, or create a new contract for the
insurer to agree to. As a result, it is
important that insureds read the contract
carefully as all the information and rules
have been written by the other party.
Related to the concept of adhesion,
contracts are unilateral. This means only
one party is legally bound to do anything
(in most jurisdictions). The insurer is
bound by the contract terms, but the
insured is not equally bound by any
promise or agreement (other than
abiding by the contract terms to
continue coverage).
1.4.1.2 The Insurance Contract
Even though a contract in one territory
may differ from one in another
jurisdiction, to be considered valid, all
contracts must satisfy certain legal
requirements within a given territory. A
legally valid contract must:
1. Pertain to a legal activity
2. Be valid in its given jurisdiction
3. Be between legal parties (i.e.,
those able to enter into a contract)
4. Have an offer and acceptance,
and
5. Provide for some consideration
(i.e., payment or performance)
Additionally, there are generally four key
insurance concepts that apply to
insurance law that affect the operation
of the insurance policy:
1. Insurable interest
2. Indemnity
3. Utmost good faith, and
4. Subrogation
Insurable Interest
Insurance contracts require that some
insurable interest exists. An insurable
interest is the legal or equitable interest
that is held by the insured in insured
property or a life. In economic terms, it
applies where an insured has suffered a
monetary or economic loss through the
damage or destruction of the subject
matter of the insurance. A monetary loss
exists if a person is liable to pay or lose
money in the event of a loss, i.e., it can
be measured in economic terms. For
example, in the case of a creditor who
insures property owned by a debtor, the
insured will not have either a legal or an
equitable interest in the property
insured, but would stand to suffer a
monetary or economic loss if the asset
was damaged or destroyed. By applying
the same principle, an employer will
have an insurable interest in the life of a
key employee should that person die or
suffer a permanent incapacity. The
employer will have an economic loss
associated with the cost of replacing
and training a replacement.
In common law, the insured must have
an insurable interest both when entering
a contract of general insurance and at
the time of a loss. In some jurisdictions
common law has been modified by
consumer legislation so that having an
insurable interest in the property when
entering the contract is no longer
required.
Change of Insurable Interest
In some jurisdiction’s insurers require
notification if the nature of the insured’s
interest changes. However, if the policy
does not contain a notification clause,
then the policy will remain valid without
notification. However, the insured will
need to advise the insurer of relevant
changes on the renewal of the policy as
renewal usually constitutes the creation
of a new contract and the disclosure
requirements will apply. This means that
all material facts that have arisen from
the inception date of the contract to the
date of renewal must be disclosed
before the policy is renewed.
Principle of Indemnity
Under most circumstances, insurance
policies are designed to make the
policyowner whole. That is, the insured
will be restored to the condition he or
she was in prior to the loss. However,
the insurer will not generally provide
enough payment to put the insured in a
better financial position than he or she
previously held. To indemnify, then, is to
be made whole, but not better than
whole. The principle of indemnity allows
an insured to purchase insurance to
protect against loss to the extent of their
insurable interest. Under the principle of
indemnity, an insured is not able to
claim more than their loss. For example,
if the owner of a house insured the
house for $400,000 against fire and the
house was subsequently destroyed by
fire, the insured would only be able to
recover $400,000, even if the property is
actually worth $500,000. If the insured
was able to recover $500,000 and so
make a profit out of insurance, this
would constitute a wager (i.e.,
speculation), which would be against the
true nature of insurance.
In some jurisdictions, it’s possible to
insure a property for its current
replacement value. Since the value of
the insured property is calculated at the
time of the loss when determining the
amount to be recovered, the amount
may be less than the replacement value
of the property unless regular
adjustments are made to the policy
addressing the effects of inflation. In
addition, the policy conditions may state
that underinsurance may result in the
policy reverting to an indemnity policy
(rather than a replacement policy),
which may result in a severe financial
loss for the insured.
The principle of indemnity does not
apply to life insurance policies, because
they are classified as ‘contingent’
insurance, i.e. a claim arising on the
occurrence of contingency of say, death.
In addition, indemnity does not apply to
valued policies. With these policies, the
insurer and insured agree in advance on
the value of the insured property (almost
always requiring an appraisal), so that in
the event of loss or damage this amount
will be paid to an insured regardless of
the actual value of the property at the
time of the loss. For example, if a solid
gold pendent is valued at $2,000, and
insured for this amount two years ago
and was subsequently stolen, the
current value of the item could be as
high as $3,000 because of the
substantial appreciation in the value of
gold over the two years. However, the
insurance would only pay the agreed
value of $2,000. Furthermore, the
insurer would still pay $2,000 even if the
value of the item actually declined to
$1,000.
The Doctrine of Utmost Good Faith
The doctrine of utmost good faith
(Latin: uberrimae fidae) is an important
concept in insurance law, as it applies to
potential insureds, current insureds and
insurers, and is linked to the duty of
disclosure. Utmost good faith refers to
the highest degree of honesty and
sincerity. The most common indicator of
the duty of good faith is in the pre-
contractual duty to disclose. It goes
without saying that the insured has the
greatest knowledge about the risk being
proposed to the insurer so the insured
should be required to disclose all those
facts that might influence the
underwriter as to whether to accept the
risk, or to do so with altered terms.
There is also a post-contractual duty
that continues throughout the policy
period. This duty generally arises in
relation to claims, either in the way the
insured made the claim or in the way the
insurer handled the claim. An insurer
would not be considered to have acted
with due regard to the insured’s
interests if the insurer consciously
delayed paying a valid claim,
speculating that the insured would not
contest the delay and give up pursuing
the matter.
In some jurisdictions, simple mistakes
are not taken to be a breach of the duty
of good faith. “Good faith” implies
intention. Neither fraudulent claims nor
an insurer’s delay tactics, as noted
above, represent “good faith”.

Duty of Disclosure
In common law, each party to the
contract is under a duty to voluntarily
disclose relevant information to the
other during the negotiations leading up
to the creation of the contract. The
matters that need to be disclosed are
any facts the parties are aware of that
might be material to the negotiation. A
failure to disclose any material fact
allows the innocent party to void the
contract from the beginning.
The duty of disclosure is important to
insurers because the insurer needs
accurate information about the risk
being proposed to calculate an
appropriate premium and apply suitable
conditions. This duty falls heavily on the
insured because he/she knows all the
facts of the risk. Therefore, if one
partner signed a proposal for insurance
and the other partners were not involved
in the negotiations but were aware of
facts that would have influenced the
insurer’s decision to accept the
proposed risk, the non-disclosure of
these facts will likely allow the insurer to
void the policy.
Non-disclosure can be potentially hard
on insureds, because of such things as
poorly drafted questions from the
insurer. These (and similar) can cause
real difficulties in disclosing all relevant
information. As a result, some
jurisdictions have modified common law
to require insurers to specifically ask the
questions for which they require
information, because insurers know
better than insureds the information they
require.
For general insurance contracts, the
duty of disclosure is required when
completing a proposal and again on the
renewal of the contract. At renewal time,
a new contract is crafted so all matters
that may have arisen since the
commencement of the original contract
must be disclosed. This could involve
such matters as a drunk driving offence,
criminal conviction or as simple as the
installation of smoke alarms. In contrast,
the duty of disclosure with life insurance
only applies during the pre-contractual
period, because these policies are
issued on a continuing basis and are not
subject to the same type of renewal. In
some jurisdictions, non-disclosure
during the formation of a life insurance
contract may only give the insurer the
right to void the policy for a limited
period, such as two or three years. After
the expiration of the two or three years
the results of the non-disclosure will not
have any effect on future claims.
Material facts may include:
• The name and occupation of the
applicant. Occupation may be
material particularly where the
occupation is hazardous.
• The health status of the applicant.
Major illnesses and operations are
important especially with life
insurance and income protection
or personal healthcare insurance.
• Insurance and loss history of the
applicant, including previous
claims and whether the applicant
has been refused insurance or
had insurance cancelled.
 • Criminal convictions (even if not
directly related to the risk under
consideration). Criminal
convictions generally indicate that
a convicted person poses an
increase in moral hazard.
However, in some jurisdictions,
criminal convictions become
irrelevant after a period, such as
10 years.
• Matters that indicate an increase
in risk for the insurer, such as the
storage of flammable liquids on
the premises and the type of
material used in the construction
of the building.
Subrogation
Subrogation is related to the principle of
indemnity. You might see a technical
definition stating that an insurer will sue
the individual who caused covered harm
to an insured after it has settled the
insured’s claim. The insurance company
may sue that individual to recover
amounts paid to the insured to cover the
loss. To some degree, this is an
extension of indemnity, because the
insurance company is ensuring overall
payment does not exceed the claimed
loss.
Consideration. A promise from one
person to do something or provide a
service for another person identifies
another contractual component. A
simple contract may involve one person
agreeing to clean another person’s
house for a certain sum of money. While
quite simple, the transaction is still
considered to be contractual. Of course,
many contracts are more involved and
complex. No matter how simple or
complex, a valid contract includes an
offer by one party and acceptance by
another.
A contract’s consideration is simply the
amount to be paid for the goods or
services involved, or some performance
that applies.
Suppose that Saura, a contractor, is
willing to help her neighbor, Kadar, find
respected suppliers for a remodeling
project, in exchange for him agreeing to
watch her home while she is on holiday.
Here, the consideration for the home
watching is information about suppliers,
and the consideration for the information
is the home watching. Contracts do not
always require financial remuneration,
but they do require some form of
consideration.
With an insurance contract, the
insurer makes an offer to provide
coverage for a given price (premium).
The applicant agrees to coverage
terms and pays the required premium
(offer and acceptance).
Claims
Claims payment and loss handling is the
‘litmus test’ of the value of insurance; it
is the actual “product” paid for. The
procedure for making a claim usually
starts with the insured notifying the
insurance company, broker or their
agent and completing the company’s
claim form. In some jurisdictions, small
claims for damage to a home or
contents can be made over the
telephone or online without submitting a
claim form.
Insurance policies generally require the
insured to notify the insurer of a loss
within a specified time, such as
‘immediately’, ‘promptly’, or within a
certain number of days. The notice of
loss allows the insurer to begin
investigating the insured’s loss and to
begin proceedings to reduce their
potential loss, such as bringing litigation
against negligent parties or arranging
salvage. For life claims, doctors’ reports,
death certificates, etc. need to be
obtained before the company will admit
liability.
Under common law, insurers have
sometimes used the claims notification
clause to deny otherwise legitimate
claims, thus causing considerable
financial distress for their clients. In
some jurisdictions insurance law
prevents insurers from relying on such
clauses, but will allow insurers to reduce
the amount of the claim by the amount
of the damage they may have suffered,
which will generally be the amount of
extra costs the insurer has incurred
because of the delay.
In addition to the notice of loss clauses,
most policies contain further clauses
requiring insureds to provide
‘satisfactory’ proof of their loss. The
‘proof of loss’ clause may be a
conditional requirement for the insured
to recover under the policy. Insureds
can comply with this requirement by
producing valuation certificates or
receipts of purchase, wage statements
and the like. The insured is also
required to show that the loss falls within
the terms of the policy. If an insurer
does not want to pay the claim, it must
prove that the loss is not covered
because of an exclusion in the policy.
Proximate Cause
Frequently a chain of events or causes
rather than a single cause, leads to a
loss. It is necessary to examine this
chain to determine the proximate (or
immediate) cause and whether it is
excluded from cover or not. If an
insured peril directly gives rise to the
loss, then it will be covered, provided
there was no uncovered peril that
effectively interrupted the chain of
events.
On the other hand, the final loss need
not be the direct result of an insured
peril, provided the cause of loss was
proximately initiated by an insured peril.
For example, fire policies generally
make no mention of water or smoke
damage, but provided that the cause of
the fire is not an uncovered peril, all
losses resulting from water or smoke
following the intervention of the fire
services are deemed to be fire damage.
The perils that must be considered can
be classified under three headings:
1. Insured Perils: those named
in the policy as insured
2. Excepted or Uncovered
Perils: those named in the policy
as excluded, either as causes of
insured perils or as results or
consequences of insured perils
3. Other Perils: those that are
not mentioned at all in the policy
but may form part of the chain of
events leading to the loss
Once the insured has proven that the
cause of loss is covered by the policy,
the onus is on the insurer to prove a
breach of the policy by the insured. If
the insurer has claimed that a breach
has occurred, then the onus is on the
insured to prove that an act or omission
that breaches the warranty or another
term of the contract does not cause or
contribute to the loss, whether wholly or
partially.
Contract Terms and Sections
• Aleatory: The outcome depends
on chance and the financial
participation between parties are
substantially unequal. Consider that
after the insured pays one relatively
small premium for a life insurance
policy, the insurer is required to pay
a large claim on the death of the
insured.
• Adhesion: The insurer is required
to abide by the terms of its
contracts. In other words, because
the company wrote the contract, it
must honor its terms.
• Unilateral: Only the insurance
company can legally be required to
honor contractual terms. The
insured must abide by any
conditions in the contract if he or
she wants the policy to pay, but the
insurer cannot require insureds to
maintain a policy against their will.
On the other hand, the insurer is
legally bound to abide by policy
terms for coverage.
• Conditional: As previously
mentioned, insurance contracts
include conditions that must be
followed for the policy to pay. For
example, an insured may be
required to provide an inventory of
household items for the insurer to
pay a claim for damage to that
property.
Insurance Policy Sections
Insurance policies usually contain the
same sections.
• Duty of Disclosure: a statement
reminding potential insureds about
their obligations to disclose all the
information asked for in the
proposal form; why honest answers
are important in assessing the
application and the consequences
of making a false declaration
• Declarations: statements made by
the policyowner, often supplied on
the application for coverage. This is
known as the ‘basis clause’ and
has been discontinued in some
jurisdictions
• Insuring Agreement: what is being
insured and the conditions of
coverage.
 • Conditions: the process or
procedures (or rules) that must be
followed for the insurer to be
required to pay a claim
• Exclusions: any related items or
instances that will not be covered
by the policy
The policy conditions are important and
insurance contracts almost always
include conditions that must be met for
the policy to pay. That is, conditions
impose an obligation on the policyholder
to comply with these requirements. This
goes beyond the requirement to pay
premiums. As an example, a
policyowner may be required to file a
claim form within a set period following
an insured event, or to take reasonable
precautions to protect the insured
property. Therefore, if the policyowner
does not file a claim form within the
required time limits, or the insured
leaves the keys in the ignition and the
car unlocked while unattended, the
insurance company may not pay the
claim (e.g., filing a claim months or
years after an event might invalidate the
claim). Often, insurance companies
require evidence of insurable interest.
Other conditions usually apply as well,
making insurance
policies conditional contracts.
Insurance policies may also include
items known as riders or endorsements.
These serve to modify policy coverage
or terms and
conditions. Rider and endorsement esse
ntially describe the same thing. Some
policies use the term rider, while others
use endorsement. Sometimes insurers
initiate endorsements. These often
make contractual changes to limit
coverage or add requirements for
continued coverage. Other times the
insurer will voluntarily increase coverage
or add some other policy benefit. This
also would be accomplished through an
endorsement. At still other times, the
policyowner may wish to add or
otherwise modify coverage. As an
example, a policyowner may wish to add
a family insurance rider to a life
insurance policy. This request would be
made in writing, and, if accepted, the
policy would be endorsed with the
additional coverage.
Exclusion Clauses
Exclusion or exception clauses are
important in insurance policies because
they define the boundaries (extent of
cover) that will apply. Some exclusions
are common to most insurance policies,
e.g. those excluding cover for claims
arising from such events as ‘war, riots,
civil commotion and radiation’. Other
exclusion clauses will relate specifically
to the type of cover provided by the
policy.
In some jurisdictions, insurance
legislation prevents insurers from relying
on an exclusion relating to a pre-existing
defect or imperfection in the insured
property or a pre-existing illness or
disability of the insured, if the insured
was not aware of this when the contract
was entered into. In addition, if an
exclusion clause states that the insurer
will not be liable for some act or
omission of the insured or third party,
the insurer will not be able to refuse to
pay a claim if the specific act or
omission does not cause or contribute to
the loss. For example, cars are
expected to be maintained in a
roadworthy condition, but if an insured
was stopped at a traffic light and was hit
in the rear by another vehicle, the
insurer will be prevented from denying a
claim because the insured vehicle had
bald tires. However, if the same vehicle
slid off a wet road during a rain storm
and suffered damage because of the
bald tires then the insurer would be able
to rely on the exclusion.
Fraudulent Claims
Insurance fraud is a major problem for
insurers. In the insurance industry, the
term ‘insurance fraud’ is most often
associated with some form of
manipulation of an insurance claim. In
some cases, this may involve fabricating
the entire claim, including deliberately
causing damage to the insured property.
Unfortunately, the cost of fraudulent
claims must be covered so this
ultimately results in a cost increase on
all insurance premiums.
Loss by Own Act
The basic purpose of insurance is to
indemnify insureds for losses caused by
fortuitous and unexpected events.
Indeed, the very principle of the pooling
of losses, the ability of losses to be
calculable and the ability of an insurer to
strike an economically viable premium
relies on the fortuitous presumption.
If an insured causes a loss with the
intention of making a claim, then they
will be denied the right to recover. For
example, if an insured deliberately sets
fire to their house to recover from their
insurance policy, such a claim will be
fraudulent and will not be admissible
under the policy.
In some jurisdictions where a policy is
issued over jointly owned property,
arson by one policyholder does not
prevent recovery on the joint policy by
an innocent co-insured policyholder for
the latter’s share of the joint property.
Unfortunately, this does not apply in all
jurisdictions so in the instance of an
aggrieved spouse burning down the
jointly owned property, the innocent co-
insured spouse will be denied
compensation under the jointly owned
policy.
Measurement of the Loss
The principle of indemnity requires the
insurer to fully compensate the insured
for the loss up to the maximum sum
insured during the currency of the
policy. This restricts the insurer’s
maximum liability even if the value of the
property or reinstatement costs are
greater than the sum insured. The
objective is to put the insured back in
the position they occupied before the
loss occurred. It is not intended that the
insured make a profit from the loss.
Establishing the actual amount of the
loss is the cause of a large number of
disputes between insurers and their
insureds.
Where the insured suffers a total loss of
property or goods, the measurement of
the loss will be the market value of the
property or goods at the time of the loss.
For example, assume a house listed for
sale for $300,000 is destroyed by a wind
storm. The current value of the house
would be the sale price less the value of
the land (land is not covered by
insurance), assuming the sale price was
not overinflated.
In the case of a life policy, the policy
face amount or death benefit determines
the amount payable under the policy.
However, with accident policies the
economic loss sustained by the insured
is calculated by referring to lost income,
medical bills, set amounts detailed in the
policy for specified injuries or
sicknesses and, in the case of residual
injuries, the levels of damages awarded
by the courts.
For liability policies, the amount that an
insured can recover is the amount of
their liability to the third party, but
restricted to the limit of liability specified
in the policy.
Valued policies, as mention above, are
an exception to the principle of
indemnity, which allows the insured to
claim the sum insured regardless of the
actual value of the property at the time
of the loss. In most cases, the
calculation of agreed value will be based
on the value declared by the insured in
the contract proposal. This declaration
often leads to disputes when cars are
insured, and in common law, a breach
of a warranty of value will allow an
insurer to void the policy if the value is
inaccurate at the time. However, in
some jurisdictions insurance law
prevents insurers from voiding a policy
based on a misstatement of value. In
these cases insurers are allowed to
reduce the amount of the claim by the
amount they have been harmed. For
example, if a car is purchased for
$25,000 and insured for $30,000 an
insurer would be required to only pay
$25,000 and be prevented from voiding
the policy.
Underinsurance
Insurance premiums are based on the
belief that insureds will insure for the full
value of their property. Therefore, if the
property was insured for less than its
value (underinsurance) then an insurer
is receiving insufficient premium income
to maintain the viability of their
insurance pool. To overcome this
problem most policies contain an
‘average’ or ‘coinsurance’ clause to
protect insurers from the economic
effects of underinsurance.
Under a coinsurance clause, only those
insureds whose property has been
totally destroyed will be covered for the
property’s insured value. Where an
insured has underinsured the property
and the loss is partial, the insured bears
a pro-rata proportion of any loss, which
is calculated as follows:

For example, if a house that is worth

$400,000 (also the required amount of
insurance) is only insured for $200,000
and the property suffers damage of
$100,000, assuming no deductible, the
insured will only be paid $50,000 by
their insurer.

In some jurisdictions, insurance law

recognizes that it is difficult to precisely
determine the true value of a household
property, particularly as inflation and
rising property values can lead to
underinsurance. Remember, this value
will be determined at the time of the loss
and not when the insurance was taken
out. In these jurisdictions insurers are
restricted from applying the average
clause to homes and contents unless
the sum insured is below a specified
amount, such as 80 percent or more of
the value. When this is the case, the
insured’s claim payment will be reduced
because of the underinsurance. As an
example, assume a house valued at
$300,000 is insured only for $200,000
(67 percent of value). If the house
suffered damage of $120,000, the claim
payment would be based on the 80
percent
($240,000) coinsurance requirement for
coverage. $200,000 divided by
$240,000 is .83. Multiply .83 by the
$120,000 loss, and the insurer will pay
$100,000, because of the
underinsurance amount. This is also
known as the coinsurance penalty.
In this chapter we saw an overview of
risk and some ways to address it,
especially risk transfer or insurance. We
will look more closely at insurance
products and types in Chapter 3. Next,
we will explore some of the risk
exposures people face.
Chapter Review
Discussion Questions
1. As you consider the four basic risk
management techniques
(avoidance, minimization, transfer
and retention), how do they
compare and practical or applicable
is each as a risk management tool?
2. The risk management rule –
consider the odds – may be a little
confusing. How would you explain it
and why does it (or does it not)
make sense?
3. Why do insurers not accept all
types of risk and what is the
function of underwriting in making
this decision?
4. How does the law of large
numbers enter into an insurer’s
coverage decisions?
 5. How does the principle of
indemnity relate to an individual’s
risk management plan?
6. Why would you say the insurer is
the only party to an insurance
contract that is required to abide by
and fulfil contract terms?
7. If a person is underinsured he or
she may not receive full payment
for a claim. Why is this true and is
this a fair policy?
Review Questions
1. What are the four primary risk
management techniques?
2. What are the three rules of risk
management?
3. How would you define risk, peril
and hazard?
4. What is underwriting and how
does it relate to insurance?
5. What are the requirements for an
insurable risk?
6. How does a loss that would be
catastrophic for an individual differ
from one that is catastrophic to an
insurer?
7. How would you describe insurable
interest?
8. What is the principle of indemnity
and how does it apply to
insurance?
9. What is subrogation and how
does it relate to insurance?
10. What are riders and
endorsements and how do they
differ?
11. Why is underinsurance a
problem for insurers, and what is
one method they use to
compensate?
Chapter 2: Risk Exposures
Learning Outcomes
Upon completion of this chapter, the
student will be able to:
2-1 Evaluate a client’s personal and
general insurance exposures
2-2 Evaluate a client’s risk management
needs
Topics
2.1 Financial obligations: existing and
potential
2.2 Analysis and evaluation of risk
exposures
Introduction
As we have seen, people face risks of
various types daily. Even eating, going
to work, traveling, and crossing the
street present the individual with
potential risk of loss. Some risks have
little long-lasting effect. Others can have
a major impact on the individual’s life. Of
those risks that can have a major
impact, those with financial implications
are of greatest interest to financial
advisors. This category includes lifestyle
and health issues, loss to a house, car
or other personal property. It also
involves liability exposures, some of
which do not require any action on the
part of the individual to become an issue
(e.g., a tree on the property falls onto a
neighbor’s house). Risk of loss can even
extend to loss of life. It is possible to
mitigate some risk exposures, especially
those that generally do not have a
significant impact, by making lifestyle
changes. However, many of the more
substantive risks require more
substantive measures, including the use
of insurance to transfer the financial
impact to a third party. We will explore
many of these risk exposures in this
chapter.
2.1 Financial Obligations: Existing and
Potential
A person should consider how much
financial loss he or she reasonably can
sustain. Another way of saying this is to
calculate the amount of financial
damage a person is capable of
incurring, or is willing to incur. When the
potential loss gets too high, the rule,
“Don’t risk more than you can afford to
lose” becomes applicable. Any loss that
has too high a financial cost is a
candidate for risk transfer (i.e.,
insurance).
Types of Risk and Potential Impact
Some of the risks of which advisors
should be aware include:
• Risk of premature death
 • Longevity risk (outliving your
retirement money)
• Health risk (declining health,
including making one uninsurable
or requiring a substandard
insurance rating)
• Risk of unemployment
• Risk of disability
• Property risks—direct and indirect
• Liability risks
A common thread through these risks is
that each holds the potential to be
financially devastating to your clients. A
premature death or extended period of
disability with the accompanying
healthcare costs could force clients to
drastically change their lifestyle for the
worse. Clients could have a lifetime of
savings wiped out because of a liability
claim for which they are found to be
responsible. While some property losses
could be minor, the loss of the family
home would be devastating.
Lifestyle issues cover a wide array of
potential risks. These can range from
certain hobbies and habits, alcohol or
drug abuse, nutritional issues and eating
disorders, and many additional areas.
Some of these, like recreational hobbies
such as mountain climbing, SCUBA
diving, or race-car driving can be
positive and enjoyable, but also present
potential risks for liability, loss of income
due to injury and the like. Others,
including alcohol or drug abuse, create
risks by their very nature. For our
purposes, it is important to identify that a
person’s life choices can have an impact
– sometimes a large impact – on risk
management. Consider mountain
climbing as we viewed previously. It can
be enjoyable to be outdoors in the
mountains, but natural hazards, slips
and falls can create losses for climbers.
Weather can change from pleasant to
potentially deadly in a very short period.
Rock slides can be severe enough to
cause serious injury and disability. If a
climber gets caught in an unexpected
snow storm he or she could die or be
greatly harmed by excess exposure.
Lightning strikes in the high mountains
cause injury and death.
The preceding perils are common to the
mountain climbing experience. As a
result, if a climber wants insurance
coverage, he or she may have to pay an
increased premium because of greater
exposure to risk. It’s possible the
climber may not even be able to
purchase some types of insurance
cover. With or without coverage, the
climber should practice risk reduction by
wearing appropriate clothing, using
proper gear, climbing with a partner,
notifying appropriate authorities about
climbing routes and other plans, and
generally taking all reasonable
precautions. In an extreme, a climber
might accidentally dislodge a boulder
that falls onto a house and creates a
liability exposure.
You can see how such lifestyle choices
can have risk management
consequences. Those choices that are
inherently harmful, such as drug abuse,
create even greater problems. Health-
related issues can also have significant
financial implications.
Health issues often go together with
lifestyle issues in the realm of risk
management. This is not to say that
individuals have the same degree of
choice in both areas. Many health
concerns are unrelated to choices made
by individuals, although there may be a
relationship with some. The real concern
is how to prepare and how to mitigate
potential losses when a health-related
issue arises. Without going into detail
about good nutrition, proper medical
care, exercise, etc., we can summarize
by stating the obvious need to maintain
one’s health. More relevant to this
discussion is what happens when a
significant health-related event occurs.
Some of the answer to that depends on
whether the individual had health-
related insurance cover prior to the
event. As you know, insurance does not
prevent such events, just as life
insurance does not prevent death.
People get coverage because they want
to prevent against financial loss in the
event of a covered event. We will
explore various types of insurance cover
in Chapter 3, so for now, we will
summarize. Some health-related events
can cause hundreds of thousands of
dollars’ worth of loss. Between actual
medical expenses and loss of income
due to disability, related expenses can
seriously harm an individual’s financial
well-being. Appropriate insurance cover,
in addition to government-provided
benefits, can minimize the damage.
There is one additional area of concern
that we should mention at this point.
You cannot purchase insurance to cover
a loss after it happens. Similarly, an
individual cannot get appropriate
medical cover to take care of a
significant health-related issue once it
has been diagnosed. This means
people must purchase the insurance
prior to the event happening, but they
often do not see the value of doing this.
To some extent, it’s human nature.
People don’t want an umbrella until it
starts to rain. They may not lock the car
doors until after personal property has
been taken. Unfortunately, after the
event, it’s too late to take adequate
precautions. This is why, as an advisor,
you should make sure to discuss these
things with clients and do what you can
to encourage them to take appropriate
action before an event needing
insurance coverage happens.
2.2 Analysis and Evaluation of Risk
Exposures
To help with the analysis and evaluation
process, we will consider the Conway
family case.
James and Mary Conway married
following graduation from university
22 years ago. They are both age 45
and have three children – Jamie,
Nancy and Barbara. Jamie, age 19,
is a first-year medical student. Nancy
(age 16) and Barbara (age 14) are in
school and living at home. James is
an executive with a global firm and
Mary, following a successful early
career in law, is a stay-at-home
mother, focusing on raising the
couple’s children. Mary also
volunteers with a legal aid
organization and sits on the board of
their neighborhood homeowner’s
association. Both are active in
competitive sports, as are Nancy and
Barbara.
James has been successful in the
firm and has risen to the level of the
firm’s chief financial officer. In
addition to a strong benefits
package, James earns enough to
allow the family to live in a beautiful
house on a small lake. The family
enjoys many hours of boating and
other water-oriented activities. James
and Mary recently purchased a
holiday home, also on a lake, in
which the family plans to spend
many spring and summer days. The
house sits back from the lake’s
shoreline, but still close enough to
provide easy access. James and
Mary are a little concerned about
potential weather-related damage
during the winter months when the
family plans to leave the house
vacant.
Jamie is a diligent student and has
done well in his first year. However,
he’s also a 19-year old who likes to
party from time-to-time. His parents
have given Jamie a car, and he has
not been quite as careful as he could
be about driving after drinking at a
party. Many of his student friends do
not have vehicles, so Jamie is often
the driver of choice. A teacher friend
of the family has confided in James
and Mary that she is a little
concerned about some of Jamie’s
activities, especially the potential of
driving and drinking.
Nancy and Barbara are good
students and seem destined for
acceptance in their preferred
universities. Nancy has just begun
working at a job several days after
school and on week-ends. She plans
to increase her hours during summer
break. Barbara plans to follow in her
sister’s footsteps when she gets old
enough. For now, she’s just enjoying
being with friends and being a
teenager. She is also an avid animal
lover and relishes the time she
spends caring for the family’s
German Shepherd dog.
James and Mary, both being quite
busy, have a part-time household
staff of two to help maintain the
inside and outside of their primary
residence. James, during his global
travels, has begun collecting a small,
but already valuable, fine art
collection. Mary, although generally
healthy and having an active lifestyle,
recently received a disturbing report
from her physician. Nothing to be
done for now, but requiring additional
tests and monitoring. Jamie has
been complaining about an increase
in headaches, some of which get so
bad that he must rest to recover.
Think about the Conway’s and their
situation for a moment. What risk
exposures does the family have now?
What seems to have potential to have
an impact in the future? If they were
your clients what concerns would you
have and what risk management
considerations might you recommend?
Without trying to recommend any
specific solutions, here are some of the
areas of potential concern along with
questions you might consider.
• James travels globally. Does he
have medical insurance to cover
him when he is away from his
home country?
• James is reasonably wealthy and
a significant member of the firm’s
upper-management team. Are
there any concerns about
 possible kidnapping and holding
for ransom?
• Mary received a troubling medical
diagnosis. What are the
implications of this?
• James and Mary are active in
competetive sports. What is the
potential for either to be injured?
Is there any increased liability
exposure that might come from
their activities?
• The family lives on one lake and
has a holiday home on another.
Both create opportunities for
water-related perils and hazards.
If any friends or neighbors join the
family on the water, and someone
gets hurt, do the Conway’s have
adequate liability cover?
• James’ art collection will not be
adequately insured by the
 homeowner’s policy. Do they have
insurance cover for the collection?
• Mary is an association director,
which creates a potential liability
situation. Does the association
carry adequate cover to protect
Mary?
• James and Mary have a small
household staff. What are the
potential risk implications and are
these covered?
• If the family’s dog bites or
otherwise harms a guest, what
are the financial implications?
• Jamie’s partying and driving
creates both legal and civil liability
concerns. What can James and
Mary do to address these?
There are other potential areas of
concern, but the preceding list should
give you an idea of the considerations
you should have as a financial advisor.
As you evaluate a client’s risk
exposures, one question you should
keep top-of-mind is whether they have
adequate insurance cover. This is not to
say that other risk management
solutions will not be important. Rather,
as we have discussed, insurance is
often the best solution to mitigate
financial losses. Also, are key areas
included or excluded, and should
coverage be increased. It’s also
possible that certain areas of coverage
might be coordinated, thereby reducing
premium cost.
As we have been discussing the use of
insurance as a risk management tool,
it’s time to explore the types of coverage
that are available and may be used to
address client concerns. We will do this
in the next chapter.
Chapter Review
Discussion Questions
1. Which type of risk do you think
creates the greatest potential for
financial loss? Why?
2. Which risks are best addressed
by insurance (risk transfer)? Which
would be better addressed using a
different approach?
3. How might lifestyle choices impact
potential risk exposure?
4. How would you approach a risk
management plan for the
Conways? What different
techniques would you suggest
using (for which specific
exposures)?
Review Questions
1. What are some of the risks people
may face about which advisors
should be aware?
2. What lifestyle issues might
increase a person’s risk?
3. According to the text, why do
people purchase insurance?
Chapter 3: Introduction to Insurance
Learning Outcomes
Upon completion of this chapter, the
student will be able to:
3-1 Identify types of coverage provided
by insurance
3-2 Explain how deductibles and risk
assumptions are used
Topics
3.1 General insurance
3.1.1 Homeowners
3.1.2 Personal property
 3.1.3 Vehicles
3.2 Liability
3.2.1 Personal liability
3.2.2 Professional liability
3.2.2.1 Malpractice and errors and
omissions
3.3 Life insurance
3.3.1 Term life insurance
3.3.2 Traditional – whole life and
endowment
3.3.3 Non-traditional – universal,
adjustable, variable, variable universal
3.3.4 Joint life policies
3.3.5 Amount of life insurance
needed
3.3.6 Annuities
3.4 Health insurance
3.4.1 Types of medical expense
insurance
3.4.2 Managed health care plans
3.4.3 Long-term care (LTC)
 3.4.3.1 Common features of LTC
insurance policies
3.5 Disability: Personal
3.5.1 Common features of disability
insurance
3.5.1.1 Definition of disability
3.5.1.2 Common continuation
provisions
3.6 Business-related
3.6.1 Key person
3.6.2 Disability: Business
3.6.3 Business overhead expense
3.6.4 Business liability and board
member cover
Introduction
Insurance, in its many forms, is perhaps
the most common risk management
tool. In many ways it provides the most
practical, and sometimes only, solution
to address a given area of risk. When an
individual chooses to purchase an
insurance policy, he or she is
transferring the risk of loss to the
insurer. For a premium payment that is
small, relative to the loss being covered,
the insurer agrees to bring the
policyholder back towards wholeness
when there is a covered loss. In some
cases, substitute funding simply would
not be available to address the loss.
Most people cannot provide the
hundreds of thousands of dollars
required to rebuild a lost home or
replace income lost due to death or
extended disability. Liability lawsuits can
expose the individual to almost
unimaginable financial losses.
Insurance, then, can provide a solution
to these and similarly pressing
concerns.
Not every risk is insurable. Underwriting
departments handle much of the
decision about whether to insure a risk.
Additionally, the insurer may determine
that it will not offer cover for a particular
risk, under specific circumstances. For
example, an insurer may decide not to
offer cover for home damage in areas
that are prone to severe storms. In their
mind, the financial exposure is too great
and would violate one of the rules of
acceptable risks (i.e., the risk cannot be
catastrophic). Other risks do not comply
with the law of large numbers. As
previously mentioned, Lloyd’s
associations will often cover singular
risks that traditional insurance
companies will not. They can do this
because they have a network of
specialists who work in syndicates and
provide funding to cover these
specialized risks.
Lloyd’s has an interesting history. They
were one of the first insurers operating
in the city of London, England.
According to their website (Society of
Lloyd's, 2017), Lloyd’s was first
mentioned in the year 1688. During that
time, it functioned as Edward Lloyd’s
Coffee House on Tower Street, and was
one of the common places of business
in that era, specializing in information
about shipping. The shipping focus gave
rise over time to an early type of
insurance covering ships and their cargo
– marine insurance. From there, Lloyd’s
grew and branched out into the
organization that exists today.
Marine insurance, both ocean and
inland, exists today as business as well
as personal cover. Although the
insurance industry began by covering
specific risks and perils (i.e., monoline
cover), and still provides this type of
insurance, it has expanded to provide
the multi-line and package plans largely
available today. In this chapter we will
explore various types of insurance,
beginning with what is known as general
insurance.
3.1 General insurance
General insurance includes cover for
many risk exposures including those
relating to:
• Property
• Personal property
• Vehicles
Some of the insurance types are quite
specialized, covering things like small
aircraft, travel, even weddings. When
consideration expands to cover provided
by Lloyd’s associations, the types of
insurance covered grow quite lengthy
and diverse. Our focus in this section
will be on cover for property, vehicles
and personal property.
Property Insurance
In this context, property refers to real
estate. More specifically, this insurance
covers personal residences,
outbuildings, warehouses, office
buildings, condominiums and town
houses, apartment buildings and the
like. Insurance covers the buildings, not
the land on which they sit. As a rule, you
cannot insure land. This is one reason
why a residence valued at $500,000 can
be considered fully insured with only
$400,000 coverage, if the missing
$100,000 reflects the value of the land
on which the house is built. As is often
the case, there is some difference
between insurance policies covering
commercial buildings (e.g., warehouses,
office buildings, apartment buildings)
and personal buildings (e.g., homes,
condominiums and townhomes). Since
commercial property insurance requires
specialization not required of most
financial advisors, we will limit our
attention to personally-owned
properties. Students should also
understand that all insurance policies
are legal contracts, and legal contracts
vary by jurisdiction. In other words, it’s
unlikely that all the terms and conditions
found in a contract from one territory will
also be found in one from another
territory. In this text we will provide
information on standard coverage as it
exists in many territories. You may need
to adjust the information somewhat to
better reflect the situation in your own
territory.
3.1.1 Homeowners
The most significant financial investment
made by most people is their personal
residence—their home. A home’s sale
price may often equal many times an
individual’s annual income. As such,
conscientious homeowners often carry
some form of homeowner insurance
coverage. Furthermore, if a loan is used
to purchase the home, the lender may
require the borrower to maintain
homeowner’s insurance on the property.
As mentioned above, the information
that follows represents a composite
example of insurance coverages
throughout the world (coverage in your
area may be different, but generally will
include some, or all, of the following).
Homeowner package policies include
two sections: Section I, which covers
property exposures; and Section II,
which focuses on liability exposures.
Section I has four coverage
subsections:
1. Coverage A insures the main
dwelling, including any additions
attached to the dwelling, and
materials and supplies located on
the property for the primary
purpose of working on the
building.
2. Coverage B provides
coverage for other structures,
such as garages and sheds,
which are situated on the property
and detached from the dwelling.
3. Coverage C covers the
insured’s personal property.
4. Coverage D protects against
loss of use, including expenses
incurred while the dwelling is
damaged, by a covered peril,
 beyond the point where the
dwelling can be occupied.
Section II often includes two areas of
coverage:
1. E - Comprehensive liability
insurance.
2. F - Medical payments to
others, claims expenses, and
damage to property of others.
Section I
Coverage A primarily protects the main
dwelling and attached structures. Except
for building materials mentioned above,
only the buildings are covered; land is
not covered.
Coverage B protects buildings that are
not attached to the dwelling. Coverage
B also covers fences, decks, and
swimming pools. Normally, insurance
protections are not extended to
business use of the other structures.
Most coverage under A and B normally
exists on a replacement cost basis.
Replacement cost eliminates any
depreciation deduction (up to policy
limits). However, some policies settle on
an actual cash value basis, in which
case, depreciation becomes a factor. A
policy may sometimes contain an
endorsement to provide inflation-based
increases to coverage amounts.
Coverage C protects an insured’s
personal property on or away from the
property. This protection extends to any
property the insured may use, but does
not own, such as a tool borrowed from a
neighbor or friend.
Coverage D protects against the loss of
use of the dwelling. When insured
property is damaged, it may also help
pay for expenses related to living
somewhere else.
The coverage for sections B, C and D
and pricing of a homeowners policy is
largely determined by the limit selected
for Coverage A on the dwelling. The
insured is not asked to determine limits
for other coverage under the policy
because they are percentages of the
Coverage A limit (or Coverage C in the
case of renter’s insurance or
condominium unit owners insurance).
Policyowners pay a deductible prior to
receiving benefits for a claim under
Section I coverage. The amount of any
deductible will have an impact on
premium cost. Smaller deductibles
increase premiums, and larger ones
reduce premiums. The difference may
be substantial or not, depending on the
company and the policy. Remember, a
deductible is a form of risk retention. So
even when transferring risk via a
homeowners insurance policy, the
policyowner almost always must retain
some of the risk by means of the
deductible.
Section II
Coverage E, under Section II, covers
personal liability. This section protects
the insured (and all family members
living in the same house) against losses
arising from legal liabilities. The
insurance company also will pay for
defense in a lawsuit. Insurance
companies do not cover intentional
injury to another or self-injury. This
coverage may be included as part of the
homeowners policy or issued as a
separate comprehensive personal
liability (CPL) policy.
Homeowner policies provide personal,
not business or professional, protection.
Some policies can be endorsed to
provide limited coverage for business or
professional activities, but limited is the
key term. Only specific business or
professional insurance provides full
protection.
Coverage F covers medical payments to
others. This coverage provides that if
someone who is not living at the
insured’s residence is injured there, the
company will pay for medical care
related to that injury. Negligence is not
required. If a friend is helping someone
paint the house and falls off a ladder
because of their own carelessness, they
can submit a claim to the homeowner’s
insurance company. Although the
homeowner did not cause the friend’s
injury, the homeowner’s policy will still
pay the claim.
The key word for this coverage
is others. Household members cannot
receive medical payments under this
section of the policy. The rationale for
this exclusion is logical—insureds
cannot be liable to themselves. All
household members are considered to
be insureds. Therefore, no household
member qualifies for medical liability
payments.
Additional Coverages
Damage to property of others. This
provision is effective even where there
is no technical liability. If the insured
causes damage to another person’s
personal property, and it is not covered
under Part I of a homeowner’s policy,
this good neighbor provision of the
homeowner’s policy will cover it. The
maximum claim is relatively low (e.g.,
$1,000). For example, if someone
borrows his neighbor’s portable music
player for a party and ruins the speakers
by increasing the volume too much, this
provision will provide payment for new
speakers up to policy limits.
Among the exclusions to this provision
is intentional damage to the property of
others. Intentional damage to others or
their property is never covered by
insurance. Property that is owned by the
insured or rented to the insured is also
excluded.
Claim Expense: This provision states
that, in addition to any damages a court
determines the insured must pay (up to
the policy liability limits), the CPL policy
will pay for the insured’s defense,
interest on judgments, and certain
related costs.
First Aid: The CPL policy will cover
costs that the insured incurs for first aid
administered to a visitor who is injured
at the insured’s residence or due to acts
of the insured. These costs are paid in
addition to the stated policy limits.
Loss Assessment Coverage: If a
member of a condominium or
homeowners association is assessed for
his or her share of the association’s
legal liability, the policy will pay that
assessment. The basic coverage is
limited to $1,000 but generally can be
increased.
Covered Perils
Different policies may provide different
levels of protection against loss by
various perils. Covered perils may be
grouped into three categories: basic
coverage, broad form coverage,
and open peril or all risks coverage.
• Basic Coverage: Includes
coverage for 11 perils: fire and
lightning, windstorm and hail,
explosion, riot and civil commotion,
vehicles, aircraft, smoke, vandalism
and malicious mischief, breakage of
glass, theft, and volcanic eruption.
• Broad Form Coverage: In
addition to the 11 perils listed
above, broad form covers falling
objects; weight of ice, snow, or
sleet; damage resulting from
heating or air conditioning systems;
accidental discharge or overflow of
water; freezing of plumbing; and
damage from artificially generated
electrical currents. It also expands
coverage for some of the basic
perils.
• Open Peril, or, All Risks
Coverage: Provides coverage for
 all perils, unless they are listed and
specifically excluded. Some perils
always are excluded, so the term all
risks is not really appropriate,
because the policy will never cover
all risks.
How Much is Enough?
When you, as financial advisor, are
reviewing a client’s homeowner’s policy,
the question that clients most often ask
is “how much coverage should I have?”
To help answer this question, the
following topics should be addressed
during any review of a client’s insurance
coverage.
One way to look at the worth of a home
is that it has three distinct values. First is
the market value. This is the value that a
willing buyer and willing seller under no
compulsion agree to exchange an item
at an agreed upon price. The second is
the assessed value. This is the value
the taxing authority places on the
property and on which they base
property taxes. Depending on the
community, this typically is less than the
market value and is usually recalculated
at least every three to five years. The
third value to consider is the
replacement value. This is what it would
cost to rebuild the home as it currently
exists.
The maxim often heard in real estate is
“location, location, location.” The
location of the property can significantly
affect market value; however, the
replacement cost is not as easily
affected. For example, in the same city,
one property might have a very high
market value while another property
might have a lower market value and yet
the two homes are virtually identical in
construction. The replacement value of
these similar homes would likely be very
similar even though the market value for
one is much higher.
Individuals need as much insurance as
necessary to provide adequate
protection. This probably means
replacement-cost coverage in an
amount equal to at least 80 percent of
the cost to replace/rebuild a dwelling. To
provide more thorough coverage,
homeowners should insure their home
to 100 percent of the replacement value.
This will provide coverage the
homeowner will need if the home is
completely destroyed. Personal property
also must be covered, with the amount
depending on the value of the specific
personal property. Those who do not
own a home will still benefit from
coverage on their personal property (this
type of coverage can easily be
purchased separately for those renting
or leasing their residence).
Replacement Cost Calculation
Many factors go into determining the
level of coverage and the premiums
required for a homeowner’s policy. The
age of the home, construction materials,
location, square footage, and number of
rooms are all factors that generally play
some role in determining amounts of the
replacement value of a home. Once the
proper level of coverage has been
determined, a client should insure the
house for the cost to replace it (i.e.
construction costs).
Most insurance agents or brokers have
access to sophisticated tools to assist
with estimating the replacement value of
the home. Many software packages
allow scalability, and will allow minimal
to very detailed inputs. At a minimum,
the style of home, square footage, and
number of bedrooms and bathrooms are
entered. On the detailed end of the
spectrum, entering the number of
fixtures in a bathroom, type of
countertops in the kitchen, an elevator,
an intercom system, irrigation system,
etc., will make the replacement
calculation more precise. However, this
is only as good as the inputs received.
It is necessary to determine if all
additions, improvements, or extra
outbuildings have been evaluated to
ensure that policy coverage is adequate.
Normally, on a base policy, other
structures are covered for up to 10
percent of the cost of the dwelling.
Detached garages, gazebos with hot
tubs, or other expensive structures may
require more than 10 percent coverage.
Just about all coverage can be
expanded beyond what is included in a
base policy.
Coinsurance Provision
As we saw in Chapter 1 in the section
on underinsurance, when insurance
companies price policies, their
expectation is that policyholders will
insure their home for the full value. Most
policies are priced on a per unit of
coverage basis (e.g., $3.50 per $1,000
of coverage). Comparatively few people
ever suffer a total loss of their home.
Most losses are partial, and many
claims are for a relatively small
percentage of the home’s full
replacement cost. If most of the
insureds determine the likelihood of
having a total loss is extremely low and
decide to insure their home at 50
percent of the replacement cost, the
premiums collected by the insurance
company would not be enough to cover
all the losses. To that end, the
coinsurance provision was added to
policies.
For insurance to work properly,
everyone in the risk group must
participate at a reasonable level. To
ensure that premiums received are
sufficient to cover claims, insurance
companies usually include a
coinsurance provision that requires a
home to be insured for at least 80
percent of its replacement cost for
partial losses to be covered completely.
Typically, if an individual does not
maintain insurance equal to 80 percent
of the replacement cost (at the time of
loss), a partial loss will be covered at
either the actual cash value (i.e.,
replacement cost minus depreciation) or
per the coinsurance penalty formula,
whichever amount is greater. Recall the
following formula:

In most cases, the coinsurance penalty

formula will provide the higher benefit.
Example: coinsurance penalty
formula. Assume the insured’s home
would cost $400,000 to rebuild.
Insurance on the home is $300,000 with
a $1,000 deductible. A kitchen fire
causes $20,000 in damage.
The first step is to calculate how much
insurance is required per the
coinsurance requirement. In this
example, that would be $320,000
($400,000 × 80 percent). The second
step is to calculate the coinsurance
penalty formula as follows: Amount of
insurance, $300,000 divided by required
amount $320,000 = .9375 × amount of
the loss $20,000 = $18,750; $18,750 -
$1,000 deductible = $17,750 to be paid
by the insurance company. Notice that
the deductible is subtracted after doing
the initial calculation.
If the loss exceeds the amount of
insurance, even if the amount of
insurance is more than 80 percent of the
replacement cost, the insurance
company will not pay more than the
actual amount of the insurance cover.
The policy limit is the most that would be
paid under any circumstance unless the
insured has a rider to pay up to a certain
amount (e.g., 115 percent or 125
percent) over the replacement value to
cover increased rebuilding cost
fluctuations. This means a house with
$400,000 coverage, but a value of
$500,000 meets the 80 percent
requirement. However, in the event of a
total loss, the insurer will only reimburse
$400,000, because that is the amount of
cover carried (assuming the policy does
not have a provision automatically
increasing coverage amounts to meet
replacement cost requirements). Any
deductible will be subtracted prior to
paying the claim.
An important factor to consider is that
the replacement value is determined at
the time of loss, not at the time the
policy was purchased. This is one of the
many reasons it is important to have
clients regularly review their insurance
coverages with their insurance agent.
Many companies offer an inflation rider,
which adjusts the coverage on an
annual basis to keep up with the
increased building costs. If this rider is
not on the policy and the client does not
meet with his or her agent, it is easy to
be placed in a coinsurance situation.
Replacement Provisions
Actual Cash Value: The actual cash
value is the replacement cost minus
depreciation.
Replacement Cost: In the event of a
total loss, the policy will reimburse a
policyowner the amount required to
replace the property up to policy limits.
Guaranteed Replacement Cost: While
a homeowner may be adequately
covered by having insurance equal to 80
percent of the replacement cost of the
home, he or she may have a substantial
out-of-pocket expense if the home is
destroyed. There also are
circumstances where even 100 percent
coverage may not be adequate. When a
natural disaster strikes, such as a
hurricane, the cost of rebuilding may
increase due to the lack of building
materials and/or shortage of skilled
labor. When this happens, the
replacement cost is often higher than
the insurance amount. A guaranteed
replacement cost benefit takes care of
this problem.
Inflation Guard Endorsement: To
acknowledge the effects of inflation,
insurance companies generally offer an
inflation guard endorsement. This
endorsement automatically increases
the dwelling coverage each year by an
amount that is usually tied to an index.
Many insurance companies subscribe to
services that track costs of construction
materials and labor and can even refine
the data to account for the specific
community where the home is. A
periodic review by the insurance agent,
the insurance company, or a contractor
can be used to confirm the replacement
value.
Factors Affecting the Cost of
Homeowners Coverage
The cost of a homeowner’s policy and
its endorsements are affected by the
factors mentioned previously, and listed
below.
Construction: The way a home is built
and maintained — materials, age,
upkeep — is important in determining
the cost of a homeowner’s policy. Brick
or stone costs more than siding. A
shake shingle roof is more expensive
than one made of composite materials
and is a greater fire hazard. Heavy
landscape growth around a home
creates a fire hazard that is greater than
that caused by a landscape of well-
maintained trees, shrubs, and plants.
Older homes have older plumbing and
wiring, which are more likely to cause
problems than new plumbing or wiring.
Location: In what type of community is
the house located? Is it a fire prone area
or is there a high vandalism and crime
rate in the area? The location of the
local fire department, the available water
supply, and the accessibility of the home
itself also will affect insurance rates.
Deductible: For obvious reasons, the
size of the deductible will affect the cost
of the policy. The higher the deductible,
the lower the premium.
Insurer: The insurer does make a
difference. Some insurers offer
insurance only to certain groups. When
insurance availability is limited, the
group’s claims may become quite
predictable, often resulting in better
rates. Some insurance companies offer
a discount to those who also have their
car insurance with them. Additionally,
each insurance company will have
unique claims results and this will affect
how they price their policies. With all of
the various factors that go into
determining homeowner’s insurance
premiums, you should encourage your
clients to shop for this coverage every
few years to ensure they are receiving
the best value for their premium dollar.
General Exclusions
Homeowners forms contain eight
general exclusions to the property
insuring agreement.
Ordinance or Law: It is common that
after a home is built, building codes
change. When a partial loss is incurred
and the room is being rebuilt, it will need
to be brought up to the current code. For
example, many cities require that
electrical outlets be placed a certain
distance from each other. The cost of
bringing the room up to code is
considered “betterment” and is not
covered by the standard insurance
policy. With the Ordinance or Law
endorsement, the additional expenses
would be covered up to the limit listed in
the declarations page. The amount is
generally expressed as a percentage of
Coverage A (i.e., the dwelling amount).
Earth Movement: This excludes
coverage for a loss caused by earth
movement, except direct loss by fire,
explosion, theft, or breakage of glass.
When losses are caused by these other
things, the concept of concurrent
causation applies. Concurrent causation
applies when two actions cause a loss
and one of them is a covered peril while
the other isn’t. The insurer will be liable
based on the perils that are covered.
Insured’s may be able to add this
coverage by endorsement or separate
policy.
Water Damage: This excludes
coverage for a loss caused by flood,
water backing up in sewers or drains,
water below the ground surface seeping
through basement walls, foundation,
floors, etc. Damage from backup of
sewers and drains may be added by
endorsement.
Power Failure: This denies coverage
for losses resulting directly from an
interruption of power or other utility
service, if the interruption takes place
away from residence premises (i.e., a
neighborhood power outage as opposed
to a specific outage at the home).
Neglect: This excludes losses resulting
directly or indirectly from neglect of the
property by the insured and failure to
use reasonable means at or after a loss
to save the property.
War: This excludes losses caused by
war in all forms (e.g., undeclared war,
insurrections, rebellion, revolution, or
discharge of a nuclear weapon).
Nuclear Hazard: This excludes losses
from nuclear reactions, radiation, and
radioactive contamination.
Intentional Loss: This excludes
intentional damage to one’s own
property.
High-Value Property
Getting adequate insurance coverage
for high-value or unique property is not
always easy. One of the core principles
of insurance is known as the law of
large numbers. Recall, this means that
normally, to be insurable, there must be
a large number of homogeneous
exposure units to make losses
reasonably predictable. Translated, this
means that an insurer wants lots of units
(e.g., houses, cars, etc.) over which to
spread its risk exposure. If you think
about it, this becomes an underwriting
guideline that favors the average or
standard (home, car, personal property,
etc.). For most people, this works well.
However, for owners of very high-value
property this can become a problem.
Why? There are substantially fewer very
high-value homes relative to the number
of homes priced more moderately.
Fewer homes means fewer
homogeneous exposure units over
which to spread the risk. At the least,
this often means higher premiums. As it
turns out, it also means that there are
fewer insurers willing to even consider
providing coverage on these properties.
Often, to insure such properties, one of
the first steps is finding an insurer that
specializes in coverage for high-value
properties. The type of coverage is also
important. Owners of standard homes
often must be satisfied with whatever
terms an insurer provides. For example,
if a wall in the home is damaged, the
insurer decides the best way to repair it.
If the home has custom plastered walls,
most insurers will pay for a basic repair
or replacement (e.g., installing drywall
and paint), but few will pay to have
custom plasterwork redone. This is
generally not a satisfactory solution for
someone living in a very-high value
home. So, the homeowner in this
situation will want to find an insurer that
will agree to bring the house back to its
original condition. Such insurance
coverage is available, but only through a
few companies.
It is also possible to obtain coverage for
perils that are excluded by typical
homeowner’s policies. For example, a
few insurers are starting to offer private
flood insurance for high-value
properties. As more insurers begin to
explore this area, high-value property
owners will likely be able to get—at a
price—coverage that more completely
meets their specific needs.
Another example should help identify
the concerns in this area. It’s easy to get
insurance for a piece of jewelry that is
somewhat over the value of the internal
homeowner’s policy limit (discussed
under personal property below). Simply
bring an appraisal to your insurer, pay
the premium, and there is a personal
property floater/inland marine policy on
the jewelry that covers it well. But,
multiply the value of the jewelry by ten
or twenty times, and the situation
changes. That may be too large an
exposure for many insurers to take.
Consider some individuals may have a
collection of jewelry, artwork, antique or
custom furniture, and the like worth a
great amount of money, and it is easy to
understand the potential difficulty of
getting all the property adequately
insured.
The same insurers that offer enhanced
or expanded coverage for high-value
properties can also provide coverage for
high-value personal property.
Coverages may be more easily tailored
to specific property owner needs, and
some perils that otherwise would not be
covered, may be covered.
Other Homeowner’s Products
Individuals who rent rather than own
their home may wish to insure their
personal property. A renter’s insurance
policy provides all the coverage of a
standard homeowner’s policy except for
Coverages A and B in Section I since
there would be no need to insure a
dwelling and other structures that the
renter does not own. More importantly,
renter’s insurance policies include the
liability protection provided by Section II.
This is an important reason for
purchasing renter’s insurance since a
liability claim poses the greatest threat
of loss to the insured.
Another type of homeowner’s insurance
covers condominium unit owners, and is
available for people who own a unit in a
multi-unit complex. Condominium unit
owner's insurance provides all the
coverage a renter’s policy covers plus
limited coverage under coverage A of
Section I. This is needed because
condominium unit owners own the
ceiling, walls, and floors of their unit
from the structure frame in and therefore
would need coverage for that portion of
the building if it should suffer loss.
3.1.2 Personal property
Standard homeowners policies typically
cover personal property at 50 percent of
the dwelling coverage. With the cost of
furniture, rugs, clothes, appliances (not
permanently installed), books, etc., this
level of coverage may be inadequate.
Some companies issue policies with
personal property covered at 75 percent
to 100 percent of the dwelling coverage.
Most homeowner’s policies provide only
limited coverage for personal property
with higher value. The following items
have relatively low limits of coverage
(examples of limited coverage in
parentheses):
• Money, bank notes, coins, bullion
($200 limit)
• Securities ($1,500 limit)
• Stamp collections ($1,500 limit)
• Watercraft and their trailers (1,500
limit)
• Jewelry, furs, cameras (loss by
theft - $1,500)
• Firearms (theft - $2,500 limit)
• Silverware, goldware, etc (by theft
- $2,500 limit)
• Business property at home
($2,500 limit)
Actual limits will vary by policy. An
inland marine policy (or personal
property endorsement—covered below)
can be used to provide adequate
coverage, however, it is a practical
impossibility to increase the personal
property coverage within a standard
homeowner’s policy to the extent that
limited coverage items (e.g., jewelry,
silverware) will be adequately protected.
The only viable method to provide
sufficient coverage on these items is to
add a personal property endorsement or
purchase a separate inland marine
policy; both methods provide essentially
the same coverage options.
Personal Property Exclusions
Nine classes of property are usually
excluded under Coverage C of all
homeowner’s forms. The classes are:
1. Articles separately described
and specifically insured under
homeowners or other insurance
2. Animals, birds or fish (the
animal itself, not the liability it
creates)
3. Motorized land vehicles (with
some exceptions)
4. Aircraft and their parts (except
model or hobby aircraft)
5. Property of roomers, boarders
and other unrelated tenants
6. Property contained in an
apartment that is regularly rented
or held for rental to others by the
insured
7. Property rented or held for
rental to others away from the
premises
8. Books of account, drawings,
paper records, and software
media containing business data
9. Credit cards or fund transfer
cards, except as provided under
 the heading of Additional
Coverages
Personal Property Endorsement
For high-value items like those listed in
the previous section, adequate
protection generally is available as an
endorsement to the policy. Coverage is
in the amount of the item’s stated (or
appraised) value, not the replacement
cost or actual cash value. For this
reason, a client may be required to
provide appraisals, invoices,
photographs, or other evidence of
ownership to obtain coverage. This
information should be properly filed and
stored, most likely in a location not on
the main premises (in case of fire or
significant destruction). It is important to
review the value of items periodically.
Occasionally, new appraisals are
required.
Coverage of this type may be called a
personal property endorsement,
personal property floater, or inland
marine coverage.
Inland Marine Insurance
Inland marine insurance provides
protection for personal property that is in
transit or that can be transported. Why
call it “inland marine” or “personal
property floater” coverage? One of the
first types of property insurance covered
the cargo of ocean-going ships (i.e.,
ocean marine). As it developed, this
type of coverage was fine, but only while
the property was on the ship. There was
no coverage for the cargo once it left the
ship and moved inland. Typically, the
cargo was loaded on barges and floated
on a river (i.e., inland marine) to a dock
or warehouse. Later, even as barge,
train, and truck transport became more
prevalent and highways and railways
supplanted inland waterways as the
transportation of choice for goods on the
move, the insurance to cover such
cargoes on these conveyances was still
known by the previous name, inland
marine. This is the origin of the
term inland marine insurance. Now, the
property could be covered while on the
ship as well as while it was
being floated inland. Later still, this
insurance coverage evolved to cover
anyone’s personal property that was
being transported.
While this policy form was originally
intended to cover personal property
while it was away from the insured’s
premises, it now usually covers personal
property anywhere in the world,
including while at the insured’s home. It
is important to remember, though, that
property that is installed will not be
covered by an inland marine policy. So,
an antique rug can be covered by an
inland marine policy, but wall-to-wall
carpeting will not be covered, except by
the homeowner’s policy. This is true
because once installed, the wall-to-wall
carpeting becomes part of the dwelling,
and is considered a fixture.
Inland marine insurance usually is
written with open perils coverage. A
primary benefit of open perils coverage
is that it extends the coverage to theft
and loss. Coverage may be written with
little or no deductible, or, depending on
the insurer and the insured’s wishes, a
higher deductible. As is true with other
types of insurance, the greater the
deductible, the lower the premium.
The insured needs some sort of
appraisal or receipt to verify the value of
the property being insured. Additionally,
coverage usually is for a stated
(appraised) value rather than the
replacement cost or actual cash value
(i.e., depreciated value). However, some
policies have built-in inflation coverage,
and others do settle either on a
replacement cost or actual cash value
basis (always look at the policy to
determine coverage).
Pair or Sets Settlement
An inland marine policy is one way to
overcome problems related to an
insurer’s pair or sets settlement option.
When one item of a pair (or set) is lost,
stolen, and/or damaged, the pair or sets
option allows the insurer to only pay for
the one item—not the set. This can
create problems, as the value of the set
is often greater when all the parts are
there. As an example, a complete
collection of investment-grade figurines
is worth more than the sum of the
individual pieces in the collection. So, if
one figurine is stolen, the actual loss to
the collector has a higher value than just
the one piece. By using an inland
marine policy for the entire collection, it
may be possible for the collector to
recoup a greater amount of the loss
related to the one piece.
What types of items can be covered by
inland marine or personal property
floaters? Just about anything that fits the
category of personal property. Following
are some examples: cameras, jewelry,
furs, silverware, golf and ski equipment,
fine art, antiques, rare stamps or coins,
musical instruments, wedding gifts, and
more. Coverage may have certain
requirements and/or exclusions, but you
can see that this type of insurance can
be used to provide coverage for many
types of personal property.
3.1.3 Vehicles
The motor vehicle has had a greater
impact on global history, as well as the
lives of individuals, than almost any
other product. Cars impact the lives of
nearly everyone in one way or another.
A car, while being a beneficial source of
private transportation, also has the
potential to create great expenses. As
such, protecting this expensive asset
with adequate insurance coverage
makes good sense. In addition to
property-related expenses, car owners
can incur expenses for personal liability.
This, too, is a good reason to maintain
adequate insurance coverage.
Specific insurance requirements vary
territory-by-territory (and sometimes by
state, province, region or other
jurisdiction within a given territory). The
information that follows is a composite
example of various types of third-party
car insurance (as with the section on
homeowner insurance policies,
coverage in your area may be different,
but generally will include some, or all, of
the coverages in the following section).
As with homeowners insurance, if this is
not an area where you are able to
provide advice because of regulations or
lack of experience, an analysis should
be referred to a licensed insurance
advisor.
Types of Policies
Motor vehicle (car) insurance normally
has four main coverage sections:
liability, medical payments, physical
damage, and uninsured motorists.
Car liability insurance protects you
against legal liability when your car
damages another person or another
person’s property. Liability coverage
extends to expenses for bodily injury to
those injured in an accident (again, not
the insured, family members, or other
occupants in the insured vehicle).
Coverage may be separated out as an
amount for each person or as a total for
all people injured in a common accident.
For example, a policy may cover liability
up to $25,000 per injured person,
$100,000 for all people injured, and
$25,000 for property damage, or it may
lump all cover together with a $250,000
limit.
Medical payments resulting from an
accident can be covered. Here, though,
because coverage does not come under
the liability insuring agreement, covered
expenses are for the insured, family
members, and occupants of the insured
vehicle (this is exactly opposite of
homeowner coverage, where this
protection does come under the liability
insuring agreement). This coverage
pays for claims due to injury for anyone
in or on the vehicle, entering the vehicle,
or alighting from the vehicle. For
example, a person exiting a car who
accidentally slams the door on a finger
breaking it would be able to submit the
bills for medical care and be reimbursed
for costs up to the policy limit.
Coverage also extends to physical
damage to the insured vehicle. This
coverage protects against losses to the
insured’s car, and has two parts:
collision and “other than collision,” or
comprehensive. Collision coverage is for
damage resulting from the insured
vehicle hitting something (e.g., another
car, fence, tree, wall, etc.).
Comprehensive coverage (also known
as “other than collision”) provides
protection when something hits and
damages the insured vehicle. Examples
include damage from hail, rocks, falling
tree limbs, and the like.
Where available, uninsured
motorist coverage provides protection
when the driver of another vehicle does
not carry insurance coverage. In an
accident situation, up to policy limits, the
insured’s coverage will pay the amount
that should have been paid by the other
driver. Underinsured motorist coverage
is similar, except it pays when the other
driver has coverage, but not enough
(usually just the required minimum
coverage level). The two coverage types
may be separate or combined into one.
Most territories require drivers to have
some level of motor vehicle liability
insurance. At times, a driver can post a
surety bond guaranteeing to make
amends if he or she becomes legally
liable for a car-related loss.
Who is Insured?
The car insurance policy makes
payments based primarily on the
obligation of the insured. The policy
defines the insured as being:
• The named insured or any family
member (living in the insured’s
household)
• Any person authorized to use the
covered car
• Any person authorized by the
insured to drive the covered
vehicle
A policy normally covers the insured and
any family member (limited to those
living in the same household) while
using a covered car. This also includes
the use of utility (small) trailers, or when
borrowing or renting another car.
Individuals who rent cars should check
coverage prior to renting the vehicle.
Coverage usually only applies within the
insured’s home territory, and may not be
applicable at all.
Cost of Insurance
Several factors are used to determine
the cost of car insurance. Some of the
factors relate to the owner/driver of the
vehicle being insured; the others have to
do with location of the vehicle, the
vehicle itself, and deductibles.
The five primary owner/driver factors
are:
1. Age and gender of the driver
2. Use of the vehicle
3. Type of vehicle
4. The driver’s record
 5. Credit
Age and Gender of Driver: Single male
drivers under the age of 25 are put in
the highest risk category. All things
being equal, their premiums are the
highest. After age 25, rates are
essentially equal between men and
women, again, all other factors being
equal. In some areas, when drivers
reach older ages, such as age 75, rates
may increase again. This reflects the
diminished reflexes of older drivers as a
group.
Vehicle Use: A car that is driven only
for pleasure costs less to insure than
one that is driven to work daily. Cars
driven less on an annual basis also
allow for lower premiums. Longer drives
to work and use of the car for business
both increase the premium. The
geographical location of the car/driver
also has a significant impact on
premiums (e.g., urban or rural, large city
or small).
Type of Vehicle: The type of car will
affect rates. High performance cars and
sports cars tend to have higher
premiums. Sport utility vehicles also
tend to have higher than average
premiums due to the increased amount
of damage they can inflict.
Generally, when an insured purchases
insurance on more than one vehicle, the
premium per vehicle is lower than if the
same vehicles were insured by different
companies. This is commonly referred
to as a multi-car discount.

Driver’s Record: The driving record of

an individual directly impacts the rate
that will be charged by an insurer to
offer auto coverage. In some instances,
as in the case of operating while
intoxicated or too many speeding
tickets, an individual may be denied
coverage, and in severe cases even the
privilege to drive may be revoked.
However, before these extremes occur,
a company will often offer coverage with
steeper and steeper premiums reflecting
the increased risk being taken in
insuring these drivers.
Credit: Most insurance companies now
use credit/credit score/credit
characteristics to determine rates
because they have found a significant
correlation between credit scores and
claims history. Insurers typically use a
different model than lenders as they are
attempting to predict the propensity for a
loss rather than the ability to repay a
loan. Those with higher credit scores
are considered better risks than those
with lower credit scores.
3.2 Liability
The concept of liability varies by
jurisdiction, and reflects that
jurisdiction’s legal code. Most of the
world’s legal codes are based on one of
three systems, or combinations thereof.
The three systems are: civil law (the
most widely used), common law, and
religious law (e.g., Sharia). Each
jurisdiction also modifies and adapts the
basic system to its own unique historical
and current environment. As a result of
the various legal systems, liability, along
with its consequences, varies.
Generally, when we discuss liability, we
are referring to what is
called civil liability. Civil liability is
different than criminal liability, and is the
result of one individual or entity being
held accountable for causing financial
loss to another. Criminal liability is the
result of violating a jurisdiction’s laws,
and may result in prosecution and legal
penalties (e.g., imprisonment). Actions
by an individual may result in both civil
and criminal proceedings, and the
person may be held both civilly and
criminally liable (with penalties assessed
from both aspects). Little or no
insurance exists to cover criminal
actions. Insurance can, however, cover
civil actions. It’s important to note that
car accidents may give rise to both civil
and criminal proceedings.
Liability is sometimes misunderstood.
Many people think it only comes into
effect when an individual does
something to cause harm to someone or
something else. This can be true, but it
goes further. More broadly, liability
refers to any situation in which one
individual or entity is legally responsible
for something such as a financial
obligation, responsibility or debt.
Liabilities can be personal or
professional, with the two requiring
different coverage. Businesses can also
incur liability, and this is a third type of
coverage. We will cover personal liability
first, then professional (of which there
are two types) and finally business
liability. Before doing this, we will
identify a few related terms, some of
which may or may not be applicable in
your territory, but all of which are
relevant globally.
Liability Terms
• A tort happens when someone
causes harm (physical, emotional
or financial) to another person.
Legally, the person causing harm
is called a tortfeasor. A tort either
may be intentional or
unintentional. In almost all cases,
the individual intentionally causing
harm cannot be protected by
insurance. Liability insurance only
covers unintentional torts. Torts
are civil rather than criminal. This
means that torts are not
necessarily considered breaking
the law. Instead, torts focus on
financial damage. However an
individual may do something that
fits into both the civil and criminal
categories, and may be guilty of
violating a law in addition to
causing financial harm to
someone. Intentional acts include
things such as assault, battery,
false imprisonment, invasion of
privacy, slander and libel.
 Unintentional torts may cover a
broader range of activities and
frequently involve at least some
degree of negligence.
• Negligence is not equal to
intentional wrong-doing.
Negligence does mean, however,
that an individual has not
exercised a reasonable degree of
care. That is, the care expected
from a responsible adult. It also
can mean that the individual
commited a breach of duty. For
negligence to result in a tort
action, there must be directly-
related financial loss or harm.
Essentially, no financial loss, no
negligence or liability. It’s
important to remember that a
person can be liable without also
being negligent. In fact, a person
 can be liable without having done
anything wrong at all. Tort law (in
its many forms) simply seeks to
determine damages in situations
where a loss has occurred.
Someone may get harmed on
property that another owns and
the owner will be deemed to be
liable as a result. He or she may
not even have been on the
property, but as owner, there is
liability.
• Absolute liability refers to a
standard imposed when there is
no specific way to show
negligence. A person that has a
wild animal as a pet may become
liable under this standard if the
animal harms a visitor. Employers
may be held liabile to an
employee by application of
 absolute liability (also discussed
in the business liability section)
• Vicarious liability is when one
person is held liable for the acts of
another person. Parents may be
considered liabile for things their
children may do that cause
financial harm to another person.
Vicarious liability may also be
applied to employers if one
employee harms another.
• Contributory negligence may be
applied when an individual is
deemed to have contributed to his
or her own loss. When this is true,
it may limit (also known
as comparative negligence) or
negate any financial remuneration
from the other person.
 • Assumption of risk applies in
some instances when a person
understands the potential risk, but
chooses to engage in the activity
regardless. Various sports come
to mind in this category. In such
cases the participant may be said
to have assumed the risk of
engaging in the activity. This may
mitigate the other person’s (or
entity’s) liabilty.
Additional terms are likely to apply in
each territory, but they tend to be
specific to the jurisdiction. As an
example, one territory imposes the
standard of negligence per se. This may
be employed when an individual violates
a statute that is in place to protect
people or a class of people. Such might
be the case when a child is harmed by a
motor vehicle driving recklessly through
a safety zone. Penalties will be greater
for someone who is guilty of negligence
per se than for someone who is merely
considered liable, and perhaps also
negligent. The concepts are frequently
the same from one territory to another,
but specific terms and application
depend on local jurisdictional law.
3.2.1 Personal Liability
One thing to keep in mind, liability
related to a motor vehicle is not the
same as other liability, and it requires
separate coverage (normally as part of a
motor vehicle insurance policy).
Adequate protection against personal
liability exposures requires regular
personal coverage in addition to car-
related coverage. We mentioned the
liability coverage available as part of a
car insurance package policy and now
we will look at more general liability
exposures.
Most individuals obtain liability
insurance through their homeowners
and automobile policies. However, in
today’s litigious world, many people
want more protection than the typical
homeowners or automobile policy offers.
Rather than merely increase the
coverage on the other two policies, your
clients will be better served if they can
obtain an umbrella liability policy. This is
sometimes called catastrophic liability
insurance.
Liability insurance protects against legal
liabilities incurred by the insured.
Protection is only extended to covered
events, and then, only up to policy limits.
A normal liability policy, or coverage
included with homeowner or auto
insurance policies, does a good job, up
to a point. That point is the financial limit
of coverage. Specifically, most standard
policies do not have very high coverage
limits. Thus, they can leave significant
protection gaps, especially for people
who have (or are perceived to have) lots
of money.
Most homeowner’s policies are issued
as a package policy, which includes the
liability coverage contained in Section II.
It is possible to purchase a standalone
policy (i.e., monoline), which is a
Comprehensive Personal Liability (CPL)
policy. Don’t be misled by
the comprehensive terminology. CPL
policies cover basic liability. The CPL
policy provides coverage for damages
payable because of the insured inflicting
bodily injury or causing property
damage that falls under the covered
portion of the policy. Note that slander
and libel are not covered under the
personal liability portion of this policy
because the policy will not cover
intentional acts. In addition to paying for
damages up to the limits of the policy,
the company will pay the legal defense
costs as well. The insurance company
also generally reserves the right to
make an out-of-court settlement at its
discretion (without obtaining consent
from the insured).
The insured is the named insured and
usually includes any member of his or
her household who are relatives or
minors (normally, 21 years or younger)
under the care of the insured. It also
extends to others who, with the
insured’s permission, have control of his
or her animals or watercraft and who
cause damages. Coverage also extends
to a child who is at college and who still
maintains the insured’s residence as his
or her weekend and/or vacation home.
Under Homeowners Section
II, insured also means any person or
organization legally responsible for the
insured’s animals or watercraft; any
person, while engaged in the
policyowner’s employment, using a
covered vehicle on an insured location
with the owner’s consent.

Liability Exclusions
The general exclusions include
intentional injury and business or
professional activities. All forms of
personal liability insurance exclude
these (because intentional injury is
never covered, and business and
professional activities are not personal
liability exposures) and some additional
sources of liability, which are discussed
below. Losses covered under
homeowners Section I, along with
owned and rented property, are also not
covered under a CPL policy.
Business Pursuits: Although business
pursuits generally are excluded from
personal liability policies, certain
persons can obtain a Business Pursuits
Endorsement. Clerical office employees,
salespersons, collectors, messengers,
and teachers can get this extension. It is
not available to provide coverage for the
business pursuits of business owners.
There are some other minor exclusions
to this coverage. Business-related
insurance will be covered below.
Rental of Property: Personal liability
policies generally do not cover losses
related to the insured’s renting his or her
property to others. However, occasional
rentals of the residence are covered.
The insured may also rent out a room or
two, if there are no more than two
roomers. Additionally, the exclusion
doesn’t apply to rental of part of the
residence used as an office, private
garage, school, or studio.
Professional Liability: Liability that
may be incurred by a professional such
as a CERTIFIED FINANCIAL PLANNER
certificant, insurance agent, lawyer,
physician, etc., is excluded and must be
covered by a professional liability policy.
These policies are discussed later.
Motor Vehicles: Since registered motor
vehicles typically require their own
liability coverage, liability arising out of
the use of an automobile is excluded
from comprehensive personal liability
policies. Some nonregistered motorized
vehicles are covered under such
policies under certain circumstances.
Comprehensive personal liability
policies also exclude coverage for
negligent entrustment. Negligent
entrustment occurs when an insured
allows someone known to be careless to
use the insured’s property, and the
result is damage to another person or
another person’s property. Remember
that there is no coverage to the
insured’s property under these policies,
because they are not property insurance
policies, they are liability insurance
policies.
Watercraft: Comprehensive personal
liability policies also exclude most
watercraft from coverage. Certain small
watercraft rented to the insured will be
covered. Negligent entrustment is also
excluded.
Aircraft: Damages inflicted through the
ownership, maintenance, or use of an
aircraft are also excluded from coverage
under CPL policies. This exclusion
extends to ultralight aircraft and hang
gliders as well.
Communicable
Disease: Comprehensive personal
liability policies generally exclude
coverage for damages claimed because
the insured infected someone with a
communicable disease. Without this
exclusion, transmission of such infection
could be considered bodily injury. It
would be difficult to know if the insured
knowingly transmitted the disease. The
exclusion avoids the problem of
determining intent.
Other Exclusions: Other exclusions
generally are included in personal
liability policies. These include war;
sexual molestation or abuse; use or sale
of controlled substances; contractual
liability; damage to property owned by,
rented to, or in the care of the insured;
workers’ compensation; nuclear perils;
and injury to insured persons.
Medical Payments to Others
This coverage is identical to the
coverage provided under Section II
coverage F of a homeowner’s insurance
policy. It provides for the payment of
medical expenses for people who do not
live at the insured’s residence
regardless of fault. The purpose of this
coverage is to be able to pay for medical
expenses incurred so that potential
lawsuits can be avoided.
Umbrella Policy
Most individuals obtain liability
insurance through their homeowners
and motor vehicle policies. However, in
today’s litigious world, many people
want more protection than the typical
homeowners or motor vehicle policy
offers. Rather than merely increase the
coverage on the other two policies, your
clients will often be better served if they
can obtain an umbrella liability policy.
This is sometimes called catastrophic
liability insurance.
While a basic liability policy may have
low coverage limits, an umbrella policy
has very high coverage limits. Umbrella,
or excess liability, policies take over
where basic policies stop. Thus, the
insured person can get protection
against potential liabilities resulting from
financial awards that are quite high.
Limits and exclusions exist, as is true
with all insurance policies, but umbrella
liability insurance provides significant
protection against liability-related losses.
In most cases, the person seeking
coverage will need to carry a minimum
level of liability coverage under both
homeowners and auto policies. There is
no standard policy form. Each company
will have its own specific set of
requirements and criteria that must be
met to issue an umbrella liability policy.
The umbrella liability policy not only
increases the coverage that is part of
the homeowners and auto policies, but it
broadens the coverage as well. Some
optional coverages, such as personal
injury coverage, are standard under an
umbrella liability policy.
If the insured gets sued and the claim
falls under the insured’s homeowners or
auto policy, the appropriate policy will
pay first. It is helpful to think of the
liability payment that is being made from
the car or homeowners insurance as a
deductible to be paid prior to the
umbrella liability policy being called
upon. If the car or homeowner’s policy
isn’t adequate to pay the claim, then the
umbrella policy picks up the difference
up to its limit of liability. For this reason,
it is typically best to have both the
umbrella policy as well as the underlying
policies with the same insurance
company.
Exclusions
Umbrella liability policies do have some
exclusions. If watercraft, aircraft,
professional services, or business
pursuits are covered by endorsements
to the homeowners or motor vehicle
policy, they usually will be covered by
the umbrella policy. If they are not
covered by the base policies, they
usually will not be covered by the
umbrella policy. Following are the
normal exclusions (remember, these are
liability, rather than property,
coverages):
• Owned or leased aircraft excluded
under the base policy
• Watercraft of the type excluded
under the basic homeowner’s
policy
• Damage to rented or borrowed
aircraft and watercraft
• Business pursuits
• Professional services (unless the
underlying insurance program
includes coverage for this risk)
• Workers’ compensation
• Any act committed by, or at the
direction of, the insured with the
intent to cause personal injury or
property damage
3.2.2 Professional Liability
Personal liability policies do not cover
an insured’s business activities. Most
individuals who are employees are
covered for liability by their employer for
activities undertaken as employees.
However, though personal liability
lawsuits are not a common occurrence,
professional liability lawsuits take place
with significantly greater frequency.
Professionals require liability protection
for their activities.
Two forms of liability coverage which
are available for professionals include:
1. Malpractice insurance
2. Errors and omissions
insurance
The cost of professional liability
insurance can be high, because people
are more likely to sue professionals for
failure to use reasonable care in pursuit
of their profession.
3.2.2.1 Malpractice and Errors and
Omissions
Malpractice
When a medical professional’s activities
unintentionally cause physical harm to a
person, malpractice insurance provides
liability protection. Physicians, dentists,
surgeons, and hospitals may use this
form. Anesthesiologists, chiropractors,
hygienists, nurses, opticians, etc.,
receive coverage using special forms
that focus on their particular
professional areas.

There is no standard form for

malpractice insurance. There are a
relatively select group of providers
offering this insurance to the medical
field; and each of those companies
designs its own form. Companies that
offer malpractice insurance provide
different forms for various specialties
rather than using a one-size-fits-all
approach. Interestingly, there is
technically no exclusion for a medical
professional’s intentional acts with most
malpractice insurance. The reason for
this is that what doctors, dentists, etc.,
do intentionally in their practice is
expected, but may have an undesirable
outcome. For example, the surgeon
intended to cut open the patient
(technically assault and battery); he or
she just did not intend for the operation
to have negative results.
Occurrence versus Claims Made Forms
Insurers use two general approaches to
determine which malpractice policy
covers a specific claim. In the past,
virtually all professional liability policies
used an occurrence form. When a claim
is made under an occurrence form, the
policy that was in place when the
alleged mistake was made must pay for
the loss. Under this form, if a physician
provided care in 2010, and in 2015 the
patient developed problems related to
the procedure done in 2010, the policy
in place in 2010 would be responsible
for paying any settlement. This creates
what is called a “long tail” of coverage. A
major concern with this approach is the
insurance company collected premiums
in 2010 dollars, but would have to pay a
claim in current dollars (this becomes
more of an issue when the original
policy is many years old).
The occurrence form creates several
problems. First, there is no way
insurance companies can anticipate
claims that might be made 10, 20 or
more years in the future. Even if they
could, it is not likely they could have
charged adequate premiums to cover
those claims. Similarly, it can sometimes
be difficult—if not impossible—to
pinpoint exactly when the damage being
referenced occurred. This can become a
problem when the professional changed
insurers at some point during the period
in dispute (i.e., which insurer should
pay). An additional problem is that the
company that wrote the policy in 2010
may no longer exist or may be out of the
professional liability business.
These problems led to the shift toward
the claims made form of liability
insurance. Under this form, the
insurance company that issued the
policy in place when the claim is made
is the insurance company responsible
for any required settlement. In the
example above, the company providing
coverage in 2015 (when the claim was
made) would be responsible for paying
the claim.
Defense and settlement
In years past, especially in the medical
field, the insured had the right to force
the insurance company to fight claims in
court. This generally was done because
of the perception that any settlement
was an admission of guilt. However,
perceptions have changed, and many
people have come to view liability cases
more in terms of economics rather than
as a determination of guilt. Under
current conditions, if it will cost less to
settle a case than to fight it, even if the
insured can win the case, the insurer
generally will try to settle the case out of
court. Few insurance companies and
even fewer policies today will allow an
insured to prevent an out-of-court
settlement.
Errors and Omissions Insurance
When a professional is in a position to
cause fiscal (financial) harm (as
opposed to physical harm) to a client,
those types of liabilities will generally
call for the use of errors and omissions
insurance rather than malpractice
insurance. An accountant, lawyer,
insurance agent, stockbroker, or
financial advisor would use this form of
insurance. Very little difference exists
between the general structure of this
form and malpractice insurance. All the
issues discussed above also apply to
this form of professional liability
insurance.
Life insurance is one of the best known
(although not necessarily best
understood) insurance types. Further,
many people have at least some level of
life insurance cover. This is so much so
that when people talk about insurance,
they often are actually referring to life
insurance. There is much to know about
life insurance and its annuity
counterpart. We will explore this area
next.
3.3 Life Insurance
Life insurance is unique among
insurance products because everyone
will eventually die and so every policy
that remains in force when the person
dies will pay a death benefit. The reason
insurance companies can take on this
risk is because the rate at which people
die on the aggregate is quite
predictable. In short, life insurance
companies are very good at predicting
how many people will die each year.
Consequently, they can develop fair
premiums to cover the risk for everyone.
Since neither the insurance company
nor the policyowner know exactly when
the insured will die, both parties are
taking some risk. The insurance
company is taking the risk that the
individual will die shortly after
purchasing the policy and that is why
they underwrite each individual. The
policyowner is taking the risk that the
insured will either live beyond the term
of the policy (term life insurance) or live
a very long time and pay premiums all
the while.
3.3.1 Term Life Insurance
Term life insurance, as the name
conveys, covers the insured for a
specified period, or term. At first,
annually renewable term life insurance
was the only product life insurance
companies sold. The purchaser of the
policy paid a premium that provided
insurance protection for a single year.
These policies were (and are)
renewable each successive year, but at
a higher premium each year as the
insured ages. It should be noted that
term policies usually are only renewable
to a certain age, usually age 90 or so
and in the years prior to that, the annual
premium to renew becomes exorbitant
relative to the protection provided. That
is why most policyowners allow term
polices to lapse when they reach their
60s or 70s and beyond. This is not
necessarily a problem, because term
insurance should be used with the idea
in mind that it is only needed for a
specific period, to cover a specific need,
and should be allowed to lapse when it
is no longer needed. For example, a
client may wish to purchase a 20-year
term policy when children are born to
provide for the lost income that would
result if the client were to die while the
child is still in the household. Once the
child reaches adulthood and is living
independently, the 20-year term policy
has served its purpose and can be
allowed to lapse.
Term products have evolved over the
years to include multiyear policies such
as 10-year, 20-year or 30-year term
policies with level premiums over the
entire term. Regular term policies offer a
level death benefit and a level premium
over the term and typically are
renewable each year at increasing rates
after the initial term. Because premiums
for multiyear policies are averaged over
the policy term, premiums paid in the
early years are higher than what an
annually renewable term policy would
cost. However, the premiums would also
be lower than annually renewable term
in the later years to create a level
premium for the entire term. If continued
protection is needed beyond the initial
period, you may find that it is better for
your clients to purchase another multi-
year term policy rather than simply pay
the annually renewable premium. The
basis of this decision would be for how
long beyond the initial term protection is
needed. For example, if a client’s 20-
year term policy expires at age 63 and
the client needs to continue the
coverage for another 10 or 20 years,
purchasing another 10-year or 20-year
term policy makes sense. However, if
the insured only needs to keep the
coverage for another three years, simply
paying the annual premium could make
more sense, assuming the premium was
reasonable relative to the amount of
coverage being provided.
Figure 1: Multi-Year Term Insurance
(Mannaoni, 2016)
Another version of term insurance that
seems to be less popular of late is
decreasing term. Whereas annually
renewable term has increasing
premiums over time and a level death
benefit, decreasing term has level
premiums, but the death benefit reduces
each year. Because the amount of
insurance protection decreases over
time, a decreasing term policy will be
less expensive than a level term policy
with the same initial death benefit. This
type of policy was designed to provide
coverage to pay off a mortgage or other
debt as the death benefit declines in a
manner that roughly approximates the
amortization schedule of the loan.
Figure 2: Decreasing Term Insurance
(Mannaoni, 2016)
Term policies generally don’t build cash
value; however, some companies offer
term products that can develop some
cash value.
3.3.2 Traditional – Whole Life and
Endowment
Cash Value (Permanent) Insurance
Some life insurance policies are called
“permanent” policies because they are
designed to remain in force as long as
the person insured is alive. Insurers can
accomplish this because these policies
retain a portion of the premium in the
form of cash value, which helps offset
the increasing cost of insurance as the
insured ages. To build this cash value,
the initial premium for permanent
policies is quite a bit higher than what a
term policy would cost for the same
amount of death benefit protection at the
same issue age.
You may be asking yourself, “Why
would a person pay more for permanent
insurance when lower-cost term policies
are available?” The answer lies in the
client’s time frame for needing
coverage. As mentioned above, term
policies are ideal when protection is
needed for a specific period and
purpose. There are some needs for
which a client would want death benefit
protection regardless of when they die
and they don’t want to risk the policy
lapsing. For example, a client may wish
to leave an inheritance for children or a
specific bequest to a favorite charity and
would use a permanent policy to provide
for this even if the client lives to age 100
or more. Another reason for preferring a
permanent policy over a term policy is
the cash value can be used as the
account grows. With many permanent
policies, once the cash value grows
significantly, it, along with policy
dividends (if available) can be used to
offset the annual premium. This
essentially may allow the policy to pay
for itself using the cash value to pay
premiums as they come due.
Common types of permanent policies
include:
• Whole life (traditional)
• Endowment (traditional)
• Universal life (non-traditional)
• Variable life (non-traditional)
• Variable universal life (non-
traditional)
• Joint life—survivorship life or first-
to-die
Whole life insurance, as the name
implies, is designed to protect the
insured for their whole life. To
accomplish this, significantly more
premium is collected in the early years
of the policy relative to what the
premium would be for a one-year term
policy so that the premium can remain
level in later years. It works similarly to
the way a 20-year or 30-year term policy
works in that premiums are averaged
over time.
The big differences are that the policy
time frame is generally to age 100 or
older and the additional premium paid in
the early years collects in the form of
cash value after policy expenses are
paid. The policy is designed actuarially
to guarantee a death benefit and to
guarantee a minimum increasing cash
value, and will be in force until the death
of the insured as long as premiums are
paid.
Some whole life policies are designed to
endow at a specified age, such as age
100 or earlier. In an endowment policy,
the cash value will equal the death
benefit at the specified age at which the
policy endows. When the policy endows,
the insurance company normally will
send the policyowner a check for the
proceeds. In some situations the
policyowner can extend the policy for an
additional period or convert the
endowment to an annuity. Endowment
policies used to be popular as savings
vehicles in addition to providing a
potential death benefit. Over time, they
have become less popular as more
options are available.
With all whole life policies, the insurance
company invests the cash value in the
company’s general account, which
consists primarily of a very conservative
real estate and bond portfolio.
Consequently, the returns are
considered safe, but also relatively low.
However, they are guaranteed, which is
a key word to remember when it comes
to describing the benefits of whole life
insurance. If a client mentions that they
want to play it safe and be certain of the
cash value growth, whole life is likely a
good fit. Because the premium, death
benefit, and cash value are guaranteed
(as long as premiums are paid), life
insurance companies can illustrate
exactly what the minimum cash value of
the policy will be at any point in the
future. Furthermore, if the policy pays
dividends – and many whole life policies
do – the cash value and death benefit
can exceed illustrated guaranteed
amounts. The cash value or death
benefit will never be lower than the
guaranteed amount unless the
policyowner at some point took out a
loan or made a withdrawal.
Limited Pay Whole Life
Limited pay policies are those that
provide coverage for the insured’s whole
life, but allow payments to be made for a
shorter period of time. While standard
whole life policy premiums continue for
the life of the insured, a limited pay
policy might only require payments until
age 65, or for 20 years (as examples).
Depending on the payment period,
premiums will be somewhat higher than
standard whole life policy premiums.
However, the policy will be paid-up
much earlier.
Modified whole life policies are different.
They often combine a term life policy
with a whole life policy. For example, the
term element may be in effect for 10
years, after which the whole life policy
and premium will begin. Full coverage
with initial lower premium payments is
the primary rationale for this type of
policy. Modified policies are often used
to insure children. When the child
reaches age 18 (or up to age 25) the
policy switches from the term policy and
lower premium to a whole life policy with
a higher premium. In this way parents
can insure children at a reasonable cost
and assure availability of continued
coverage as the child enters adulthood,
regardless of what happens to the
child’s insurability.
Insurers often offer additional variations
on the basic policy types. You may see
hybrid policies, graded premium
policies, single premium policies,
adjustable life policies and others. The
adjustable life variation became the
forerunner of universal life insurance,
part of what we can call the group of
non-traditional policies.
3.3.3 Non-traditional – Universal,
adjustable, variable, variable universal
Universal Life
Whole life insurance policies are fixed or
bundled. That is, the policy face amount
or death benefit, mortality charges,
premium and cash value components
are all bundled into the policy. As such,
they are essentially
inseparable. Universal life (UL) policies
are often referred to on the policy as
flexible premium adjustable life. They
have the same elements as a whole life
policy, but unbundle the components—
mortality charges, expense charges,
and interest rates—and keep them
separate. Rather than the fixed
premiums associated with whole life,
conventional universal life allows for
some flexibility in the amount of
premium paid. In fact, flexibility is
probably the real distinction of UL.
Premiums may even be skipped
occasionally as long as the cash value
has enough funding to cover the
expense and mortality charges to keep
the policy in force.
When premiums are paid into the policy,
the insurance company deducts a
portion for the cost of insurance
(mortality expense) and an expense
load the company deems it needs for
itself. While the company expense load
is generally level for the life of the policy,
mortality costs increase each year. Note
that the risk premium – or term premium
– is the cost of providing insurance to
cover the net amount at risk at any
given time. The balance of the premium
remains in the cash value and earns
interest. As long as the amount of
premiums received and interest earned
exceeds the cost of insurance and
policy expenses, the cash value will
grow. If costs and expenses exceed
premiums paid and interest, the cash
value will decline.
Figure 3: The UL Bucket Illustration
(Mannaoni, 2016)
The cash value that builds can be used
to offset the amount of one-year term
death benefit protection (level death
benefit option – type I or A) or it can be
used to add to the death benefit
protection (increasing death benefit
option – type II or B). The level death
benefit option will have lower expenses
for the pure life insurance protection
than the increasing death benefit option
because less life insurance is being
purchased each year even though the
cost per thousand of insurance is
increasing. As is true for any permanent
product, the policyowner technically is
buying an increasing cash value fund
and a decreasing amount of term
insurance. The net amount at risk for the
insurer decreases over time as the cash
value component increases. Policies
normally are designed to maintain a
corridor between the increasing cash
value and decreasing (term) death
benefit. Many people do not understand
that when an insured dies, policies
usually do not pay out both the face
amount and cash value as a total death
benefit. The policy, with few exceptions,
only pays the face amount. The nature
of permanent life insurance is, in the
early policy years the insurer has a
greater amount at risk. As the policy
ages and the cash value grows, the
insurer’s amount at risk decreases and
the policyowners amount at risk
increases. This reflects the aleatory
nature of the insurance contracts.
Figure 4: Universal Life (Type I or A)
Level Death Benefit (Mannaoni, 2016)
UL policies may also be designed as
Type II or B policies where the death
benefit increases over time. With the
increasing death benefit option, the
policyowner is technically purchasing a
one-year term policy in the amount of
the current cash value. Although the
owner likely will not recognize that this is
happening, it is the way in which both
the face amount plus the cash value
amount can be paid as a death benefit
(one of the very few situations where
this happens). With this option the death
benefit increases year-by-year as the
cash value amount increases, thus
maintaining the insurer’s amount at risk.
This option is a way to increase the
death benefit (within limits) without
having to get a medical exam or go
through underwriting again. Often, if the
policyowner does not increase premium
payments each year, the cash value
growth will slow, or might stop as the
real policy cost increases sufficiently.
Remember that as the insured grows
older, the mortality costs to insure him
or her increase. This is true in all life
policies, but is more visible in UL
policies.
Figure 5: Universal Life (Type II or B)
Increasing Death Benefit Option
(Mannaoni, 2016)
Most universal life illustrations state a
current interest rate that is presently
being paid, as well as a lower minimum
interest rate that may be guaranteed.
Since the underlying investments are
tied to short-term interest rates, they can
react to changes in the marketplace
more rapidly. Using current interest rate
and expense assumptions, insurance
companies can illustrate an estimated
premium needed to keep the policy in
force. A UL policy normally will have a
minimum required premium (necessary
to keep the policy in force), a target
premium (based on the assumed
interest and expense rates) and a
maximum premium (the largest amount
the insurer will accept for the policy).
Credited interest has four main
possibilities.
 1. Minimum Guaranteed: The
rate guaranteed in the contract
2. Current Rate: The interest
credited on the current premium
deposit, usually guaranteed for
one year or less
3. Blended Rate: Last year’s
premium payment (or older
payments) may receive a different
rate than current premiums.
These amounts are blended with
pools of interest rates that reflect
earlier economic conditions
(higher or lower than current)
4. Loan amounts: Interest
credited on amounts loaned out
may receive current rates or a
lower rate
Some companies offer what is called a
secondary guarantee universal life
product, which is designed to provide a
level annual premium throughout the
premium-paying years of the contract
even though it may not generate any
available cash value. In essence, this
makes the contract a long-term level-
premium term policy.
Early UL policies were based on an
assumption of high interest rate
crediting that was unrealistic over the
long term. As a result, as interest rates
reverted to the mean, policy values
dropped and some policies lapsed.
Realizing this, insurers either stopped
offering UL policies or restructured them
using more realistic crediting rates.
Potential policy lapses are still a
concern because of the flexible premium
arrangements. A policyowner may pay
so little that, as the insured ages and
costs increase, there is not enough cash
value to pay the higher costs. When this
happens, the policyowner must increase
premium payments or the policy will
lapse.
Initially, no life insurance policy used
mutual funds or their equivalent when
investing cash values (they were not
even available in the earliest years).
Money was put in the company’s
general account. While this practice
worked well to support policy security, it
was not a good option as an investment.
Unfortunately, more than a few life
insurance agents had been selling
policies as a secure investment that also
had a death benefit. True, returns were
low, but they were secure.
Over time, as mutual funds and other
investment options became more widely
available, policyowners began dropping
policies and depositing the money in
investments that had a higher return. UL
policies were among the first to use
money-market funds as an alternate
investment option. This does not seem
radical today, but in the late 1970s and
early 1980s when the policies were
developed, rates were high and UL
policies retained many customers. As
mentioned, rates began reverting to the
mean and dropping. As they did,
insurers felt they had to do something.
That something was to use mutual funds
or their equivalent (e.g., subaccounts) in
new variable and variable universal life
policies.
Variable Life
Variable life was first introduced in the
Netherlands, and later became popular
in the United Kingdom and other parts of
the world. It is estimated that variable
life insurance sales account for 15
percent to 30 percent of Europe’s new
business production. Variable life is
essentially built on the same type of
platform as traditional whole life, with
one main difference. Rather than
investing the cash value in the
company’s general account, money is
invested in one of the available sub-
accounts. The sub-accounts are similar
to pooled / collective investments (e.g.,
mutual funds or unit trusts). The
investment concept is similar to that
found in variable universal life policies,
but usually not having quite the same
amount of variety or opportunity for
diversification.
Simply put, variable life combines the
traditional protection and savings
functions of life insurance with the
growth potential of equities. A variable
life policy normally includes a guarantee
that the death benefit in any year will
never be less than the initial face
amount. However, the cash value is not
guaranteed. Premiums are fixed, like
traditional whole life. After deducting
policy expenses, the company invests
the remaining premium in mutual fund-
like separate accounts (or sub-
accounts) as directed by the
policyowner. Variable insurance
products require use of a prospectus
that includes all the same types of
information usually found in a mutual
fund or unit trust prospectus.
Variable life separate accounts are
normally invested in equities, bonds,
and/or money market instruments. In
return for possible improved investment
performance, the policyowner must be
willing to give up a guaranteed cash
value amount. The policyowner also
assumes all policy investment risk.
Variable Universal Life
Variable universal life (VUL) policies are
similar to universal life policies in the
same way variable life policies are
similar to whole life policies. The two
have a similar structure, with VUL
policies also providing the opportunity
for the policyowner to invest in several
mutual fund-type offerings. The
investment risk is transferred from the
insurance company to the policyowner,
and there is greater potential for better
investment returns. The policy also has
potential for investment losses. VUL
buyers need to be aware of policy
investment performance to ensure there
are adequate values to sustain the
policy for life since the costs for
insurance, and possibly administration
expenses, increase as the insured ages.
Unlike variable life policies, a VUL
usually does not have a guaranteed
death. Absent a guarantee, the entire
contract can lapse with no residual
coverage. Some VUL contracts offer a
guaranteed death benefit rider at an
additional cost to provide at least some
protection if the performance of the
subaccounts would result in the policy
lapsing.
VUL policies may also be called flexible
premium variable life. This recognizes
that essentially, VUL combines the
flexibility of universal life with the
investment aspect of variable life. Keep
in mind, unlike variable life, VUL
guarantees only mortality charges and
the right to keep the policy in force. You
can review information on UL policies to
get a good idea of how VUL policies are
structured (remembering that cash
values are handled differently).
Subaccounts versus Mutual Funds
Inside variable products you may find
the names of the subaccounts to be
exactly the same as or very similar to
well-known mutual funds, but it is
important to remember that they are not,
in fact, mutual funds. Their structure is
different and because of this, regulators
require them to carry different
identification codes. Taxable mutual
funds distribute all capital gains each
year, but this is not the case with life
insurance policies and annuities whose
values typically grow on a tax-deferred
basis. Therefore, subaccounts can be
managed without regard to tax
efficiency. Finally, the fees charged are
also different (generally higher with
subaccounts), so the performance of
subaccount funds will be different from
the similarly named mutual funds.
While variable product subaccounts are
not mutual funds, they are securities
and individuals who wish to sell them
need to be properly registered or
licensed.
3.3.4 Joint Life Policies
Joint life insurance policies cover more
than one insured in a single policy.
There are two types of joint life
policies—first-to-die and second-to die.
These policies may be structured either
as whole life or universal life policies.
They are designed for specific situations
where this feature is important.
First-to-die policies cover two or more
individuals and pay the death benefit
when the first covered person dies. This
makes them ideal tools to fund business
buy-sell agreements. For example, if
one of four covered business partners
die before retiring, the business, as a
beneficiary, will have enough money to
buy his or her share of the business
without impacting current assets. The
business can then use the funds to
settle with the deceased owner’s
survivors. These policies can also be
used when a couple chooses to leave a
bequest upon the first death. It may also
be possible to have a contract that gives
the survivor the right to purchase a new
policy, similar to the original, without
evidence of insurability. Premiums are
generally higher than the cost to insure
either individual, but lower than if two
individual policies are purchased.
Second-to-die (or last-to-die) policies
cover two people as well, but do not pay
a death benefit upon the first death.
Instead, these policies pay the death
benefit after both individuals pass away.
As a result, they are also known as
survivorship policies. This unique
feature makes the product a good estate
management tool when a couple wishes
to provide liquidity for estate taxes or to
leave a specific bequest upon the
second death. Premiums usually are
lower than the cost of two separate
policies, as is true of first-to-die
coverage.
Features & Provisions of Individually-
Owned Life Insurance
Standard Provisions
Life insurance policies consistently
contain certain normal provisions.
Common policy provisions include:
• Entire contract clause
• Ownership rights
• Grace period
 • Contestable period
• Misstatement of age
• Reinstatement provision
• Nonforfeiture values
• Policy loans
• Beneficiary
• Suicide/aviation/war
• Dividends
• Conversion clause
• Common disaster clause
• Settlement options
• Common riders
• Installment or annuity table
showing direct recognition
Entire Contract Clause
This clause states that the policy, along
with the attached application, constitutes
the entire contract. Further, this clause
states that changes to the contract must
be made in writing and must be signed
by an officer of the company. This is
also known as the waiver clause.
Ownership Rights
Three potential parties exist in a life
insurance policy. The policyowner owns
the policy. The owner may or may not
be the insured. The insured is the
individual (or sometimes individuals)
covered by the policy. When the insured
dies, the policy pays a death benefit.
The beneficiary (sometimes more than
one) receives payment of the policy
proceeds on the death of the insured. All
three entities may be involved—owner,
insured, beneficiary—or fewer. In fact,
there may be only one party involved in
a contract, who is owner, insured, and
beneficiary (i.e., the estate of the
insured).
The owner has all policy rights, including
receipt of cash values and dividends
and the ability to name beneficiaries,
assign the policy, or borrow against the
policy. An assignment is a policy
transfer. Two basic types of
assignments are available to the
policyowner. An absolute assignment
transfers all ownership rights in the
contract from the owner to someone
else. A collateral assignment transfers
some rights, but not all. Collateral
assignments are usually temporary and
may be used as security for a loan.
When the loan is terminated, policy
rights revert to the policyowner.
Grace Period
The grace period is the term, usually 30
or 31 days, after the life insurance
premium is due. Technically, if the
premium is not paid on the due date, the
contract will lapse. However, the grace
period allows the contract to remain in
full force. The purpose of this provision
is to prevent unintentional lapsing of the
policy. However, if the individual dies
during the grace period, the insurer will
subtract any outstanding premium
amount from the death benefit
proceeds. Also, following the end of the
grace period, if the premium remains
unpaid, the policy will lapse – either
triggering nonforfeiture options (covered
below) or terminating if there is no cash
value.
Contestable Period
After a life insurance contract has been
in effect for a certain period (called the
contestable period), the insurer may not
deny a claim based on any
misstatement or misrepresentation of
the insured. The usual contestable
period lasts for one or two years. If the
insured dies within the time limit, the
clock stops, and the insurance company
can take any reasonable amount of time
required to investigate and determine if
there was any material
misrepresentation or concealment in the
application. Blatant fraud may have no
statute of limitations, and in some cases
a fraudulent application allows the
insurance company to avoid payment of
a death claim even beyond the
contestable period. This is handled on a
case-by-case basis in the courts.
Misstatement of Age
An insured may unintentionally misstate
his or her age on the application. When
this happens, and the insured is older or
younger than indicated, the policy death
benefit will be adjusted. The adjustment
will be based on the amount the
premium would have provided if the
correct age was used. Some people
believe the insurer will cancel the policy
for this misrepresentation, but that is not
what typically happens. Another
common error is assuming the premium
will be adjusted. However, the premium
remains the same; the benefit is
adjusted.
Reinstatement
This provision allows the policy to be
reinstated following lapse. Past due
premiums must be paid and the insured
normally must provide current evidence
of insurability. However, no insurance
coverage will have been in place from
the date of lapse to the date all
reinstatement requirements are
submitted, assuming the reinstatement
is granted. Upon lapse, and following
reinstatement, some companies begin a
new, full-term contestable period.
With some companies, the
reinstatement clause extends the grace
period to some extent. For these
companies, there is no requirement to
provide proof of insurability if the
request is made within 31 days of the
lapse date. Many companies allow an
application for reinstatement to be made
for as long as seven years after lapse.
No company will allow reinstatement if a
policy has been surrendered for its cash
value. Unless otherwise requested,
lapse of a whole life policy would result
in extended term insurance for a period.
This is one of the nonforfeiture options.
Nonforfeiture Options
When you own a cash value insurance
policy and decide that you no longer
wish to continue to pay premiums on it,
you have several options. Over the
years of ownership, the policy builds
reserves. Since the owner contributed to
the reserves that have built up in the
cash value account, these options allow
the owner to not forfeit those reserves,
thus the term nonforfeiture options.
Every cash value of life insurance
includes a nonforfeiture table. This table
shows the option and amounts available
for each policy year. Option amounts
are listed as being per thousand of
insurance coverage (e.g., values for
$100,000 will be listed as 100).
• Cash
• Paid-up reduced amount – cash
value used as a single premium to
pay for a fully paid-up policy with
a face amount (i.e., death benefit)
that is reduced from (lower than)
the original policy benefit. The
policy type remains the same, and
 continues to build cash values,
but the benefit is reduced.
• Extended-term insurance – cash
value used to convert the existing
policy to term insurance with the
same face amount as the original.
The nonforfeiture table will show
the number of years and days
coverage will continue before
terminating. The policy will no
longer build cash values, and it
will only continue as an insurance
policy for the term indicated on
the table. After this, the policy will
laspe without further coverage.
Policy Loan
Depending on the policy, an owner may
borrow money from the cash value. The
policyowner uses the policy as
collateral, and borrows money, at
interest, from the insurance company.
For example, if someone borrows
$1,000 at eight percent for one year, the
interest due, if charged in arrears, will
be $80 at the end of the year. The
present value of $80 due in one year, at
eight percent, is $74.07. If another
company charges any rate of interest in
excess of 7.407 percent in advance, its
interest rate is actually higher than eight
percent in arrears. This can be an
important and somewhat expensive
distinction.
The interest rate may be fixed or
variable. Participating policies (i.e.,
those paying dividends) generally use a
variable rate. A participating policy that
has a fixed interest rate, such as eight
percent, generally includes a provision
called “direct recognition.” This provision
recognizes that the insurance company
can earn either more or less than the
eight percent being charged for policy
loans. If it can earn more, it may
compensate by reducing policy when
borrowing takes place. If the insurance
company cannot earn as much as the
eight percent, it may increase dividends.
When a variable interest rate is used for
borrowing, the dividends are generally
the same whether or not borrowing
takes place.
When a policy loan is taken from a
variable product, an amount of the cash
value equal to the amount borrowed is
generally moved to a guaranteed
interest rate account within the policy.
The insurance company is accepting the
policy values as collateral for the loan,
and as any good business would, it
wants those values in a secure
investment, not one where the values
may fluctuate.
There is no requirement that the loan or
interest be repaid. If the loan (and
interest) is not repaid prior to the
insured’s death, the company deducts
any unpaid loan balance from policy
proceeds before sending policy
proceeds to beneficiaries. In some
cases an unpaid policy loan can
become large enough, as a result of
unpaid interest, to cause the policy to
lapse. Depending on the territory, such
a policy lapse may also create a tax
liability.
Beneficiary
The beneficiary is the entity designated
to receive all or a portion of the
proceeds of the insurance contract at
the insured’s death. The policyowner
may name more than one beneficiary. A
policy can have primary and contingent
(i.e., secondary) beneficiaries. A primary
beneficiary is the one who is designated
to receive the proceeds first. If the
primary beneficiary is unable (e.g.,
cannot be found or has died) or is
unwilling (perhaps due to estate
complications) to receive the proceeds,
a contingent beneficiary may receive the
proceeds. It is possible, and sometimes
advisable, to have several layers of
contingent beneficiaries (e.g.,
secondary, tertiary, and so on).
A beneficiary designation can be
revocable or irrevocable. Most
beneficiary designations are revocable,
meaning the owner can change
beneficiaries at will. There are times,
however, when the owner may choose,
or be required, to designate an
irrevocable beneficiary (i.e., one who
cannot be changed). An irrevocable
beneficiary must approve any contract
changes before they can be
implemented. The owner may not
change beneficiaries, borrow against the
policy, surrender the policy, or assign it
absolutely or collaterally without the
irrevocable beneficiary’s written
permission. This gives an irrevocable
beneficiary a great amount of control
over a life insurance policy, so such a
designation should only be used with
careful consideration. Divorce
arrangements often require the
policyowner to name the ex-spouse
(usually as guardian for the couple’s
children) as irrevocable beneficiary.
Beneficiary payments, especially when
there are both children and
grandchildren, may be made either on a
per capita or per stirpes basis. When
there are grandchildren, the policyowner
may inadvertently cause an undesired
distribution among beneficiaries.
Without proper wording, if one of the
beneficiary/children dies before the
insured, the deceased child’s children
(grandchildren) may share equally with
any remaining primary beneficiaries.
This is a result of a “per capita” or equal
distribution. To avoid this, the
policyowner must state that multiple
beneficiaries in a single class (e.g.,
children as secondary beneficiaries) are
to receive their portion “per stirpes” (“by
line of descent” or “by right of
representation”). If this is done, the
children of a deceased child will each
receive an equal share of their parent’s
share, without impacting the share of
any remaining primary beneficiaries.
As an example, if the policy lists two
primary beneficiaries, both of whom
have two children (i.e., four total), and
one of the two predeceases the insured,
a per capita distribution would divide
policy proceeds equally among the
remaining primary beneficiary and both
children (contingent beneficiaries) of the
deceased (total of three; 33.3 percent
each). A per stirpes distribution under
the same scenario would provide for a
50 percent distribution to the remaining
primary beneficiary. The other 50
percent would be equally divided among
the two children of the deceased (each
getting 25 percent). A per stirpes
distribution, therefore, does not dilute
the benefit going to any remaining
primary beneficiaries.
Suicide/Aviation/War
Death by suicide is normally excluded
during a specified period following policy
inception. The exclusion period usually
is one or two years. This clause
provides that if the insured commits
suicide within the exclusion period, the
insurance company only has to return
premiums paid, perhaps with interest.
Once the exclusion period passes,
suicide is treated as any other death.
The exclusion was created to protect
insurers against those who deliberately
purchase the coverage in advance of a
suicide attempt.
Historically, almost all life insurance
policies had exclusions for death
resulting from aviation accidents. Most
current policies cover this eventuality,
although coverage for private pilots and
pilots and crews of commercial airlines
may require an additional premium.
During times of declared war, insurance
companies may include a clause stating
that, in lieu of full payment, premiums
will be returned with interest for deaths
resulting from war exclusions. Typically,
anyone serving in the military is
excluded, as is anyone who dies as a
direct result of war. For obvious
reasons, war exclusions are generally
included only during times of war. Also,
military personnel are generally offered
policies (by the military/government)
specifically designed to cover them
(even in the event of war).
Dividends
Some life insurance policies pay
dividends to policyowners. When a
policy pays a dividend to a policyowner,
that policy is said to be participating.
These are usually issued by mutual
companies. Mutual companies are
owned by policyowners, and stock
companies are owned by shareholders.
Policies that do not pay dividends to
policyowners are called
nonparticipating, and are issued by
stock companies. When a life insurance
company has revenues in excess of
expenses, it has a surplus. Some of the
surplus is used for contingency
reserves, some for working capital, and
some is given back to the policyowners
or stock holders as dividends. (Stock
dividends are not considered part of an
insurance policy, and we will not cover
them in this course.) Each year, the
company’s board of directors declares a
dividend scale, and the policyowners
share in what is called the divisible
surplus. Policyowners can use dividends
in several ways. These include the
following; dividends may be:
• Taken in cash
• Left to accumulate at interest with
the insurance company
 • Applied toward premium
payments
• Used to purchase paid-up
additions (PUAs) to the insurance
policy
• Used to purchase one-year term
insurance (also called the fifth
dividend option)
In the early years of a participating
policy, the dividends are small. In fact,
some companies don’t pay a dividend
the first policy year or so at all. It may
seem like a very minor choice at first,
but the dividend choice can have a big
impact on the policy in later years. For
example, when dividends are left with
the company—either to accumulate or
as paid-up additions—there may come a
time when the policyowner will not need
to make any further out-of-pocket
premium payments because of the
dividend account value. It also is
possible that the dividends may allow
the policy to become paid up earlier
than expected.
Whether from dividends or premium
payments, as long as enough
accumulated value exists in the policy,
the policyowner may not need to make
any further out-of-pocket payments. This
approach will lower the total cash
accumulation that would have been
achieved if regular payments had
continued, but will also free up cash to
use for other purposes.
Conversion Clause
Term insurance policies generally
include a provision that permits the
policyowner to convert the term
insurance into a cash value (permanent)
form of insurance. Individuals often
purchase term insurance to meet their
long-term needs because they can’t
afford to purchase permanent
insurance. Once their income increases,
they may want to replace all or part of
the term insurance with a policy that
more appropriately addresses their long-
term needs. This clause often limits
conversion to specific forms of cash
value insurance, and usually permits
conversion only up to the policy
anniversary nearest the insured’s
age Some low-cost term insurance
policies further limit the conversion right
or exclude it altogether. When the
conversion right is restricted, it is often
limited to the first five years or so after
the issue date of the original term policy.
Common Disaster Clause
This is sometimes called a payment
delay clause. Simply stated, if the
insured and the primary beneficiary die
in a common disaster, even if the deaths
occur as much as 30 days apart, the
beneficiary is presumed to have died
first. This automatically gives the
proceeds to the secondary beneficiaries.
Think of the complications that would
occur if a couple are killed in an
accident and they each have a life
insurance policy naming the other as
primary beneficiary. It could be
impossible to determine who died first
and even if that could be determined, it
would be disadvantageous to have the
death benefit paid to the now-deceased
spouse. This clause essentially
bypasses the primary beneficiary and
allows for the secondary beneficiary,
who would receive the benefits
eventually anyway, to collect the
proceeds faster, with minimal
complications.
Settlement Options
When the proceeds of a life insurance
policy are paid out as a death benefit, or
when the cash values are paid out, a
lump-sum payment is the most
commonly used method of distribution.
Sometimes, however, some other
method of distribution is better suited to
the needs of the recipient. Policies offer
many distribution options. All the
proceeds may be distributed using any
given option, or several options may be
used with different portions of the
proceeds.
Annuities and life insurance policies
offer the same settlement options.
Settlement options are covered in detail
when we cover annuities below.
Common Riders
Insurance companies, being creative
marketers of their products, are always
looking for ways to give their product a
competitive advantage. As a result,
policies can come with several riders
and options that allow for customization
of the policy to meet a client’s needs
and to compete in the marketplace.
Riders are the same as endorsements
on general insurance policies. They vary
by company and policy, but common
examples include the following:
• Return of Premium: Pays the
policyowner an amount equal to the
premiums paid over the term if the
insured survives the term.
• Spouse and Children: Allows
more than one person to purchase
term insurance in one policy with a
single policy fee versus multiple
policies with a policy fee on each.
• Waiver of Premium: Allows the
policyowner to keep the policy in
 force if the owner becomes
disabled. Typically, this rider kicks
in when the policyowner is totally
disabled for 90 days.
• Accidental Death
Benefit: Typically doubles or triples
the death benefit if the insured dies
as a result of an accident. These
riders sometimes include coverage
for dismemberment as well.
• Accelerated Death
Benefit: Provides certain living
benefits to insureds with special
circumstances.
• Terminal Illness: Allows an
insured who is terminally ill to
receive all or a portion of the death
benefit while he or she is still alive.
• Critical Illness: Pays if an insured
has suffered certain life-threatening
catastrophic illnesses such as
 kidney failure or certain types of
cancer.
• Cash Value Policies: May also
offer two additional riders.
• Guaranteed insurability allows
policyowners to insure the
insured’s ability to buy more life
insurance in the future regardless
of their health.
• Long-term care pays benefits if
the insured requires long-term
care in a nursing home or
hospital.
3.3.5 Amount of Insurance Needed
There are two basic techniques for
dealing with financial risk related to
death. You can retain the risk or transfer
it. To help make this decision, ask,
“When you die, who will suffer economic
loss?”, and, “Are there enough liquid
assets to cover all final expenses, pay
off debts and any taxes that are due,
and provide sufficient income for the
dependents left behind?”
Since every family’s situation is unique,
time and care need to be taken to
conduct a thorough needs analysis that
considers these unique situations. The
process involves recognizing and
evaluating the client’s qualitative and
quantitative goals and evaluating these
variables to determine what amount of
insurance is needed. Even then,
ultimately, the best solutions are
something of an educated guess
(another good reason for regular client
reviews).
One reason for this is that the word
“needs” implies deciding the minimum
amount of insurance required. It is also
important that a client’s “wants” are
included in these calculations. For
example, be careful not to assume a
given client merely wants survivors just
to get by. Many people want family
lifestyles continued and dreams fulfilled,
even if they are unable to participate.
For many people, life insurance is the
best option for transferring the risk of
financial loss caused by death. There
are several good methods for
determining the necessary amount of
life insurance coverage. This section will
consider two basic approaches.
The human life value (income-based)
method puts a value on replacing
economic worth. The needs-based
method analyzes potential needs and,
applying a present value to the needs,
calculates the required amount of
insurance.
One additional note: life insurance is a
cash substitute. The economic need at
death is for cash to help dependents
pay final expenses, settle the estate,
and continue their lives—without
experiencing adverse financial
consequences. This money can come
from existing assets or from life
insurance proceeds. Unless a person
has the required assets, life insurance
can provide cash when the need arises.
As one’s personal estate increases, it
may be worth considering the retention
of more of the risk, or perhaps
completely forgoing the use of life
insurance. However, it is unlikely that
anyone who has dependents will
completely outgrow the need for at least
some life insurance.
Human Life Value (Income-Based)
Method
With the income-based method, five
basic steps determine a person’s human
life value:
1. Estimate future average
annual earnings.
2. From these future earnings,
subtract income taxes, insurance
premiums, and personal living
expenses. This shows how much
income the rest of the family
actually uses, and becomes the
annual payment needed at the
beginning of each year (PMT).
3. Estimate the number of
productive years (N) the individual
has left (i.e., until retirement).
4. Determine an appropriate
discount rate (I/YR) for the future
earnings.
 5. Calculate the present value for
the payment stream as an annuity
due (PVAD).
Example (Mannaoni, 2016)
Use the income-based, human life
value approach to determine a life
insurance need. Estimate average
annual earnings in the future (assume
$50,000 for this example). Deduct
personal living expenses, insurance
premiums, and taxes (assume
$20,000). Determine the number of
years prior to retirement (assume 25
years). Determine the discount rate
(assume four percent). Now do the
calculation. Set the calculator to
BEGIN mode. This example would be
calculated as follows:
PMT = $50,000 – $20,000 = $30,000
N = 25
I/YR = 4
PVAD = $487,409
For this example, the income-based
need for life insurance is $487,409.

The strength of this method is that it

accounts for the working life of the
deceased, and by inflating the income-
producing ability, a more accurate
present value can be calculated. The
weakness of this approach is that it
limits the needs analysis to final
expenses and the income-producing
ability of the deceased. There is often
much more to the client’s situation than
just these factors. For instance, this
method fails to incorporate potential
promotions or job changes and the
additional income that would
accompany these events. Additionally,
the amount needed is depleted since
this method uses a capital utilization.
This will be discussed further below.
Needs-Based Method
The second basic method of
determining life insurance needs is
much more specific. A personalized
needs-based approach allows the
advisor and the client to include all the
client’s needs and wants to determine
how much life insurance a client wishes
to purchase. This approach is more
thorough in that it accounts for much
more than just income replacement and
final expenses (it also requires more
steps and takes longer).
To begin the conversation through this
process you can use the acronym LIFE:
• Liabilities
• Income replacement
• Final expenses
 • Education funding
Liabilities
Using this as a guide, the first item to
determine is whether the client wants
enough life insurance to pay off all debt.
Most clients can come quite close to the
total amount of debt they have from
memory. However, a more precise
determination can be calculated by the
client’s Statement of Financial Position,
which includes things like mortgages,
education loans, car loans, and credit
card balances.
Income Replacement
Income replacement is a bit more
complicated to calculate. Using the
human life value approach (capital
utilization) for this portion of the
calculation would certainly be an option.
Another option would be to take a
capital retention approach to this need.
The difference between capital
utilization and capital retention is
whether the principal used to generate
income is gradually depleted or remains
intact.
Capital Utilization
For example, let’s assume a 45-year-old
client named Anna wishes to replace
$50,000 of her $80,000 annual income
for her spouse’s benefit, upon her death.
We will further assume that the client
expects this salary to increase 3 percent
per year and she plans to live to age 90.
Since this money is needed to provide
for lost income, it may be wise to use a
conservative interest (discount) rate
assumption in this calculation. For this
example we’ll use six percent. We will
also use the real or inflation-adjusted
rate of return in the calculation. The
keystrokes on a financial calculator in
BEGIN mode are:
• 45, N
• ([1.06/1.03] – 1) = .0291 x 100 =
2.9126, I/YR;
• 50,000, PMT
• Solve for PV = $1,281,305
This indicates that $1,281,305 invested
at six percent will generate $50,000
starting tomorrow (when we assume the
death will occur) and an increasing
amount (i.e., inflation-adjusted) each
year thereafter until the Anna would
have reached age 90. At that time, the
fund would be fully depleted. As long as
the surviving spouse dies before that
happens, this approach will suffice.
Capital Retention
The capital retention method is a simple
capitalization calculation. Using the fact
set from the previous example, we
would simply divide $50,000 by the
inflation-adjusted rate of return. In this
example, we divide $50,000 by 2.9126
percent, which results in $1,716,667 as
the amount needed to generate $50,000
the first year and an increasing amount
hereafter without touching the principal.
This approach requires a greater
amount of insurance coverage, along
with increased premium cost. However,
there are several reasons many clients
prefer this method of calculating income
replacement:
• It is simple and easy to
understand
• While it generates a larger
number, and therefore means
more life insurance needs to be
purchased, few people complain
that a death benefit check is too
 large, and the additional premium
is relatively small compared to the
additional coverage provided
• When the surviving spouse
reaches retirement age, the
principal can be used for
retirement plans
• If the beneficiary lives beyond the
anticipated life expectancy, the
principal continues generating
income
• When the beneficiary dies, the
principal is available for heirs
Final Expenses
The calculation for final expenses is
rather straightforward. Final expenses
include the costs of funeral
arrangements, establishment of an
emergency fund, and funds to cover any
final medical costs, or to simply provide
additional cash for an adjustment
period. Additionally, this would be where
clients include any specific bequests
they may have. For instance, a desire to
leave a sum to a charity or a grandchild
would be included in the calculation of
final expenses.
The primary purpose for this portion of
the needs calculation is to provide
enough liquidity to have cash to pay for
expenses likely to be incurred shortly
after death. As an advisor, you should
be aware of what funeral costs are in
your area. It is generally a good idea to
round the amount up for the same
reason mentioned in the previous list.
Add to this number an amount that
would cover the family’s expenses for a
transition period, perhaps six months’
worth. Add an additional amount that the
client would like to have just in case
there are additional out-of-pocket
medical expenses. These added
together comprise the total for this
portion of the needs calculation.
Education Funding
Education funding can be determined
similarly to income replacement. Using
the three-step process described below
where the current cost of college is
inflated, the present value of an annuity
due (serial payment) is determined for
the college years, and then this sum is
discounted to its present value will
establish a specific number that can be
used for the college funding portion of
the needs determination.
Another less complicated option would
be to simply take today’s cost for college
and multiply that by four or five to
account for the number of years the
student will be in college. Since we
always assume death will happen
tomorrow when calculating life
insurance needs, the assumption under
this methodology is the surviving parent
can invest the money such that it can
keep pace with the rising cost of college.
To illustrate education funding, let’s
assume the clients have one child who
is currently five years old and will be in
college for four years, beginning at age
18. We will further assume that a year of
college expenses totals $25,000,
inflation for college costs is six percent,
and our clients can earn seven percent
on their investments. We will apply the
real/inflation-adjusted rate to reflect how
inflation offsets investment return. Using
the three-step approach the keystrokes
for the first step (inflating the cost of
college) would be:
• 13, N
• 6 I/YR;
 • 25000, +/-, PV
• Solve for FV = $53,323 – this
amount represents the cost of the
first year of college in 13 years
The keystrokes for the second step
(after setting the calculator to BEG
mode since colleges insist on tuition
being paid at the beginning of the school
year) would be:
• 4, N
• ([1.07/1.06] = 1.094) – 1 =
.009434 x 100 = .9434, I/YR
• 53323, +/-, PMT
• Solve for PV = $210,321 – this
amount represents the sum
needed at the beginning of the
first year of college required to
cover the costs over four years
The keystrokes for the third step
(discounting this lump sum back to
today) are:
• 13, N
• 7, I/YR
• 210,321, FV
• Solve for PV = $87,276 – this
represents the amount of life
insurance needed today to cover
the cost of college for the clients’
child in 13 years making the usual
assumption that the death of the
parent occurs tomorrow
By adding the totals calculated in each
of the four categories covered using the
LIFE acronym, the gross life insurance
need is calculated. Subtract existing life
insurance amounts from this to arrive at
the net life insurance need. Some
advisors include other financial assets
that could be used by the survivors to
further reduce the net amount of life
insurance needed. Care should be
taken when reallocating savings and
investment assets as the survivors may
wish to retain these for their intended
purpose. The safe option is to leave
savings and investment assets alone
unless the client insists they be used to
reduce the life insurance need.
By using a personalized approach, an
individual’s situation and attitudes are
reflected when determining life
insurance needs. The following
worksheet illustrates the LIFE approach
using a capital retention approach
(Mannaoni, 2016).
Liabilities (mortgage, $400,000
education loans, car +
loans, credit card
balances)
Income replacement $1,716,667
($50,000 per year in +
today’s dollars
assuming 6 percent
returns and 3 percent
inflation)
Final Expenses (funeral, $50,000
emergency fund, +
charitable bequest)
Education funding (two $200,000
children for four years =
each at $25,000 per
year)
Gross death benefit $2,366,667
needed –
Existing life insurance $250,000
=
Net new life insurance $2,116,667
needed
It is important to remember that, with
married couples, a life insurance needs
analysis calculation should be
completed for each spouse individually.
While the amounts needed to cover
liabilities, final expenses, and education
may be identical, if the respective wages
of each spouse differ, the need for
income replacement will be different.
Finally, the life insurance analysis
process requires review at various
intervals as objectives are achieved or
modified and as circumstances change.
When working through the life insurance
needs determination process,
calculations are made as of today (i.e.,
as if the client were to die tomorrow).
3.3.6 Annuities
Annuities have been called the flip side
of life insurance. Life insurance protects
against the risk of dying too soon, while
annuities protect against the risk of
living too long. Insurance companies
offer annuities because they have the
expertise to provide the annuitant with a
guaranteed lifetime income. The only
way to do this is to have actuaries
include mortality factors into the income
calculations. Actuaries work for insurers,
so insurance companies offer annuities.
In today’s world, annuities are simply
another investment option, one that, in
some territories, provides tax benefits.
However, annuities also offer, as one of
their most valuable options, the
possibility of a lifetime income. In a time
value of money context, an annuity is a
stream of payments. We can apply that
concept to the annuity product. At its
core, it was (and remains) designed to
provide a stream of regular payments to
the annuitant (i.e., the owner and
recipient of the payments). An annuity’s
function is to spread invested capital
and earned interest over a period – such
as the life of the annuitant. Actuaries
and mortality calculations enter the
picture to determine, based on age, and
sometimes gender, the amount of each
periodic payment to the annuitant. When
the capital and interest turns into an
income stream, the contract is said to be
annuitized.
Annuities do not have to be annuitized
over the lifetime of the annuitant.
Payments can be structured to last for a
specified period, such as 10 or 20 years.
In fact, many of today’s annuities do not
have to be annuitized at all. Unlike with
their original iteration, annuity owners
may simply make withdrawals at those
times when they want to add some
income to their cash flow. We should
note that some jurisdictions, notably
those offering tax-deferred earnings,
might require that withdrawals, in
specified amounts, begin by a certain
age. Further, depending on the contract,
either the insurer or the government
may assess taxes, surrender charges
and penalties against withdrawals.
Definitions
To help with our understanding of
annuities, let’s review the definition of
some terms.
• Annuity: A contract sold by life
insurance companies that
guarantees a fixed or variable
payment to the annuitant
(beneficiary).
• Annuitant: The owner and
individual entitled to receive the
annuity’s income stream.
• Premium Payments: May be
single (required with an immediate
annuity) or flexible (i.e., more than
one). Flexible payments allow the
owner to deposit money into the
annuity at irregular intervals, or on
a fixed plan (e.g., monthly). In some
jurisdictions, and depending on the
annuity’s structure (e.g., in a
qualified retirement account),
relevant laws may limit the amount
and timing of payments.
• Single Premium: One payment
only.
• Fixed Premium: A predetermined
amount stated in the contract that
is to be paid on each scheduled
premium due date.
• Flexible Premium: The amount
of the premium deposit can be
changed, within limits, by the
annuity owner at any time.
• Immediate Annuity: Income
payments start shortly after a single
premium payment is made.
• Deferred Annuity: Income
payments start at a date in the
future.
• Joint and Survivor: Income
payments are made to the primary
annuitant while both are alive, and
the survivor receives some
payment after the death of the
primary annuitant.
• Pure Life Annuity: Income
payments last for the lifetime of the
annuitant, and then terminate.
• Life and Period Certain: Income
payments last for the lifetime of the
annuitant, with a minimum specified
payment period (e.g., 10 years)
guaranteed.
• Refund Annuity: If the value of the
income payments over the life of
the annuitant does not equal the
principal value of the annuity at the
date of annuitization, the balance is
paid to the beneficiary either as
continued payments or a lump sum.
• Fixed Annuity: Payout based on
an amount guaranteed in the
contract. Payments are normally
fixed and level. The insurance
company bears investment risk.
• Variable Annuity: Payout based
on the number of units
accumulated. Payments are
variable and not guaranteed,
although contracts may offer
minimum guarantees as an option.
Unlike a fixed annuity, the owner
bears all investment risk. However,
many contracts offer minimum
 earnings levels and other
protections as options (these
options almost always increase
contract expenses).
• Annuitize: Begin a series of
payments from the amount
accumulated within the annuity
contract. For most contracts, once
annuity payments begin, the owner
can no longer make contributions
into the annuity contract.
Technically, the accumulation
vehicle has been sold to purchase
the income stream. Payments may
be fixed or variable, and may begin
shortly after the contract is
executed (i.e., immediate annuity)
or at some point in the future (i.e.,
deferred annuity).
Immediate Annuities
Immediate annuities are those where a
single sum is deposited and payments
to the annuitant normally begin one
benefit period after the contract is
issued. The annuity payments are either
a fixed amount (immediate fixed
annuity) or an amount that varies with
the unit value of the underlying fund
(immediate variable annuity).
An immediate annuity (annuitization)
most often is purchased because the
buyer wants to begin receiving a stream
of regular periodic payments that are
guaranteed by the insurer to last for
some pre-specified period of time,
generally the remaining life of the
beneficiary(s) or some other pre-
selected time frame.
Two very important considerations exist
when contemplating annuitization. First,
annuitization is generally irrevocable.
Once payment begins, no option exists
to reverse the decision and retrieve the
principal. The second consideration is
the erosive long-term effect of inflation
on purchasing power; inflation at four
percent per year halves purchasing
power in a mere 18 years. This
substantial risk cannot be ignored by the
advisor; clients should always be alerted
to this risk and presented with the option
of inflation-adjusted payments.
Deferred Annuities
Deferred annuities allow for payment of
either a single sum (single-premium
deferred annuities) or a series of
payments over a period of years
(fixed or flexible-premium deferred
annuities). The accumulation period
begins once the first premium payment
is received and the contract is issued.
This period lasts until the time when the
funds are removed from the contract
under an annuity option.
The policy owner normally has the
option of making occasional
withdrawals, receiving periodic (i.e.,
annuity) payments under one of several
possible annuity options, or taking a
lump-sum cash payment.
Annuity payments begin at the date
stated in the contract, although
generally the annuity start date can be
changed by the policy owner at any time
before annuity payments begin. The
amount of the payments depends on
several variables, including the amount
invested, the return earned on that
amount, the age of the annuitant when
payments begin, and the period for
which payments are guaranteed.
Payments consist of both principal and
interest.
Annuity payments can be based on the
life of one person or on the lives of two
or more people. An annuity contract
issued on two lives, where payments
continue in whole or in part until the
second person dies, is called a joint and
last survivor annuity. An annuity issued
on more than one life, under which
payments stop upon the death of the
first person, is called a joint life annuity.
While withdrawals may be permitted if
funds are needed prior to annuitization,
they may be subject to tax or other
penalties (depending on the company
and jurisdiction). The issuing insurance
company may impose penalties
(called surrender charges) on annuity
distributions. Surrender charges
normally do not last throughout the
entire contract period. Instead, they
normally decrease over a period of
years until they are eliminated. After the
first year, investors usually can withdraw
a percentage of the annuity’s value
without incurring a surrender charge.
Because of possible penalties and tax
considerations, individuals should
consider whether an annuity is the best
option for their money.
Once the annuitant selects an annuity
income option and payments begin, the
annuity account is more or less frozen.
At this point the owner has used the
amount accumulated in the annuity to
purchase an annuity payment stream
from the insurance company—so any
amount previously accumulated in the
annuity no longer belongs to the owner
(it was “sold” to the insurance company
for the income stream). When someone
says the funds in an annuity are
“annuitized,” he or she is referring to this
purchase. Some companies are making
changes to annuities that allow for
increased distribution (payout) flexibility.
Fixed Annuities
Annuities may be fixed or variable, and
the two options are quite different. In the
same way that a whole life insurance
contract[1] is fixed, meaning preset
premiums, cash values and death
benefit, a fixed annuity contract is
preset. A fixed annuity payment period
may be immediate or deferred, but
either way, the amount is fixed in the
contract.
Contracts almost always vary by
company, so even though we can
identify basic or core contract types and
benefits, it is highly likely that individual
insurers will offer variations. Also, we
are talking about base contracts.
Insurance contracts and annuities often
provide options (i.e., riders or
endorsements or additional features)
that modify basic coverage. As an
example, we may identify that a basic
fixed annuity contract provides for level
payments throughout the contract
period. However, the annuity may also
have an option that provides for inflation
(e.g., cost-of-living) adjustments. These
additional coverage options and
guarantees almost always increase a
contract’s expenses. As such, you
should do a careful cost-benefit analysis
to determine which options, if any, you
should recommend.
Fixed annuities are generally more
appropriate for conservative individuals,
and those who want a guarantee of
future income. The relatively low,
guaranteed rate of return paid on a fixed
annuity is a potential downside.
Remember the basic investing rule: low
risk usually results in low returns. This
holds true for annuities. In fact, if an
advisor sees a fixed annuity offering
overly high returns or payouts, he or she
should investigate how the high returns
are being generated. Chances are good
that the insurer is using hedging
techniques (not always a bad thing) or
increasing risk levels in some way that
may not be appropriate for a client.
Peace of mind is the biggest value of
fixed annuities for many individuals.
Some people are willing to forego higher
returns and income payments in favor of
a guarantee. However, others are not so
willing, and for them, a variable contract
may be appropriate.
A deferred fixed annuity is a savings
account that earns a fixed rate of
interest for a time specified by the
insurer. After that period, the insurer
establishes a new rate. A bailout
provision is an annuity contract
provision in which the company agrees
that if any new rate established by the
company is below the rate specified in
the provision, money in the contract can
be withdrawn without a company-
imposed penalty. Not all contracts offer
a bailout provision. The insurance
company typically guarantees both
principal and interest in a fixed annuity.
Assets backing fixed annuities stay in
the company’s general account and are
subject to creditors’ claims in the event
of insurer financial difficulty.
Variable Annuities
One big problem with fixed annuity
payments is that they are fixed. The
guaranteed payout amounts are a two-
edged sword. On the one hand, the
annuitant can feel secure (assuming
ongoing insurer financial viability) in
knowing exactly how much money will
be coming in each month. That very
security, however, often creates
problems. A fixed payment never
changes, but cost of living almost
always does. As discussed in FPSB’s
Investment Planning and Asset
Management course, market risk is not
the only type to note. Especially for
those who live long, maintaining
purchasing power can be a risk that is
as big, or bigger. With any amount of
inflation, the cost of an item tomorrow
will almost certainly be greater than
today’s cost. The same is true for all
inflation-sensitive expenses, and if all
the annuitant’s payments are fixed,
eventually he or she may begin to
struggle.
A variable annuity may provide a
solution, in that, depending on
investment returns, annuity payments
may keep pace with inflation. If we can
compare a fixed annuity to a whole life
insurance policy (minus the life
insurance part), we can compare a
variable annuity to a variable (or VUL)
life contract. The variable annuity
accumulation account invests in owner-
chosen mutual funds, or their insurer
equivalent. This means that variable
annuities are securities, and must be
treated as such (including observing all
licensing-related requirements).
All annuities, other than those with
immediate annuitization, have two
primary periods. During
the accumulation phase, the owner
makes deposits into the annuity (or one
deposit, with a single-premium annuity).
In a fixed annuity, these deposits go into
the general fund and earn whatever rate
has been contractually guaranteed (plus
any excess, if applicable). This is not
what happens with a variable annuity.
Variable annuity deposits
purchase accumulation units, and are
invested in whatever fund or funds the
owner has selected. For example,
assume the cost of an accumulation unit
is $100 and the owner deposits $100.
He or she would have purchased one
accumulation unit. If the deposit were
$500, the owner would have purchased
five units. When the time comes to
annuitize, the initial annuity payment
amount would be determined based on
the number of accumulation units in the
contract. From that time on, as the value
of each unit (now called an annuity or
payment unit) increases or decreases,
annuity payments would raise or lower
in response (more on this later). The
value of each accumulation unit would
vary, just as the value of each mutual
fund share varies, based on market
returns. Some annuities offer minimum
earnings guarantees, but such
guarantees always come at a price,
which must be weighed against the
benefit provided.
As is the case with variable life
insurance policies, some contracts offer
just a few investment alternatives, while
others may offer hundreds of options.
Investment options have all the same
type of expenses as with any mutual
fund, including those related to
investment management and
distribution. Additionally, all annuities
have expenses related to the actual
annuity contract. These include
administrative charges along with
mortality-related expenses. Some
contracts may have sales charges, and
if so, they are usually of the contingent-
deferred or surrender variety. That is, if
the owner withdraws money from the
contract within a set period following the
original purchase (e.g., 10 years), the
insurer may deduct a percentage from
the withdrawal as a way of recapturing
sales charges. Some contracts, but not
all, allow minimum withdrawals without
assessing a sales charge. Typically,
surrender charges eventually fall away.
A financial advisor should be aware of
the period and amount of any surrender
charges and advise accordingly. Most
contracts allow the owner to move
money from one investment option to
another, but the number of times this
can be done annually may be limited,
and fees sometimes accompany the
transfers.
If you are getting the idea that at least
some variable annuity contracts can
have a lot of fees, you are correct. While
annuities, like most investment options,
can serve a valuable function, advisors
must exercise caution to determine
whether related fees are excessive.
Also, when trying to calculate annuity
investment returns, you may see a
sizable difference between gross and
net returns – especially in the contract’s
early years. Focus on the need, as is
true with any investment option, to
weigh benefits against expenses, and
carefully consider whether to use or
recommend annuities accordingly.
The annuity phase or payout period
follows sometime after the accumulation
phase. In the case of fixed annuities,
payments will be fixed and clearly
identified at the beginning of the payout
period (remember that some contracts
offer inflation adjustments). Variable
annuity payments are not fixed, and only
the initial payment will be identified. We
should mention that it’s always possible
that the owner will simply want to
liquidate the contract and receive all
available funds in a lump sum. This
payout may or may not be taxable (at
least in part), depending on regulations
in the jurisdiction, and the type of
contract.
Assuming the owner elects to have a
payment stream, the insurer would
convert accumulation units to annuity or
payment units. All the same distribution
options apply to variable contracts as
are available with fixed annuities (e.g.,
single life, joint life, period certain, etc.).
The owner often has the option to opt
for a fixed payout or one that is variable.
Sometimes, both options can be applied
– to part of the contract’s value, of
course. Since the variable payout option
is a big part of the rationale for variable
annuities, most people choose this path.
The payment amount of each annuity
unit reflects the annuitant’s age, and
sometimes gender, life expectancy (just
as with fixed annuities), payout option
(e.g., single life, period certain, etc.),
and investment return. That last item is
what causes each payment to vary.
Sometimes payments are guaranteed
for a period, but if not, each payment will
rise or fall as the value of the underlying
investments does the same. For this
reason, annuitants cannot accurately
predict the amount of each payment
they would receive. At the same time,
assuming solid investment performance,
the annuitant should be able to count on
at least the potential that payments
would keep up with inflation.
Remember, the number of annuity units
does not change, but their value does.
This may be re-calculated on a monthly,
quarterly, semi-annual or (often) annual
basis.
Indexed Annuities
Indexed annuities (IAs) offer some of
the growth potential of the stock market
with the downside protection of a
guaranteed annuity. These products are
fairly sophisticated, so both financial
advisors and their clients should have a
firm understanding of these annuities
before adding them to a portfolio.
Further, there are several variables in
these products, which can make
comparisons difficult. Many regulators
have issued warnings expressing
concern over the complexity of and
potential problems associated with IAs.
Indexed annuities have characteristics
of both fixed and variable annuities. IAs
usually provide a guaranteed minimum
interest rate and an interest rate tied to
a market index. They typically are linked
to a benchmark (such as the S&P 500),
which provides the growth potential in
these accounts. The participation
rate determines how much of the
underlying index’s gain will be applied to
the account value. For example, if the
participation rate is 90 percent, and the
S&P 500 increases by 10 percent in a
period of time (called the index interval,
which can be 1, 5, 7, or even 10 years),
the annuity’s account value would
increase by 9 percent (90 percent of the
10 percent increase). Some
annuities may also have a rate cap,
which will limit the amount of growth that
can be applied to the account value for
a given interval.

There are different methods of

measuring the change in the underlying
index. The percentage change method
measures the percentage change in the
index from the beginning to the end of
the index interval. Only the index’s
starting and ending points matter;
market fluctuations in between are
ignored. In those intervals when the
index declines, no gain is credited to the
account. The ratchet method (also
called point to point) locks in the gain
credited to the account each policy year.
The index value at the end of one policy
year becomes the starting value for the
next policy year. The spread
method subtracts a fixed percentage
(such as two percent or three percent)
from the index’s percentage change in a
given interval. If the index grew by 30
percent over a three-year interval and
the insurance company used a two
percent spread, the account would be
credited with a 28 percent increase in
value.
In terms of downside protection, assume
the S&P 500 declined 10 percent over a
given index interval. In this case, the
annuity’s account value would remain
unchanged from its starting point for that
interval. While the annuity owner did not
earn any interest or have any gain
during this period, neither did the
account lose money due to the market’s
drop. This downside protection can be
very appealing to a client who wants to
participate in the market’s gains (to a
limited degree) while avoiding market
losses.
The idea is that the account value in an
indexed annuity will not decline unless
the owner takes a withdrawal. In
particular, the timing of a withdrawal can
have a significant impact on the
participation rate. The ideal situation
would be for the annuity owner
to only take withdrawals immediately
after the participation rate (for a given
interval) has been credited to the
account. Once the participation rate has
been credited to the account, the
increase in account value is locked in
and guaranteed into the next index
interval. So you can see that a
withdrawal in the middle, or towards the
end, of a participation rate interval could
minimize the growth potential of the
account for that period of time. One final
note: as mentioned above, regulators
are giving IAs extra scrutiny. They are
concerned that these products may be
too complex, that IAs are not being
adequately described (with adequate
disclosures) to potential clients, and that
there is too much opportunity for abuse.
Settlement and Payout Options
Annuity payment options are essentially
the same as life insurance settlement
options. In both cases, lump sum
payment is the option most commonly
used. This gives the beneficiary all the
funds at once. These can then be used
for any purposes and serve a valuable
cash flow function. When beneficiaries
choose to receive regular payments in
lieu of a lump sum, the life income
option is most frequently chosen. This
option will make payments during the
life of the beneficiary. At death, all
payments stop, regardless of whether
money remains in the account or not. As
an example, assume an account has
$100,000 and the beneficiary has
chosen a life income (or single life)
payment option. If the beneficiary dies
after receiving payments of $20,000, the
remaining $80,000 will stay with the
insurer. There is no recourse. This is
why this option is seldom
recommended, except possibly for
situations in which only one individual is
involved, and he or she does not wish to
leave a bequest to anyone.
In addition to life income, annuities (and
life policy settlements) also offer other
options:
Payout and settlement options:
• Joint (and Survivor): Payments
continue during the lifetimes of both
annuitants, after which they
terminate. Joint payments may
remain level during both lifetimes,
or may be reduced (e.g., one-half)
following the death of the primary
annuitant. If the annuity has a
survivor option (certain jurisdictions
only) any amount of the basis (i.e.,
capital plus earnings) that remains
after the deaths of the annuitants
will be paid to a beneficiary.
• Period Certain: Annuity payments
continue for at least a minimum
number of years (e.g., 10).
Depending on the contract terms,
 payments may end once the set
number of years has passed, or
may continue for the remaining
lifetime of the annuitant. If the
annuitant predeceases the period
certain, remaining funds go to a
beneficiary.
• Fixed Amount: Annuity payments
made in a fixed amount (e.g., 1,000
pesos) for as long as the principal
(and earnings) last, after which all
payments stop.
• Refund: Depending on the payout
option chosen, the contract may
allow for a refund of any remaining
money (principal plus earnings) left
in the contract at the end of the
annuity period (i.e., when the
annuitant dies). Where included,
the total of payments will be
calculated, and if less than the total
 amount of principal and earnings in
the contract, the remainder will be
paid to a beneficiary. As an
example, if the principal is
$100,000, and total payments add
up to $80,000, the beneficiary will
receive the remainder of $20,000.
However, if total payments are
more than $100,000 (in this
example), the beneficiary will
receive nothing, as the original
principal has been fully distributed.
Some contracts may allow for variations
on the primary options listed above.
Further, it may be possible to allocate
some of the capital to more than one
payout option. Finally, the preceding
annuity option list refers to annuitization,
not periodic withdrawals. Withdrawals,
where allowed, enable the owner to
receive money from the contract without
changing the contract’s structure, and
keep annuitization options open.
The life insurance and annuity section of
this chapter has a lot of content, and
much more exists. This is one of the
areas of study that can support entire
degree programs. We have covered the
fundamentals, and now will begin
looking at other types of cover,
beginning with health insurance.
3.4 Health Insurance
A significant medical claim is one of the
most potentially devastating losses an
individual can experience. Medical
events such as heart attacks, cancer,
strokes, and catastrophic injuries, such
as those that result in paralysis or
permanent brain damage, can leave a
person or family devastated with
enormous medical bills.
Governments in many territories provide
a base-level of healthcare for citizens.
Coverage usually comes with limitations
and any number of requirements, but it
has one strong benefit – it doesn’t cost
money (other than the taxes that may be
required to fund programs).
Unfortunately, the benefits provided
under these programs sometimes have
large coverage gaps. This is especially
true when an individual desires a
specific type or level of care that is not
offered with the base benefits. This
situation results in either not getting the
desired care or getting it, and having to
pay a large amount of money for the
services.
Private health insurance is designed to
help people manage this risk area. Even
with insurance, there can be significant
out-of-pocket costs due to deductibles,
copayments, coinsurance, and high
maximum out-of-pocket limits. In
addition to a health insurance plan,
individuals and families would be well-
advised to have enough cash reserves
(i.e., emergency funds) to handle a
catastrophic medical event.
While most routine medical issues are
relatively inexpensive, the cumulative
cost of doctor visits and prescriptions
can add up over the course of a year.
Most individual health insurance policies
require the insured to pay for a portion
of these costs until the deductible
amount is reached and then additional
costs until a specified maximum out-of-
pocket amount is reached.
Having a coordinated plan that includes
health insurance and savings is
important to managing the cost of
healthcare. Even without a significant or
catastrophic medical event, healthcare
costs can mount up and drain a family’s
or an individual’s savings account.
Additionally, the cost to consumers for
healthcare continues to increase each
year as the cost of healthcare itself rises
and many people find that deductibles
and out-of-pocket maximums increase.
Coordinating health insurance coverage,
which provides protection against large
losses with a cash reserve and policies,
can help clients manage the out-of-
pocket costs health claims will generate.
Healthcare plans provide coverage
against the risks of sickness and
accidents. In addition to government-
provided healthcare programs,
individuals may be able to obtain
coverage from their employers. Clients
also may wish to purchase primary or
supplemental insurance to cover
expenses not covered by government or
employer-provided benefits. Different
territories may offer different types of
coverage.
Two categories of people may need
coverage in a given territory: citizens
and expatriates. Coverage requirements
are likely to vary—sometimes greatly—
between these two categories of people.
As a result, even if citizens of your
territory may not need or use a
particular type of healthcare coverage,
those in the expatriate community may.
Some of these people may be clients,
so it is worthwhile to know the types of
coverage they may have or need.
The content that follows highlights the
major types of coverage that may be
available in a territory.
Sources of Coverage
Group Coverage: Some employers are
able to offer group health plans at a
lower rate than what would be available
if employees purchased plans
individually because they may offer a
large number of potential covered
people to a plan provider. Some plans
require a waiting period, such as 60
days, before a new employee becomes
eligible to join a company’s health plan,
but some plans provide immediate
eligibility. Employers offer a variety of
types of plans, some of which will be
discussed later.
Privately Purchased Coverage: As
with group coverage, a variety of plan
types are available. Costs for individual
plans (meaning a plan purchased by a
single person or by a family) typically
are much higher than an equivalent
group plan. While employers are
sometimes able to negotiate a lower
group rate, an individual is not able to
leverage group bargaining power. As
with most types of insurance, individuals
can reduce costs by “self-insuring” as
much as possible. When an individual
self-insures, he or she assumes a
higher deductible, a higher co-payment,
or a higher coinsurance provision (terms
to be defined later in this unit).
3.4.1 Types of Medical Expense
Insurance
Basic Medical Expense
Policies: These policies typically cover
doctor visits while the insured is in the
hospital, as well as office visits,
laboratory services, and other care
provided outside the hospital. They do
not generally cover additional expenses,
especially those in the “major” category.
Comprehensive Medical
Coverage: Major comprehensive
insurance products provide coverage for
the large medical expenses associated
with a serious injury or long-term illness
that could become financially damaging.
Relatively few exclusions occur in most
comprehensive medical policies (at least
insofar as normal medical procedures
are concerned), but specific procedures
often contain limits (similar to a
scheduled benefit), or benefits may be
limited to what the carrier considers
“usual and customary” or the “prevailing
rate.” Normal maximum policy limits can
range above $1 million (or sometimes
offer coverage without an upper limit).
With such high coverage limits,
comprehensive medical policies may
have three cost containment features to
help keep costs
down: deductibles, coinsurance,
and copayments.
The deductible in health insurance
works in the same way as a deductible
on a homeowners or motor vehicle
policy. This is the amount that the
insured must pay before the plan pays
anything (although homeowner
deductibles come off the back end).
However, health insurance policies differ
in that the deductible doesn’t apply to
every service. For example, preventive
care and wellness benefits, such as
mammograms and well-baby care, may
be paid 100 percent by the insurance
company.
Another difference is that health
insurance deductibles are normally
annual deductibles, not per incident
deductibles. As an example, if a driver
has three accidents over the course of a
year, the collision deductible would be
applied to each claim. If an individual
has three health insurance claims in a
year, the deductible is not normally
applied to each claim, but instead, costs
apply cumulatively to the deductible. So,
if an insured has a $2,000 deductible
and the covered expenses of the first of
three claims is more than $2,000, there
would be no deductible required on the
remaining claim coverage.
Coinsurance is a percentage of the
expenses that are paid by the insurance
company once the deductible has been
met for covered services. A plan might
have a deductible of $2,000 and then a
coinsurance percentage of 80 percent
up to the maximum out-of-pocket limit of
$6,350. If a service is provided that
costs $5,000, the insured would be
responsible for the $2,000 deductible
and another $600 due to the
coinsurance. The insurance company
pays 80 percent of the remaining
amount (following the deductible), so the
insured pays 20 percent ($3,000 x .2 =
$600) and the insurance company
would pay the remaining $2,400.
Copayments, or “copays” as they are
often called, are easily confused with
coinsurance, but they are quite different.
A copayment is a set amount that the
insured will pay for a service, such as a
doctor visit. The copay amount may or
may not be applied to the annual
deductible or coinsurance percentage
depending on the plan. Copayments are
another cost-sharing feature that varies
among the different plan categories.
Another term with which you need to be
familiar when discussing health
insurance is maximum out-of-pocket
limit (MOOP limit), or just out-of-pocket
limit. The MOOP limit is a set amount
that varies among the plans beyond
which the insurance company pays 100
percent of the expenses for covered
services. This is a stop-loss amount that
allows individuals to know exactly the
most they might have to pay in any
given year for healthcare expenses. For
many people, this is a new term and yet
very important because it is this dollar
amount that they need to make plans to
pay in a worst-case scenario.
3.4.2 Managed Healthcare Plans
Managed healthcare plans came about
to address the rising costs of medical
care and encompass a variety of
healthcare programs. First developed in
the United States, these plans have
spread to other territories. While there
are many variations, not all of which are
likely to be offered in every territory, the
following identifies the major types of
managed healthcare plans and terms.
Capitation: Various managed care
plans use capitation to control costs.
Capitation is where primary care
physicians are paid a fixed fee for every
healthcare plan subscriber who names
that physician as their primary care
physician. The physician then provides
whatever services the patient needs. If
the patient never visits the doctor, the
doctor profits. If the patient visits every
week, the doctor loses money on that
patient. Managed care plans often use
capitation payments for primary care
physicians and use negotiated fee
reductions for specialists.
HMOs: A health maintenance
organization (HMO) provides, through
its own or contracted physicians and
contracted hospitals, comprehensive
healthcare services in return for a set,
prepaid premium. The standard HMO is
both the financier and the provider of
healthcare. When an insurance
company offers HMO-style coverage, it
is technically called an exclusive
provider organization (EPO), although
most people won’t be able to tell the
difference between an EPO and an
HMO. With EPOs, the insurer is the
financier, but not the service provider.
HMOs may be self-run, but there also
are many HMOs sponsored by a variety
of physician groups, insurance
companies, employers, labor unions,
hospitals, and consumer groups.
The prepaid monthly premium allows
HMOs to provide healthcare at little cost
(a copay) or no extra cost at the time of
service. HMOs encourage subscribers
to have regular medical checkups along
with other preventive care. Although the
monthly premiums for some HMOs may
be slightly higher than those of other
healthcare coverage providers, the
subscriber receives a greater number of
services available at a lower cost. One
of the primary drawbacks of the HMO
system is that the patient must get the
required care from an HMO physician.
Individuals who prefer to choose their
own care providers may see this as a
significantly limiting factor.
HMOs normally operate using a
gatekeeper concept. The gatekeeper is
your primary care physician. Under
normal circumstances, when seeking
medical care, you first must see your
primary care physician. He or she will
determine the recommended course of
action, including whether you should be
referred to a specialist. Since you nearly
always must first go through the primary
care physician (except in emergencies),
he or she has a great deal of control
over the healthcare services you
receive.
PPOs: Preferred provider organizations
(PPOs) are business entities formed by
physicians and hospitals that contract
with an insurer, a plan administrator, or
an employer (if self-insured) to provide
healthcare services. The network
providers (those participating in the
PPO) are promised increased business
in return for lower fees. Insureds going
to network providers for needed
services are subject to lower deductibles
and coinsurance percentages, or they
may have to pay only a small set fee for
office visits. If an insured chooses to use
a non-network provider (unlike HMOs,
some PPOs offer this choice),
deductibles and coinsurance will be
higher. PPOs are designed to hold
medical costs down by using several
cost containment measures.
POS Plans: Like an HMO, point of
service (POS) plans may use the
gatekeeper mechanism to keep costs
down. Like a PPO, the insured chooses
where he or she will receive needed
care, and the level of benefits received
varies, depending on where he or she
goes.
Now that you have seen the different
type of healthcare options, you need to
know that these plans continue to
change how they operate and often
incorporate characteristics of other plan
types. Changes in the regulatory
environment are just one of the many
factors that can serve as a catalyst for
change. As a result, many plans today
don’t fit neatly under any one definition.
It is important to know the basic plan
types, but, in practice, each plan must
be reviewed for its operation to be fully
understood.
How Much and What Type of Coverage
is Appropriate?
In many instances, the decision about
how much medical coverage to carry is
easy. You have whatever amount of
coverage the government or your
employer’s group insurance provides.
Some people will supplement their
group insurance benefits by purchasing
some form of additional coverage, such
as an accident plan or a hospital
indemnity plan. If group insurance is not
available, the decision about how much
non-government coverage to carry often
comes down to cost.
As with all risk management decisions,
the health insurance risk management
analysis comes down to this: How much
will have to be paid in premiums,
deductibles, copays, and coinsurance to
obtain a given level of coverage? Better
coverage, of course, tends to cost more
money. As an advisor, you can help
your clients find a balance between the
cost savings (for the amount of risk they
keep through deductibles and
coinsurance) and the amount of risk
they transfer to the insurance company.
Choosing Coverage
Sometimes, people find it difficult to
choose the type(s) of coverage they
need. Aside from the general cost-
benefit analysis, a person needs to
assess the types of care needed (or
might be needed, based on family
history, lifestyle, etc.) as well as
determine the level of benefits desired.
If preventive care is desired, the person
may need to use an HMO. If going to
your regular personal physician is
important, an HMO or a PPO might not
work if they are not part of those
networks. With children who require
frequent, regular visits to the doctor’s
office, an HMO or a PPO might be a
good fit. Individuals who live or travel
regularly outside of an HMO network
area may need to choose a non-
managed healthcare plan or a POS
plan. These, along with the premium
costs, are among the factors to consider
when deciding what type of coverage is
appropriate.
As people in most territories are living
longer, they often require another level
of healthcare. In many places, hospital-
based care tends to be somewhat short-
term. This works well for addressing the
initial problem, but does not fully support
the recovery period. Additionally, many
older people do not require full
hospitalization, but do need ongoing
medical care. This may be provided at
home, as an outpatient, briefly in a
hospital, or in an extended care facility
or nursing home. These expenses may
or may not be covered under typical
healthcare insurance plans. As a result,
insurers have developed a type of cover
to specifically meet these ongoing and
rehabilitation needs: Long-term, or
extended, care insurance. We will
explore this next.
3.4.3 Long-Term Care
Before we begin coverage of long-term
care (LTC) insurance, it is important to
distinguish between long-term care and
long-term care insurance. Long-term
care is the skilled, intermediate or
custodial level of care that individuals
often need when they get older, but is
also provided for younger people who
have been severely injured or contract a
debilitating disease.
Long-term care insurance, on the other
hand, is the insurance product
specifically designed to help pay for the
long-term care needs individuals may
have. Oftentimes, long-term care
insurance is shortened to simply long-
term care, but the two terms mean two
different things.
As life expectancies have continued to
rise beyond normal retirement age, an
increasing number of people find that
they need at least some form of critical
or ongoing care as they get older.
Although nursing homes have existed
for many years, the types of care
available have expanded to include
home-based care, adult day care, and
assisted living communities, as well as
the skilled nursing care available in
nursing homes and hospice (end-of-life)
care that can be provided in a facility or
at home. Some long-term care providers
have developed a continuum of care
communities that allow seniors to
initially stay in independent living units,
then, as their health declines, shift to
assisted living, and finally, skilled
nursing as the need for care develops—
all without having to leave that specific
location. Alzheimer’s and memory care
communities have also developed to
provide for the specific needs mental
impairment creates.
Consequently, with the increased
demand for long-term care, long-term
care insurance was developed as a way
to help people with the cost of senior
care. Because extended periods of
healthcare are expensive, long-term
care costs can be the greatest risk to
retirement security. As is true of other
insurance cover, long-term care
insurance is a risk transfer technique
that transfers much of the cost of care
from the individual to the insurance
company. The concept is fairly
straightforward in that individuals buy
the policy while they are healthy and
then, if their health deteriorates to the
point where care is needed, they have
the insurance to help with the cost.
Many elderly people tend to get sick or
hurt more frequently and for longer
periods of time than most young people.
Like many insurance policies, there are
many options that can be selected that
determine the cost of the policy. These
will be covered shortly.
Long-term care (LTC) is generally
divided into three categories: skilled
nursing care, intermediate care, and
custodial care. Most LTC is at a
custodial care level, and often provided
while the recipient is at home.
Frequently, once an individual moves
from his or her home to an LTC facility,
the level of care increases to
intermediate or skilled nursing care. This
is not always true, but as most people
wish to remain at home for as long as
possible, the generality is apt. As
already mentioned, LTC is not reserved
for seniors. Anyone of any age needing
extended care is technically receiving
LTC. For our purposes, we will focus on
the needs of seniors. Most current
individual policies cover all levels of care
and also offer what is known as respite
care (discussed below).
Skilled nursing care is the highest
level of care and generally refers to 24-
hour-a-day availability of a registered
nurse under a doctor’s supervision.
Intermediate care refers to less-
intensive nursing, or rehabilitative care.
This level of care doesn’t require 24-
hour availability of a registered nurse or
physician.
Custodial care generally refers to care
that is not medical in nature, but is
nonetheless necessary for the health of
the individual. This includes such things
as assistance with bathing, moving from
bed to chair, eating, etc. These activities
are known as activities of daily living
(ADLs), and will be discussed later.
Assisted living is one of the more
recent developments in long-term care.
An individual typically pays a basic
monthly fee and lives in a private
apartment, which may include some
limited cooking facilities. The assisted
living facility generally provides meals in
a common dining room. Other levels of
care are provided as needed, and the
individual is charged as services are
used.
Home care market forces have created
a greater emphasis on home healthcare
needs. These may range from 24-hour-
a-day care to a few visits a week to help
with specific chores. The typical
coverage for home care currently has a
somewhat limited reimbursement
schedule.
In addition, some policies treat adult day
care programs and community-based
and assisted living facilities as home
care. Realizing that many people do
better and need less attention at home,
some companies provide the money for
specialized equipment to be used in the
home so that the qualified insured can
remain at home. More companies are
also paying for a personal care
advocate, who provides an objective
evaluation of the care being received.
3.4.3.1 Common Features of LTC
Insurance Policies
Activities of Daily Living
Insurance companies often use a list of
activities of daily living (ADLs) to
determine when coverage will be
triggered. The typical list of ADLs
includes: bathing oneself, feeding
oneself, transferring (say, from a chair to
a bed or vice versa), dressing oneself,
using the bathroom, and maintaining
continence.
When it is determined that an individual
can no longer perform any two of these
ADLs (usually by a physician), they are
eligible for benefits under the policy.
Mental impairment such as Alzheimer’s
disease or dementia can trigger benefits
if either of these issues alone is
diagnosed.
Coverage Amount
The amount of coverage (i.e., benefit)
has a significant effect on the cost of
long-term care insurance, because the
higher the benefit amount, the higher
the cost. When selecting a policy,
advisors need to be aware of the
average costs of care in their client’s
location so that an appropriate level of
coverage is selected.
If you know what the average annual
cost for assisted living in your area is
per year, then a monthly benefit amount
can be more easily determined when
alternative sources of funding are taken
into consideration. Most policies have
minimum and maximum benefit
amounts that can be selected, which
allow for a great deal of customization.
Individual LTC policies generally pay a
set amount per day toward care
expenses. Often the average daily cost
of care in a nursing home is used as a
starting point in determining the daily
benefit. A policy might pay a certain
amount per day (e.g., $200); the amount
is chosen by the insured. Typically, a
higher daily benefit means a higher
premium. Coverage may also be
provided simply as paying expenses
rather than stating a daily benefit. This is
less common, but it occurs, and when it
does, it functions in much the same
manner as a regular healthcare benefit
plan. It is rare to find insurance policies
that cover 100 percent of assessed
charges.
Elimination Period
Similar to disability income insurance
policies, long-term care policies use an
elimination period that substitutes a
dollar amount for a time period that
functions as a deductible. During this
period, which begins with initial
diagnosis and treatment, no benefits will
be paid. The most common elimination
period is 90 days, which requires the
individual to pay expenses for all care
during the first 90 days after being
diagnosed. Longer elimination periods
are often available that can help
manage costs because the longer the
elimination period, the lower the cost of
the policy.
Benefit Period
After the elimination period ends, the
insurance company begins paying
benefits throughout the policy benefit
period while the insured is being cared
for. Maximum benefit periods typically
range from two years to 10 years, and
when combined with the benefit amount,
determine the maximum benefit the
policy will pay. Some older policies may
have offered lifetime benefits.
For example, if a policy pays a $3,000
monthly benefit ($100 daily benefit x 30
days) and has a five-year benefit period,
then the policy has a maximum benefit
pool of $180,000 ($3,000 x 60 months).
If the monthly benefit is not used each
month, then the potential benefit period
will lengthen. For instance, if the
monthly expense is only $2,500, the
remaining $500 stays in the pool, which
can extend the benefit period. With a
lifetime benefit amount, there is
technically no ascertainable maximum
benefit. To manage costs, the benefit
period chosen can be shortened; the
shorter the benefit period, the lower the
cost of the policy.
Waiver of Premium
As with disability income insurance
policies, long-term care policies often
include a waiver of premium benefit that
states that once the insured qualifies for
benefits, he or she no longer needs to
pay the premiums while under care. If it
is determined that the insured no longer
needs long-term care, then the waiver of
premium ceases and premiums are
once again payable when due.
Respite Care
Many long-term care policies include a
provision for respite care. Sometimes, a
family member will be the caregiver for
an individual who would otherwise need
assisted living arrangements or skilled
nursing care. The respite care provision
provides for the policy to pay for
professional care when the family
caregiver needs a break. Consider,
even shopping for groceries takes the
care-giver away from the one being
cared for, and this may not be
acceptable. Without provision for
periods when he or she is not providing
care, it’s likely the elderly person will
have to move from the home into an
extended care facility (or just not get the
care they require).
The reason insurance companies
include this coverage, typically at no
cost, is because when family members
provide care for the insured, the policy
does not pay benefits. Most policies
state that the care received must be
from a duly licensed care provider, so
unless the family member is approved to
provide care, the benefits aren’t
payable.
Respite care can be provided for several
hours per week or for several weeks per
year, depending on the policy language.
This allows the caregiver to remain able
to provide care and lessens the
likelihood of the insured needing to go to
a nursing home.
Additional Features
Bed Reservation: In addition to the
features already discussed, most long-
term care policies include a bed
reservation provision that allows the
insured to leave the care facility for a
period of time without losing his or her
place at the care facility. For instance, if
the family wants to take the insured on a
two-week vacation, this provision would
provide for payment to the care facility
to hold the insured’s spot. This can be
valuable if the supply for long-term care
can’t keep up with demand in the area
where the insured lives or if the insured
goes back to the hospital for a period.
Spousal Discounts: Many long-term
care policies will offer a discounted rate
if both a husband and wife obtain
coverage. Also, if there is a spouse in
the home who does not obtain
coverage, there may be a lesser
discount available even if the other
spouse is not applying or is uninsurable.
Shared Policy Benefits: Some long-
term care policies are issued for couples
whereby the total benefit amount is
available to either spouse. Both spouses
are covered by the same policy and
benefits may be paid to either or both;
however, the total benefit available limits
what will be paid. For example, let’s say
a couple purchases a shared policy
benefit that pays a monthly benefit of
$3,000 and has a maximum benefit of
$210,000. At some point in the future
the husband needs care and collects
$90,000 in benefits. This leaves
$120,000 available for the wife if
needed. If the husband’s care used all
the benefits available—$210,000 in this
example—there would be no benefit left
for the wife. At the other extreme, if the
husband never needs care, then the
entire $210,000 would be available for
the wife. Some shared care riders
provide an additional pool of funds that
spouses can share in addition to each
individual’s benefit.
Common Riders
Inflation Rider
Inflation riders allow for the benefit to
increase over time. Older policies that
offered this rider used a fixed amount of
increase per year stated as a simple
percentage of the initial benefit amount.
For example, if the inflation rider is 5
percent and the initial benefit amount is
$3,000 per month, then the rider will
increase monthly coverage by $150
each year.
Compounded rate inflation riders are
more common now, as the costs of care
have increased dramatically. This
version of the rider increases the benefit
by, most often, 3 or 5 percent. This
produces an ever-increasing daily
benefit amount as a result of
compounding.
Either version of the rider may be in
place for the life of the policy or for a
period, such as 10 or 20 years.
Regardless of the length of time, there is
an additional cost for adding riders.
Return of Premium Rider
As with other insurance products, a
return of premium rider states that for an
additional premium, an amount equal to
the premiums paid will be refunded in
the event no benefits are paid or, in
some cases, if benefits paid are less
than the premium paid. It’s important to
weight the cost/benefit of adding this
nonrefundable rider.
Restoration of Benefits Rider
Some long-term care policies may offer
a rider that provides for the total benefit
amount available to be restored if the
insured recovers from the need for care
for a period, such as six months, if prior
to the benefit pool being totally
exhausted. For example, let’s say an
insured has been collecting benefits
under a policy for eight months after
satisfying the elimination period. Let’s
also assume the policy provides for a
benefit of $3,000 per month for up to
five years, which would make the total
benefit amount $180,000. Over the eight
months the insured has been paid
$24,000, which reduces the total benefit
available for future use to $156,000. In
this example, though, the insured’s
health improves such that care is no
longer needed and remains healthy for
at least the six-month period for
restoration stated in the rider. The rider
would then restore the total benefit
amount to the original $180,000.
Nonforfeiture Option Riders
These riders state that if you cancel
your policy after a period of time, a
minimal amount of paid-up insurance
will remain in force in the event of a
claim. Typically, this amount is equal to
the premiums paid.
How Much and What Type of Coverage
is Appropriate?
Costs for long-term care can vary
dramatically by location, as well as by
institution. The insured can contact local
long-term care facilities to get an idea of
typical costs in his or her area. In
general, the cost of LTC insurance
increases with age, so a person buying
LTC insurance at age 60 would pay less
than if they purchased the same
coverage at age 70. In addition to age,
other factors such as overall health,
gender, and optional benefits (such as
inflation protection) will also affect the
amount of the premium. As mentioned
above, a person can choose the amount
of daily benefits that meets his or her
financial needs. In general, a higher
daily benefit, a shorter elimination
period, and a longer benefit period all
result in higher policy premiums.
A financial advisor skilled in elder-care
advice can be of tremendous benefit to
an elderly person or the adult children of
an elderly person looking for long-term
care. An important part of this is helping
clients determine how much coverage is
actually needed. Beginning with the cost
of nursing home care (which is usually
the most costly type of care), subtract
income sources the client has that will
continue regardless of whether they are
in their own home or a care facility. For
married clients where only one spouse
needs care, it will be important for
income sources allocated to elder care
to not reduce support for the spouse
remaining in the family home.
Additional income sources may come
from government pensions, pensions
from employers, annuities, or
investment income. These additional
sources of income can significantly
reduce the amount of LTC insurance
that should be purchased, thereby
reducing the cost of the insurance.
Hybrid Policies
Hybrid Policies can help clients who
may be reluctant to purchase long-term
care insurance because they believe
they will not ever need long-term care.
To address this and still provide
protection for the possibility that long-
term care will be needed, insurers have
developed hybrid policies.
A hybrid policy pairs a life insurance or
annuity contract with long-term care
insurance. The cost for the policy would
be more than what it would be for life
insurance or long-term care insurance
by themselves, but less than buying the
two policies individually. The concept is
that if the insured dies without needing
the long-term care insurance, the death
benefit is paid, but if the insured needs
long-term care, the insurance can be
used for that.
The long-term care insurance portion of
a life insurance policy typically pays a
percentage of the death benefit each
month for a specified period. For
example, if the death benefit is
$250,000 and the long-term care
insurance benefit is 2 percent per
month, the benefit would be $5,000 per
month payable for perhaps up to 50
months.
When paired with an annuity, a lump
sum is deposited with a minimum
amount typically being required. The
long-term care insurance protection is
two or three times the amount deposited
and an inflation rider may be available
as well. As an example, let’s say an
individual deposits $100,000 into a
deferred annuity paying 3 percent
compound interest with a 300 percent
long-term care maximum benefit and a
five-year benefit period with no inflation
rider. The amount available for long-
term care expenses would be $300,000.
Assuming no withdrawals have been
made, in 20 years at 3 percent, the
account value of the annuity would grow
to $180,611. If this person needs long-
term care, then the annuity would have
$5,000 per month available ($300,000 /
60 months) for those expenses. If the
insured dies without needing long-term
care, the account value would be
available for the heirs. If the insured
needs some long-term care and then
dies, the heirs would receive the
account value minus what was paid out
for long-term care expenses.
A nice feature of hybrid policies is that
the premium for the long-term care
insurance is guaranteed to never
increase beyond a certain amount.
Stand-alone long-term care insurance
policies can increase premiums if the
insurance company determines
additional premium is needed to cover
claims costs on the aggregate.
Insurance companies can guarantee the
long-term care insurance premiums in
hybrid policies because they pay lower
than market interest rates on the cash
values. If interest rates rise, they are
under no obligation to share the
additional earnings with policy owners.
Is LTC Insurance Worth the Money?
This is a question many researchers
and end-users are asking. The answer,
as is true of many healthcare-related
questions, is not simple and not
uniformly applicable. Let’s look at some
of the considerations.
Two general statements can be made
up front. First, if your clients are very
wealthy (i.e., assets in the multimillions)
they probably do not need long-term
care insurance (LTCI). They can pay the
expenses out-of-pocket. Second, if your
clients are on the other end of the
financial spectrum, with less assets,
LTCI probably does not make sense.
The cost of coverage is likely to be too
high. Can you dispute both these
statements and show situations in which
they are wrong or not applicable?
Absolutely! However, both statements
can stand as reasonable generalizations
(realizing that every person and
situation is different and requires
individual analysis).
People between those two poles have a
more difficult time deciding to what
degree LTCI makes sense. Among the
factors to consider are quality and
availability of LTC, maintaining personal
choice and freedom, premium cost, and
asset and income protection.
In a capitalistic society, whether we like
it or not, those who have can generally
get better care than those who have not.
This is not to say that it’s fair or the best
way for things to be done. The
implication is, if you have your own
funds you can afford to purchase
whatever type of care you desire. If you
do not have those funds in the bank,
LTCI may provide at least a partial
solution. With LTCI, insureds can pay
for many of the healthcare services they
desire.
It may also be true that more services
will be made available to them. Those
who have neither funds nor coverage
may not have access to all possible
healthcare options. Beds may not be
available. The best doctors may not
wish to treat these people. Alternative
forms of treatment will not likely be
offered. If someone wants full flexibility
in pursuing any and all reasonable
forms of treatment, that person will have
to have the financial means to do so. In
the absence of a large bank account,
LTCI can provide all—or at least
some—of those funds.
It will do so, however, at a price. Annual
premiums for LTCI can be more than
$1,000—often quite a bit more. In
addition to being impacted by the benefit
amount (e.g., $150 per day), the
premium can be controlled to some
extent by adjusting the waiting (or
elimination) period and the benefit term.
The waiting/elimination period is the
length of time between when LTC
services are needed and when the
policy begins paying benefits. The
longer the period, the lower the policy
premium (up to a point). Choosing a
longer period must be balanced with the
resulting increase in out-of-pocket
expenses. However, if funds are
available, longer is probably better.
Many policies have a maximum
elimination period of about 180 days.
However, some offer periods of up to 12
months.
How long of a benefit period to choose
is another big concern when trying to
manage premiums. The average length
of time someone over age 65 might
need LTC seems to be around three
years (women slightly longer, men
slightly less). It would seem logical to
choose a benefit period of around this
length of time. Many people do. Others
want a greater margin of error, and
prefer a longer benefit period. However,
the longer the benefit period, the higher
the premium. As a result, people may
choose a much shorter benefit period in
an attempt to manage LTCI premiums.
Some individuals might combine an
extended benefit period with a very long
waiting period (e.g., 12 months) in an
attempt to keep premiums a little more
reasonable. Use of such a plan might be
termed a catastrophic LTCI policy. Why
catastrophic? While the average need
for care may only be around two or
three years, what happens if an
individual needs LTC for longer—say for
10 or 20 years? Had this person chosen
a three-year benefit period, he or she
would almost certainly be facing the
depletion of available financial assets,
perhaps even to the point of having to
file for bankruptcy. For those with the
means to pay for an extended initial
period of LTC, being able to increase
the benefit period would help protect
against the possibility of a much longer
need for care (the catastrophic need).
Certainly, this would not be an
appropriate choice for everyone, but it
might be worth considering for some
people.
3.5 Disability: Personal
While the loss of a loved one is certainly
more emotionally devastating to a
family, a long-term disability can be
more financially devastating. This is
because a disability can cause
significant medical expenses in addition
to the disabled person not being able to
fully function or earn an income. As a
result, some have referred to disability
as “the living death”.
The difference between life insurance
and disability income insurance is the
difference between mortality and
morbidity. Mortality refers to the
potential of death; specifically, the
number of people who die in a
population. Morbidity refers to a
condition of unhealthiness or disease.
Life insurance protects against the risk
of premature death—mortality. Disability
insurance (and other health-related
insurance products) protect against
morbidity risks, which are associated
with reduced health.
This difference is also evidenced in the
way disability income insurance and life
insurance are underwritten. With life
insurance, underwriters are concerned
with the likelihood of premature death.
With disability income insurance,
underwriters are concerned with the
likelihood of becoming sick or injured. A
person who is currently disabled, and
therefore unable to buy disability income
insurance, may still qualify for life
insurance. Likewise, a person who
might not qualify for life insurance may
be able to obtain disability income
insurance.
Additionally, underwriters either approve
or decline life insurance policies and
then determine which rate class is
appropriate (e.g., preferred, standard, or
substandard). With disability insurance,
they may agree to insure the individual
with one or more exclusions, such as no
coverage if the disability is due to an
illness or injury to a specific body part.
For instance, a person with previous
back problems may be able to buy
disability insurance, but if a disability is
due to a back injury or illness, that
would be excluded.
Understanding these differences and
knowing intuitively that the likelihood of
people getting sick or hurt prior to
reaching retirement age is far more
likely than dying, puts the need for
managing the risk of disability into
perspective. Furthermore, unless they
have government-provided benefits or
purchase coverage through work as an
employee benefit, most people don’t
have adequate protection in place to
manage the financial impact of losing
their ability to bring home a paycheck.
Clearly, loss of income due to a
disability is a significant risk
management concern.
This risk can be managed by having an
adequate emergency fund, disability
insurance, or—perhaps best—a
combination of the two. An emergency
fund that can provide funds to cover the
out-of-pocket medical expenses and
replace lost income for a period can
protect against the financial impact of a
short-term disability. If used in
conjunction with a long-term disability
insurance policy to provide the funds
needed until the insurance starts paying,
individuals can more easily manage the
financial risk a long-term disability
creates. Additionally, if the individual
has a good source of unearned (i.e.,
investment) income, the need for other
funding may be reduced.
3.5.1 Common Features of Disability
Insurance
Three of the most important disability
insurance considerations are the:
1. Benefit amount
2. Benefit period (including the
elimination period)
3. Definition of disability
An insurer determines the maximum
amount of coverage it will write based
on the insured’s income. Typically, the
maximum amount of coverage will be
between 60 and 70 percent of earned
income at the time the policy is issued.
(This amount does not include income
from investments or other unearned
income; however, the insurer may use
unearned income to reduce the amount
of coverage it will underwrite.)
The benefit period can be short term
(generally from six months to two years)
or long term (as long as to age 65 or
occasionally, for life). Most benefit
periods begin with an elimination or
waiting period, that is, a length of time
during which no monthly payment will
occur. You might think of the waiting
period as a disability policy’s deductible.
The insurance premium will decrease in
direct relation to increases in the
elimination or waiting period. Premiums,
coverage periods, and benefit limits are
also based on the insured’s occupation.
In a broad disability classification, most
office workers (e.g., white collar) are
generally offered better coverage at
better rates and for longer maximum
benefit periods than most non-office
workers (e.g., blue collar).
Disability income insurance coverage
makes monthly payments to the insured
to replace part of lost income. Coverage
can be written to make payments only if
the disability is the result of an accident
or if the disability results from either an
accident or sickness (sickness-only
coverage almost never occurs).
Accident-only disability income
insurance will be less expensive than
combined accident and sickness plans
because disability due to accidents is
much less likely than disability due to
illness.
In addition to individual coverage from
commercial insurers, disability income
benefits can be obtained from
governments, employers (through group
plans, sick days, and self-insurance),
and various other organizations (such
as service groups and unions) on a
specialized basis. Some of these
benefits are available at no cost to the
disabled individual (other than perhaps
taxes or dues), but most involve the
payment of a premium. In the absence
of an adequate emergency fund, a
short-term disability policy would protect
the client by replacing a portion of his or
her lost income until a long-term
disability insurance policy would begin
paying benefits. However, there would
still be the out-of-pocket medical
expenses to consider. While long-term
disability insurance policies can be
purchased by individuals, short-term
disability insurance policies are more
difficult to buy individually and are more
commonly offered as a group product
through employer benefit plans.
A coordinated plan to manage this risk
should include cover for unexpected
medical expenses and enough income
replacement to provide at least basic
living expenses. Doing so with an
emergency fund plus short- and long-
term disability insurance products allows
the individual to focus on recovering and
not have to worry about how the bills will
be paid. With a protection plan in place,
individuals will be able to manage a
disability whether or not public
insurance programs provide any
benefits.
Sources of Coverage
Government: In many territories, the
government is the primary provider of
disability benefits. These may come as
a form of workers’ compensation or as a
separate program providing income.
Benefit payments may only continue for
a short period or may be provided for life
(or any period between the two).
Group Policies: Group disability
income insurance is provided in two
basic forms: short-term and long-
term. Short-term plans are characterized
by a limited benefit period, frequently no
longer than 26 or 52 weeks. Usually
plans include a very short or no
elimination or waiting period. This is the
period between the onset of a disability
and when the initial policy payment is
made. A short-term disability income
policy does not provide long-term
protection and needs to be
supplemented by a long-term disability
income policy. Benefit periods often are
tailored to end when long-term disability
benefits begin.
Long-Term Group Disability: Income
plans provide protection during periods
of extended disability. Maximum
monthly benefits are typically a
percentage (such as 60 or 70 percent)
of regular monthly income, and they
may have a preset limit (e.g., 60 percent
of income up to $4,000 a month). Long-
term plans usually have longer
elimination periods (such as 90 days, six
months, or a year), to help reduce
overall premium costs. If a long-term
policy is coordinated with a short-term
policy, there may be no benefits gap. As
an example, a short-term policy that
pays for 26 weeks combined with a
long-term policy that has a six-month
(i.e., 26 week) elimination period, would
provide continuous coverage once
benefits begin.
Most long-term plans will coordinate
benefits with other available sources of
disability income. Benefits normally will
be reduced under a coordination-of-
benefits provision by the amount of any
other benefits payable by workers’
compensation or other government-
sponsored disability benefits, other
employer-sponsored disability benefits,
or select pension benefits. Not all plans
coordinate benefits, however. Employer
plans, for example, do not normally
reduce benefits for payments made from
individually owned policies.
An employee’s group disability income
coverage normally terminates when
employment ends. Coverage will also
end if the employer decides to terminate
the policy or does not pay the
premiums.
Individual Policies: Whether you do
not have any group disability benefits
available or want to augment the
benefits you have, an individual
disability income policy may be a good
addition to your risk management
portfolio. Some individual policy
provisions are similar to those of group
insurance. Coverage will be written for a
specified amount of benefits, with an
elimination period, for a specific period.
Individual disability policies can cover
income that is lost due to accidents
alone or income lost from accidents or
sickness.
The costs of individual policies can vary
considerably. Items that affect premium
rates include occupation class (e.g.,
blue collar, white collar, professional),
coverage amount, elimination period,
maximum benefit period (whether
coverage is for both accident and
sickness or accident alone), age,
definition of disability used, cost-of-living
adjustments, and other optional
provisions. An insurer may limit the
amount of coverage it will write on an
individual, based on existing policies
from the insurer itself or other insurers.
Policies can provide ongoing monthly
benefits or a preset number of benefits
(e.g., $2,000 per month for three years).
Common Riders
Individual disability policies have riders
available that may enhance basic
coverage.
Inflation Riders
When an inflation rider is added to a
disability income policy, the benefit
increases, usually by some fixed
amount or percentage, in an attempt to
keep pace with inflation. The inflation
rider begins increasing
benefits after there is a claim. The
benefit will increase each year, but there
may be a maximum amount by which it
is allowed to increase. There is an
additional cost to this benefit, but it may
be less expensive than periodically
purchasing additional coverage. Since
the benefit can increase over time
without additional underwriting, it is a
much simpler way of adding coverage
as time goes by.
Guaranteed Purchase Option
A guaranteed purchase option (GPO)
rider states that the insured can
purchase additional coverage at specific
times in the future without additional
evidence of insurability. This option
allows the insured to increase benefits
coverage before there is a claim, by
increasing the basic benefit amount. For
instance, a disability income policy with
a GPO rider might allow the insured to
add an additional $500 per month
benefit two years after the original issue
date and then again two years after that.
The insured will have a relatively short
period of time in which to decide to
purchase the additional coverage and
once the opportunity passes, he or she
will not be able to exercise the option.
The cost of exercising the option is
based on the insured’s age at exercise.
Return of Premium
A return of premium rider on a disability
income insurance policy is very similar
to a return of premium rider on a life
insurance policy. Basically, if the insured
reaches a certain age or the policy has
been in force for a certain period and
there has been no claim, an amount
equal to the premiums paid is returned
to the insured. The balance also may be
payable if the amount paid in claims is
less than the total of premiums paid with
some carriers.
Partial Disability
After a period when the insured is totally
disabled, he or she may have recovered
enough to return to work on a part-time
basis. Most policies allow for a reduced
benefit to be paid, such as 50 percent of
the full benefit amount, if the insured
returns to work, but is still unable to
work full time. The purpose of this
provision is to encourage the worker to
return to work rather than simply collect
disability benefits.
To collect partial disability benefits, most
policies require the insured to have
been totally disabled for a specific
number of months. There is also a time
limit for how long these benefits can be
received. For example, the provision
may state that partial disability benefits
are payable for up to two months after
the insured has been totally disabled for
a period of three months or more. Partial
disability is normally based upon the
inability to perform certain duties
identified in the policy.
Residual Disability
Similar to a partial disability provision,
a residual disability provision allows for
a lesser amount of benefits to be paid if
the insured is able to return to work in
some capacity. The difference is that
partial disability is generally paid for a
shorter period when the insured cannot
work full time, whereas residual
disability benefits may be payable for
the entire benefit period if, as a result of
the disability, the insured’s income is
reduced even when working full time.
The reduction in income usually must be
greater than a stated percentage of
gross earnings, such as 20 percent.
For example, if the insured was earning
$5,000 per month prior to the disability,
and has a disability income policy that
has a $3,000 benefit amount and 25
percent residual disability provision, the
insured finds that when he or she can
return to work, his or her earnings are
only $3,500 per month because of the
residual effects of the injury or illness.
As a result, the 20 percent reduction in
income threshold has been reached and
the policy would pay the residual
disability benefit amount of $750 (25
percent of the full benefit) making the
total income $4,250. Residual disability
is based solely on the lost income above
a certain percentage.
3.5.1.1 Definition of Disability
A policy’s definition of disability is critical
in determining the level of benefits it will
provide. Insurance companies have
traditionally used three working
definitions of disability. An insured is
disabled if he or she cannot work:
• At any occupation: This definition
is the most restrictive and says that,
to be considered disabled, the
insured must not be able to work in
any occupation. For example,
under this definition, an electrician
or a doctor who is disabled to the
point of not being able to do his or
her regular job, but is able to work
at a fast-food restaurant at a
significant loss of income, would
not receive any benefits.
• In any occupation for which the
person might be (or might
 become) qualified: This is a
modified any occupation definition
and is somewhat less restrictive in
that it puts a limit on the types of
work a person would be expected
to do. This definition may also
include terms that take into
consideration the insured’s prior
education, training, or experience.
• In his or her own
occupation: This definition is the
most liberal because it says that a
person will be considered disabled
if he or she is unable to work at his
or her own prior occupation. As an
example, a surgeon who becomes
disabled to the point of not being
able to do surgery would be
considered disabled even if
eventually employed as an
instructor at a medical school. This
 additional provision is sometimes
accomplished by the insurer issuing
a letter, known as a specialty letter,
modifying the terms of the policy.
Some companies may issue a
policy rider to provide this level of
coverage. Changes within the
disability income insurance industry
have made the own occupation
provision less available than it was
only a few years ago.
• Split definition: Many insurance
companies, especially in group
coverage where there is little or no
underwriting, make available a split
definition of disability. A split
definition typically uses the liberal
own occupation definition for a
specific time (often the first two to
five years of disability), after which
a stricter modified own occupation
 definition or any occupation
definition takes effect for the
duration of the benefit period.
A primary purpose of the split definition
is to encourage disabled employees to
return to productivity. If they become
disabled to the extent that they can’t
do their jobs, they receive benefits for
two to five years. In those years, they
can learn new skills so that they will be
able to earn a living when the own
occupation definition ends. If they are
capable of working, but choose not to,
benefits generally will cease.
• Loss-of-income policies: These
policies pay a benefit if the loss of
income is due to illness or injury,
even if the insured continues to
work. Notice that the insured need
not be fully disabled. The duties or
 occupations in which the insured
can engage are not significant
factors. If, as a result of injury or
sickness, the insured suffers a loss
of income, benefits based on that
loss are payable regardless of
whether the insured returns to work
and regardless of the occupation.
While this definition may not be as
desirable as an own occupation
definition, it nonetheless does cover
the risk of lost income, generally at
a lower cost than the own
occupation definition. Loss of
income policies are becoming more
popular among insurance
companies.
When using the loss of income
definition, it is important to identify how
the policy defines loss. Policies vary
both in how they define loss and how
and when benefits are paid. No actual
definition of disability is used, so the
starting point of the period during which
income is lost must be identified. It may
be the date on which the insured no
longer is earning an income due to
illness or injury (the income-earned
method) or the date on which received
income drops (the income-received
method). It may include a component for
number of hours worked. For an insured
with significant receivables (e.g., a
business owner), the second definition
could delay the beginning of the
elimination period by a month or more.
Likewise, if benefits end as soon as the
insured can return to work full time,
regardless of when the income is
received, this could create a problem. It
is easy to see that substantial
differences may exist in the benefits
received under the income-earned
definition and the income-received
definition. Some policies give the
insured a choice between the two.
Loss of income policies and residual
disability benefits must define average
earnings to determine the amount of
base income used to identify the
percentage reduction in income. Each
policy has its own method of calculating
this number, which may be the average
of the last two years, the two highest
income years among the last five years,
or some other variation. Better policies
automatically increase the identified
average earnings by the consumer price
index so that inflation does not further
reduce the benefits received by a
claimant who already is earning a
reduced income due to illness or injury.
The loss of income form of disability
income insurance is the only one that
will provide progressive benefits to a
person who is afflicted with a
progressive disease such as multiple
sclerosis or muscular dystrophy. As the
income of these individuals decreases,
benefits start, usually after the insured’s
income drops by at least 20 percent.
Most other policies will not begin paying
a benefit until the insured reaches a
point where he or she can’t work or has
a reduction of income that amounts to
80 percent.
Presumptive Disability
Another provision worth noting is the
presumptive disability clause. Most
policies provide that full disability
benefits will be paid if the insured loses
his or her sight, hearing, speech, both
hands, both feet, or one hand and one
foot. Under any of these circumstances
the insured is presumed to be
disabled—hence the term presumptive
disability. However, some policies do
not cover all of these losses. Some
policies require the loss to be total and
permanent, while others cover even a
temporary loss. Regarding hands and
feet, some policies graphically explain
that the appendage must be severed to
receive benefits, while others simply use
the terms loss of use and/or as long as
the loss continues. In other words, the
difference is missing feet or hands
versus paralysis or even two broken
legs from an accident.
Conversion
Group disability income policies
generally cannot be converted to
individual coverage; thus, leaving one’s
employer usually will result in loss of
coverage. It is important to know,
however, that a few carriers do offer
group disability coverage with provisions
allowing conversion upon termination of
employment. Such a provision is, of
course, desirable, but generally it is
limited to those in a professional
occupation category. Typically, there is
a very limited time period, such as 30
days, in which the policy can be
converted. The policy may also have a
built-in rating (i.e., premium expense).
Even if there is a rating, if a client has
this provision to convert, it is wise to
convert the policy initially and apply for
coverage with more favorable rates.
Therefore, if the client is unable to
obtain coverage for some reason, he or
she will still be protected. The client can
always drop the policy if a better policy
is acquired. This factor emphasizes the
importance of the portability of individual
policies.
Other Common Provisions
Misstatement of age clause. As with life
insurance, this clause provides that if
the insured files a claim, and it is
determined at that time that his or her
birth date is different from the one in the
application, the benefits will be adjusted
to the amount that would have been
purchased for the same premium at the
correct age.
Grace period. Most policies contain a
provision to allow the insured to have a
specific number of days from the policy
due date in which to pay the premium
without fear of a policy lapse. This is
generally 30 days, but some policies
have shorter grace periods.
Reinstatement. If the policy owner
allows the policy to lapse, he or she
generally may apply to reinstate the
policy. Proof of insurability normally is
required.
Relation of earnings clause. This clause
protects the insurance company from an
insured who may benefit financially by
being disabled. If the disability insurance
was purchased when the insured was
making more money than he or she is
now, policy benefits may be higher than
current earnings. This might encourage
the insured to become, or remain,
disabled to collect the high benefits. The
relation of earnings clause allows the
insurance company to do financial
underwriting at the time of claim. If the
insured’s income is substantially lower
than when the insurance was
purchased, the company may lower the
benefit so that the amount paid in
relation to the insured’s earnings is
appropriate. Excess premiums would be
returned to the insured, usually with
interest.
Premiums and Benefits
Premiums usually are based on a rate
per unit (e.g., $100) of monthly benefit.
However, an individual may purchase
any amount of disability insurance for
which he or she qualifies. If the premium
is paid within a given time frame, policy
coverage will be continuous. Beyond the
grace period, an unpaid premium will
result in a policy lapse, and
reinstatement normally requires
repayment of all back premiums and
proof of insurability.
Disability income insurance premiums
can be high, but policies provide
significant monthly benefits. Remember,
too, some degree of disability is fairly
common for many people. For example,
if a policy has a $550 annual premium
for a $1,000 per month benefit, the first
thought often is that over every two
year-period, one would pay more than
one month’s benefits in premiums.
However, assuming a 90-day
elimination period, a one-year disability
would provide $9,000 in benefits. It
would take 16 years to pay that much in
premiums. A five-year disability would
result in $57,000 in benefits, and a 20-
year disability would result in $237,000
in benefits.
It helps clients to hear these calculations
and compare them to the amount they
are paying for other protection. Car
insurance may just be covering
$300,000 in liability and $50,000 in
property damage for a total liability of
$350,000. It is not uncommon for clients
to pay $1,200 a year for this coverage.
When compared to homeowners and
automobile coverage, clients are
insuring a higher value—their income
over their working lifetime. If a cost-of-
living rider is added to the policy, the
amount being covered is most likely
more than the individual will accumulate
during his or her lifetime. Don’t let
clients lose sight of the fact that their
ability to earn an income is their largest
asset.
How Much and What Type of Coverage
is Appropriate?
How much disability income insurance
should a person have? The simple
answer is, as much as he or she can
get. The importance of maintaining an
income, especially with the potentially
crippling expenses of an extended
disability, will become apparent during
any disability. On a practical level, there
are several limits regarding how much
coverage a person can or should carry.
The first limitation is the easiest—
insurance companies limit the maximum
amount of coverage they will write. After
a certain point (e.g., 60 to 70 percent of
pre-disability income), an insurer will no
longer offer to underwrite new coverage.
Cost of coverage is the second
limitation. An insurance company can
assume a huge potential liability in
settling a long-term disability claim,
since benefits must be paid as long as
the individual qualifies, up to the end of
the benefit period. This potential liability,
in addition to the great likelihood of
people becoming disabled at some
point, contributes to disability insurance
being relatively expensive.
The coordination of benefits clause is
another provision that may reduce
benefits below the amount shown in the
declarations page. Such provisions,
which usually are found in group
disability policies and sometimes are
found in individual policies, reduce the
benefit otherwise payable by amounts
received from government benefits,
workers’ compensation, or other
sources of indemnity related to
employment. As mentioned, it is rare for
a group disability income policy to
reduce benefits based on individual
disability income policy benefits
received.
It may also be possible that employment
income is only a small portion of total
income. If, for example, the individual
has significant investment income or
unearned income from some other
source, there may be little need to
protect employment earnings.
To determine the need for disability
income coverage, first determine
monthly expenses. To this add any
additional expenses that may be caused
by the disability (an admittedly difficult
job, since you must predict with no
concrete frame of reference). Consider
that the expenses associated with
earning a living (e.g., clothing,
transportation) will no longer exist. From
this amount, subtract any sources of
income, such as income from
investments. Also subtract other
sources of disability income protection
(e.g., from a group disability plan or
government benefits). The remaining
amount is roughly equal to the amount
of coverage that should be carried.
3.5.1.2 Common Continuation
Provisions
Policy Durability (Renewal Provisions)
An extremely important consideration in
the purchase of disability insurance, and
one also directly influenced by the
occupational classification of the
applicant, is the renewal provision found
in each policy. Generally, the better the
renewal provisions, the higher the
premium. It is important that you
understand the terms that relate to
policy durability because these terms
can be confusing.
Noncancelable: The first term
is noncancelable. The obvious
implication is that this term means the
same as guaranteed renewable
described below. The confusion is
compounded because this type of policy
often is called noncancelable and
guaranteed renewable. Noncancelable
means that not only can the insured
renew the policy for the full term
specified in the policy (the same as
under guaranteed renewable), but the
company cannot change the premium
from what is stated in the contract.
Noncancelable is the obvious choice
from the insured’s point of view,
although it should be noted that
actuaries have priced into the contract
the company’s inability to raise the
premium. Thus, these are more
expensive initially than a guaranteed
renewable policy. Noncancelable
policies may not be available for all
classes of workers. Many disability
income insurance companies have
stopped selling noncancelable policies
because of unfavorable experience, and
the difficulty of predicting the future
when it comes to determining adequate
premiums.
Guaranteed Renewable: This option
means that the insured has the right to
renew the policy to the age specified in
the policy. The company does not have
the right to change the premium unless
it makes the change for an entire policy
class (note the subtle difference
between guaranteed renewable and
noncancelable: with noncancelable
policies, the insurer cannot raise the
rates—at all during the policy period.
Guaranteed renewable rates may be
raised for an entire class). Thus, the
company cannot discriminate against a
policyholder based on claims
experience. A guaranteed renewable
provision is good, but not as good as a
noncancelable provision.
Conditionally Renewable: Two
different forms of conditionally
renewable disability policies are
available. The first, and least common,
gives the insurance company the right to
disallow renewal/continuation of a policy
under certain conditions. The second,
which is more common, is attached to
many policies that provide benefits to
age 65. It allows an insured individual
who reaches age 65, and who continues
to have earned income, to renew his or
her policy to provide protection against a
disability interrupting those earnings.
The premium for the policy after age 65
is based on the attained age of the
insured, and benefits are typically
provided to age 70.
Nonguaranteed Continuation: Two
provisions exist that remove from the
insured any security of coverage
continuity. One is the renewable at the
option of the company provision. In this
case, the insurance company may
choose to renew or not to renew a policy
on its anniversary. No reason must be
given. The other provision relates to
when a policy is cancelable. With this
provision, the insurer may give the
required notice and cancel the policy at
any time. This provision and the
following one often may be found in
group and association policies.
3.6 Business-related
So far, we have been looking at
insurance types targeted primarily to
individuals. In some cases, businesses
may offer policies to employees such as
for healthcare, disability income, even
life insurance. However, businesses
themselves, along with owners, may
also require insurance cover. The
policies may be the same as those used
by individuals, but terms and
beneficiaries are often at least
somewhat different. Additionally,
businesses may have risk exposures
that require specialized policies. In the
next section we will explore policies
covering business disability and
overhead expense, liability and board
member cover. We will begin by looking
at key person cover – both life insurance
and disability.
3.6.1 Key person
For businesses, a key person is one on
whom the business depends to remain
viable. When considering retirement
plans, “key person” has a specific
identity as one who is an owner or
officer of the organization. We may
reasonably extend this to the current
discussion. However, a key person may
be key, but not be in either of those
categories. He or she could be an
executive, or a sales person, a
manager, in some cases, even an
administrative support person. Key
means vital more than it identifies
status. However, you identify a key
person, you can be sure the business
wants to protect itself and him or her in
the event of an adverse event. This
often takes the form of one or more life
insurance policies and/or a disability
income policy often in addition to
contractual language describing the
company’s intentions upon the death or
disability of the key person. Key person
insurance is usually thought of first as
life insurance. However, it can also
include disability income insurance. We
will look at life insurance first.
Life Insurance
Key person life insurance is no different
from any other life insurance policy.
However, in this situation, the business,
with the individual’s consent, will apply
and pay for a policy on the life of the key
person. The business will also name
itself as the primary beneficiary. With
this policy in place, if the key person
dies unexpectedly, the business will
receive a policy payout that it can use
for one of several purposes. The
primary policy function is to provide
money to help the business cope with
the loss of the employee. A regular
employee (i.e., non-key) may not cause
much financial distress for the
organization, but a key person is, by
definition, vital to the ongoing well-being
of the business. The loss may well be
more than simply financial, but there will
almost certainly be a financial impact.
As policy beneficiary, the business will
have financial support during the period
in which it will attempt to replace the key
person, hire temporary replacement(s)
or simply continue cash flow that will
have been lost due to the key
employee’s passing.
Taking out a policy like this can be
especially important when the key
person is also a partner or majority
shareholder in a closely held
corporation. Technically, this may not be
considered key person coverage, but in
reality, it fits the criteria. If a partner or
majority shareholder dies without having
well-crafted documents such as a buy-
sell agreement, the future of the
company may be in jeopardy. Often, the
deceased’s share of the business will
pass to his or her heirs, often a spouse.
This is true whether the spouse or other
heir is capable or even desirous of
stepping into the position. Regardless,
the spouse will likely be counting on
money from the business holding to
support him or herself and the family. A
well-structured buy-sell agreement
along with an appropriate life insurance
policy to provide necessary funding is
one of the best solutions to this problem.
The policy can make payment to the
business (or other owners) and the
owners can pass along the money the
spouse in exchange for the deceased’s
share of the business ownership. In this
way both the business and the spouse
(heir) receive what each need most.
Buy-sell agreements may not exist in all
territories or may be called by another
name. However, the concept of a
business having a life policy that can
take care of this type of obligation is a
valuable use of life insurance.
Almost as a side note, a key person
policy can encourage the key employee
to remain employed by the company. If
the benefits are properly structured, the
employee will want to remain employed
to not lose the potential benefits. By
itself, this will probably not provide
enough incentive if a new offer is strong
enough. It can, however, be a part of a
package of benefits targeted at keeping
key employees on board.
3.6.2 Disability: Business
The problems faced by an organization
when a key person dies are replicated
when a key person becomes disabled
and unable to fulfill some or all previous
duties. Additionally, just as with a
regular disability situation, the disabled
person is not only unable to generate
income, he or she is also likely to be
incurring increased costs related to
healthcare. When addressing concerns
about a key person, the organization
often would like to keep the person
employed and receiving an income.
However, many times the company also
needs to hire a worker to fulfill the duties
the disabled individual can no longer (at
least temporarily) fulfill. Adding to the
problem is the likelihood that the
company is not large. This means that
the key person’s contributions to the
company’s well-being probably are
significant. A key person disability
income plan can help to solve the
problem.
A key person disability income
insurance policy is designed to provide
the business with funding to help the
organization deal with the loss of the
key person’s contribution to the
company. The need may be temporary
(even if temporary is several years) or
long-term. Generally, the policy will pay
policy funds to the company. Once paid,
the company can use the funds to hire a
replacement employee to pick up some
of the lost work and (perhaps) income
generated by the key person. Some of
the funds may also be used as
additional compensation for the disabled
key person, but there is a need for
caution to ensure that payments from
the company do not interfere with
payments to the individual from his or
her personal disability income policy.
Sometimes insurance payments can be
made as a lump sum benefit, or the
claim could be paid monthly. Policies
typically have elimination periods
between 30 to 180 days, and may have
benefit periods up to around two years.
Disability buy-out cover is similar to key
person coverage, but targeted to
owners. When one of the owners
becomes permanently disabled and
unable to continue supporting the
company, remaining owners may need
to act. Small business owners depend
on the business to generate income, as
well as to build equity. When an owner
is disabled, he or she will eventually
want and need to sell the business
share. The remaining owners will almost
certainly want to retain ownership of the
company, so they will also want to buy
the disabled owner’s share. A disability
buy-out policy can provide the funds to
purchase the disabled owner’s share.
Such a policy should be part of the
organizations business continuation
plans. In many ways these disability
insurance policies can go a long way to
helping the business remain viable and
profitable.
3.6.3 Business Overhead Expense
Think about the expenses an
organization may have as part of doing
business. It is not uncommon for a
business to incur regular expenses for
things like:
• Employee salaries
• Legal services and accounting
• Professional and trade dues
• Mortgage, rent or lease payments
• Mortgage or other loan interest
• Utilities
• Maintenance services
• Car expenses
• Equipment lease and
maintenance expenses
• Insurance premiums
 • Taxes
You can probably think of at least a few
more expenses businesses might have.
In a professional office (or similar),
where the key person (e.g., doctor,
accountant, financial advisor, etc.)
becomes disabled and can no longer
generate income, how will the business
continue to function? It’s likely that the
business can continue to generate
revenue without the owner if the
business can retain the staff and pay
bills. Even if the owner has decided to
sell the company, it will sell for more
with a staff on-board. Additionally, he or
she most likely will not want to put all
the staff out of work because of a
personal disability. It’s possible that the
professional has enough funds to make
necessary payments out-of-pocket, but
not likely. Further, if he or she is
disabled, there will be a greater need to
use assets to provide for living
expenses in addition to any personal
disability income insurance payments
that are made. How will the business get
enough income to continue operations
until the owner can return to work or
decide to sell?
Business overhead expense insurance
cover is not a replacement for personal
disability income insurance. Instead, it is
specifically designed to provide income
to the business for a period so it can
remain viable and pay salaries and
other expenses. Like all disability
policies, there is an elimination or
waiting period before payment of
benefits. Usually, this period lasts for up
to 90 days (it’s shorter because the
business will likely have great need for
the payments sooner rather than later).
Coverage normally lasts for up to 24
months. As usual, benefit payments
begin following the elimination and
continue throughout the coverage
period. The business owner
(policyowner) must select a monthly
benefit amount when arranging for the
policy. This amount will be based on
normal business expenses. This amount
may or may not be paid. The policy will
pay based on actual e xpenses, up to
policy limits. It may be possible to carry
unused benefits from one month to the
next, but not all policies provide for this.
It’s even possible for unused benefits to
continue being paid beyond the normal
benefit period (for as long as the excess
lasts). Policies are often written as being
noncancelable or guaranteed
renewable, with ongoing renewable
potentially adjusted as the owner gets to
be older than age 65 (or so). Depending
on the jurisdiction, premium payments
may be tax deductible as a business
expense.
3.6.4 Business Liability and Board
Member Cover
Business insurance cover often is
issued as monoline policies. That is, the
policy covers one type of risk, such as
plate glass damage, fire, crime,
equipment damage and so forth.
However, in addition to monoline
policies, businesses may also purchase
a package of cover, normally including
both property and liability cover, in
addition to the terms, exclusions and
conditions of coverage. Package plans
tend to focus either on smaller
companies (Business Owner’s Policy;
BOP) or larger commercial
organizations (Commercial Package
Policy; CPP). The policies are similar,
but focused on the needs of each size
organization. Within either package
type, a business will get general liability
cover. This will provide basic coverage
and will almost certainly require
purchase of additional coverage with
higher limits and protection against a
broader array of perils (including
business-owned vehicles), in addition to
items relevant to a specific business’s
needs.
Commercial general liability policies, like
most other business insurance, provide
cover for a company’s specific needs.
Most policies protect against non-
vehicle liability exposures, and do not
generally extend coverage to liabilities
involving employee injuries (although
this can be added). Most policies
include cover for crime and some
include surety coverage (e.g.,
guarantees for financial obligations and
various contracts). Remember, these
policies do not cover personal or
professional liabilities. Those require
separate cover. These policies cover
business liability exposure only. We will
look at a few examples.
Employer’s Liability: In many
territories, employers are liable for any
injuries employees receive while
working. This is considered a form of
absolute liability – the employer is
responsible regardless of the cause,
even without negligence. On the one
hand, this prevents many (but not all)
employee lawsuits. However, it also
automatically exposes the employer to
employee-related liability. Liability is
greater if it can be shown that the
employer actually was negligent in some
way.
Employment Practices Liability: In
today’s environment, it is becoming
more common to individuals to sue
employers over what are considered
inappropriate employment practices.
These may include harassment (sexual
or otherwise), discrimination, wrongful
termination, and other situations.
Territorial governments may issue
related fines and penalties, and no
insurance will cover this. However,
insurers will likely pay for defending
against the charges and making
payments resulting from civil litigation.
Businesses may also incur liability
exposures related to customers, product
end-users, as well as employees. Some
of these include:
• Thefts and embezzlement
 • Injuries (to customers, end-users,
or employees)
• Product liability
• Damage to employee or customer
property
• Pollution / environmental clean-up
• Motor vehicle related (will require
separate cover)
• Directors’ and officers’ errors and
omissions (also board member
cover, discussed below)
Remember that we are discussing
liability exposures. These may include
payment for property that does not
belonging to the business, but not
business-owned property. That requires
property-based coverage, just as is true
for individuals.
Commercial Umbrella Liability
Coverage: A business may want to
purchase umbrella liability coverage, in
much the same way as do individuals.
Normally, there is no standard form of
commercial umbrella liability policy (also
called a blanket catastrophe excess
liability policy). Also, like individual
umbrella policies, the commercial form
requires substantial underlying liability
coverage. Underlying or supporting
insurance normally must cover a risk or
peril for it to be covered by the umbrella
policy (as is true of individual policies).
Board Member Cover: Individuals who
sit on nonprofit boards can be held liable
for the organization’s activities. People
may sit on the boards of religious
institutions, hospitals or other medical
associations, community associations
and similar. In most cases, board
members’ personal liability insurance
cover will not protect them for this type
of liability. A directors’ and officers’
liability policy (sometimes known as
directors’ and officers’ errors and
omissions insurance) will help to cover
this exposure.
In this chapter we have explored many
types of insurance cover. While there
are many additional policy types, we
have covered the major ones: general,
including property, vehicles and
personal property, liability, both personal
and professional, life, health, disability
income, long-term (extended) care, and
business-related cover for key persons,
expenses, and liability, including the
special liability of those who sit on
boards of directors. We also looked at
determining the amount of coverage an
individual might need, given their
situation and objectives. In the next
chapter, we will cover some aspects
related to selecting an insurance
company and an insurance advisor.
Chapter Review
Discussion Questions
1. How does homeowners insurance
coverage work in your territory? Are
any coverages mentioned in the
text different?
2. There are three levels of perils
coverage in a homeowners policy.
How would you describe the three
types to a client and what would
you say about the implications of
each level?
3. How are actual cash value and
replacement cost different? Which
would provide better protection for
the homeowner?
4. How does insuring high value
property potentially violate the law
 of large numbers? How do insurers
address this potential problem?
5. High value personal property is
not normally covered adequately
under typical homeowners
insurance. What types of personal
property does this include, how can
the problem be addressed and is it
really necessary to do so?
6. Which type of personal motor
vehicle (car) coverage – liability or
property – is most important
because of the greatest potential
for financial loss?
7. How would you explain to a client
the fact that they may be liable to
pay someone even when they have
not done anything wrong? Under
what conditions might this be true?
8. What is the best use for term life
insurance?
9. What is the best use for
permanent life insurance?
10. How would you explain the
purpose of a life policy’s cash value
account and how it functions in
various policy types?
11. Which life insurance policy
types would you recommend for
someone with a low risk tolerance
who wants stability and security?
How would this change with
someone who has a higher risk
tolerance level?
12. Which of the nonforfeiture
options is best used under various
circumstances?
13. Why is the choice between
having a normal beneficiary
designation for someone versus an
irrevocable designation so
significant?
14. How are the human life value
and needs-based methods
different? Which is the better
approach?
15. Why does an immediate
annuity require a single-premium
payment?
16. How are annuities and life
insurance different? How are they
the same?
17. What is the potential problem
with a life income settlement or
payout option? How would you
solve this problem?
18. Even when the government
provides healthcare benefits to all
citizens, why might it be a good
idea for someone to purchase
private insurance cover?
19. Under what circumstances
would an individual benefit from
 having a long-term care insurance
policy versus a regular healthcare
policy?
20. How would you respond to a
client who asked you whether LTC
insurance is worth the money to
purchase it?
21. In what ways does a disability
potentially create greater financial
exposure than a death?
22. How does the loss-of-income
disability definition differ from the
other definitions? Which definition
is better or worse?
23. If you had to choose between
a policy that was noncancelable
and one that was guaranteed
renewable, which would you
choose and why?
 24. Why is key person insurance
cover (life and disability) so
important to a business?
25. How is business overhead
expense coverage different from
regular disability insurance
coverage? Why might it be
necessary?
26. If you are a board member of a
charitable organization, what
liability exposure might you have?
Review Questions
1. How much land value is
included when writing insurance
coverage on a home and why?
2. What coverages are normally
included in the two sections of a
standard homeowners policy?
3. Why are coverages A and B
not included on any renter’s
insurance policy, and what
coverage is always included?
4. What perils are included under
standard basic, broad form and
open peril coverage?
5. How much would an insurance
policy reimburse a homeowner
who has a house valued at
$400,000 insured for $300,000
after experiencing a fire that
causes $20,000 in damage? The
house has an 80 percent
coinsurance provision and a
$1,000 deductible,
6. How does actual cash value
compare to replacement cost
coverage?
7. Why would a homeowner want
a policy with a guaranteed
replacement cost provision
instead of a simple replacement
cost provision?
8. What is the problem with basic
personal property coverage
included in a standard
homeowners policy and what can
help solve it?
9. On what basis is inland marine
insurance usually written?
10. What is the main difference
about the medical payments
coverage on a motor vehicle
insurance policy compared to
coverage on a homeowners
policy?
11. How does a standard car
insurance policy define the
insured?
12. How does civil liability compare
with criminal liability?
13. What is a tort and how does it
relate to liability?
14. What are absolute and
vicarious liability and how may
they be applied to employers?
15. How does an umbrella liability
policy differ from a standard
liability policy?
16. What are the two basic types
of professional liability coverage
and which professionals use
either type?
17. What are the two broad
divisions in life insurance types?
18. How would you describe the
way a regular term life insurance
policy works?
19. What does an insurer do to a
term life insurance policy so that it
can cover an insured for his or her
entire life?
20. Where is the cash value
invested in a whole life insurance
policy; a universal life policy, a
variable universal life policy?
21. Why are universal life
insurance policies called
unbundled and why are they also
known as flexible premium
adjustable life policies?
22. What is the main difference
between universal life type I or A
and Type II or B policies?
23. How does variable life (VL)
compare with variable universal
life (VUL)?
24. What are the two main types of
joint life policies and when would
you use either one?
25. What three potential parties
exist in a life insurance policy?
26. How do the grace period and
reinstatement provision of a life
insurance policy relate?
27. What are the nonforfeiture
options of a standard cash value
life insurance policy?
28. Why should a policyowner be
careful when thinking about
making a beneficiary irrevocable?
29. What are five dividend
payment options with a
participating life insurance policy?
30. Other than simple rules of
thumb, what two methods are
used to determine the amount of
life insurance an individual may
need?
31. Using the capital retention
method, and assuming there is no
existing life insurance available,
how much insurance cover would
an individual require who wants
beneficiaries to have an additional
$75,000 annual income that
increases by the rate of inflation
each year?
32. How much life insurance must
an individual purchase today to
fully fund college education costs
for a 10-year old child who will
enter a four-year university
program at age 18? Assume
current first-year expenses of
$20,000, five percent tuition
inflation and a seven percent
discount rate, with all funds
available at the beginning of
college.
33. What is the fundamental
difference between annuities and
life insurance?
34. Under normal circumstances,
how many times may a
policyowner change the payment
options once a contract is
annuitized?
35. How may a variable annuity
address inflation-related
concerns?
36. What happens to annuity
payments under a single (or
straight) life annuitization or
settlement option when the
beneficiary dies, and how can the
refund option solve the problem?
37. How is the period certain
option different from the fixed
amount payout option?
38. In what way are deductibles on
homeowners, motor vehicle and
health insurance policies
different?
39. How are copayments different
than coinsurance?
40. In a managed care health plan,
what is a gatekeeper?
41. What is the biggest coverage
difference between HMOs and
PPOs?
42. Why might someone who has
good healthcare insurance also
benefit from having a long-term
care (LTC) insurance policy?
43. What is the highest level of
LTC and the second highest
level?
44. What are activities of daily
living (ADLs) and how do they
apply to LTC insurance policies?
45. What is the elimination period
found on most LTC and disability
income insurance policies?
46. How much benefit will a normal
LTC insurance policy pay for
expenses incurred when a family
member provides LTC care
services, and what is one
solution?
47. Why do some individuals refer
to disability as a living death?
48. What are three of the most
important disability insurance
considerations?
49. What is the difference between
a partial and a residual disability
benefit.
50. What are the four primary
disability definitions used in a
policy?
51. In what way is a loss-of-
income policy different from other
disability income policies?
52. How is a noncancelable
renewal provision different from a
guaranteed renewable provision?
53. What is the general purpose of
key person insurance, whether life
or disability?
54. How is business overhead
expense insurance different from
standard disability insurance
cover on an individual?
55. What type of liability exposure
is not covered by either a
comprehensive personal liability
policy (CPL) or
business/commercial liability
policy?
 56. Why might a person sitting on
a non-profit organization board
require liability coverage?
Chapter 4: Insurance Company and
Advisor Selection
Learning Outcomes
Upon completion of this chapter, the
student will be able to:
4-1 Explain the elements to consider
when selecting an insurance company
4-2 Explain the elements to consider
when selecting an insurance
intermediary
4-3 Evaluate the roles and
responsibilities of insurance
intermediaries
4-4 Discuss the role of insurance
industry regulators
Topics
4.1 Company and intermediary selection
and due diligence
4.1.1 Company evaluation and
selection
4.1.2 Intermediary selection and
responsibilities
4.1.3 Choosing an insurance policy
4.2 Legal and financial characteristics of
insurance parties involved in an
insurance contract
4.2.1 Insurance company
4.2.2 Policy owner
4.2.3 Beneficiary
4.2.4 Insured
4.3 Regulation and compliance
Introduction
Insurance policies are complex, as is
the insurance industry. Many financial
advisors are less familiar with insurance
than with investments. As a result, they
may have less understanding of
insurance companies, related products,
and those who market and sell them. It
is important for advisors to have a good
grasp of these things. Given that many
students are likely less familiar with
insurance, it may be especially
important to understand the parameters
around selecting insurers as well as
insurance agents with whom to work.
Having a more complete understanding
of insurance company and insurance
advisor (agent) selection will help you to
be a more knowledgeable financial
advisor and provide better service to
clients.
As we have mentioned in this course,
insurance is ancient. While modern
inland marine and property-related
insurance dates back four-hundred
years or so, some types of insurance
have several thousand years of history.
Ancient Babylonians, Chinese,
Persians, Greeks and Romans had
forms of disability and property-related
insurance (especially relating to the
military and commerce). Some
historians also add forms of life
insurance to the list. Regardless of
actual insurance cover availability, it’s
safe to say it’s an ancient and diverse
industry. Having said that, we can also
say that modern insurance companies,
policies and agents/advisors are more
easily categorized and understood. This
is a good thing, because as a financial
advisor, you will need to perform
appropriate due diligence or due care in
helping clients select appropriate
policies, insurers and agents. We will
begin looking at the process of doing
this.
4.1 Company and Advisor (Agent)
Selection and Due Diligence
4.1.1 Company Evaluation and
Selection
When selecting an insurance company,
it’s important to choose one that is
known for having good customer
service. Equally, if not more important,
is choosing a company that offers the
type of insurance cover your client
needs at a competitive price point,
having good underwriting processes.
Some companies are quite specialized.
They only offer a few insurance types. In
fact, many companies traditionally have
specialized in one type of cover or
another. Life insurers often did not offer
property-related products. Motor vehicle
insurers often did not offer health or
disability cover. None of the companies
focused on personal products likely
would offer business or commercial
policies (this remains true in many
cases). Much of this comes from starting
out offering monoline policies – one type
of insurance – to the exclusion of all
other policy types. Most insurers began
this way, and many continue operating
in this general mode, although it’s rare
to find a company that exclusively offers
one type of insurance cover. Given the
potential that an insurer may not offer
the type of cover your client needs, this
should be your first consideration.
When you identify several companies
that offer the insurance cover for which
your client needs, it’s a good idea to
price-shop. Prices can vary significantly.
Even though the core parameters may
be similar (e.g., mortality expenses,
underwriting charges, etc.) one
company’s costs of doing business and
desired profit margin can be quite
different from another’s. The
organizational form also can make a
difference, with mutual, stock,
association and fraternal companies all
potentially have different cost structures.
A company’s history also must enter the
picture. If they offer the type of
insurance cover you are researching, is
it a new product for them or have they
successfully offered it for many years?
As you would think, companies develop
areas of expertise. You want a company
that has expertise in the area of your
insurance need.
All these areas are worthy of
consideration, but there is another
question to ask that may be most
important. How financially solvent and
stable is the company? When someone
buys insurance, they actually are
purchasing the insurer’s promise to pay
a valid claim when it is presented. To do
this, the company must be financially
sound, and have a history of fiscal
strength. The last thing you want is for
your client to file a claim only to learn
that the company is insolvent and out of
business. As a result, it is of utmost
importance for financial advisors to
investigate and evaluate an insurer’s
financial stability. Unfortunately, in many
cases, this is close to an impossible
task. Unless you have an inside track to
the information, you most likely will only
be able to get a glimpse of an insurance
company’s true financial status. If so,
what can you do? Thankfully, you can
tap into resources from several rating
agencies.
Rating agencies have been around for
many years. According to an article by
the BBC (Marston, 2014), the major
rating agencies have been in existence
since the late 1800s and early 1900s.
Many rating agencies exist around the
world, but four are primary: Standard
and Poor’s, Moody’s, Fitch and A.M.
Best. Of the four, Standard and Poor’s is
the oldest and largest, closely followed
by A.M. Best, Moody’s and Fitch which
is similar and smaller.
Standard & Poor’s (S&P) was begun
as Poor’s in 1860 by Henry Poor. His
organization was joined by
the Standard Statistics Bureau, and
almost 80 years later became known as
S&P. The company publishes two
separate insurer ratings. The first, a
“claims-paying ability rating,” is done by
request, and public as well as nonpublic
financial information is used. S&P also
publishes “qualified solvency ratings.”
These are done with public records only
and at no charge to the companies
being rated. Standard & Poor’s provides
ratings via their website
at www.standardandpoors.com.
A.M. Best possibly has the greatest
coverage of insurers. Founded in 1899
by Alfred M. Best, the company began
rating insurers, and currently evaluates
around 3,400 companies in more than
80 countries worldwide. According to
their website (www.ambest.com), they
are recognized as a benchmark for
assessing a rated organization’s
financial strength as well as the credit
quality of its obligations. Advisors can
find insurer financial information and
related news on the website.
Moody’s was started by John Moody in
1909. Both Moody and Henry Poor
began focusing on railroad finances.
The company now rates many types of
organizations, including insurers. To do
so, it uses a similar approach of
generally rating a company at its
request, but Moody’s rates some
companies with public information
alone. Moody’s publishes a “financial
strength rating.” Ratings can also be
accessed by registering on their website
at www.moodys.com.
Fitch, started by John Fitch in 1913,
provides ratings on around 1,000
insurance entities (and many other
entities), along with fixed income
security ratings. Fitch provides ratings
via their website
at www.fitchratings.com.
Using the Information
What can you do with this information?
For the most part, the companies whose
reputation and business are based on
how well they evaluate the financial
soundness of the financial services
industry believe the insurance industry,
as a whole, is quite stable. However,
with the thousands of insurance
companies, it is easy to understand that
many companies have not been rated
by any organization. One of the reasons
for this is that many companies are
considered too small to evaluate,
especially when compared to the largest
companies, each with assets in the
billions. When doing research, it is a
good idea to check with more than one
rating service. This will help to confirm a
company’s rating, or perhaps will point
out possible discrepancies between
different rating agencies.
There is, however, a problem with
depending on rating agency results.
Looking back at the global financial
crisis beginning in 2007, none of the
major agencies correctly identified the
financial straits in which several large
insurers would find themselves. There
may be many reasons for this, but the
fact remains, you would have been
misled and disappointed by the
information you gleaned from the rating
agencies. Since then, especially in the
U.S. and Europe, governments have
increased oversight of the rating
agencies and the agencies themselves
say they have adjusted their
procedures. They may have problems,
but given the realities, rating agencies
continue to be the most widely available,
most reliable source of financial
information for insurer evaluation.
NAIC Criteria
There is no truly global organization that
oversees insurer solvency. As such, the
following information is provided as a
guideline for evaluation, but should not
be viewed as a model for any territory.
In the U.S., each of the 50 states has a
commissioner of insurance that
oversees the industry in that state. The
commissioners meet regularly and as a
group – the National Association of
Insurance Commissioners (NAIC) –
create model rules to oversee the
insurance arena. One of those rules,
designed to supervise insurer financial
solvency, is called the watchlist. It has
twelve financial ratios to help evaluate
insurance companies. While the
watchlist is not directly applicable
outside the U.S., the financial ratios it
includes can provide reasonable
guidance as an evaluation tool.
According to the NAIC, if a company
has 4 of its 12 ratios outside the “usual
ranges,” it is put on the NAIC Watchlist
and selected for immediate regulatory
attention, targeted regulatory action,
or no regulatory action, depending on
the problem ratios and the extent to
which they are outside of the “usual
ranges.” The 12 ratios used in the NAIC
Watchlist are as follows:
1. Net Change in Capital and
Surplus: Greater than –10% and
less than 50%
2. Gross Change in Capital and
Surplus: Greater than –10% and
less than 50%
3. Net Gain to Total
Income: Greater than 0%
4. Commissions and Expenses
to Premiums and
Deposits: Less than 60%
5. Adequacy of Investment
Income: Greater than 100%
6. Nonadmitted to Admitted
Assets: Less than 10%
7. Real Estate to Capital and
Surplus: Less than 200% for
companies with capital and
surplus greater than $5 million;
less than 100% for companies
with capital and surplus equal to
or less than $5 million
8. Investments in Affiliates to
Capital and Surplus: Less than
100%
9. Surplus Relief: Greater than –
99% and less than 39% for
companies with capital and
surplus greater than $5 million;
greater than –10% and less than
10% for companies with capital
and surplus equal to or less than
$5 million
 10. Change in Premium: Greater
than –10% and less than 50%
11. Change in Product Mix: Less
than 5%
12. Change in Asset Mix: Less
than 5%
The NAIC incorporates the preceding
financial ratios as part of evaluating risk-
based capital. Remember, a primary
purpose of insurance companies is to
pay valid claims when presented. To do
this, they must maintain sufficient
capital. Risk-based capital ratios
measure the minimum amount of capital
an insurer requires to support business
operations. There are four main
categories of risk that are included in the
ratio mix:
1. Asset Risk: An asset’s default
of principal or interest or
 fluctuations in market value
because of market changes.
2. Credit Risk: Default risk on
amounts that are due from
policyholders, reinsurers or
creditors.
3. Underwriting Risk: Risk
arising from underestimating
liabilities from existing business or
not properly pricing prospective
business
4. Off-balance Sheet
Risk: Excessive rates of growth,
contingent liabilities or other non-
balance sheet items.
Additional Evaluation Items
Beyond financial ratios and rating
agencies, an advisor can use several
other characteristics to determine
whether to work with an insurer. We
mentioned a few of these in the
introduction, but the following list puts
them all together.
Size and Age: How long has a
company been in business, and what is
its asset base? A client with a $1 million
life insurance need might be better
served by a company with assets more
than $1 billion than by a company with
only $90 million in assets. Also, it’s likely
a better idea to work with an insurer that
has a long track record than one of
fewer years. Life insurance policies (and
others) may be in place for many
decades. A newer company may turn
out to be very good, but an older
company has the history to prove its
position.
History: Has the company experienced
severe financial problems in the past?
What is the dividend or earnings history
of the company? Has it consistently met
its obligations? Does it have a history of
treating all policyholders fairly or does it
emphasize making its current products
perform at the expense of long-term
policyholders? Has the company
generally met the illustrated numbers in
its policy illustrations, or have the
illustrations consistently been more
optimistic than their historic
performances?
Operating Ratios: The various rating
companies provide several financial
operating ratios for each of the
companies they rate. Taking the time to
understand these ratios and how they
can show how a given company stands
relative to other companies can provide
an advisor with valuable insight.
Lapse Ratio: Another indicator of how a
company treats its policyholders is its
lapse ratio. The lapse ratio represents
the percentage of policies that are
terminated each year out of all policies
in force. This is known as the company’s
persistency (agents also have
persistency ratings). It is important to
look at a company’s persistency relative
to that of the industry. If a company’s
lapse ratio is high (10% or more), some
effort should be made to determine why.
It may be an indication of poor results
relative to illustrated values or unusually
high premiums. It may reflect poor
service after the sale of a policy. In the
worst case possible, it may indicate that
the company is experiencing financial
difficulties and policyholders are leaving
to protect their policy values.
Average Life Insurance Policy
Size: The average policy size by itself
may give some indication of the type of
business a company is writing. A very
large average policy size generally
indicates they are primarily selling term
insurance. Compare this company’s
assets and insurance in force with those
of other companies. It may show that
the company has a substantially smaller
number of dollars available to support
the average policy size than would a
company that has a broader policy mix.
A company with a very small average
policy size may be selling burial
insurance. Its assets will likely be quite
high relative to the insurance in force.
Most important is to research the
amount of insurance in force relative to
the assets.
Lines of Business: Obviously, if a
company does not offer the kind of
policy you want, you will not buy it there.
For example, some companies
specialize in certain types of business. It
may be homeowners and auto
insurance, estate and business planning
insurance, the family market, low-cost
term products, or variable (investment-
oriented) products.
Investment Return: Every company
operates in the same world economy
and under similar regulations and
limitations (at least in a particular
territory). Some companies do a little
better than average investing their
assets. A company’s investment return
will vary constantly, but it is valuable for
the advisor to know how a company’s
overall investment strategy relates to
other companies as well as whether it
can support its rate of return
assumptions. It does not make much
sense that a company earning an
average of 4.5 percent on its assets is
paying six percent or even 5 percent. If
a company seems to be earning much
more than the others, either it is very
lucky or there is substantially more risk
in its investments (or they are
exaggerating return statements).
After you have determined one or more
insurance companies with which you
want to do business, the next step is to
identify and advisor or agent with whom
you can work.
4.1.2 Intermediary Selection and
Responsibilities
In some ways, selecting an insurance
advisor or agent is similar to choosing a
company with which to work. Although
the primary criteria – financial stability –
is not typically part of agent selection,
several other areas of consideration are
the same. Throughout the text we will
use the terms insurance agent and
insurance advisor to describe the same
functions. Technically, an agent is a
legal representative of one or more
insurers. An insurance advisor is not
legally bound to any company, and is
sometimes referred to as a broker.
Neither option is inherently better or
worse, and we will use both terms to
refer to these individuals.
A good insurance agent/advisor can
provide an educated opinion on an
insurance need, alternate approaches to
meeting it, guidance as to what kind of
insurance is best in the situation, and an
estimate of how much insurance is
necessary. An agent who represents
more than one company can help
determine which companies would best
provide the coverage.
As with all financial advice areas, if this
isn’t an area in which a financial advisor
specializes, it is wise to seek the opinion
of an expert. There is no simple method
for selecting a good insurance advisor.
However, factors that should be
considered include competence,
inclination to service, experience,
training, education, specialization, and
reputation.
Competence and Inclination to Service
An advisor will find that, most often, the
quality of an agent has more to do with
how inclined he or she is to service than
any other factor. If the agent will not
listen, make the extra effort to assist, or
competently execute what is asked, it is
hard to imagine what he or she could do
that would compensate for these
shortcomings.
Experience, Training, Education and
Specialization
These factors are very important.
Experience (and where that experience
is concentrated) is especially important
since much of the knowledge needed to
successfully serve a client’s needs is not
widely taught outside the industry. An
agent who specializes in a particular
area will have concentrated expertise in
that area. If you are dealing with a
particularly technical insurance need, an
agent with such experience can be a
valuable aid. In life and health
insurance, areas of specialization might
include pensions, tax-sheltered
annuities, or estate planning. An agent
with significant experience also may
have access to other professionals who
can assist in technical areas.
Because the industry is complex and
diverse, some insurance offices
maintain “advanced underwriting”
departments, often staffed by attorneys
or others with backgrounds in the more
technical areas of the business. Some
also maintain pension departments
similarly staffed. These people are often
available for telephone consultation and
sometimes also make “field” visits,
allowing them to be personally present
to assist.
As to an agent’s specialty, a financial
advisor should understand a practical
difference between a specialization in
the life and health (including pension)
areas and a specialization in the
property, liability, and surety areas. Most
life and health companies make their
products available to any insurance
producer. If a producer is not an agent
with a company, the insurer generally
makes the product available through a
broker’s contract with the producer. The
type of agent with whom you are
working will determine product
availability. Some agents have contracts
with their primary carriers that prevent
them from dealing with other insurance
companies unless their primary
company is unable to fill the need. If an
agent specializes in the life and health
area, he or she tends acquire more
expertise in this area of specialization
and usually has a greater awareness of
the many products available to meet
those specific needs.
On the other hand, the property, liability,
and surety areas often operate
differently in terms of product
availability. These carriers normally will
not sell product through anyone except
those they have selected and given a
contract. This practice can cause the
availability of product in these areas to
be much more restricted than it would
be with life and health insurance.
Further, even for a producer who has
acquired a contract to distribute product
for a certain company, not all that
company’s products may be available to
the producer. This is not often a problem
when trying to fill homeowners or auto
coverage needs, but if the advisor has
clients with specialized business
exposures such as aviation or
construction bonding, product
availability becomes a major
consideration.
One other consideration with property
and liability agents is that some have
what is known as “draft authority,” and
the amount of this authority varies from
agent to agent. Draft authority is the
authority to handle minor claims in the
office, without having to go through a
long adjustment process. Service may
be quicker on such claims since the
agent can settle a claim in the office up
to the limit of authority.
Reputation
The agent must be responsible in his or
her dealings with the public. It seems
likely that the most important area to be
investigated here is, once again,
service. Incidents of actual fraud or
malfeasance are rare. It is far more
likely that a financial advisor or client will
have a controversy with an agent over a
misunderstanding. The complexity of
insurance, combined with how easily an
expert can be misunderstood by
someone not familiar with the area,
makes such problems all too common.
With this in mind, the advisor can take a
few steps that will help avoid
misunderstandings.
Steps to Avoid Misunderstandings
The first step is to put key points in
writing. The formality of such a step
tends to improve everyone’s accuracy.
Remember though, an agent does not
have authority to change the insurance
contract.
The second step is to read and
understand the insurance contract.
Insurance contracts are complex
because they are legal documents
addressing real-world situations.
Step three is to understand the
insurance company’s internal
procedures. These are not identified in
the insurance contract, but they can
directly affect the client.
The fourth step requires realizing the
marketplace has an impact on the
services an agent can deliver. As a
practical matter, it is virtually impossible
to know all the detailed information
about a large number of companies.
Generally, advisors and clients look to
the agent to find the best rates or
underwriting available. However, with so
many companies from which to choose,
it can be difficult for either an agent or
financial advisor to really get to know all
the companies. Concentrating on a few
companies helps the agent become
more familiar with their policies and
capabilities.
Finally, the fifth step: Maintain a
professional working relationship. When
a financial advisor shops for insurance
products, there are two basic options. If
it is necessary to review a wide range of
proposals from several agents, the
financial advisor should personally do
the comparison, evaluation, and
selection. If, on the other hand, the
financial advisor uses one agent
extensively to compare many insurance
products, the advisor should find an
agent who is widely licensed and shop
through that agent. An agent used in
this manner can provide a
comprehensive comparison, effectively
pointing out the strengths and
weaknesses of each plan.
At this stage, the financial advisor has
determined one or more insurers with
which to work and selected an agent as
an intermediary. The big question now is
how to choose an insurance policy. We
will consider this next.
4.1.3 Choosing an Insurance Policy
The way to choose a policy may seem
self-evident. Pick a company, select an
agent, get their recommendation for the
product you need and choose the policy.
That approach may work sometimes,
but often, something else will be
needed. It’s not that a company or agent
will try to misdirect you. Instead, you, as
the financial advisor, are in the best
position to determine the policy type and
contract features that best supports your
client’s objectives.
Sometimes, financial advisors and
clients find it difficult to choose the type
of coverage or policy they need. Aside
from the general cost-benefit analysis, a
person needs to assess the types of
care and other cover needed (or might
be needed, based on family history,
lifestyle, etc.) as well as determine the
level of benefits desired. As an example,
for healthcare, if preventive care is
desired, the person may need to use an
HMO. If going to a regular personal
physician is important, an HMO or a
PPO might not work. With children who
require frequent, regular visits to the
doctor’s office, an HMO or a PPO might
be a good fit. Individuals who live or
travel regularly outside of an HMO
network area may need to choose a
non-managed healthcare plan or a POS
plan. These, along with the premium
costs, are among the factors to consider
when deciding what type of healthcare
coverage is appropriate. Other types of
insurance cover can follow a similar
process.
As a financial advisor, it will be helpful
for you to be aware of the alternatives
for coverage in your area so that you
can provide competent advice in a
variety of situations.
Let’s focus on life insurance to illustrate
the policy-selection process. We
explored the way to determine coverage
amounts in Chapter 3, in the section
about how much life insurance do
people need. You might want to go back
and review that section.
In many situations, the amount of life
insurance needed to cover all financial
needs is quite high. It is not uncommon
for a family to be unable, or unwilling, to
purchase sufficient life insurance to
cover all the needs. As a result, the
client will need to identify priorities and
focus on funding them. For example,
suppose the parents’ primary goal is to
have enough money to cover final
expenses, and to provide adequate
income while the children remain at
home. That would become the focus of
life insurance coverage. This does not
mean the other areas are unimportant. It
simply recognizes that not everyone has
enough money to cover all financial
needs. Prioritization is a key element in
providing good financial advice. This is
also a reason to explore use of term
insurance rather than a permanent
product. Coverage will be easier to
afford, thereby making it more likely the
client will fully cover the need. Type of
insurance (i.e., term, permanent) should
always be a secondary concern. Having
enough coverage should come first.
Choosing the Right Policy
How do you choose which type of life
policy to recommend to a client? The
following list will provide guidance in
items to consider when selecting which
type of policy may be most beneficial for
a given situation or client.
• Level Term: Client wants
predictable cost with a finite need,
and displays good saving and
investing habits
• Annually Renewable
Term: Client has substantial need
with limited funds or a relatively
short-term need and wants to
minimize cash flow to insurance
• Decreasing Term: Client has a
need that decreases annually
over a predetermined period of
time (e.g., mortgage)
• Whole Life: Can be used when a
client wants predictability and
guarantees regarding cost, death
benefit, and cash accumulations
• Limited Payment Life: Client
wants lifetime coverage and
wants assurance that premiums
will stop by a certain date (e.g.,
age 65)
• Modified Whole Life: Client
needs to minimize cash flow now
and wants a predictable premium,
 a death benefit, and cash
accumulation for long-term needs;
the client also expects income
and cash flow to improve within
three to five years
• Variable Life: Client wants the
premium and minimum death
benefit predictability of whole life,
is not risk averse, and wants to
participate in the equity/bond
market
• Universal Life: Client wants
lifetime coverage, wants flexibility
of premiums, does not want to
participate in the equity/bond
market, and is willing to accept
uncertainty about cash values
• Variable Universal Life: Client is
not risk averse, likes the idea of
buying term and investing the
difference or participating in the
 equity/bond market, and needs
long-term insurance coverage
The question remains, after seeing
available options, how do you choose
the best policy type to meet a client’s
need? Here are some thoughts.
If a client can qualify for one type of life
insurance policy, he or she generally
can qualify for any type of life insurance.
The main exception to this guideline is
that term products often are not offered
to prospective insureds over the age of
65, whereas permanent products may
be available at age 70 or 80 (or slightly
beyond). Therefore, except when
dealing with a client of advanced age,
age and health factors do not preclude
the availability of any type of product.
On the other hand, age and health may
influence product selection by making a
permanent product more expensive than
the client’s situation allows.
Original issue rates on any kind of
insurance become higher with
advancing age. If the client is in poor
enough health to require a rating, the
insurance premium will increase even
further. Nevertheless, if the client can
afford the premium, a permanent
product still may be quite attractive
compared with a rated term product.
Since the details of the client’s situation
will be the determining factor, the
financial advisor may need to do some
modeling to reach a final decision.
With this in mind, a client typically will
have a total life insurance need that will
be greater than available money to pay
premiums of any permanent product.
This probably means the bulk of the
need will require using a term policy.
When choosing the policy, pick one that
is both renewable and convertible to a
permanent product throughout the
desired policy period. It’s unlikely that
the total life insurance need will continue
for the client’s entire life. Any funding
specifically targeted to protecting
children will end when the children are
grown. Amounts focused on meeting
those needs may well be met using a
term product, because of lower
premiums and higher coverage amounts
that are temporary (even
if temporary means 20-25 years or so).
Some of the need, though, will probably
be more permanent, making one of the
permanent policy types more
appropriate. Which type will be best?
Try not to assume the client wants to
purchase a particular type of permanent
product. As already mentioned, having
adequate cover is of first importance,
and probably will require a term product.
Policy type is a secondary
consideration. It’s worth considering
whether a variable product will
outperform a more traditional product.
The premise always sounds good – take
advantage of market-rate returns – but
experience shows that real-world results
are sometimes less desirable. Increased
expenses often offset better market
returns, with the result that overall
performance between variable and
traditional products can be hard to
predict.
The client’s risk tolerance is one factor
to use in making this decision.
Conservative clients will probably not do
very well with variable products. Even if
you choose one of the money market or
guaranteed investment options, the
increased expenses will make doing so
unreasonable. In such cases a more
traditional product or perhaps a
universal life contract will be better. On
the other hand, a client with greater risk
tolerance will probably prefer one of the
variable contracts.
Price is one of the next major
considerations. Simply, how much does
a policy from one company cost as
compared to a similar policy from
another company? If all the features are
the same and the companies have
similar history and credibility, you will
likely want to pick the policy that costs
less . . . and there can be quite a bit of
cost difference from one company to the
next. Part of the price consideration
includes the amount of time the client
wants to pay for the policy. It may be
that a limited payment option (e.g., 20
years) will be a better choice than a
policy that requires payments for life.
For traditional policies, check whether
the policy pays dividends or not. If so,
what is their crediting rate and payment
history? For variable products, look
through the prospectus to determine the
available investment options and related
expenses.
Payment options are another
consideration. Depending on the holding
vehicle, it may make more sense to use
a single-premium policy than one
requiring periodic payments. One
specific use comes to mind – an
irrevocable life insurance trust (ILIT).
ILITs may not be used in your territory,
but the concept may be applicable. With
an ILIT, the policyowner places a policy
into a trust or holding vehicle with the
expectation of removing policy proceeds
from his or her estate, as well as
potentially exerting some level of
additional control over disposition of
policy proceeds. With such uses, a
single premium payment is often a good
choice. Additionally, sometimes
individuals simply want to pay “one and
done”. Make one payment and be
finished. Rather than a single premium
policy, a client may be better served
using a universal life policy. This will
allow for premium payment flexibility –
providing for greater or lesser payments
made more or less frequently. To get
this flexibility requires a universal or
adjustable life policy.
From the preceding discussion, you can
see how choosing a policy requires
knowledge of the client, his or her goals
and financial situation. Chances are
good that more than one policy type
should be used. Choices may be more
straightforward with different types of
cover (e.g., property, liability, etc.), but
the general decision-making framework
will remain the same. Meet coverage
needs first, then choose on the most
cost-effective policy type from the most
reputable insurer that satisfies the client
the best.
4.2 Legal and Financial Characteristics
of Insurance Parties Involved in an
Insurance Contract
Insurance policies are legal contracts.
Each party to a contract has a legal
relationship with the company and vice
versa. As a legal contract, there are
standard terms and conditions, many of
which we have covered in this course. In
this section we will look at the legal
relationships between insurers,
policyowners, insureds and
beneficiaries.
4.2.1 Insurance company
We begin with the insurer because it is
the major party to any insurance
contract. Earlier, we used the
terms aleatory,
adhesion and unilateral as descriptions
of an insurance contract. The terms are
copied below as a reminder.
• Aleatory: The outcome
depends on chance and the
financial participation between
parties are substantially
unequal. Consider that after the
insured pays one relatively small
premium for a life insurance
policy, the insurer is required to
pay a large claim on the death of
the insured.
 • Adhesion: The insurer is
required to abide by the terms of
its contracts. In other words,
because the company wrote the
contract, it must honor its terms.
• Unilateral: Only the insurance
company can legally be required
to honor contractual terms. The
insured must abide by any
conditions in the contract if he or
she wants the policy to pay, but
the insurer cannot require
insureds to maintain a policy
against their will. On the other
hand, the insurer is legally
bound to abide by policy terms
for coverage.
Notice the primacy of the insurer in
these contract terms. Contracts are
aleatory because the policyowner pays
a relatively small premium for a
potentially large payment from the
insurer. They are contracts of adhesion
because the courts have recognized
that policyowners seldom have the legal
wherewithal that insurers do, and even if
they did, they could not change or
negotiate insurer contract terms. All the
authority rests with the insurer. Partly as
a result, it is the insurer alone that can
be forced to honor contract terms. This
is another way of saying insurance
contracts are unilateral. While
policyowners may be required to abide
by contract conditions, only the insurer
will be held accountable in court to
uphold the terms of a legally issued
contract.
The insurer is represented by its agents.
Agents are authorized representatives
of the insurer. The insurer, as principal,
gives its agents authority to solicit,
create, modify or terminate insurance
contracts, subject to the limitations of
the agency agreement between them,
and as modified by laws in each
jurisdiction. This is to say that the agent
is the face and voice of the insurer. As
such, agents have express authority.
This authority is identified in the agent’s
contract with the insurer and typically
identifies exactly the scope of activities
the agent is authorized to undertake on
behalf of the insurer.
The agent also has implied authority.
This is not expressly granted, but is
authority the agent is assumed to have
as he or she does business in the
insurer’s name. Practically, implied
authority relates to areas such as
collecting premiums, completing
applications, ordering medical exams,
and the like. These things are not
usually spelled out in the contract, but
are a necessary part of doing business.
One final type of authority is not a
positive one. This is known as apparent
authority, sometimes called ostensible
authority, and it is not an authority the
agent actually possesses. Instead, it is
the appearance of having authority to do
something based on the actions of the
agent, and perhaps actions of the
insurer. An example might be an agent
who is licensed to offer health insurance
agreeing to write a life insurance policy
application. The agent is not authorized
to do so, but the client has no way of
knowing this. Even though there is no
legal authority involved, if the client pays
a premium and is given a receipt, and
the insured subsequently dies, the
insurer will most likely be held
responsible for paying the policy claim.
This serves as a good example of the
relationship between an insurer and its
authorized agents. The acts of the agent
can (and often do) legally bind the
insurer. The insurer may press charges
against the agent, but that will not
negate its responsibility to honor policy
terms (however, it is also likely that the
whole situation will result in legal action
by insurer and policy owner as one
disputes the other).
As we previously identified, insurers
may also be represented by brokers.
These individuals or entities are not
agents, meaning they do not legally
represent the insurer. Unlike agents,
who are legally bound to support the
insurer’s interests, brokers represent the
client’s interests. They technically have
no authority, but can do most of the
things done by agents. Brokers normally
work with several insurers and
sometimes also have an agency
relationship with one or more.
4.2.2 Policyowner
The person who purchases an
insurance contract is the policyowner.
This person may also be the insured,
but not necessarily. The policyowner
pays contract premiums to the insurer,
sometimes through an agent and
sometimes directly. As owner, the
individual has all the contract rights. He
or she can apply for more or less
coverage, request contract
modifications, name beneficiaries,
assign the policy, along with any
additional contract-related benefits. The
policyowner, however, cannot change
the insured, alter contract conditions, or
modify the premium (with a few
exceptions, such as with a universal life
policy). All legal rights and
responsibilities are transacted between
the insurer and the policyowner.
The policyowner is required to have
(and show) some level of insurable
interest. As a reminder, an insurable
interest is the legal or equitable interest
that is held by the insured in insured
property or a life. In economic terms, it
applies where an insured has suffered a
monetary or economic loss through the
damage or destruction of the subject
matter of the insurance. Without some
degree of acceptable insurable interest,
an individual may not purchase a policy
to insure anything or anybody. To do so
would move the insurance contract into
the realm of speculation, and this is not
allowable. As an example, a person can
insure their own house, but not one
owned by someone else. He or she can
purchase a policy to insure a spouse,
but not a neighbor. Another aspect of
this is that contracts must be for legal
activities, and it’s not considered legal to
purchase insurance where there is no
insurable interest.
4.2.3 Beneficiary
It’s possible for the policyowner to also
be the insured and the beneficiary.
However, it is equally likely that the
beneficiary is another individual (or
entity). The beneficiary is the party who
will receive policy benefits resulting from
a legal claim. Beneficiaries may be
companies or other organizations, and
probably most often are individuals. A
beneficiary has few responsibilities
beyond filing a claim, along with any
requested corresponding
documentation, and receiving payment.
Beneficiaries are sometimes hard to
locate, so it is a good idea for them or
their representative to maintain current
address and contact information with the
insurer (often through the policyowner).
It’s important to recognize that a named
beneficiary (i.e., one who is identified in
policy documents) has a legal right to
receive payment. The insurer must pay
the claim as long as it is legitimate and
properly filed. It’s also important to
remember, at least in many jurisdictions,
a policy beneficiary designation
supersedes a legal will insofar as paying
a life insurance (or annuity) claim. As
identified in the preceding section, a
regular beneficiary may be changed at
will by the policyowner. An irrevocable
beneficiary cannot be changed without
his or her approval. Irrevocable
beneficiaries must approve any contract
changes before they can be
implemented. The policyowner may not
change beneficiaries, borrow against the
policy, surrender the policy, or assign it
absolutely or collaterally without the
irrevocable beneficiary’s written
permission.
4.2.4 Insured
The insured is the focus of an insurance
contract. The insured may be a person,
property or some other item. Financially,
the insured has no responsibility in the
contract. If the insured is property, and
it’s damaged, the policyowner will file a
claim to get the property replaced or
repaired. If the insured is a person, any
of the three parties (policyowner,
beneficiary, insured) may initiate a
claim. Of course, with a life insurance
policy, the insured cannot file a claim.
Insurers will often require some degree
of investigation into the insured’s
condition. This means the company
might call for a property inspection or
require a medical examination for an
insured individual. Most often, the
company will rely on information on the
policy application to determine these
requirements. This is one of the writing
agent’s responsibilities.
4.3 Regulation and Compliance
Securities industry regulators are
primarily concerned with investment
company solvency. Many of their rules
and regulations target requirements
designed to enforce prudent company
management and disciplines financial
operations. Additionally, regulators
develop regulations for people who
interact with the public to ensure they do
so ethically and with compliance on
relevant regulations.
Insurance industry regulators have the
same concerns and areas of oversight.
The insurance industry is vested in the
public interest. Individuals purchase
insurance to protect themselves against
financial loss at some time in the future.
Public welfare mandates that the insurer
promising to indemnify insureds for
future losses fulfills its promises.
Regulation is necessary, in part, to
protect the industry (and its customers)
from destructive competition. Too much
competition cannot be allowed in the
insurance industry because price
competition directly affects the financial
health of insurers and the amount of
their reserves. There is a temptation for
companies to compete on price by
underestimating future losses and
subsequently failing. There are three
main global purposes for regulation: to
maintain competition, to prevent abuse
of consumers, and to correct market
failures. That last one requires a little
explanation.
The market failure theory is based on
the view that one purpose of regulation
is to correct market failures. Market
failure occurs when the free market
produces too much or too little of a
product or service at too high or too low
a price, e.g., a monopoly or an unstable
competitive process. Translated, this
means that an insurance company may
find itself in financial difficulty as a result
of too much competition and/or
unfavorable market forces. While this
might not matter too much if you are a
candy manufacturer, it can have a
significant impact with insurers. When a
candy manufacturer has significant
financial difficulty, it may stop producing
candy. This might be unpleasant for
consumers, but not life-changing. When
an insurer faces insolvency, its insured’s
stand to lose their insurance coverage
and related financial well-being – which
definitely is not a good thing.
Not all territories have dedicated
insurance regulators, but most do.
Some territories also have state or
regional regulators. For example,
Canada has regulators at both the
federal and provincial (i.e., regional)
levels. The international member
organization to which most territorial
regulatory bodies belong is called the
International Association of Insurance
Supervisors (IAIS). IAIS is a voluntary
membership organization of insurance
supervisors and regulators from more
than 200 jurisdictions. Its mission,
according to the website
(http://www.iaisweb.org/home) is to
promote effective and globally
consistent supervision of the insurance
industry in order to develop and
maintain fair, safe and stable insurance
markets for the benefits and protection
of policyholders and to contribute to
global financial stability.
While the primary focus of the IAIS is on
insurer financial stability, the
organization also is concerned with
supervision. This includes organizational
supervision, again, to promote financial
stability. It also includes intermediary
(i.e., agents and brokers) supervision to
promote best practices and encourage
compliance. Each jurisdiction has a
unique regulatory environment for
agents and brokers, but we can
summarize by emphasizing the
requirement to operate ethically and in a
manner that serves and supports
policyowners. As is true in the broader
financial services world, the overarching
concept is to treat clients in a way that is
in their best interest. Compliance with
this concept should be automatic with all
financial professionals.
Summary
In this chapter we have explored some
aspects of insurer and agent selection
due diligence (or due care). We have
also reviewed legal and financial
characteristics of parties involved in
contracts. In prior chapters we covered
the nature of risk, how it relates to
individuals, and methods of addressing
various risks. One method, risk transfer,
led us to cover various types of
insurance as a primary risk
management tool. Now, we will turn to
investigating ways to develop and
implement risk management strategic
solutions.
Chapter Review
Discussion Questions
1. Some insurers are quite
specialized? How does this enter
into your selection of a company
with which to do business?
2. What are the rating agencies and
how can they help you select an
insurer? Are there any potential
problems that might arise from
depending on their services?
3. Why is an insurer’s financial
condition so important?
4. When you are looking for an
insurance advisor/agent with whom
to work, what criteria would you use
to make your selection?
 5. What potential solutions would
you recommend to a client who
currently has limited financial
resources, but needs a large
amount of life insurance coverage,
and is unsure which policy type to
choose and how to make the
necessary premium payments.
6. What is the problem with apparent
or ostensible authority? Have you
ever experienced this?
Review Questions
1. What are the primary factors to
include when evaluating an
insurance company for possible
use?
2. What are the four main rating
agencies and what type of rating
do they provide?
 3. What is a company’s lapse
ratio and how does it apply to
insurer evaluation and selection?
4. What are some of the factors
to include when evaluating an
insurance agent?
5. What is the difference between
express and implied agent
authority?
6. Will an insurer usually be liable
when an agent abuses apparent
or ostensible authority?
7. What is the primary concern of
securities industry as well as
insurance industry regulators?
Chapter 5: Strategic Solutions
Learning Outcomes
Upon completion of this chapter, the
student will be able to:
5-1 Determine potential risk
management strategies for a client
5-2 Identify the advantages and
disadvantages of risk management
strategies
5-3 Optimize risk management
strategies to make recommendations
5-4 Prioritize action steps to assist a
client in implementing risk management
strategies
Topics
5.1 Risk management priorities
5.1.1 Risk review and evaluation:
Property and liability
5.1.2 Risk review and evaluation: Life
5.2 Risk management tools to address
risk exposures
5.3 Risk management needs
5.4 Risk management optimization
5.4.1 Risk management audit
 5.4.2 Implement the chosen
approaches
5.4.3 The road map
Introduction
In this chapter we will try to develop
strategies to address clients’ risk
management needs. To some extent,
we have included aspects of this as we
explored prior sections and this chapter
will serve as a review and summary.
Here, we will coordinate what we have
learned to develop one or more plans to
help clients achieve their goals and
objectives.
As a reminder from the course content,
the major risk management areas are:
• Property
• Liability
• Life
• Health (including long-term care)
• Disability and Loss of Income
To these we can add the failure of
others, in that they might cause loss
based on inappropriate action or
inaction (that they should have taken). If
we accept that we cannot accurately
predict losses in any of the areas, we
can also accept the need for planning
and protection, likely using insurance to
some degree. While we cannot
accurately predict the likelihood of a loss
or when it will occur, we can address
whether a client may be affected and if
so, the potential financial loss. Doing
this, we can decide whether the cost of
insurance to protect against a potential
loss is reasonable.
As an overly simplified example,
consider the potential that an outbuilding
might collapse. We built the shed
ourselves at nominal cost, using
materials that were not very expensive.
In fact, the total cost to build the shed
was $1,200. Let’s say the annual
premium cost of insuring the shed
against collapse is $600. In two years,
we will have paid as much in premiums
as the replacement cost of the shed. In
such a case, there is little, if any, reason
to purchase insurance against collapse
(unless the shed houses valuable
content, in which case we might
reconsider). On the other hand, if the
shed sits behind our home, which has a
replacement cost of $1,000,000, it would
be wise to carry adequate insurance.
As a general rule, if a client cannot
afford to pay for repairs or replacement,
either as a result of not having enough
money or the negative impact of using
available funds for the repair or
replacement, he or she should consider
purchasing insurance to transfer the risk
of loss.
There is, however, another factor to
consider. What is the likelihood that a
loss will occur? If the shed would simply
collapse if there were an earthquake,
and the ground on which it sits has not
experienced a quake for more than 500
years, it’s not likely to experience an
earthquake-induced collapse anytime
soon. However, if the shed sits in a
particularly snowy locale, and we shift
the peril (i.e., cause of loss) to snow, or
the weight of snow, the potential for
collapse increases greatly. The two
factors (replacement cost and
likelihood), taken together, provide a
good rationale for either insuring the
property or not purchasing insurance.
Property-related issues seem relatively
straightforward, and the same may be
true with liability, but what about loss of
income areas related to a disability, or
medical expenses, or even loss of life?
Can we apply the same guidelines to
determine the value of purchasing
insurance coverage? In many ways, the
answer is yes. For example, actuaries
can identify the odds of a person
becoming disabled, and that information
may be available through insurance
companies and other resources.
Healthcare-related issues are a little
more nebulous, in that we don’t really
know whether someone will develop a
significant illness or experience a major
accident. However, we do know that
such events happen, and that related
expenses can be high. Some territories
fully cover medical expenses, so this is
less of an issue. However, where the
individual is wholly or partially
responsible to pay healthcare bills,
adequate funding can be a concern.
Life insurance is a little different.
Actuaries and mortality tables can tell us
the odds that someone in a class of
people may die at a certain age, but
nothing more exact than that exists for
an individual. Further, placing a
monetary value on a human life is an
inexact science. We know that everyone
will face death at some point. We also
can calculate the relative financial
impact of someone’s death at various
life stages (e.g., the death of a young
mother with three dependent children
will likely have greater financial impact
than that of a single older person with
no dependents). Previously in this
course, we looked at the process to
determine life value (which can be an
uncomfortable activity, but is necessary,
and beneficial for those who remain).
Even in the case of life insurance,
though, the amount of coverage must be
compared to premium cost. That is, ‘I
may feel my spouse has immeasurable
value, but the cost of insuring
“immeasurable” is likely to be
prohibitive’.
The general principle is to reduce or
avoid the risk of loss whenever it’s
practical to do so. When impractical,
consider risk transfer and the purchase
of insurance. As part of the insurance
evaluation process, consider both the
potential likelihood of loss and its
probable cost. Compare the value or
cost to the insurance premium required
to transfer the risk. If the cost-benefit
analysis, as with the $600 shed
insurance, shows premiums to be out of
line with the insured object’s value, skip
the insurance. On the other hand, if the
cost-benefit analysis leans in favor of
insurance, move to the next step of
evaluating appropriate insurance
coverage.
Assess Exposure to Financial Risk
Risk management requires recognizing
the risk areas to which an individual may
be exposed. A financial advisor cannot
simply say that a client might be
exposed to all possible risks, therefore
he or she should protect against that
possibility. This is neither practical nor
possible. Plus, where risk transfer is
required, excess amounts of insurance
can quickly run through available cash
flow. Remember, financial advice is a
holistic process, and recommendations
a financial advisor makes in one area
often have an impact on one or more
other areas. If most available cash flow
goes to pay insurance premiums, how
would the individual accomplish other
financial goals?
One can assess risk exposure in several
ways. For example, it’s not hard to
evaluate an individual’s healthcare
coverage, whether provided by the
government, employer, private
insurance, or some combination. Once
the financial advisor and client review
the options, they can discuss areas of
over or under coverage, the cost to
provide that coverage (or savings from
cutting unneeded coverage), and work
together to execute that part of the plan.
This process would need to be reviewed
periodically as government benefits and
private insurance coverage changes,
and as client needs change.
The process to determine disability
income risk exposures is also
straightforward. Deciding which
coverage to purchase at what price is
less clear cut, but determining the
exposure level is relatively easy. As with
medical expense exposure, first identify
the amount of existing benefits from all
sources. Remember, those sources may
not involve insurance (also true for all
other risk management areas). A person
may have sufficient financial resources
to self-fund a risk exposure area.
Assuming insurance is involved, first
consider any benefits available from
government or employer programs. Add
in privately owned insurance, if any.
Now determine the amount needed,
after factoring in existing assets such as
an emergency fund, to protect against
financial harm in the event of a
disability-related loss of income. To do
this part of the analysis, a financial
advisor would evaluate cash flow and
asset/liability statements, along with
available income sources. Is there a
point in the future when government-
provided or other benefits would begin?
If so, are they sufficient to cover the
need? If not, you now know the potential
risk exposure. Disability income
insurance tends to be expensive, so the
next step would be to determine how
much coverage to purchase, with what
kinds of deductibles (waiting periods)
and coverage periods (e.g., to age 65,
life, etc.). All this information could be
included in a cost-benefit analysis to
determine potential insurance
requirements.
Evaluating long-term care needs is a
little more complicated, because it
involves a few more unknown factors,
and because it can be expensive to
purchase. As with the other areas,
government or employer-provided
benefits may cover all or most of the
need. One question to ask is what might
be considered long-term care versus
regular medical care? In some
territories, long-term care refers to just
about any medical expense that
requires lengthy recuperative periods
and what is sometimes called
rehabilitative care. This is especially true
when the individual is elderly. Other
territories include 100 percent of this
type of care as part of their regular
healthcare benefits. The exposures are
different in these two cases, and
therefore it’s important to learn the
situation in your territory.
One of the more difficult parts of long-
term care evaluation is trying to
anticipate the length of time care may
be needed. Some sources identify an
average length of long-term care
rehabilitation as around two to four
years. If the average is valid, the next
step is to learn the average annual cost
of care. Combine these two, and you
have completed part of the analysis.
The next step is like evaluating disability
income risk exposures. Identify available
assets, including cash reserves and
emergency funds, liquid assets, other
insurance coverage and the like (and of
course, available benefits from the
government or employer). Then,
determine the length of time an
individual could go without any
additional coverage and still be
financially sound. Remember to include
the disability area and others that might
have an impact. Existing funds can only
cover so many needs. It’s sometimes
hard to make a single peso work to
satisfy multiple needs. As with disability
insurance, the amount of coverage,
deductible (waiting or elimination
period), and length of coverage, are the
biggest factors affecting potential
premium costs. Optional coverages and
additional benefits can also increase
premiums.
Long-term care expenses not covered
by government or employer-provided
programs can have a significant impact
on a person’s retirement situation. As an
example, a person who incurs $50,000
of personally funded expenses would
not have that amount to apply to future
income needs. For some people,
$50,000 represents a large portion of
their available funds, and has the
potential to significantly lower their
retirement standard of living. This is
another example of the holistic nature of
financial advice. It also illustrates why
appropriate advice can be very
important, and make a big difference in
a person’s life.
Property and liability, and life risk
exposures require a bit more analysis.
5.1.1 Risk Review and Evaluation:
Property and Liability
Most financial advisors would agree that
property or liability-related losses can
seriously damage an individual’s
financial wellbeing. It’s not hard to
envision a scenario where someone
could experience a net-worth-
decimating loss.
Some questions for your evaluation
include:
 • Are homeowners and motor
vehicle insurance policies in
place?
• Are the liability and
uninsured/underinsured limits
adequate?
• Is there an umbrella or personal
excess liability policy in place and
is it adequate?
• Is the client involved in any
activities that might cause risk to
their, or others’, life, limb, or
property?
The preceding questions represent only
the beginning of a good exploration of
this risk area, especially with clients who
have greater than normal wealth.
Affluent individuals can have far more
liability and property risks than most
people—and far more to lose. These
risks include expensive property,
property in different geographic areas,
employees who maintain their property,
assets and interests that create potential
liabilities, and valuable collections that
are often difficult to value and replace.
The complexity of their situations makes
crafting a solid personal risk
management plan more difficult and
considerably more important. All clients
are not created equal. Some individuals
have unique risk exposures. As a result,
they typically should use specialized risk
management and insurance tools.
It’s also important to coordinate multiple
insurance policies. Consider an
individual who owns property in several
territories. He or she may have
purchased separate insurance policies
for each property, and may not have
checked to see how well the different
policies coordinate. You should check
whether there are gaps in coverage or
overlaps. Also, determine whether there
any coordination or tracking mechanism
for policy renewal dates. You don’t want
the client to incur unintended policy
lapses.
Some individuals invest in high-value
fine arts and collectibles. Most basic
property insurance has coverage limits
on these types of assets that are quite
low. A personal property endorsement
or personal property floater may solve
the problem, but additional issues may
need to be addressed.
• Was a professional appraisal
used to establish the item’s
current value?
• Would the insured be required to
replace or repair an item, or would
the policy allow for a cash
payment option?
 • Would items such as antiques be
covered for full value, or would
they be depreciated?
• Would new items automatically be
covered, and if so, for how much
and for how long?
• Are items covered when they are
outside the home (perhaps on
display at a museum or other
venue)?
• Would items be covered in full
when they are in other residences
or in transit?
These are all questions that should be
considered when evaluating property
coverage.
Liability exposures are another
important area to consider. Some clients
have relatively few assets, but others
have many assets. Those with more
assets have more to lose, and may be
more frequent targets for litigation. A
high-coverage-limit umbrella liability
policy, coordinated properly with
underlying coverage, is a good first step.
However, some individuals have other
areas of exposure that would not be met
by personal liability coverage. If an
individual is a director or officer of a
nonprofit board, he or she probably has
increased liability exposure. A directors’
and officers’ liability policy would help to
cover this exposure. Some people
employ household help and personal
assistants. Liability exposures from
these employees could be covered by a
separate policy (and probably would not
be covered by homeowners or other
personal liability insurance).
Another area worth a brief mention is
increased personal safety concerns.
Under most circumstances, the average
person does not need to be concerned
about things like kidnapping, carjacking,
abduction, or extortion. This is not
always true for some high-profile
individuals.
There are two main areas of concern
here: maintaining personal safety, and
having adequate/appropriate insurance
coverage for these exposures. A high-
profile individual may require increased
personal security services (e.g., hiring a
driver trained in evasive maneuvers),
and may require things like a more high-
tech home security system with
increased monitoring. While this is not
usually something that falls within a
financial advisor’s purview, you could
encourage the individual to explore
solutions to these problems with
appropriate professionals. A few
insurers offer insurance against these
risks (e.g., stalking, kidnapping,
abduction, and the like), and it may be a
good idea to discuss these risks, as
appropriate, with high-profile/affluent
clients.
5.1.2 Risk Review and Evaluation: Life
Humans are not property, and human-
life risk evaluation differs both
quantitatively and qualitatively from
similar property-related evaluations. We
will not discuss the emotional toll the
end of life often produces, focusing
instead on things financial. Death often
brings financial turmoil, especially when
the deceased was a primary income
earner with dependents. Financial well-
being depends upon adequate cash
flow. When that is disrupted, even well-
made plans can be upended. Protecting
against the potential disruption of
income is a major reason for life
insurance, and in addition to covering
final and estate-distribution expenses, is
the major focus of evaluation.
Selecting a life insurance policy can be
challenging, in that it requires evaluation
of not just the policy, but also the
company offering it. As important as it is
to make the right policy choice,
determining the amount of required
coverage is even more important.
Covering final expenses is one of the
two, and by far the easiest, main tasks
for life insurance. Although some
estates can be complicated to settle, in
most cases, tallying up final expenses is
a fairly simple process. As a reminder,
final, or postmortem, expenses may
include:
• Funeral costs
• Unpaid medical expenses
• Outstanding loans and debts
 • Some debts may be forgiven at
death, but many require
repayment.
• Loans in joint names (e.g.,
husband and wife) may transfer
to the remaining joint holder.
However, that individual must be
financial able to continue
repayment.
• Estate-settlement costs
• Adjustment period fund
• It can be difficult for dependents
to quickly adapt to a significant
change in income. Further,
available funds may sometimes
be temporarily tied-up at death,
creating an income bottleneck
until released. An adjustment
period fund can help with this
process.
 • Miscellaneous
• This is to cover any additional
expenses that may arise.
Once the individual has totaled an
estimate of final expenses, he or she
should determine the amount of any
available liquid assets. Life insurance is,
for all practical purposes, a means to
provide cash or liquidity at death. Any
available liquid assets not earmarked for
other purposes may be used to offset
final expenses. There may be enough
liquid assets to cover all final expenses.
If not, the amount needed to pay any
uncovered expenses should be
identified and included as part of the
potential life insurance need.
The process to determine ongoing
income needs is more involved.
Assuming that a spouse and children
survive, you should consider five
potential income categories:
• Dependent income for the
children until they reach the age
at which they are able to live on
their own
• Additional income for the surviving
spouse while the children remain
in the home
• Funds to pay for education
expenses (primary, secondary
and higher)
• Funds needed to supplement
income for the surviving spouse
after children have left the home,
and before reaching retirement
age
• Supplemental retirement income
funds
Where there is neither a spouse nor
dependent children, the process
becomes simpler. In such cases, the
individual may not need life insurance,
as long has he or she can pay for final
expenses. We should point out that
every situation is different, and not all
individuals will desire (or be able to) fully
fund each of the income categories. Part
of the “art” of life-needs analysis is to
help individuals decide what they do and
do not want to fund, and then, the
amount they can afford to cover with life
insurance. In some cases, there will be
the need for compromise.
The first step in determining potential
income-related needs is to have an
open discussion with the client about
how he or she wants to proceed. Such
discussions can be difficult, because
they involve providing funds for the
wellbeing of any surviving dependents.
Spouses do not always agree on the
amount of income to be provided in the
various categories. You should be
aware of potential disagreement and
stress when discussing end-of-life
needs (especially when they involve
spouses and children). The economic
value of a stay-at-home spouse is one
area that can be difficult to determine. It
may seem that there is no economic
benefit if the spouse is not producing an
income, but once you begin to add up all
the services provided by that spouse,
and the cost to replace them, you begin
to recognize that person’s significant
economic value.
Once the hard work of deciding how
much should be provided for the
surviving dependents and spouse, the
financial advisor can begin to calculate
the funding requirements. We covered
the process to do this in Chapter 3 in the
section on “How much life insurance do
people need?” It would be worthwhile to
go back and review the information in
that section now.
To help make the process a little more
concrete, let’s look at one example of
funding an income-related need.
Faber Case
Frederick and Frieda Faber are working
through the steps in a life-needs
analysis. Frieda is a stay-at-home
mother, taking care of the couple’s two
children. The Fabers have decided they
would like Frieda to continue staying at
home until the children leave home. The
couple has reached the place in their
calculations where they need to decide
how much income would be required to
provide adequate income to care for the
two children: Eva, age 10 and Emma,
age 8, until each child reaches age 18.
Step one is determining the amount of
cash inflow required to sustain a
desirable lifestyle for Frieda, Eva and
Emma. This process involves looking at
the budget, backing out expenses
directly related to Frederick, and settling
on the appropriate amount. Calculations
would need to factor an acceptable
inflation rate so purchasing power would
remain relatively constant. We will also
need to agree to a discount rate (i.e.,
return on savings/investments). For our
purposes, let’s settle on the following:
• Annual income need with Frieda
and both girls at
home: $20,000
• Annual income need with Frieda
and Emma at home: $14,500
• Inflation rate: 3.5 percent
 • Discount rate: 5.0 percent
• Years remaining at home
• Eva: 10
• Emma: 8
We will first calculate the need while
Eva and Emma are both at home, then
for the remaining period while Emma
remains at home.
Prior to working the calculations, we
need to identify the annualized real rate
of return (how inflation impacts the
nominal rate).
The equation to calculate real rate of
return is:

We will use the real rate to help

maintain purchasing power for Frieda
and the girls.
After doing the initial work, the process
to determine the funding requirement
has three steps:
1. Inflate the current income
amount (using only the inflation
rate) for the number of years until
it will be needed. In this example,
no inflation is needed for the first
calculation (because the income
need begins immediately), but will
be required to calculate the
amount needed for the two years
Emma will remain at home after
Eva leaves.
2. Calculate the present value
(annuity due – BEGIN mode) of
the future income stream using
the real rate of return.
3. Discount the amount from Step
1 to determine the lump sum
needed to fund that amount
 (because the income need when
Frieda, Eva, and Emma are all at
home begins “today” – at the
same time the present value
annuity due (PVAD) is being
calculated, there is no need to
apply the discounting step.)
All life insurance-needs calculations
have “today” as their starting point, i.e.,
the day on which the calculations are
being worked.
Amount needed while Eva and Emma
are both at home:
• 8N
• 1.4493 I/YR
• 20,000 PMT
• [0 FV]
• PVAD (BEGIN mode) = 152,224
(rounded)
Now that we know the amount required
to fund the income stream while both
girls are at home, we can move on to
calculate the amount needed to fund the
additional two years when Frieda and
Emma remain in the home. Because
this second income stream begins after
Eva leaves home, we must add a
calculation step to inflate the current
$14,500[2] annual income amount for
eight years, using the rate of inflation
only. This is a simple future value
calculation.
Step 1 (inflate the current income
amount)
• 8N
• 3.5 I/YR
• 14,500 PV
• [0 PMT]
• FV = 19,094 (rounded)
In eight years, to maintain the
purchasing power of $14,500, Frieda
and Emma would need $19,094.
Step 2 (calculate the sum needed to
fund the remaining two years of income
while Emma is at home)
• 2N
• 1.4493 I/YR
• 19,094 PMT
• [0 FV]
• PVAD = 37,915 (rounded)
Step 3 (discount the $37,915 back to
today, NOT just back two years to the
point where Eva and Emma are both at
home. We want to find out how much
will be needed today to fund the future
need, so we discount back to today)
• 8N
• 5 I/YR
• [0 PMT]
 • 37,915 FV
• PV = 25,663 (rounded)
By adding the two amounts: $152,224
and $25,663, we conclude that
$177,887 would be required to fully fund
the inflation-adjusted future income
stream for Frieda, Eva, and Emma. If no
liquid assets or existing insurance is
available, $177,887 is the amount of life
insurance the Frederick’s would need to
fund this future income stream.
If we were doing a full life-insurance
needs calculation, we would move
forward to determine amounts needed
to fund Frieda’s pre-retirement and
retirement-period income (based on
what the couple decides that amount
should be). If the Fabers want to fund all
or part of their daughter’s university
tuition, we would also work through the
amount necessary for that need. The
result, after adding all the amounts, is
likely to be quite large. This would be
true in many situations, and is one
reason why term life insurance is often
best for providing the necessary death
benefit at the most cost-effective (and
non-budget busting) premium. In the
case of the Fabers, we would probably
recommend a 10-year level-term life
insurance policy to fund the need while
Eva and Emma remain at home.
It may be that a different type of life
insurance would make more sense for
Frieda’s pre-retirement or retirement
need, but we would need more
information to make that determination.
We would need to know about available
discretionary income, balanced by the
need for other investment funding. Also,
we would need to find out whether
Frieda would be working outside the
home after the girls leave, and if so,
what impact that would have on her
retirement-funding needs. Finally,
whether from investments or other
sources, we need to determine Frieda’s
net financial need during both the pre-
retirement and retirement periods. We
will not work through these calculations,
but you should recognize this as another
example of the holistic, inter-related
nature of financial advice.
The proper method to assess risk
exposures is to conduct a step-by-step
audit. If an advisor does a complete risk
management plan, he or she would
assess each of the risk exposure areas.
In some cases, the client may desire a
more focused approach, and the advisor
should adapt accordingly. As an
example, the client may have already
addressed all healthcare related risk
exposures, and does not want to include
that area in a broader risk-assessment
audit. At the same time, an advisor
should not assume that any area has
already been addressed. It’s best to
assess all potential areas of need and
let the client advise otherwise if
appropriate.
Part of the process of risk assessment
includes evaluating the tools (e.g.,
insurance) and risk- management
approaches being used to address risk
areas. The focus is to identify any gaps
so they can be closed. We will explore
this process next.
5.2 Risk Management Tools Being Used
to Address Risk Exposures
We previously identified four primary
risk management strategies:
• Avoidance
 • Reduction
• Retention
• Transfer
The primary focus when auditing this
area is to ensure that risk management
tools and strategies are in proper use,
and that the individual is aware of the
potential financial implications for each
option.
Avoidance is perhaps the easiest, and
paradoxically, the most difficult, option.
It’s easy to declare your intention to
avoid a risk. However, following through
can be difficult. To be sure, some risks
are easy to avoid. For example, if you
don’t want to get hurt playing sports,
don’t play sports. On the other hand,
think of the example of avoiding car-
related losses. At the core, this requires
not owning a car. While this may not be
difficult in a city with good public
transportation, it might become quite
hard when the individual lives out in the
countryside with little or no public
transportation.
Retention is also relatively simple to
assess, but it can create problems if
financial implications from the retained
risks mount too high. The advisor should
help the client keep a running total of
potential out-of-pocket expenses for all
retained risks. If potential financial
exposure gets too great, the advisor
should probably consider risk transfer. A
simple spreadsheet is not necessarily
the most elegant tracking tool, but
serves well for this purpose.
Reduction is perhaps the trickiest
strategy, in that it does not seek to
eliminate financial exposure, nor does it
intend to retain it 100 percent. Instead,
reduction intends to retain the risk, but
reduce the likelihood of financial impact.
So, a person might install an alarm
system in a home or office building. He
or she might park the car in a guarded
or otherwise safe, enclosed space. Any
costs for these options would need to be
added. At the same time, there is no
guarantee that someone would not
break into the house, building, or car
sanctuary anyway. If that happens, not
only did the individual incur the expense
of implementing the risk-reduction
strategy, he or she suffered the financial
loss, too. Perhaps there would be some
cost mitigation from, for example, the
security service, but perhaps not. As an
advisor, you would want to identify these
areas and discuss potential outcomes
with your client. It’s possible that some
or all the potential exposure would be
best served by including insurance
(transfer) in the mix.
Transfer is probably the easiest strategy
to quantify in terms of cost and benefit.
Assuming the coverage is properly
written and maintained, the policy owner
would have a good idea of premium cost
and the coverage provided by the policy.
With this in mind, ask yourself a few
questions as you evaluate insurance
coverage.
• What risk is the policy intended to
cover?
• As written, does the policy provide
the desired coverage?
• What is the upper limit of
coverage, and is this sufficient?
Should it be increased?
• What is the lower limit of
coverage? Should it, or any
deductibles, be raised?
• For how long is coverage or policy
payout expected to last? Is this
appropriate or should the term be
increased or decreased? For
example, is a disability income
policy with a five-year benefit
period sufficient?
• Are beneficiary arrangements in
good order? Do they coordinate
with any relevant legal
documents, such as wills or
trusts?
• If there are different policies
addressing the same risk area, is
there too much overlap, or are
there still gaps in coverage?
• What are the renewal provisions,
and does the policy owner need
to be aware of any potential
renewal premium increases or
other problems?
• For healthcare coverage, are the
proper health conditions covered,
and in sufficient amounts?
• Is the life insurance coverage
sufficient, and is the policy type
appropriate? Do existing policies
need to be modified in any way?
• Do risk exposure gaps exist, and
can they (or should they) be
addressed through risk transfer?
This is especially a concern with
liability risk exposures, and when
the individual is a professional, or
an employer, or a director / officer
of a company.
• If household staff is employed in
more than one location (and
perhaps different territories) are
all legal requirements satisfied?
 • Is the policy cost effective and
issued by a financially sound
insurer?
The preceding list is not intended to be
all-inclusive. However, it can serve as a
guide for the advisor in his or her
evaluation. As part of the evaluation
process, the financial advisor works with
the client to prioritize risk management
needs, and then optimize strategies to
effectively address those needs. We will
look at this next.
5.3 Risk Management Needs
We have identified that few individuals
can effectively address all financial
needs to the same degree and at the
same time. Money is a key issue, but
time and energy may also be practical
factors. Especially at the start of a
financial advice relationship, addressing
100 percent of existing financial needs
in all areas can be overwhelming. This
is one reason why it’s beneficial to work
through the process to determine which
needs have top priority. This also
applies to the area of risk management.
Even though risk transfer is not the only
available tool, it is often appropriate, and
always costs money to implement. In
the case of a client with limited funds,
risk-management goal prioritization is a
valuable activity.
On what basis do you prioritize risk
management needs? To start, the
advisor must discuss prioritization with
the client. While it’s true that an advisor
will recognize needs to address, the
client will often express his or her desire
to work on some areas over others.
Recognizing the value in discussion with
the client, the advisor will need to
understand the criticality of meeting
certain needs over others.
Remember, the purpose of risk
management is to protect against
potential losses that can harm a person
financially. An advisor needs to evaluate
which risks could cause more financial
harm than others, and therein lies the
problem. The act of prioritizing a list of
roughly equal needs often results in a
lack of distinction between them.
Consider which is most important:
• Protecting against a total loss of
your house or the need to protect
against personal liability (auto,
home or other)?
• Having the money to pay family
medical expenses or protecting
against potential long-term care
expenses?
 • Protecting against financial
exposure resulting from an
untimely death or protecting
against loss of income due to a
long-term illness?
As you read through the questions, two
things probably came to mind. First, all
those needs are important. At the same
time, some needs probably seemed
more significant than others. When
funds to pay insurance premiums are
limited, it is important to have a process
in place to prioritize needs. From a
purely financial standpoint then, with
one exception, top risk management
priorities should be those areas of risk
that can cause the most harm. You must
give some consideration to the
likelihood of an event happening. If a
risk can cause great financial harm, but
the likelihood of being affected by that
risk is low, the risk probably should not
be given the same priority as one where
the potential impact is far greater.
Part of the prioritization process should
include existing options to address a
need. As an example, loss of income
due to a disability is potentially quite
harmful, but it may not need to be
addressed if the individual has enough
coverage or benefits (government or
employer-provided) to protect against
the loss. Further, it may be that the
person has enough assets so that
purchasing insurance is not necessary.
If so, some risk areas might be given
lower priority than others, based on the
individual’s willingness to apply existing
assets should the need arise.
With these things in mind, we might be
able to agree that having an adequate
life insurance portfolio is a top need.
However, this is not always true, either.
Someone with no dependents may not
have much need for life insurance
(except perhaps enough to cover final
expenses). Therefore, it would be
incorrect to arbitrarily place life
insurance – or any other need area – as
the top priority.
You can see that the only effective way
to prioritize risk management needs is to
use the same process advisors use to
prioritize all other needs. Analyze areas
of greatest exposure or need, and in
concert with client goals, work through
the prioritization on a case-by-case
basis.
Having said all that, we can make some
generalizations. For people with
dependents (e.g., spouse and children),
protecting against loss of income due to
premature death will normally be one of
the top priorities. Having enough
insurance coverage to protect against
the loss of a primary residence and
personal property will also be high on
the list. For those who want to drive a
car where the law requires adequate
liability, and perhaps physical damage
coverage, having appropriate coverage
will be key. Where the government
and/or employer do not provide
adequate healthcare coverage, having
adequate insurance can make the
difference between bankruptcy and
financial stability. The same is true for
disability-related risk exposures.
If we total the premium cost to provide
appropriate insurance coverage for each
of the preceding areas, we have the
potential for a large percentage of the
individual’s cash flow to be deployed for
premium payments. This is a good
reason to find the most cost-effective
ways to provide necessary coverage.
Even by doing this, though, the
individual may have to make some hard
choices between the various risks to
insure. The individual may choose to
provide for partial, rather than total, risk
coverage. For example, for life
insurance, he or she may decide to
cover only half of the income-
replacement need while children remain
dependents. While not ideal, it may
provide enough financial stability to
keep the family going.
Risk management prioritization is often
a matter of balancing needs with
available resources. The process may
not always require a choice between
total coverage and no coverage.
Instead, the advisor may be able to
determine levels of coverage that, while
not perfectly providing total risk
protection, address the client’s risk-
management needs. Also, don’t forget
that not all risks require insurance.
Some can be addressed by lifestyle
changes and choices.
5.4 Risk Management Optimization
Following the prioritization process, the
next step is to make optimal strategic
risk management recommendations. As
we have already discussed, after needs
analysis and consideration of goals, the
next most important step is to determine
available resources. We probably
should include assessing which risks
might be best managed through
avoidance or reduction. We also need to
consider the risks a client may decide to
retain. Retention includes insurance
deductibles, which can add up. More
than one person has had their pleasure
over low premium payments greatly
diminished the first time they submitted
a claim and had a large out-of-pocket
expense from a high policy deductible.
Risk management recommendations
should be based on meeting critical
need areas. Then, depending on
available resources, a cost-benefit
analysis will determine how much of a
given risk to cover, as well as the type of
insurance to use (e.g., term versus
whole life insurance). Finally, as is true
with the rest of financial advice, you
need to develop a roadmap to help the
client reach appropriate coverage levels
over time (when adequate funds are not
available to meet the whole need).
5.4.1 Risk Management Audit
Conducting a risk management audit is
the most appropriate way to begin
developing and optimizing a risk
management strategy. This will often be
done as part of the initial client intake
and exploration process. Assuming the
financial advisor has a good, in-depth
data survey or fact-finding form, he or
she will gather a lot of the basic
information.
Depending on the client, a risk-
management audit can be simple and
quick or complex. Either way, begin by
talking with the client to gain an
understanding of his or her situation and
potential risk exposures. Then, collect
and review all existing insurance
policies. When you do this, be sure to
identify any areas where no policy
exists, but where coverage might be
needed. Also, when reviewing coverage,
ensure beneficiary and ownership
arrangements are in good order. Make
note of deductibles and other coverage
limits, along with relevant policy
provisions.
When you have completed the audit,
compile the information in a report
identifying risk areas compared with
existing coverage. Also identify any
coverage gaps, and provide possible
solutions. Following is an example of
what an abbreviated audit report might
look include:
Risk Management Audit
Coverage Recommendedations
Areas
Inadequate Purchase an umbrella
liability (excess liability)
coverage: insurance policy to
Not enough cover car and
coverage for personal liability
car and exposures. Increase
personal liability underlying liability
relative to the
client’s net limits to coordinate
worth with umbrella policy.
Premature Earmark assets for
death: final expenses. No
Has enough need for additional life
assets to cover insurance coverage.
final expenses
and dependent
income needs.
Long-term Purchase individual-
disability: owner policy to
Existing supplement existing
employer- benefits and provide
provided the increased
insurance plus coverage levels.
government Check with employer-
benefits should coverage to ensure
cover one-half new policy will not
current income. impact existing
Preferred benefits.
coverage level
would provide
two-thirds
current income
with appropriate
inflation
adjustments.
Healthcare No additional
expenses: insurance protection
Existing needed.
employer-
sponsored and
government-
provided
benefits
adequately
cover potential
medical
expense
exposure.
The preceding chart is an abbreviated
sample of what could become an
extensive report. The report should
highlight areas of coverage the advisor
believes should be addressed. An actual
report would identify coverage amounts
and type of policy. As the advisor and
client discuss the report, the advisor
would find out which of the areas the
client wanted to address now. By the
end of the discussion, advisor and client
should agree on a strategic course of
action. The final step would be to shop
for insurance coverage and begin
incorporating any lifestyle (or other)
changes to address risk management
areas not requiring insurance.
Between the audit (and client review)
and implementing suggested actions,
the advisor and client should agree on
the most appropriate strategic risk-
management approach. In some cases,
the strategy would be as simple as
working through the audit list and
agreeing or disagreeing on each item.
After that, the planner can put together a
list of actions and he/she and the client
can begin implementation.
Sometimes where needs are
straightforward, but far greater than
available financial resources, the
process will require a little more work. A
risk management strategy should
include the following steps:
• Identify the risks
• Review (and inspect) current
situation
• Analyze the information
• Select the most appropriate risk
management technique
• Implement the chosen
approaches
• Monitor results
This process is essentially the same as
for all financial advice engagements. In
this case, with emphasis on risk
management. We have already covered
the steps, except for implementing the
chosen approaches. We will look at that
now.
5.4.2 Implement the Chosen
Approaches
The implementation process may take
some time. New insurance coverage
must be underwritten. With life and
health-related coverage, this may
involve health exams, financial reports,
personal interviews and the like. For life
policies with high face amounts, the
underwriting process can be long and
involved. Sometimes, one insurer may
reject coverage, which may require
applying with another carrier or,
perhaps, modifying the plan. Unlike
most investment options, insurance
policy applications are sometimes
rejected. Underwriting is the process an
insurer uses to decide whether it wants
to accept a risk, and the company
always maintains the right of rejection.
Even with an initial rejection, the client
may be able to get coverage.
Sometimes the insurer just needs more
information. Perhaps it needs more
financial or medical information. Or, it
may be that the amount of coverage
requested (e.g., with life or liability
insurance) is too high for that insurer to
carry. In some cases this may lead the
company to decide it will reinsure a
portion of the coverage. Reinsurance
means one company decides to share –
or reinsure part of its risk exposure with
another company. An advisor should
evaluate a reinsurer in the same way as
the original company. Reinsurance
would only be an issue when dealing
with very high coverage amounts, and
should not normally be an area of
concern.
If one insurer absolutely rejects an
application (i.e., even after new
information, etc.), the advisor may
decide to try another company.
However, before doing so, it’s worth
determining the odds of getting a policy.
Sometimes previously unrevealed
information can come to light as a result
of inspections and reports. When this is
true, it’s possible that the advisor may
determine that getting a policy at a
reasonable price – or at all – is not
feasible. In such cases, it’s time to
explore alternatives. In the worst case,
the alternative may be that there is no
way, other than retention, to address a
risk.
As an advisor, what would you
do if you find that, for example,
a client simply cannot purchase
new life insurance coverage?
The money and the desire are there, but
you cannot find any insurer to issue a
policy. Assuming the need remains
valid, it may be possible to reallocate
other resources to substitute for the
insurance. For example, money
earmarked for retirement may now be
targeted to meeting the need that
otherwise would have been covered by
insurance. To be sure, this may mean
that another area (e.g., retirement)
would need to be modified, but doing so
may provide a solution. It would
probably be a less-than-optimal solution,
but at least the need will be addressed.
Advantages and Disadvantages
How do you determine the relative
advantages or disadvantages of a risk
management solution? Simply, ask
whether it appropriately addresses the
need or not. A big part of determining a
strategic approach includes exploring
options. Ultimately, the chosen solution
should be the one that best meets risk-
management needs. The problem, of
course, is to determine what is best.
Best may be the least expensive, but
often low cost is not necessarily a good
indicator of value. It may, however, be
the only way to meet a need. Financial
advice, and for discussion purposes,
risk management, is often a matter of
determining the most reasonable
compromise. Sometimes this means
deciding not to fully cover all risks. As
long as the client understands the
potential results, this may be an
acceptable, if less than optimal, solution.
At other times, a combination of options
may be best. For example, the client
may purchase an insurance policy with
a higher deductible than the most
preferable option. Risk management
choices can sometimes be reduced to –
some coverage is better than no
coverage. However, at other times, such
as when satisfying legal requirements,
the client may have no option except to
purchase full coverage and then modify
other risk management goals.
Ultimately, the best solutions will be
those that provide the most positive
results after doing a cost-benefit
analysis. Of course, solutions must fall
within the client’s implementation ability.
This may mean that, rather than
implementing the plan all at once, the
approach will need to be stepped or
staggered. We will explore an option for
doing this next.
5.4.3 The Road Map
The road map concept is not unique to
risk management. In fact, it’s just an
analog for an overall financial strategy.
The illustration below is an example of
how an advisor might construct a risk
management roadmap[3].
1. First quarter
1. Risk management goal
determination
2. Risk management review and
analysis
3. Create risk management
strategic plan
2. Second quarter
 1. Goals review
2. Modify life insurance
beneficiary arrangements for
existing policies
3. Submit application to XYZ
company for new life insurance
policy
4. Schedule property and liability
review with agent
3. Third quarter
1. Goals review
2. Monitor life insurance
application and issue status
3. Evaluate property-and-liability-
review report from agent
4. Submit application for new
umbrella liability policy
5. Increase car insurance
deductible per agent’s report
 6. Get bids to install protective
fence around swimming pool
4. Fourth quarter
1. Goals review
2. Hire fence contractor
3. Monitor liability policy issue
process
4. Check status of car-insurance-
deductible change
5. Review newly issued life
insurance policy for accuracy
and make copy of face page for
records
At each step, the advisor can guide the
client along the path to implementing all
recommendations. Notice, in this
example, which covers a year, some
solutions are not implemented for six to
nine months. Some of this is the result
of time required to get policies issued,
but some is a recognition that not all
solutions can be implemented at the
same time. The roadmap serves as a
guide as well as a means to evaluate
progress. The advisor could easily
expand the map to include multiple
years. It then would serve as a means
by which both financial advisor and
client could monitor progress.
The optimization process is reasonably
clear cut. First, determine the greatest
need and work on that. What is the
greatest need? The one that will cause
the highest level of financial disruption if
it is not addressed. This may be
satisfying legal requirements. It may be
purchasing life insurance on parents’
lives to ensure their children are
financially secure in the event one or
both parents die. Perhaps modifying
homeowner coverage will top the list. It’s
impossible to provide a “one-size-fits-all”
approach. What may be most important
to one person may be least important to
another. The best analytical approach is
for advisor and client to determine the
greatest need together and address that
area first. When financial resources are
constrained, the advisor and client
should discuss compromise positions,
but it’s still important to keep first things
first. Additional areas can be addressed
at later times as appropriate.
Summary
The material in this course covered risk
management and insurance. Having
completed the course, you should have
a good understanding of risk
management need areas and ways to
address them. You should be able to
evaluate existing insurance coverage
and how it addresses the client’s risk
management needs. Finally, you should
be able to develop various strategies to
protect the client’s financial wellbeing
through appropriate risk management.
This course explored risk management
areas including:
• Risk management principles
• Insurance as a risk management
tool
• Risk-transfer techniques
• Risk exposures
• Primary areas of concern:
• Property
• Liability
• Life
• Health and long-term care
• Disability and Loss of Income
• Business
• Company and advisor selection
 • Risk management strategies
• Regulation
Risk Management and Insurance
Planning
1. Collection
1.1 Collect Quantitative Information
1. Collect details of the client’s
existing insurance coverage
2. Identify potential financial
obligations of the client
1.2 Collect Quantitative Information
1. Determine the client’s risk
management objectives and risk
exposures
2. Determine the client’s tolerance
for risk exposure
3. Determine relevant family and
lifestyle issues and attitudes
4. Determine health issues
 5. Determine the client’s willingness
to take active steps to manage
financial risk, including lifestyle and
health issues
2. Analysis
2.1 Assess the Client Situation
1. Determine characteristics of
existing insurance coverage
2. Examine current and potential risk
management strategies
2.2 Identify and Evaluate Strategies
1. Assess exposure to financial risk
2. Assess the client’s risk exposure
against current insurance coverage
and risk management strategies
3. Assess the implications of
changes to insurance coverage
4. Prioritize the client’s risk
management needs
3. Synthesis and Recommendation
1. Develop risk management
strategies
2. Evaluate advantages and
disadvantages of each risk
management strategy
3. Optimize strategies to make risk
management recommendations
Prioritize action steps to assist the client
in implementing risk management
recommendations
4.
Risk Management and Insurance
Planning
Chapter Review
Discussion Questions
1. How would you make the decision
about whether to purchase
insurance cover for a particular risk
or to choose an alternative method
to address the risk?
2. How would you help a wealthy
client coordinate property and
liability coverage? What questions
would you ask? What criteria would
you use when deciding whether to
recommend coverage changes?
3. What are the potential life-
insurance related expenses
someone might need to address?
How would you help the individual
determine which expenses to cover
by insurance?
 4. How would you apply risk
retention, avoidance or reduction,
and why might any of these
methods be difficult to employ?
5. How would you evaluate a client’s
insurance coverage to determine
the degree to which it is meeting
risk management needs?
6. Few people can address all risk
management needs in the same
way at the same time. How would
you help a client prioritize risk
management needs and how best
to address them?
7. How would you apply a road map
to help you and your client address
risk management needs over time?
Review Questions
1. Why is it important for a
financial advisor to assess an
 individual’s exposure to financial
risk?
2. What questions are good to
ask when evaluating insurance
coverage on high-value fine art
collections?
3. What are six final expense
areas to address when
considering potential life
insurance needs?
4. What are five potential income
categories to include as part of
determining ongoing income
needs for a surviving spouse and
dependent children?
5. What questions should a
financial advisor ask when
evaluating existing insurance
coverage?
 6. What steps should a financial
advisor include as part of a risk
management strategy?
Chapter Review Answers
Chapter 1 Review Answers
1. What are the four primary risk
management techniques?
• Avoidance
• Minimization or Reduction
• Transfer
• Retention
2. What are the three rules of risk
management?
• Consider the odds, don’t risk a lot
for a little, don’t risk more than
you can afford to lose.
3. How would you define risk, peril
and hazard?
 • Risk is the possibility for loss,
perils are the causes of loss, and
hazards increase the chance of
loss by a peril.
4. What is underwriting and how
does it relate to insurance?
• The process of underwriting
determines whether a risk is
reasonable to accept, at what
price, and with what conditions.
Applications for insurance
coverage are sent to the insurer
for underwriting. Upon
acceptance of a risk, the insurer
issues a policy and completes the
underwriting process.
5. What are the requirements for an
insurable risk?
 • The law of large numbers must
apply;
• The loss must be by chance (i.e.,
accidental or fortuitous);
• The loss must be measurable and
able to be defined; and
• The loss must not be financially
catastrophic.
6. How does a loss that would be
catastrophic for an individual differ
from one that is catastrophic to an
insurer?
• A catastrophic loss to an insurer is
not the same as a catastrophic
loss to an individual. Loss of a
house might be financially
catastrophic to a family. However,
loss of one house would not make
much financial difference to an
insurer. On the other hand, the
 loss of 10,000 houses could
definitely be financially
catastrophic for an insurer, to the
extent that the company might no
longer be viable as a business.
7. How would you describe insurable
interest?
• Insurance contracts require that
some insurable interest exists. An
insurable interest is the legal or
equitable interest that is held by
the insured in insured property or
a life. In economic terms, it
applies where an insured has
suffered a monetary or economic
loss through the damage or
destruction of the subject matter
of the insurance. A monetary loss
exists if a person is liable to pay
or lose money in the event of a
 loss, i.e., it can be measured in
economic terms.
8. What is the principle of indemnity
and how does it apply to
insurance?
• Under most circumstances,
insurance policies are designed to
make the policyowner whole. That
is, the insured will be restored to
the condition he or she was in
prior to the loss. However, the
insurer will not generally provide
enough payment to put the
insured in a better financial
position than he or she previously
held. To indemnify, then, is to be
made whole, but not better than
whole. The principle of indemnity
allows an insured to purchase
insurance to protect against loss
 to the extent of their insurable
interest. Under the principle of
indemnity, an insured is not able
to claim more than their loss.
9. What is subrogation and how
does it relate to insurance?
• Subrogation is related to the
principle of indemnity. You might
see a technical definition stating
that an insurer will sue the
individual who caused covered
harm to an insured after it has
settled the insured’s claim. The
insurance company may sue that
individual to recover amounts paid
to the insured to cover the loss.
To some degree, this is an
extension of indemnity, because
the insurance company is
 ensuring overall payment does
not exceed the claimed loss.
10. What are riders and
endorsements and how do they
differ?
• Insurance policies may include
items known as riders or
endorsements. These serve to
modify policy coverage or terms
and conditions. Rider and
endorsement essentially describe
the same thing. Some policies use
the term rider, while others use
endorsement.
11. Why is underinsurance a
problem for insurers, and what is
one method they use to
compensate?
• Insurance premiums are based on
the belief that insureds will insure
for the full value of their property.
Therefore, if the property was
insured for less than its value
(underinsurance) then an insurer
is receiving insufficient premium
income to maintain the viability of
their insurance pool. To overcome
this problem most policies contain
an ‘average’ or ‘coinsurance’
clause to protect insurers from the
economic effects of
underinsurance. Under a
coinsurance clause, only those
insureds whose property has
been totally destroyed will be
covered for the property’s insured
value. Where an insured has
underinsured the property and the
 loss is partial, the insured bears a
pro-rata proportion of any loss.
Chapter 2 Review Answers
1. What are some of the risks people
may face about which advisors
should be aware?
• Risk of premature death
• Longevity risk (outliving your
retirement money)
• Health risk (declining health,
including making one uninsurable
or requiring substandard
insurance rating)
• Risk of unemployment
• Risk of disability
• Property risks—direct and indirect
• Liability risks
2. What lifestyle issues might increase a
person’s risk?
 • Lifestyle issues cover a wide array
of potential risks. These can
range from certain hobbies and
habits, alcohol or drug abuse,
nutritional issues and eating
disorders, and many additional
areas. Some of these, like
recreational hobbies such as
mountain climbing, SCUBA diving,
or race-car driving can be positive
and pleasurable, but also present
potential risks for liability, loss of
income due to injury and the like.
Others, including alcohol or drug
abuse, create risks by their very
nature.
3. According to the text, why do people
purchase insurance?
• Insurance does not prevent such
events, just as life insurance does
 not prevent death. People get the
coverage because they want to
prevent against financial loss in
the event of a covered event.
Chapter 3 Review Answers
1. How much land value is included
when writing insurance coverage on a
home and why?
• A home’s insurance coverage
does not include any value for
land because you cannot insure
land.
2. What coverages are normally
included in the two sections of a
standard homeowners policy?
• Section I has four coverage
subsections:
• Coverage A insures the main
dwelling, including any
 additions attached to the
dwelling, and materials and
supplies located on the
property for the primary
purpose of working on the
building.
• Coverage B provides
coverage for other structures,
such as garages and sheds,
which are situated on the
property and detached from
the dwelling.
• Coverage C covers the
insured’s personal property.
• Coverage D protects against
loss of use, including expenses
incurred while the dwelling is
damaged, by a covered peril,
beyond the point where the
dwelling can be occupied.
 • Section II often includes two
areas of coverage:
• E - Comprehensive liability
insurance.
• F - Medical payments to
others, claims expenses, and
damage to property of others.
3. Why are coverages A and B not
included on any renter’s insurance
policy, and what coverage is always
included?
• Coverages A and B protect
against loss to the dwelling
(home) and outbuildings. Renters
are not responsible for these so
the coverage is not included.
Renter’s insurance always
includes personal property
coverage C to protect the
insured’s belongings.
4. What perils are included under
standard basic, broad form and
open peril coverage?
• Basic Coverage: Includes
coverage for 11 perils: fire and
lightning, windstorm and hail,
explosion, riot and civil
commotion, vehicles, aircraft,
smoke, vandalism and malicious
mischief, breakage of glass, theft,
and volcanic eruption.
• Broad Form Coverage: In
addition to the 11 perils listed
above, broad form covers falling
objects; weight of ice, snow, or
sleet; damage resulting from
heating or air conditioning
systems; accidental discharge or
overflow of water; freezing of
plumbing; and damage from
artificially generated electrical
 currents. It also expands
coverage for some of the basic
perils.
• Open Peril, or, All Risks
Coverage: Provides coverage for
all perils, unless they are listed
and specifically excluded. Some
perils always are excluded, so the
term all risks is not really
appropriate, because the policy
will never cover all risks.
5. How much would an insurance
policy reimburse a homeowner who
has a house valued at $400,000
insured for $300,000 after
experiencing a fire that causes
$20,000 in damage? The house
has an 80 percent coinsurance
provision and a $1,000 deductible.
 • Insurance would reimburse the
homeowner $17,750 as a result of
the coinsurance penalty for being
underinsured. Required insurance
is 80 percent of replacement
value or $320,000, and the house
is insured for 93.75 percent of the
required amount. To determine
the amount that will be
reimbursed, divide $300,000 by
$320,000 and multiply the loss
amount by the result, then
subtract the deductible: $300,000
/ $320,000 = .93.75 x $20,000 =
$18,750 - $1,000 = $17,750.
6. How does actual cash value
compare to replacement cost
coverage?
• In the event of a total loss, a
replacement cost policy will
 reimburse a policyowner the
amount required to replace the
property up to policy limits. Actual
cash value is the replacement
cost minus depreciation.
7. Why would a homeowner want a
policy with a guaranteed
replacement cost provision instead
of a simple replacement cost
provision?
• While a homeowner may be
adequately covered by having
insurance equal to 80 percent of
the replacement cost of the home,
he or she may have a substantial
out-of-pocket expense if the home
is destroyed. There also are
circumstances where even 100
percent coverage may not be
adequate. When a natural
 disaster strikes, such as a
hurricane, the cost of rebuilding
may increase due to the lack of
building materials and/or shortage
of skilled labor. When this
happens, the replacement cost is
often higher than the insurance
amount. A guaranteed
replacement cost benefit takes
care of this problem.
8. What is the problem with basic
personal property coverage
included in a standard homeowners
policy and what can help solve it?
• Standard homeowners policies
typically cover personal property
at 50 percent of the dwelling
coverage. With the cost of
furniture, rugs, clothes, appliances
(not permanently installed),
 books, etc., this level of coverage
may be inadequate. Further, most
homeowner’s policies provide only
limited coverage for personal
property with higher value. A
personal property endorsement or
inland marine policy can help to
solve this problem.
9. On what basis is inland marine
insurance usually written?
• Inland marine insurance usually is
written with open perils coverage.
Coverage may be written with little
or no deductible, or, depending on
the insurer and the insured’s
wishes, a higher deductible.
Additionally, coverage usually is
for a stated (appraised) value
rather than the replacement cost
 or actual cash value (i.e.,
depreciated value).
10. What is the main difference
about the medical payments
coverage on a motor vehicle
insurance policy compared to
coverage on a homeowners policy?
• On a motor vehicle (car) policy
coverage does not come under
the liability insuring agreement,
covered expenses are for the
insured, family members, and
occupants of the insured vehicle
(this is exactly opposite of
homeowner coverage, where this
protection does come under the
liability insuring agreement, and
does not cover any family
member).
11. How does a standard car
insurance policy define the
insured?
• The policy defines the insured as
being:
• The named insured or any
family member (living in the
insured’s household)
• Any person authorized to use
the covered car
• Any person authorized by the
insured to drive the covered
vehicle
12. How does civil liability compare
with criminal liability?
• Civil liability is different than
criminal liability, and is the result
of one individual or entity being
held accountable for causing
 financial loss to another. Criminal
liability is the result of violating a
jurisdiction’s laws, and may result
in prosecution and legal penalties
(e.g., imprisonment). Actions by
an individual may result in both
civil and criminal proceedings,
and the person may be held both
civilly and criminally liable (with
penalties assessed from both
aspects).
13. What is a tort and how does it
relate to liability?
• A tort happens when someone
causes harm (physical, emotional
or financial) to another person.
Legally, the person causing harm
is called a tortfeasor. A tort either
may be intentional or
unintentional. In almost all cases,
 the individual intentionally causing
harm cannot be protected by
insurance. Liability insurance only
covers unintentional torts. Torts
are civil rather than criminal. This
means that torts are not
necessarily considered breaking
the law. Instead, torts focus on
financial damage.
14. What are absolute and
vicarious liability and how may they
be applied to employers?
• Absolute liability refers to a
standard imposed when there is
no specific way to show
negligence. Employers may be
held liable to an employee by
application of absolute liability.
Vicarious liability is when one
person is held liable for the acts of
 another person. Parents may be
considered liable for things their
children may do that cause
financial harm to another person.
Vicarious liability may also be
applied to employers if one
employee harms another.
15. How does an umbrella liability
policy differ from a standard liability
policy?
• Most individuals obtain liability
insurance through their
homeowners and motor vehicle
policies. Many people want more
protection than the typical
homeowners or motor vehicle
policy offers. Rather than merely
increase the coverage on the
other two policies, an individual
might obtain an umbrella liability
 policy. This is sometimes called
catastrophic liability insurance.
While a basic liability policy (CPL)
may have low coverage limits, an
umbrella policy has very high
coverage limits. Umbrella, or
excess liability, policies take over
where basic policies stop. Thus,
the insured person can get
protection against potential
liabilities resulting from financial
awards that are quite high.
16. What are the two basic types
of professional liability coverage
and which professionals use either
type?
• Malpractice and errors and
omissions insurance are the two
forms of professional liability
coverage. Medical professionals
 use malpractice coverage and all
others use errors and omissions.
17. What are the two broad
divisions in life insurance types?
• Life insurance is offered either as
a term policy, which covers the
insured for a specified period, or a
permanent policy which covers
the insured throughout life.
18. How would you describe the
way a regular term life insurance
policy works?
• Regular term policies offer a level
death benefit and a level premium
over the policy term and typically
are renewable each year at
increasing rates after the initial
term.
19. What does an insurer do to a
term life insurance policy so that it
can cover an insured for his or her
entire life?
• Insurers can accomplish this
because permanent policies
retain a portion of the premium in
the form of cash value, which
helps offset the increasing cost of
insurance as the insured ages. To
build this cash value, the initial
premium for permanent policies is
quite a bit higher than what a term
policy would cost for the same
amount of death benefit protection
at the same issue age.
20. Where is the cash value
invested in a whole life insurance
policy; a universal life policy, a
variable universal life policy?
 • With whole life policies, the
insurance company invests the
cash value in the company’s
general account, which consists
primarily of a very conservative
real estate and bond portfolio.
Universal life policies invest the
cash value in interest-bearing
investments, such as money
market funds rather than the
general account. Variable
universal life policies invest the
cash value in the equivalent of
collective (mutual fund)
investments.
21. Why are universal life
insurance policies called unbundled
and why are they also known as
flexible premium adjustable life
policies?
 • Universal life (UL) policies are
often referred to on the policy as
flexible premium adjustable life.
They have the same elements as
a whole life policy, but unbundle
the components—mortality
charges, expense charges, and
interest rates—and keep them
separate. Rather than the fixed
premiums associated with whole
life, conventional universal life
allows for some flexibility in the
amount of premium paid. In fact,
flexibility is probably the real
distinction of UL.
22. What is the main difference between
universal life type I or A and Type II or
B policies?
• UL Type I or A policies have a
level death benefit. UL Type II or
 B policies have a death benefit
that increases along with the cash
value. Technically, the
policyowner pays for a one-year
term insurance policy in the
amount of that year’s cash value.
At death, both amounts will be
paid.
23. How does variable life (VL) compare
with variable universal life (VUL)?
• VL compares to VUL in the same
general way as whole life
compares to UL. VL policies are
bundled and fixed. VUL policies
are unbundled and flexible. VL
policies invest the cash value in
various sub-accounts, while VUL
invests in the equivalent of mutual
funds.
24. What are the two main types of joint
life policies and when would you use
either one?
• First-to-die policies cover two or
more individuals and pay the
death benefit when the first
covered person dies. This makes
them ideal tools to fund business
buy-sell agreements. Second-to-
die (or last-to-die) policies cover
two people as well, but do not pay
a death benefit upon the first
death. Instead, these policies pay
the death benefit after both
individuals pass away. As a result,
they are also known as
survivorship policies. This unique
feature makes the product a good
estate management tool when a
couple wishes to provide liquidity
for estate taxes or to leave a
 specific bequest upon the second
death.
25. What three potential parties exist in
a life insurance policy?
• The policyowner owns the policy.
The owner may or may not be the
insured. The insured is the
individual (or sometimes
individuals) covered by the policy.
When the insured dies, the policy
pays a death benefit. The
beneficiary (sometimes more than
one) receives payment of the
policy proceeds on the death of
the insured. All three entities may
be involved—owner, insured,
beneficiary—or fewer. In fact,
there may be only one party
involved in a contract, who is
 owner, insured, and beneficiary
(i.e., the estate of the insured).
26. How do the grace period and
reinstatement provision of a life
insurance policy relate?
• The grace period is the term,
usually 30 or 31 days, after the
life insurance premium is due.
Technically, if the premium is not
paid on the due date, the contract
will lapse. However, the grace
period allows the contract to
remain in full force. The
reinstatement provision allows the
policy to be reinstated following
lapse (following the grace period).
Past due premiums must be paid
and the insured normally must
provide current evidence of
insurability. However, no
 insurance coverage will have
been in place from the date of
lapse to the date all reinstatement
requirements are submitted,
assuming the reinstatement is
granted.
27. What are the nonforfeiture options of
a standard cash value life insurance
policy?
• When you own a cash value
insurance policy and decide that
you no longer wish to continue to
pay premiums on it, you have
several options. Over the years of
ownership, the policy builds
reserves. Since the owner
contributed to the reserves that
have built up in the cash value
account, these options allow the
owner to not forfeit those
 reserves, thus the term
nonforfeiture options. The three
options are cash, paid-up reduced
amount and extended term
insurance.
28. Why should a policyowner be careful
when thinking about making a
beneficiary irrevocable?
• A beneficiary designation can be
revocable or irrevocable. Most
beneficiary designations are
revocable, meaning the owner
can change beneficiaries at will.
An irrevocable designation cannot
be changed without receiving
permission from the beneficiary in
writing. An irrevocable beneficiary
must approve any contract
changes before they can be
implemented. The owner may not
 change beneficiaries, borrow
against the policy, surrender the
policy, or assign it absolutely or
collaterally without the irrevocable
beneficiary’s written permission.
29. What are five dividend payment
options with a participating life
insurance policy?
• Dividends may be:
• Taken in cash
• Left to accumulate at interest
with the insurance company
• Applied toward premium
payments
• Used to purchase paid-up
additions (PUAs) to the
insurance policy
• Used to purchase one-year
term insurance (also called the
fifth dividend option)
30. Other than simple rules of thumb,
what two methods are used to
determine the amount of life insurance
an individual may need?
• The human life value and needs-
based methods may be used.
31. Using the capital retention method,
and assuming there is no existing life
insurance available, how much
insurance cover would an individual
require who wants beneficiaries to
have an additional $75,000 annual
income that increases by the rate of
inflation each year? Assume a real
(inflation-adjusted) rate of 2.9126
percent.
• An individual would require
$2,575, 019 to provide the
inflation-adjusted equivalent of
$75,000 annual income for
 however long it will be needed. To
arrive at the amount, divide
$75,000 by .029126. The principal
will never be diminished.
32. How much life insurance must an
individual purchase today to fully fund
college education costs for a 10-year
old child who will enter a four-year
university program at age 18? Assume
current first-year expenses of $20,000,
five percent tuition inflation and a
seven percent discount rate, with all
funds available at the beginning of
college.
• To fully fund education expenses,
the individual will need to
purchase life insurance in the
amount of $66,887 (rounded).
First, inflate $20,000 by five
percent for eight years until the
 child enters university (8N, 5I/YR,
20,000PV, FV = $29,549.11).
Next, calculate the real (inflation-
adjusted) rate ([1.07/1.05]-1 X
100 = 1.9048). Use this rate to
determine the amount required in
the future to fund four years of
college (4N, 1.9048I/YR,
29,549.11PMT, PVAD =
$114,923.62). Finally, solve for
the amount of insurance cover
needed today to fund the future
education need (8N, 7I/YR,
114,923.62FV, PV = $66,886.60).
33. What is the fundamental difference
between annuities and life insurance?
• Annuities have been called the flip
side of life insurance. Life
insurance protects against the risk
of dying too soon, while annuities
 protect against the risk of living
too long.
34. Under normal circumstances, how
many times may a policyowner change
the payment options once a contract is
annuitized?
• The policyowner cannot make any
changes. Annuitization is
generally irrevocable. Once
payment begins, no option exists
to reverse the decision and
retrieve the principal.
35. How may a variable annuity address
inflation-related concerns?
• Fixed annuities provide annuity
payments that do not change and
are therefore subject to
purchasing power risk. Variable
annuities, because they are
 invested in securities, may
provide a solution because
investment returns may keep
pace with inflation growth, thereby
maintaining purchasing power.
36. What happens to annuity payments
under a single (or straight) life
annuitization or settlement option
when the beneficiary dies, and how
can the refund option solve the
problem?
• Single life income payments
cease when the beneficiary/owner
dies and the insurance company
retains all remaining payments.
Several options can help solve
this problem, one of which is the
refund option. Under this option,
the contract will refund any
remaining principal and earning
 left in the contract at the end of
the annuity period (when the
annuitant dies).
37. How is the period certain option
different from the fixed amount payout
option?
• With the period certain option
annuity payments continue for at
least a minimum number of years
based on the sum in the account.
The fixed amount options makes
payments in a fixed amount for as
long as the principal and earnings
last.
38. In what way are deductibles on
homeowners, motor vehicle and health
insurance policies different?
• Deductibles in each policy type
have the same function. They are
an amount that must be paid prior
to receiving policy benefits. Not all
benefit payments require a
deductible, but where applicable,
any deductible also serves as a
type of risk retention. Automobile
and health insurance deductibles
are factored into the claim
payment calculation on the front
end, before making the remaining
benefit calculation. Homeowners
policy deductibles are subtracted
from the back end of the claim
payment calculation. The
calculation is determined first and
the deductible amount is
subtracted from what would have
been paid. Finally, a policyowner
may satisfy a health insurance
policy deductible at some point,
and not have to pay any further
 deductible for the rest of the year,
at which point the deductible
resets. This is not true for motor
vehicle or homeowner insurance
policies.
39. How are copayments different than
coinsurance?
• Coinsurance is a percentage of
the expenses that are paid by the
insurance company once the
deductible has been met for
covered services. The insured is
responsible for a percentage of
bill payment and the insurer is
responsible for its share. When
the coinsurance percentage
amount has been satisfied, the
insurer will pay 100 percent of
remaining covered claim amounts.
Copayments are set amounts the
 policyowner will pay for covered
services each time a service is
provided, regardless of deductible
or coinsurance amounts.
40. In a managed care health plan, what
is a gatekeeper?
• The gatekeeper is the primary
care physician. Under normal
circumstances, when seeking
medical care, patients first must
see the primary care physician.
He or she will determine the
recommended course of action,
including whether the patient
should be referred to a specialist.
Since patients nearly always must
first go through the primary care
physician (except in
emergencies), he or she has a
 great deal of control over the
healthcare services received.
41. What is the biggest coverage
difference between HMOs and PPOs?
• HMOs do not pay for medical
services received outside their
network. PPOs also have a
network, but also often will pay a
reduced amount for out-of-
network services.
42. Why might someone who has good
healthcare insurance also benefit from
having a long-term care (LTC)
insurance policy?
• LTC insurance is specifically
designed to pay for long-term or
extended care needs. Most often,
regular health insurance coverage
 does not apply to or pay for long-
term or extended care expenses.
43. What is the highest level of LTC and
the second highest level?
• Skilled nursing care is the highest
level of care and generally refers
to 24-hour-a-day availability of a
registered nurse under a doctor’s
supervision. Intermediate care
refers to less-intensive nursing, or
rehabilitative care, and is the
second highest level of care. This
level of care doesn’t require 24-
hour availability of a registered
nurse or physician.
44. What are activities of daily living
(ADLs) and how do they apply to LTC
insurance policies?
 • Insurance companies often use a
list of ADLs to determine when
coverage will be triggered. The
typical list of ADLs includes:
bathing oneself, feeding oneself,
transferring (say, from a chair to a
bed or vice versa), dressing
oneself, using the bathroom, and
maintaining continence. When it is
determined that an individual can
no longer perform any two of
these ADLs (usually by a
physician), they are eligible for
benefits under the policy. Mental
impairment such as Alzheimer’s
disease or dementia can trigger
benefits if either of these issues
alone is diagnosed.
45. What is the elimination period found
on most LTC and disability income
insurance policies?
 • The elimination period has the
same function with both policy
types. It is the period, following
initial diagnosis and treatment,
when no benefit payments are
available to the policyowner. A
typical elimination period lasts for
90 days, but may be shorter or
longer. The elimination period is
similar to a policy deductible.
46. How much benefit will a normal LTC
insurance policy pay for expenses
incurred when a family member
provides LTC care services, and what
is one solution?
• Typically, the insurer will pay no
amount for services provided by a
family member. Some policies
include a respite care benefit that
allows the caregiver to take a
 break from caregiving by paying
for another caregiver to step in.
47. Why do some individuals refer to
disability as a living death?
• A disability can cause significant
medical expenses in addition to
the disabled person not being
able to fully function or earn an
income. As a result, some have
referred to disability as a living
death.
48. What are three of the most important
disability insurance considerations?
• Benefit amount, benefit period
(including the elimination period)
and definition of disability.
49. What is the difference between a
partial and a residual disability benefit?
• After a period when the insured is
totally disabled, he or she may
have recovered enough to return
to work on a part-time basis. Most
policies allow for a reduced,
partial, benefit to be paid, such as
50 percent of the full benefit
amount, if the insured returns to
work, but is still unable to work full
time. Similar to a partial disability
provision, a residual disability
provision allows for a lesser
amount of benefits to be paid if
the insured is able to return to
work in some capacity. The
difference is that partial disability
is generally paid for a shorter
period when the insured cannot
work full time, whereas residual
disability benefits may be payable
for the entire benefit period if, as a
 result of the disability, the
insured’s income is reduced even
when working full time. The
reduction in income usually must
be greater than a stated
percentage of gross earnings,
such as 20 percent.
50. What are the four primary disability
definitions used in a policy?
• At any occupation: This
definition is the most restrictive
and says that, to be considered
disabled, the insured must not be
able to work in any occupation.
For example, under this definition,
an electrician or a doctor who is
disabled to the point of not being
able to do his or her regular job,
but is able to work at a fast-food
restaurant at a significant loss of
 income, would not receive any
benefits.
• In any occupation for which the
person might be (or might
become) qualified: This is a
modified any occupation definition
and is somewhat less restrictive in
that it puts a limit on the types of
work a person would be expected
to do. This definition may also
include terms that take into
consideration the insured’s prior
education, training, or experience.
• In his or her own
occupation: This definition is the
most liberal because it says that a
person will be considered
disabled if he or she is unable to
work at his or her own prior
occupation. As an example, a
surgeon who becomes disabled to
 the point of not being able to do
surgery would be considered
disabled even if eventually
employed as an instructor at a
medical school. This additional
provision is sometimes
accomplished by the insurer
issuing a letter, known as a
specialty letter, modifying the
terms of the policy. Some
companies may issue a policy
rider to provide this level of
coverage. Changes within the
disability income insurance
industry have made the own
occupation provision less
available than it was only a few
years ago.
• Split definition: Many insurance
companies, especially in group
coverage where there is little or
 no underwriting, make available a
split definition of disability. A split
definition typically uses the liberal
own occupation definition for a
specific time (often the first two to
five years of disability), after which
a stricter modified own occupation
definition or any occupation
definition takes effect for the
duration of the benefit period.
51. In what way is a loss-of-income
policy different from other disability
income policies?
• A loss-of-income policy pays a
benefit if the loss of income is due
to illness or injury, even if the
insured continues to work. The
insured need not be fully disabled.
The duties or occupations in
which the insured can engage are
 not significant factors. If, as a
result of injury or sickness, the
insured suffers a loss of income,
benefits based on that loss are
payable regardless of whether the
insured returns to work and
regardless of the occupation.
52. How is a noncancelable renewal
provision different from a guaranteed
renewable provision?
• The two are similar, but not
identical. Noncancelable means
that not only can the insured
renew the policy for the full term
specified in the policy (the same
as under guaranteed renewable),
but the company cannot change
the premium from what is stated
in the contract. A guaranteed
renewable provision allows the
 insurer to increase the premium
for an entire policy class, which
may include the policyowner.
53. What is the general purpose of key
person insurance, whether life or
disability?
• A key person is vital to the
operation and ongoing success of
a business. The business wants
to protect itself in case of the key
person’s death or disability. To do
so, and to provide funding to
support the business while it
adjusts, the business may
purchase life and/or disability
insurance cover on the key
person.
54. How is business overhead expense
insurance different from standard
 disability insurance cover on an
individual?
• Business overhead expense
insurance cover is not a
replacement for personal disability
income insurance. Instead, it is
specifically designed to provide
income to the business for a
period so it can remain viable and
pay salaries and other expenses.
Like all disability policies, there is
an elimination or waiting period
before payment of benefits, but it
is usually shorter than for
personal disability policies. Benefit
period usually do not exceed two
years.
55. What type of liability exposure is not
covered by either a comprehensive
 personal liability policy (CPL) or
business/commercial liability policy?
• Liability exposure from motor
vehicles is not covered by
standard liability policies. To get
coverage, the individual or
business must purchase motor
vehicle liability insurance
coverage. When umbrella policy
underlying coverage includes
motor vehicle liability, the
umbrella policy will cover motor
vehicle liability.
56. Why might a person sitting on a non-
profit organization board require
liability coverage?
• Individuals who sit on nonprofit
boards can be held liable for the
organization’s activities. People
may sit on the boards of religious
 institutions, hospitals or other
medical associations, community
associations and similar. In most
cases, board members’ personal
liability insurance cover will not
protect them for this type of
liability. A directors’ and officers’
liability policy (sometimes known
as directors’ and officers’ errors
and omissions insurance) will help
to cover this exposure.
Chapter 4 Review Answers
1. What are the primary factors to
include when evaluating an
insurance company for possible
use?
• When selecting an insurance
company, it’s important to choose
one that is known for having good
customer service. Equally, if not
 more important, is choosing a
company that offers the type of
insurance cover your client needs
at a competitive price point,
having good underwriting
processes. When you identify
several companies that offer the
insurance cover for which you are
looking, it’s a good idea to be a
wise consumer and price-shop.
Prices can vary significantly. A
company’s history also must enter
the picture. How financially
solvent and stable is the company
is one of the most important
factors to consider.
2. What are the four main rating
agencies and what type of rating do
they provide?
 • The four are Standard and Poor’s,
Moody’s, Fitch, and A.M. Best.
Each of these organizations rate
insurer’s financial stability and
well-being.
3. What is a company’s lapse ratio and
how does it apply to insurer evaluation
and selection?
• Lapse ratio is an indicator of how
a company treats its policyholders
is its lapse ratio. The lapse ratio
represents the percentage of
policies that are terminated each
year out of all policies in force.
This is known as the company’s
persistency (agents also have
persistency ratings). It is important
to look at a company’s
persistency relative to that of the
industry. If a company’s lapse
 ratio is high (10% or more), some
effort should be made to
determine why. It may be an
indication of poor results relative
to illustrated values or unusually
high premiums. It may reflect poor
service after the sale of a policy.
In the worst case possible, it may
indicate that the company is
experiencing financial difficulties
and policyholders are leaving to
protect their policy values.
4. What are some of the factors to
include when evaluating an insurance
agent?
• Consider an agent’s level of
competence and inclination to
provide good service. Also learn
about experience, training and
education. Find out whether the
 agent has a history with a
particular specialization area.
Also, learn about an agent’s
overall reputation.
5. What is the difference between
express and implied agent authority?
• Express authority is identified in
the agent’s contract with the
insurer and typically identifies
exactly the scope of activities the
agent is authorized to undertake
on behalf of the insurer. Implied
authority is not expressly granted,
but is authority the agent is
assumed to have as he or she
does business in the insurer’s
name. Practically, implied
authority relates to areas such as
collecting premiums, completing
applications, ordering medical
 exams, and the like. These things
are not usually spelled out in the
contract, but are a necessary part
of doing business.
6. Will an insurer usually be liable when
an agent abuses apparent or
ostensible authority?
• Yes, the acts of an agent legally
bind the insurer. The insurer may
press charges against the agent,
but that will not negate its
responsibility to honor policy
terms.
7. What is the primary concern of
securities industry as well as insurance
industry regulators?
• Securities industry regulators are
primarily concerned with
investment company solvency.
Many of their rules and
regulations target requirements
designed to enforce prudent
company management and
disciplines financial operations.
Additionally, regulators develop
regulations for people who
interact with the public to ensure
they do so ethically and with
compliance on relevant
regulations. Insurance industry
regulators have the same
concerns and areas of oversight.
The insurance industry is vested
in the public interest. Individuals
purchase insurance to protect
themselves against financial loss
at some time in the future. Public
welfare mandates that the insurer
promising to indemnify insureds
 for future losses fulfills its
promises.
Chapter 5 Review Answers
1. Why is it important for a financial
advisor to assess an individual’s
exposure to financial risk?
• Risk management requires
recognizing the risk areas to
which an individual may be
exposed. A financial advisor
cannot simply say that a client
might be exposed to all possible
risks, therefore he or she should
protect against that possibility.
This is neither practical nor
possible. Plus, where risk transfer
is required, excess amounts of
insurance can quickly run through
available cash flow.
2. What questions are good to ask when
evaluating insurance coverage on
high-value fine art collections?
• Was a professional appraisal
used to establish the item’s
current value?
• Would the insured be required to
replace or repair an item, or would
the policy allow for a cash
payment option?
• Would items such as antiques be
covered for full value, or would
they be depreciated?
• Would new items automatically be
covered, and if so, for how much
and for how long?
• Are items covered when they are
outside the home (perhaps on
display at a museum or other
venue)?
 • Would items be covered in full
when they are in other residences
or in transit?
3. What are six final expense areas to
address when considering potential life
insurance needs?
• Funeral costs
• Unpaid medical expenses
• Outstanding loans and debts
• Some debts may be forgiven at
death, but many require
repayment.
• Loans in joint names (e.g.,
husband and wife) may
transfer to the remaining joint
holder. However, that
individual must be financial
able to continue repayment.
• Estate-settlement costs
 • Adjustment period fund
• It can be difficult for
dependents to quickly adapt to
a significant change in income.
Further, available funds may
sometimes be temporarily tied-
up at death, creating an
income bottleneck until
released. An adjustment period
fund can help with this
process.
• Miscellaneous
• This is to cover any additional
expenses that may arise.
4. What are five potential income
categories to include as part of
determining ongoing income needs for
a surviving spouse and dependent
children?
 • Dependent income for the
children until they reach the age
at which they are able to live on
their own
• Additional income for the surviving
spouse while the children remain
in the home
• Funds to pay for education
expenses (primary, secondary
and higher)
• Funds needed to supplement
income for the surviving spouse
after children have left the home,
and before reaching retirement
age
• Supplemental retirement income
funds
5. What questions should a financial
advisor ask when evaluating existing
insurance coverage?
• What risk is the policy intended to
cover?
• As written, does the policy provide
the desired coverage?
• What is the upper limit of
coverage, and is this sufficient?
Should it be increased?
• What is the lower limit of
coverage? Should it, or any
deductibles, be raised?
• For how long is coverage or policy
payout expected to last? Is this
appropriate or should the term be
increased or decreased? For
example, is a disability income
policy with a five-year benefit
period sufficient?
• Are beneficiary arrangements in
good order? Do they coordinate
with any relevant legal
 documents, such as wills or
trusts?
• If there are different policies
addressing the same risk area, is
there too much overlap, or are
there still gaps in coverage?
• What are the renewal provisions,
and does the policy owner need
to be aware of any potential
renewal premium increases or
other problems?
• For healthcare coverage, are the
proper health conditions covered,
and in sufficient amounts?
• Is the life insurance coverage
sufficient, and is the policy type
appropriate? Do existing policies
need to be modified in any way?
• Do risk exposure gaps exist, and
can they (or should they) be
addressed through risk transfer?
 This is especially a concern with
liability risk exposures, and when
the individual is a professional, or
an employer, or a director / officer
of a company.
• If household staff is employed in
more than one location (and
perhaps different territories) are
all legal requirements satisfied?
• Is the policy cost effective and
issued by a financially sound
insurer?
6. What steps should a financial advisor
include as part of a risk management
strategy?
• Identify the risks
• Review (and inspect) current
situation
• Analyze the information
 • Select the most appropriate risk
management technique
• Implement the chosen
approaches
• Monitor results
Appendix 1: Provision for Dependents
When determining amounts of life
insurance required to provide for
dependents – normally children – the
best process is to work through a needs
analysis approach. This was discussed
in chapters three and five. In this
section, we will review the approach
using algebraic equations rather than a
financial calculator. Otherwise, the
approach remains the same. This
information comes from Australia and
reflects that environment. It mirrors the
content in this course almost exactly,
and will allow students to observe the
process in another territory along with
the global applicability of the related
content (Teale, 2014)[4].
Once it has been determined that life
insurance is required as part of a plan to
provide for dependents, the next step is
to determine how much life insurance is
required. This process is important
because buying too much life insurance
is expensive and diverts funds away
from other needed areas, like
investments. On the other hand, buying
too little life insurance could ultimately
prove disastrous. To avoid these
problems, a rigorous and accurate
method is needed to calculate how
much insurance is necessary. The
approach used by the financial planning
profession is called the ‘needs analysis’
and this is described next.
Needs Analysis
Needs analysis focuses on the actual
income needs that the dependents will
have if the income earner dies. A
family’s needs change over time, so an
advisor will need to re-examine the plan
periodically to check that the figures are
still sufficient. This method involves
three steps:
1. Calculate the total economic
resources required by the
dependents if the main income
earner were to die
2. Identify and quantify all financial
resources available after death,
including existing life insurances
and superannuation death benefits
3. Deduct available financial
resources from the amount needed
to arrive at the additional life
insurance required
Step 1: Assessment of Family’s Total
Economic Needs
This step requires the preparation of a
family budget of monthly expenditure
required to live a comfortable life. This
budget includes items such as expenses
for clothing, education, housing, food,
utilities, and dental and healthcare.
Other items would be insurance costs,
rates, recreation and travel. Children’s
needs change over time, consuming
considerable financial resources in the
early years but reducing substantially
once they have grown up
This step also involves calculating the
final expenses and the amount required
to liquidate any existing debt and to look
after any special needs. If there are
elderly dependents, then an allowance
may be necessary for the long-term care
of disabled or chronically ill dependents.
It may also be necessary to establish a
special fund for financial emergencies or
an education fund for the children’s
university education.
Step 2: Determine the Availability of
Financial Resources
Once the dependents’ financial needs
have been estimated, it is then time to
list all the available resources that can
be applied to meet these needs. These
could include money from savings,
investments, proceeds from employer-
sponsored group life insurance policies,
and from superannuation funds. There
may also be old whole-of-life policies
available that have a term life rider
attached to the policy. If the surviving
spouse is able to work, their earnings
will be an important resource for the
family. It may also be possible to
liquidate some assets such as jewelry,
real estate or other investments in order
to meet the financial needs. Once these
resources have been identified, it should
be possible to assign a reasonable
estimate of their value.
Step 3: Calculation of additional life
insurance requirements
Finally, the total value of resources
available is deducted from the total
needed to satisfy the dependents’
financial objectives. If the financial value
of the resources is greater than the
needs, then no further life insurance is
needed. However, if the resources are
less than the needs, then the difference
represents the amount of life insurance
needed.
Where there is more than one income
earner, a separate calculation needs to
be made for each person. The need for
cover for each income earner should not
be overlooked. The mathematical
method used to calculate the amount of
life insurance needed to finance future
living is called the present value of an
annuity.
Present Value of an Annuity Calculation
This calculator is used to determine
what a future income stream is worth in
today’s dollars. This is done by using
the following formula:

Where: PV = present value

PMT = periodic payment
amount
n = number of compounding
periods
i = interest (or, discount rate)
The PV of an annuity formula is used to
calculate how much a stream of
payments is worth currently where
‘currently’ does not necessarily mean
right now but at some time prior to a
specified future date.
In practice the PV calculation is used as
a valuation mechanism. It evaluates a
series of payments over a period of time
and reduces or consolidates them into a
single representative value at a certain
date.
Note however that the PV of an annuity
formula does not inherently take into
account the effect of inflation. The value
mechanism for the current value of a
stream of future payments is the time
value of money as represented by
prevailing market interest rates, not the
inflation rate.
The PV of the annuity equation above
can be rearranged algebraically to solve
for the payment amount (PMT) that will
amortize (pay off) a loan or equate to a
current sales price.
The formula above assumes an ordinary
annuity, one in which the payments are
made at the end of each compounding
period. An annuity-due is one in which
the payments are made at
the beginning of the compounding
period.
Distinction Between an Ordinary Annuity
and an Annuity-due
Each payment of an ordinary
annuity belongs to the payment
period preceding its date, while the
payment of an annuity-due refers to a
payment period following its date.
The meaning of the above statement
may not be immediately obvious until it
is looked at it graphically (Teale, 2014).
A more simplistic way of expressing the
distinction is to say that payments made
under an ordinary annuity occur at the
end of the period while payments made
under an annuity due occur at the
beginning of the period.
A third possibility is to define an annuity
due in terms of an ordinary
annuity: an annuity-due is an ordinary
annuity that has its term beginning and
ending one period earlier than an
ordinary annuity. This definition is useful
because this is how an annuity due is
computed, i.e., in relation to an ordinary
annuity (discussed below).
Most annuities are ordinary annuities.
Instalment loans and coupon bearing
bonds are examples of ordinary
annuities. Rent payments, which are
typically due on the day commencing
with the rental period, are an example of
an annuity-due.
Note that an ordinary annuity is
sometimes referred to as an immediate
annuity, which is unfortunate because it
implies that the payments are made
immediately (ie, at the beginning of the
period, which would be the case with an
annuity-due). However, ordinary
annuity is the more widely used term.
Calculating the Value of an Annuity Due
An annuity due is calculated in
reference to an ordinary annuity. In
other words, to calculate either the
present value (PV) or future value (FV)
of an annuity-due, the value of the
comparable ordinary annuity is
calculated and multiplied by a factor
of (1 + i) as shown below.
AnnuityDue = AnnuityOrdinary x (1 + i)
This makes sense because if the earlier
definitions are considered, it can be
seen that the difference between the
ordinary annuity and the annuity due is
one compounding period.
Note also that the above formula implies
that both the PV and the FV of an
annuity due will be greater than their
comparable ordinary annuity values.
The following examples illustrate the
mechanics of the ordinary annuity
calculation and subsequent annuity due
calculation.
Present Value of an Annuity
Using the present value of an
annuity calculation formula above, the
PV of an ordinary annuity of $50 per
year over three years at 7% can be
expressed as follows
and the present value of an annuity
due under the same terms is calculated
as

In this example, the PV of the annuity

due is greater than the PV of the
ordinary annuity by 9.18.
Putting it All Together
The application of the needs approach
is illustrated in the following example
(Teale, 2014).
Illustrated example
The Morrison family has sought advice
on the amount of life insurance cover
needed to fully protect their family. John
Morrison, aged 32, is an architect who
has been in his own business for 12
months. His wife, Anna, aged 30, is a
full-time homemaker. They have two
children: Simon, aged four, and Kathy,
aged two. John earned $100,000 in
wages in his first year in business, with
an after-tax income of approximately
$72,000.
The family’s living expenses are $5,200
per month. Of this, each parent uses
$600 for personal expenses and $2,500
is used for household expenses and a
further $1,500 per month in mortgage
repayments. The amount owing on
credit cards is $6,000. John’s car is
leased through his business and Anna’s
car is owned outright.
The Morrisons’ house is valued at
$500,000 and has a mortgage of
$250,000. They want their two children
to attend a private school for their high
school years and then university. They
estimate that schooling will last from
age 13 to 25 and cost, on average,
$10,000 per year.
If Anna were to die prematurely, it is
anticipated that John would need to
spend $600 per month on assistance in
raising the children. John’s only
personal insurance is a term life cover
for $350,000, while Anna does not have
any life insurance. The calculation for
the sum insured would be:
Clean-up expenses
Funeral and other
expenses $15,000
Final medical
expenses $20,000
Mortgage
repayment $250,
000
Credit
cards $6,000
Readjustment
expenses $25,000
Taxes $
5,000
Total $32
1,000
Plus: dependents’ support
Anna
Anna’s life expectancy is approximately
83 years of age, so she will be a
dependant for the longest time.
Household expenses are $2,500 per
month and Anna’s personal expenses
are included in her calculations. The
mortgage repayments will cease, so
expenses can be reduced by $1,500.
The annual amount required is:
[($2,500 + $600) − $1,500] × 12 =
$19,200.
Anna is likely to live to age 83, so she
will need to be provided for a total of 53
years. Therefore, using the present
value of an annuity formula and a
discount rate of four per cent, the
amount required is $419,955.
Children
The children will need to be provided for
until age 25, for which an amount of
$600 per month has been allowed.
Simon needs to be provided for 21
years and Kathy for 23 years. A
separate calculation will need to be
made for each child to age 25. Using
the present value of an annuity formula
and a discount rate of four per cent, the
amount required per child is $207,979.
In addition, education expenses of
$10,000 per annum per child from 13 to
25 have been allowed. The children’s
education requirements come to:
$10,000 × 24 = $240,000.
Total insurance requirements
Anna $4
19,955
 Children’s
care $207,979
Children’s
education $240,00
0
Clean-up
expenses $321,00
0
Total sum
insured $1,188,340
Less: existing
insurance $350,000
Amount of insurance
required $838,934
Term life insurance cover of $838,934
needs to be arranged on the life of
John. However, should John already
have some life insurance, for example
contained in his superannuation
(retirement) plan then this needs to be
deducted.
Life Insurance for a Non-Income Earner
During this analysis, the value of the
homemaker should not be overlooked,
especially when there are young
children. If the homemaker were to die
or become totally disabled, then the
family’s financial situation could be
severely compromised. It may be
necessary for the surviving spouse to
pay for childcare or for specialist nursing
for the disabled spouse. These costs
would also have to be considered and
life insurance arranged to cover them.
In the previous example, if Anna were to
die prematurely, then John’s income
would be sufficient to meet normal
family needs. However, the children
would need to be taken care of until age
13 and the amount allowed was $600
per month. This means that Simon
would need care for nine years and
Kathy for 11 years.
Childcare needs: Using the present
value of an ordinary annuity a term life
policy for an amount of $116,609 or
more likely $120,000 (rounding) should
be arranged on the life of Anna.
It is important to realize that life
insurance needs do not stay the same
forever, because the family situation
changes over time. An advisor should
conduct regular reviews, particularly
when important life events take place,
such as a promotion for the
breadwinner, a new job, a new baby or
an increase in debt.
Effect of Inflation on the Life Insurance
Payout
The calculation of the death cover
insurance requirements for the
Morrisons (see illustrated example) has
ignored the eroding effects of inflation.
The proceeds from the insurance
policies are calculated to meet future
needs, but they may prove to be
inadequate when ultimately received.
For example, the Reserve Bank of
Australia indicates that historically the
inflation rate from 1951 to 2012 was 5.3
per cent. $100 worth of goods bought in
1997 cost $131.53 at an inflation rate of
5.6 per cent in 2007.
Alternatively, $1,000,000 life insurance
cover taken out in 1997 and paid out in
2007 would have a purchasing power of
$684,742 at an inflation rate of 5.6 per
cent. This is a significant reduction in
purchasing power, particularly as this is
not a particularly high inflation rate. So
the question arises as to how to allow
for the effects of inflation when it is not
possible to predict what inflation will be
over different periods.
The insurance proceeds will not all be
needed at once, as only a small portion
will be needed each year. Therefore, the
balance can be invested and interest
earned can be used to supplement the
invested funds. The interest earned will
help to offset inflation because, while
inflation cannot be predicted, interest
rates are historically higher than the
inflation rate. The interest income will be
subject to taxation, but future taxation
rates cannot be predicted so it is not
possible to allow for this charge. There
are other variables to consider, e.g., the
dependent spouse may decide to work
and so supplement the insurance
proceeds.
Using interest to offset the effects of
inflation is a reasonable approach given
the unpredictable variables that may
apply in the future. This approach
ensures that the required amount will be
available if and when it is needed.
[1] No annuity qualifies as life insurance.
Some contracts may offer a life
insurance rider as an option, and some
life insurance policy payouts may be
annuitized, but the annuity itself is not
life insurance. The two are
fundamentally different, even though life
insurers offer both.
[2] The income amount applicable to
Frieda and Emma, without Eva
[3] Based on Russell Investment’s Client
Engagement Roadmap (now FTSE
Russell; www.russell.com)
[4] As drafted and delivered by John
Teale, Melbourne, Australia, by
permission