PRINCIPLES OF

    RISK MANAGEMENT AND INSURANCE The Pearson Series in Finance

    BekaertHodrick

    International Financial Management

    BerkDeMarzo

    Corporate Finance

    BerkDeMarzo

    Corporate Finance: The Core

    BerkDeMarzoHarford

    Fundamentals of Corporate Finance

    Brooks

    Financial Management: Core Concepts

    CopelandWestonShastri

    Financial Theory and Corporate Policy

    DorfmanCather

    Introduction to Risk Management and Insurance

    EitemanStonehillMoffett

    Multinational Business Finance

    Fabozzi

    Bond Markets: Analysis and Strategies

    FabozziModigliani

    Capital Markets: Institutions and Instruments

    FabozziModiglianiJones

    Foundations of Financial Markets and

    Institutions

    Finkler

    Financial Management for Public, Health, and

    Not-for-Proi t Organizations

    Frasca

    Personal Finance

    GitmanZutter

    Principles of Managerial Finance

    GitmanZutter

    Principles of Managerial Finance—

    Brief Edition

    Goldsmith

    Consumer Economics: Issues and Behaviors

    Haugen

    The Inefi cient Stock Market: What Pays Off

    and?Why

    Haugen

    The New Finance: Overreaction, Complexity,and?Uniqueness

    Holden

    Excel Modeling in Corporate Finance

    Holden

    Excel Modeling in Investments

    HughesMacDonald

    International Banking: Text and Cases

    Hull

    Fundamentals of Futures and

    Options Markets

    Hull

    Options, Futures, and Other Derivatives

    Hull

    Risk Management and Financial Institutions

    Keown

    Personal Finance: Turning Money into Wealth

    KeownMartinPetty

    Foundations of Finance: The Logic and Practice

    of Financial Management

    KimNofsinger

    Corporate Governance

    Madura

    Personal Finance

    Marthinsen

    Risk Takers: Uses and Abuses of Financial

    Derivatives

    McDonald

    Derivatives Markets

    McDonald

    Fundamentals of Derivatives Markets

    MishkinEakins

    Financial Markets and Institutions

    MoffettStonehillEiteman

    Fundamentals of Multinational Finance

    Nofsinger

    Psychology of Investing

    OrmistonFraser

    Understanding Financial Statements

    Pennacchi

    Theory of Asset Pricing

    RejdaMcNamara

    Principles of Risk Management and Insurance

    Seiler

    Performing Financial Studies: A Methodological

    Cookbook

    SmartGitmanJoehnk

    Fundamentals of Investing

    SolnikMcLeavey

    Global Investments

    StretcherMichael

    Cases in Financial Management

    TitmanKeownMartin

    Financial Management: Principles and

    Applications

    TitmanMartin

    Valuation: The Art and Science of Corporate

    Investment Decisions

    WestonMitchelMulherin

    Takeovers, Restructuring, and Corporate

    Governance

    denotes MyFinanceLab titles Log onto www.myi nancelab.com to learn more George E. Rejda

    Michael J. McNamara

    TWELFTH EDITION

    Principles of

    RISK MANAGEMENT

    AND INSURANCE

    Boston Columbus Indianapolis New York San Francisco Upper Saddle River

    Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montréal Toronto

    Delhi Mexico City S?o Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Editor in Chief: Donna Battista

    Acquisitions Editor: Katie Rowland

    Editorial Project Manager: Emily Biberger

    Editorial Assistant: Elissa Senra-Sargent

    Director of Marketing: Maggie Moylan Leen

    Director of Production: Erin Gregg

    Managing Editor: Jeff Holcomb

    Associate Managing Editor: Karen Carter

    Senior Operations Supervisor: Evelyn Beaton

    Senior Operations Specialist: Carol Melville

    Art Director, Text and Cover Design: Jonathan Boylan

    Permissions Specialist: Samantha Graham

    Cover Photo: ShutterstockChudakov

    Media Director: Susan Schoenberg

    Full-Service Project Management: GEX Publishing Services

    PrinterBinder: Edwards Brothers Malloy

    Cover Printer: Lehigh-Phoenix ColorHagerstown

    Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook

    appear on the appropriate page within text.

    Copyright ? 2014, 2011, 2008 by Pearson Education, Inc. All rights reserved. Manufactured in the United States of

    America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to

    any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic,mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please

    submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River,New Jersey 07458, or you may fax your request to 201-236-3290.

    Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks.

    Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations

    have been printed in initial caps or all caps.

    Library of Congress Cataloging-in-Publication Data

    Rejda, George E.

    Principles of risk management and insurance George E. Rejda, Michael J. McNamara. -- Twelfth edition.

    pages cm

    Includes index.

    ISBN 978-0-13-299291-6 (casebound)

    1. Insurance. 2. Risk (Insurance) 3. Risk management. I. McNamara, Mike. II. Title.

    HG8051.R44 2014

    368--dc23

    2012049473

    10 9 8 7 6 5 4 3 2 1

    ISBN 10: 0-13-299291-4

    ISBN 13: 978-0-13-299291-6 v

    CONTENTS

    Preface xv

    PART ONE BASIC CONCEPTS IN RISK MANAGEMENT AND INSURANCE

    CHAPTER 1 RISK AND ITS TREATMENT 1

    D e i nitions of Risk 2

    Chance of Loss 3

    Peril and Hazard 4

    Classii cation of Risk 5

    Major Personal Risks and Commercial Risks 7

    Burden of Risk on Society 12

    Techniques for Managing Risk 12

    Summary 15 ■ Key Concepts and Terms 16 ■ Review Questions 16 ■ Application

    Questions 17 ■ Internet Resources 18 ■ Selected References 18 ■ Notes 18

    Case Application 15

    INSIGHT 1.1: FINANCIAL IMPACT ON DISABLED INDIVIDUALS CAN BE STAGGERING,SAYS NEW STUDY 9

    CHAPTER 2 INSURANCE AND RISK 19

    D e i nition of Insurance 20

    Basic Characteristics of Insurance 20

    Characteristics of an Ideally Insurable Risk 22

    Two Applications: The Risks of Fire and Unemployment 24

    Adverse Selection and Insurance 26

    Insurance and Gambling Compared 26

    Insurance and Hedging Compared 26

    Types of Insurance 27

    Benei ts of Insurance to Society 31

    Costs of Insurance to Society 32

    Summary 35 ■ Key Concepts and Terms 36 ■ Review Questions 36 ■ Application

    Questions 36 ■ Internet Resources 37 ■ Selected References 37 ■ Notes 37

    Case Application 35

    INSIGHT 2.1: INSURANCE FRAUD HALL OF SHAME—SHOCKING EXAMPLES OF INSURANCE

    FRAUD 33

    INSIGHT 2.2: DON’T THINK INSURANCE FRAUD IS COMMITTED ONLY BY HARDENED CROOKS 34

    Appendix Basic Statistics and the Law of Large Numbers 39

    CHAPTER 3 INTRODUCTION TO RISK MANAGEMENT 43

    Meaning of Risk Management 44

    Objectives of Risk Management 44

    Steps in the Risk Management Process 45 VI CONTENTS

    Implement and Monitor the Risk Management Program 54

    Benei ts of Risk Management 55

    Personal Risk Management 55

    Summary 58 ■ Key Concepts and Terms 59 ■ Review Questions 59 ■ Application

    Questions 59 ■ Internet Resources 60 ■ Selected References 61 ■ Notes 61

    Case Application 57

    INSIGHT 3.1: ADVANTAGES OF SELF INSURANCE 50

    CHAPTER 4 ADVANCED TOPICS IN RISK MANAGEMENT 62

    The Changing Scope of Risk Management 63

    Insurance Market Dynamics 68

    Loss Forecasting 71

    Financial Analysis in Risk Management Decision Making 76

    Other Risk Management Tools 78

    Summary 81 ■ Key Concepts and Terms 82 ■ Review Questions 82 ■ Application

    Questions 82 ■ Internet Resources 82 ■ Selected References 83 ■ Notes 84

    Case Application 80

    INSIGHT 4.1: THE WEATHER DERIVATIVES MARKETS AT CME GROUP: A BRIEF HISTORY 73

    PART TWO THE PRIVATE INSURANCE INDUSTRY

    CHAPTER 5 TYPES OF INSURERS AND MARKETING SYSTEMS 86

    Overview of Private Insurance in the Financial Services Industry 87

    Types of Private Insurers 88

    Agents and Brokers 93

    Types of Marketing Systems 95

    Group Insurance Marketing 98

    Summary 99 ■ Key Concepts and Terms 99 ■ Review Questions 99 ■ Application

    Questions 100 ■ Internet Resources 100 ■ Selected References 101 ■ Notes 102

    Case Application 98

    INSIGHT 5.1: SHOW ME THE MONEY—HOW MUCH DO INSURANCE SALES AGENTS

    EARN? 94

    CHAPTER 6 INSURANCE COMPANY OPERATIONS 103

    Insurance Company Operations 104

    Rating and Ratemaking 104

    Underwriting 105

    Production 108

    Claims Settlement 108

    Reinsurance 110

    Alternatives to Traditional Reinsurance 115

    Investments 116

    Other Insurance Company Functions 117 CONTENTS VII

    Summary 119 ■ Key Concepts and Terms 119 ■ Review Questions 119 ■ Application

    Questions 120 ■ Internet Resources 121 ■ Selected References 121 ■ Notes 122

    Case Application 118

    INSIGHT 6.1: BE A SAVVY CONSUMER—CHECK THE INSURER’S CLAIMS RECORD BEFORE

    YOU BUY 111

    CHAPTER 7 FINANCIAL OPERATIONS OF INSURERS 123

    Property and Casualty Insurers 124

    Life Insurance Companies 130

    Rate Making in Property and Casualty Insurance 131

    Rate Making in Life Insurance 135

    Summary 136 ■ Key Concepts and Terms 137 ■ Review Questions 137 ■ Application

    Questions 138 ■ Internet Resources 138 ■ Selected References 139 ■ Notes 139

    Case Application 136

    INSIGHT 7.1: HOW PROFITABLE IS THE PROPERTY AND CASUALTY INSURANCE

    INDUSTRY? 129

    CHAPTER 8 GOVERNMENT REGULATION OF INSURANCE 141

    Reasons for Insurance Regulation 142

    Historical Development of Insurance Regulation 144

    Methods for Regulating Insurers 145

    What Areas Are Regulated? 146

    State Versus Federal Regulation 151

    Modernizing Insurance Regulation 156

    Insolvency of Insurers 157

    Credit-Based Insurance Scores 158

    Summary 160 ■ Key Concepts and Terms 160 ■ Review Questions 161 ■ Application

    Questions 161 ■ Internet Resources 162 ■ Selected References 163 ■ Notes 163

    Case Application 159

    INSIGHT 8.1: QUALITY OF INFORMATION PROVIDED TO CONSUMERS ON AUTO

    AND HOMEOWNERS INSURANCE VARIES WIDELY AMONG STATE INSURANCE

    DEPARTMENTS 143

    INSIGHT 8.2: WIDE RATE DISPARITY REVEALS WEAK COMPETITION IN INSURANCE 153

    PART THREE LEGAL PRINCIPLES IN RISK AND INSURANCE

    CHAPTER 9 FUNDAMENTAL LEGAL PRINCIPLES 165

    Principle of Indemnity 166

    Principle of Insurable Interest 169

    Principle of Subrogation 170

    Principle of Utmost Good Faith 172

    Requirements of an Insurance Contract 174

    Distinct Legal Characteristics of Insurance Contracts 175

    Law and the Insurance Agent 177 VIII CONTENTS

    Summary 179 ■ Key Concepts and Terms 180 ■ Review Questions 180 ■ Application

    Questions 181 ■ Internet Resources 182 ■ Selected References 182 ■ Notes 182

    Case Application 179

    INSIGHT 9.1: CORPORATION LACKING INSURABLE INTEREST AT TIME OF DEATH CAN RECEIVE LIFE

    INSURANCE PROCEEDS 171

    INSIGHT 9.2: AUTO INSURER DENIES COVERAGE BECAUSE OF MATERIAL MISREPRESENTATION 172

    INSIGHT 9.3: INSURER VOIDS COVERAGE BECAUSE OF MISREPRESENTATIONS IN PROOF

    OF LOSS 173

    CHAPTER 10 ANALYSIS OF INSURANCE CONTRACTS 184

    Basic Parts of an Insurance Contract 185

    D e i nition of “Insured” 187

    Endorsements and Riders 189

    Deductibles 189

    Coinsurance 190

    Coinsurance in Health Insurance 192

    Other-Insurance Provisions 192

    Summary 195 ■ Key Concepts and Terms 195 ■ Review Questions 196 ■ Application

    Questions 196 ■ Internet Resources 197 ■ Selected References 197 ■ Notes 197

    Case Application 194

    INSIGHT 10.1: WHEN YOU DRIVE YOUR ROOMMATE’S CAR, ARE YOU COVERED UNDER

    YOUR POLICY? 188

    PART FOUR LIFE AND HEALTH RISKS

    CHAPTER 11 LIFE INSURANCE 198

    Premature Death 199

    Financial Impact of Premature Death on Different Types of Families 200

    Amount of Life Insurance to Own 201

    Types of Life Insurance 208

    Variations of Whole Life Insurance 213

    Other Types of Life Insurance 221

    Summary 225 ■ Key Concepts and Terms 226 ■ Review Questions 226 ■ Application

    Questions 227 ■ Internet Resources 228 ■ Selected References 229 ■ Notes 230

    Case Application 224

    INSIGHT 11.1: WHY DOES THE UNITED STATES LAG BEHIND MANY FOREIGN COUNTRIES IN

    LIFE EXPECTANCY? 200

    INSIGHT 11.2: CASH-VALUE LIFE INSURANCE AS AN INVESTMENT—DON’T IGNORE

    TWO POINTS 212

    INSIGHT 11.3: BE A SAVVY CONSUMER—FOUR LIFE INSURANCE POLICIES TO AVOID 222

    CHAPTER 12 LIFE INSURANCE CONTRACTUAL PROVISIONS 231

    Life Insurance Contractual Provisions 232

    Dividend Options 238

    Nonforfeiture Options 239

    Settlement Options 241

    Additional Life Insurance Benei ts 246 CONTENTS IX

    Summary 251 ■ Key Concepts and Terms 251 ■ Review Questions 252 ■ Application

    Questions 252 ■ Internet Resources 253 ■ Selected References 254 ■ Notes 254

    Case Application 250

    INSIGHT 12.1: IS THIS DEATH A SUICIDE? 234

    INSIGHT 12.2: SELECTION OF THE BEST DIVIDEND OPTION IN A PARTICIPATING WHOLE LIFE POLICY 240

    INSIGHT 12.3: ACCELERATED DEATH BENEFITS—REAL LIFE EXAMPLE 249

    INSIGHT 12.4: WHAT IS A LIFE SETTLEMENT? EXAMPLES OF ACTUAL CASES 249

    CHAPTER 13 BUYING LIFE INSURANCE 255

    Determining the Cost of Life Insurance 256

    Rate of Return on Saving Component 260

    Taxation of Life Insurance 262

    Shopping for Life Insurance 263

    Summary 266 ■ Key Concepts and Terms 266 ■ Review Questions 267 ■ Application

    Questions 267 ■ Internet Resources 268 ■ Selected References 268 ■ Notes 268

    Case Application 266

    INSIGHT 13.1: BE CAREFUL IN REPLACING AN EXISTING LIFE INSURANCE POLICY 259

    Appendix Calculation of Life Insurance Premiums 269

    CHAPTER 14 ANNUITIES AND INDIVIDUAL RETIREMENT ACCOUNTS 275

    Individual Annuities 276

    Types of Annuities 277

    Longevity Insurance 282

    Taxation of Individual Annuities 283

    Individual Retirement Accounts 284

    Adequacy of IRA Funds 288

    Summary 291 ■ Key Concepts and Terms 292 ■ Review Questions 292 ■ Application

    Questions 292 ■ Internet Resources 293 ■ Selected References 293 ■ Notes 293

    Case application 1 290

    Case application 2 290

    INSIGHT 14.1: ADVANTAGES OF AN IMMEDIATE ANNUITY TO RETIRED WORKERS 278

    INSIGHT 14.2: BELLS AND WHISTLES OF VARIABLE ANNUITIES 281

    INSIGHT 14.3: TEN QUESTIONS TO ANSWER BEFORE YOU BUY A VARIABLE ANNUITY 284

    INSIGHT 14.4: WILL YOU HAVE ENOUGH MONEY AT RETIREMENT? MONTE CARLO SIMULATIONS

    CAN BE HELPFUL 289

    CHAPTER 15 HEALTH-CARE REFORM; INDIVIDUAL HEALTH INSURANCE

    COVERAGES 295

    Health-Care Problems in the United States 296

    Health-Care Reform 303

    Basic Provisions of the Affordable Care Act 303

    Individual Medical Expense Insurance 309

    Individual Medical Expense Insurance and Managed Care Plans 311

    Health Savings Accounts 312

    Long-Term Care Insurance 313

    Disability-Income Insurance 316 X CONTENTS

    Individual Health Insurance Contractual Provisions 319

    Summary 321 ■ Key Concepts and Terms 322 ■ Review Questions 322 ■ Application

    Questions 323 ■ Internet Resources 323 ■ Selected References 324 ■ Notes 325

    Case Application 321

    INSIGHT 15.1: HOW DOES U.S. HEALTH SPENDING COMPARE WITH OTHER COUNTRIES? 298

    INSIGHT 15.2: MORE THAN SEVENTY PERCENT OF THE UNINSURED HAVE GONE WITHOUT HEALTH

    COVERAGE FOR MORE THAN A YEAR 300

    CHAPTER 16 EMPLOYEE BENEFITS: GROUP LIFE AND HEALTH

    INSURANCE 327

    Meaning of Employee Benei ts 328

    Fundamentals of Group Insurance 328

    Group Life Insurance Plans 330

    Group Medical Expense Insurance 332

    Traditional Indemnity Plans 333

    Managed Care Plans 334

    Key Features of Group Medical Expense Insurance 336

    Affordable Care Act Requirements and Group Medical Expense Insurance 337

    Consumer-Directed Health Plans 340

    Recent Developments in Employer-Sponsored Health Plans 340

    Group Medical Expense Contractual Provisions 343

    Group Dental Insurance 344

    Group Disability-Income Insurance 345

    Cafeteria Plans 346

    Summary 348 ■ Key Concepts and Terms 349 ■ Review Questions 350 ■ Application

    Questions 350 ■ Internet Resources 351 ■ Selected References 352 ■ Notes 352

    Case Application 348

    INSIGHT 16.1: WHAT ARE THE FINANCIAL IMPLICATIONS OF LACK OF COVERAGE? 339

    CHAPTER 17 EMPLOYEE BENEFITS: RETIREMENT PLANS 353

    Fundamentals of Private Retirement Plans 354

    Types of Qualii ed Retirement Plans 357

    D e i ned-Benei t Plans 358

    D e i ned-Contribution Plans 360

    Section 401(k) Plans 360

    Proi t-Sharing Plans 363

    Keogh Plans for the Self Employed 364

    Simplii ed Employee Pension 365

    SIMPLE Retirement Plans 365

    Funding Agency and Funding Instruments 365

    Problems and Issues in Tax-Deferred Retirement Plans 366

    Summary 368 ■ Key Concepts and Terms 369 ■ Review Questions 369 ■ Application

    Questions 370 ■ Internet Resources 370 ■ Selected References 371 ■ Notes 371

    Case Application 368

    INSIGHT 17.1: SIX COMMON 401(K) MISTAKES 361 CONTENTS XI

    CHAPTER 18 SOCIAL INSURANCE 372

    Social Insurance 373

    Old-Age, Survivors, and Disability Insurance 375

    Types of Benei ts 376

    Medicare 384

    Impact of the Affordable Care Act on Medicare 389

    Problems and Issues 390

    Unemployment Insurance 392

    Workers Compensation 395

    Summary 399 ■ Key Concepts and Terms 400 ■ Review Questions 400 ■ Application

    Questions 401 ■ Internet Resources 402 ■ Selected References 403 ■ Notes 403

    Case Application 399

    INSIGHT 18.1: TAKING SOCIAL SECURITY: SOONER MIGHT NOT BE BETTER 381

    INSIGHT 18.2: WHAT ARE YOUR SOLUTIONS FOR REFORMING SOCIAL SECURITY? 392

    PART FIVE PERSONAL PROPERTY AND LIABILITY RISKS

    CHAPTER 19 THE LIABILITY RISK 405

    Basis of Legal Liability 406

    Law of Negligence 407

    Imputed Negligence 409

    Res Ipsa Loquitur 410

    Specii c Applications of the Law of Negligence 410

    Current Tort Liability Problems 412

    Summary 421 ■ Key Concepts and Terms 421 ■ Review Questions 422 ■ Application

    Questions 422 ■ Internet Resources 423 ■ Selected References 424 ■ Notes 424

    Case Application 420

    INSIGHT 19.1: JUDICIAL HELLHOLES 2011–2012 415

    CHAPTER 20 HOMEOWNERS INSURANCE, SECTION I 426

    Homeowners Insurance 427

    Analysis of Homeowners 3 Policy (Special Form) 431

    Section I Coverages 432

    Section I Perils Insured Against 437

    Section I Exclusions 440

    Section I Conditions 442

    Section I and II Conditions 447

    Summary 448 ■ Key Concepts and Terms 449 ■ Review Questions 449 ■ Application

    Questions 450 ■ Internet Resources 451 ■ Selected References 451 ■ Notes 452

    Case Application 448

    INSIGHT 20.1: LESSON TO BE LEARNED FROM APARTMENT FIRE 430

    INSIGHT 20.2: HOW DO I TAKE A HOME INVENTORY AND WHY? 443

    INSIGHT 20.3: THE BIG GAP BETWEEN REPLACEMENT COST AND ACTUAL CASH VALUE

    CAN EMPTY YOUR WALLET 444 XII CONTENTS

    CHAPTER 21 HOMEOWNERS INSURANCE, SECTION II 453

    Personal Liability Insurance 454

    Section II Exclusions 457

    Section II Additional Coverages 460

    Section II Conditions 462

    Endorsements to a Homeowners Policy 462

    Cost of Homeowners Insurance 465

    Summary 473 ■ Key Concepts and Terms 473 ■ Review Questions 473 ■ Application

    Questions 474 ■ Internet Resources 475 ■ Selected References 475 ■ Notes 476

    Case Application 472

    INSIGHT 21.1: DOG BITES HURT, SO DO LAWSUITS 455

    INSIGHT 21.2: TRYING TO SAVE MONEY? AVOID THE FIVE BIGGEST INSURANCE MISTAKES! 471

    CHAPTER 22 AUTO INSURANCE 477

    Overview of Personal Auto Policy 478

    Part A: Liability Coverage 479

    Part B: Medical Payments Coverage 483

    Part C: Uninsured Motorists Coverage 485

    Part D: Coverage for Damage to Your Auto 489

    Part E: Duties After an Accident or Loss 497

    Part F: General Provisions 498

    Insuring Motorcycles and Other Vehicles 499

    Summary 500 ■ Key Concepts and Terms 500 ■ Review Questions 500 ■ Application

    Questions 501 ■ Internet Resources 503 ■ Selected References 503 ■ Notes 504

    Case Application 499

    INSIGHT 22.1: RECESSION MARKED BY BUMP IN UNINSURED MOTORISTS 485

    INSIGHT 22.2: TOP 10 REASONS TO PURCHASE THE RENTAL CAR DAMAGE WAIVER 491

    INSIGHT 22.3: NO CALL, NO TEXT, NO UPDATE BEHIND THE WHEEL: NTSB CALLS FOR NATIONWIDE

    BAN ON PEDS WHILE DRIVING 494

    CHAPTER 23 AUTO INSURANCE AND SOCIETY 505

    Approaches for Compensating Auto Accident Victims 506

    Auto Insurance for High-Risk Drivers 516

    Cost of Auto Insurance 517

    Shopping for Auto Insurance 522

    Summary 527 ■ Key Concepts and Terms 528 ■ Review Questions 528 ■ Application

    Questions 529 ■ Internet Resources 529 ■ Selected References 530 ■ Notes 530

    Case Application 527

    INSIGHT 23.1: FILING AN AUTO CLAIM WITH THE OTHER PARTY’S INSURANCE COMPANY 510

    INSIGHT 23.2: PROTECT YOURSELF: INSURING YOUR TEEN DRIVER 520

    INSIGHT 23.3: INCREASING THE COLLISION DEDUCTIBLE TO SAVE MONEY—SOME IMPORTANT

    CONSIDERATIONS 523

    CHAPTER 24 OTHER PROPERTY AND LIABILITY INSURANCE COVERAGES 532

    ISO Dwelling Program 533

    Mobile Home Insurance 535

    Inland Marine Floaters 535

    Watercraft Insurance 536 CONTENTS XIII

    Government Property Insurance Programs 538

    Title Insurance 543

    Personal Umbrella Policy 545

    Summary 548 ■ Key Concepts and Terms 549 ■ Review Questions 549 ■ Application

    Questions 550 ■ Internet Resources 551 ■ Selected References 551 ■ Notes 552

    Case Application 548

    INSIGHT 24.1: DISPELLING MYTHS ABOUT FLOOD INSURANCE 541

    INSIGHT 24.2: TITLE INSURANCE: PROTECTING YOUR HOME INVESTMENT AGAINST UNKNOWN

    TITLE DEFECTS 544

    PART SIX COMMERCIAL PROPERTY AND LIABILITY RISKS

    CHAPTER 25 COMMERCIAL PROPERTY INSURANCE 554

    Commercial Package Policy 555

    Building and Personal Property Coverage Form 557

    Causes-of-Loss Forms 559

    Reporting Forms 560

    Business Income Insurance 561

    Other Commercial Property Coverages 564

    Transportation Insurance 567

    Businessowners Policy (BOP) 571

    Summary 574 ■ Key Concepts and Terms 575 ■ Review Questions 575 ■ Application

    Questions 576 ■ Internet Resources 577 ■ Selected References 578 ■ Notes 578

    Case Application 573

    INSIGHT 25.1: EXAMPLES OF EQUIPMENT BREAKDOWN CLAIMS 566

    CHAPTER 26 COMMERCIAL LIABILITY INSURANCE 580

    General Liability Loss Exposures 581

    Commercial General Liability Policy 582

    Employment-Related Practices Liability Insurance 588

    Workers Compensation Insurance 589

    Commercial Auto Insurance 592

    Aircraft Insurance 594

    Commercial Umbrella Policy 595

    Businessowners Policy 597

    Professional Liability Insurance 597

    Directors and Ofi cers Liability Insurance 599

    Summary 600 ■ Key Concepts and Terms 602 ■ Review Questions 602 ■ Application

    Questions 603 ■ Internet Resources 604 ■ Selected References 604 ■ Notes 604

    Case Application 600

    INSIGHT 26.1: BASIC FACTS ABOUT WORKERS COMPENSATION 590

    CHAPTER 27 CRIME INSURANCE AND SURETY BONDS 606

    ISO Commercial Crime Insurance Program 607

    Commercial Crime Coverage Form (Loss-Sustained Form) 608

    Financial Institution Bonds 613

    Surety Bonds 614 XIV CONTENTS

    Summary 617 ■ Key Concepts and Terms 618 ■ Review Questions 618 ■ Application

    Questions 619 ■ Internet Resources 619 ■ Selected References 620 ■ Notes 620

    Case Application 616

    INSIGHT 27.1: SMALL BUSINESS CRIME PREVENTION GUIDE 610

    Appendix A Homeowners 3 (Special Form) 621

    Appendix B Personal Auto Policy 646

    Glossary 660

    Index 678 xv

    The twelfth edition of Principles of Risk

    Management and Insurance discusses these issues

    and other insurance issues as well. As in previous

    editions, the text is designed for a beginning under-

    graduate course in risk management and insurance

    with no prerequisites. The twelfth edition provides

    an in-depth treatment of major risk management and

    insurance topics. Coverage includes a discussion of

    basic concepts of risk and insurance, introductory and

    advanced topics in risk management, functional and

    · nancial operations of insurers, legal principles, life

    and health insurance, property and liability insurance,employee bene? ts, and social insurance. In addition,the new Affordable Care Act is discussed in depth.

    Once again, the twelfth edition places primary empha-

    sis on insurance consumers and blends basic risk

    management and insurance principles with consumer

    considerations. With this user-friendly text, students

    can apply basic concepts immediately to their own

    personal risk management and insurance programs.

    KEY CONTENT CHANGES IN

    THE?TWELFTH EDITION

    Thoroughly revised and updated, the twelfth edition

    provides an in-depth analysis of current insurance

    industry issues and practices, which readers have

    come to expect from Principles of Risk Management

    and Insurance. Key content changes in the twelfth

    edition include the following:

    · Health-care reform. Chapter 15 has an in-depth

    discussion of the broken health-care delivery

    system in the United States, which led to enactment

    of the Affordable Care Act.

    · Enactment of the Affordable Care Act.Chapters 15

    and 16 discuss the major provisions of the new

    Affordable Care Act and its impact on individual and

    group health insurance coverages. Primary attention

    is devoted to provisions that have a major ? nancial

    impact on individuals, families, and employers.

    This text deals with risk and its treatment. Since

    the last edition of Principles of RiskManagement

    and Insurance appeared, several unprecedented

    events have occurred that clearly demonstrate the

    destructive presence of risk in our society. In 2010,one of the most devastating earthquakes in recent his-

    tory struck poverty-stricken Haiti, causing enormous

    human suffering, an estimated 316,000 deaths, one

    million homeless people, and widespread property

    destruction. In 2011, a deadly earthquake hit Japan

    that caused a devastating tsunami and a nuclear acci-

    dent crisis. More than 18,000 people died, thousands

    more are missing, and estimated property damage

    may exceed 300 billion. During the same period,the Obama Administration introduced legislation to

    reform a broken health-care delivery system. Despite

    formidable opposition by the Republicans, and heated

    and bitter debate, Congress enacted the Affordable

    Care Act in March 2010. The new law extends health

    insurance coverage to millions of uninsured people,provides subsidies to purchase insurance, and prohibits

    certain abusive practices by insurers.

    Finally, in 2012, a deranged gunman randomly

    killed 12 people and wounded at least 58 others in

    a theater in Aurora, Colorado. This tragic act again

    highlights the fact that spree killings are not isolated

    events, and that the risk of death or injury is mark-

    edly present.

    Flash forward to the present. The economy and

    housing markets are slowly recovering from the sec-

    ond most severe economic downswing in the nation’s

    history; although declining, unemployment remains at

    historically high levels; and a dysfunctional Congress

    remains hopelessly deadlocked because of deeply held

    ideological beliefs by its members. The Affordable

    Care Act remains controversial, and Republicans in

    Congress are determined to repeal it. The House has

    already enacted legislation to repeal the Affordable

    Care Act. To say that we live in a risky and dangerous

    world is an enormous understatement.

    PREFACE XVI PREFACE

    to take a self-assessment quiz after studying the chap-

    ter material. Students can use the Internet to view

    real world examples of risk and insurance concepts

    discussed in the text.

    Printed Instructor’s Manual and Test Item

    File. Designed to reduce start-up costs and class

    preparation time, a comprehensive instructor’s

    manual contains teaching notes; outlines; and

    answers to all end- of-chapter review, application,and case questions. The test bank, prepared by

    Professor Michael J.McNamara of Washington State

    University, enables instructors to construct objective

    exams quickly and easily.

    Computerized Test Bank. In addition to the printed test

    bank, these same questions are also available in Word,PDF, and TestGen formats. The easy-to-use TestGen

    software is a valuable test preparation tool that allows

    busy professors to view, edit, and add questions.

    PowerPoint Presentation. Prepared by Professor

    Patricia Born of Florida State University, this tool con-

    tains lecture notes that re? ect the new edition. It also

    includes the complete set of ? gures from the textbook.

    Depending on interest, instructors can choose among

    hundreds of slides to assist in class preparation.

    Study Guide. Also prepared by Michael J.

    McNamara, this study tool helps students analyze

    and internalize the topics learned in class. Every chap-

    ter includes an overview, learning objectives, outline,and extensive self-test with answers. The self-test

    section contains short answer, multiple choice, true

    false, and case application questions that challenge

    students to apply the principles and concepts covered

    in the twelfth edition.

    ACKNOWLEDGMENTS

    A market-leading textbook is never written alone. I

    owe an enormous intellectual debt to many profes-

    sionals for their kind and gracious assistance. In par-

    ticular, Professor Michael McNamara, Washington

    State University, is a new coauthor of the text.

    Professor McNamara is an outstanding scholar and

    researcher who has made signi? cant contributions to

    the twelfth edition. As a result, the new edition is a

    substantially improved educational product.

    · New homeowners insurance policies. The

    Insurance Services Of? ce (ISO) has introduced a

    new 2011 edition of the homeowners insurance

    policies that are widely used throughout the

    United States. Chapters 20 and 21 discuss

    important changes in homeowners insurance,especially the Homeowners 3 policy.

    · Updated discussion of life insurance marketing.

    The section on life insurance marketing and dis-

    tribution systems has been completely updated

    and substantially rewritten. Chapter 5 discusses

    the current distribution systems and marketing

    practices of life insurers.

    · New developments in employer-sponsored health

    insurance plans. Employers continue to grapple

    with the rapid increase in group health insurance

    premiums and continually seek new solutions for

    holding down costs. Chapter 16 discusses new

    developments in group health insurance to con-

    tain higher health-care costs and premiums.

    · Impact of the Affordable Care Act on Medicare.

    Chapter 18 discusses important provisions of the

    Affordable Care Act that have a direct impact

    on the Medicare program. These provisions are

    designed to control cost and make Medicare a

    more ef? cient program in protecting seniors

    against the risk of poor health.

    · New Insight boxes. The twelfth edition contains

    a number of new and timely Insight boxes.

    Insights are valuable learning tools that provide

    real-world applications of a concept or principle

    discussed in the text.

    · Technical accuracy. As in previous editions,numerous experts have reviewed the text for

    technical accuracy, especially in areas where

    changes occur rapidly. The twelfth edition pres-

    ents technically accurate and up-to-date material.

    SUPPLEMENTS

    The twelfth edition provides a number of supple-

    ments to help busy instructors save time and teach

    more effectively. The following supplements are avail-

    able to quali? ed adopters through the Instructor’s

    Resource Center at pearsonhighered.comirc.

    Companion Web Site. The twelfth edition has an

    Internet site at pearsonhighered.comrejda that allows

    students to work through a variety of exercises and PREFACE XVII

    Eric Wiening, Insurance and Risk Management

    Author-Educator, Consultant

    Millicent W. Workman, Research Analyst,International Risk Management Institute, Inc.

    (IRMI), and Editor, Practical Risk Management

    I would also like to thank Kelly Morrison at

    GEX Publishing Services and Donna Battista, Katie

    Rowland, Emily Biberger, Karen Carter, Elissa Senra-

    Sargent at Pearson for their substantive editorial com-

    ments, marketing insights, and technical suggestions.

    The views expressed in the text are those solely

    of the authors and do not necessarily re? ect the view-

    points or positions of the reviewers whose assistance

    I am gratefully acknowledging.

    Finally, the fundamental objective underlying

    the twelfth edition remains the same as in the ? rst

    edition—I have attempted to write an intellectually

    stimulating and visually attractive textbook from

    which students can learn and professors can teach.

    George E. Rejda, Ph.D., CLU

    Professor Emeritus

    Finance Department

    College of Business Administration

    University of Nebraska—Lincoln

    In addition, numerous educators, risk manage-

    ment experts, and industry personnel have taken time

    out of their busy schedules to review part or all of the

    twelfth edition, to provide supplementary materials, to

    make valuable comments, to answer questions, or to

    provide other assistance. They include the following:

    Burton T. Beam, Jr., The American College (retired)

    Patricia Born, Florida State University

    Nick Brown, Chief Underwriting Of? cer, Global

    Aerospace, United Kingdom

    Ann Costello, University of Hartford

    Joseph Fox, Asheville-Buncombe Technical Community

    College

    Edward Graves, The American College

    Eric Johnsen, Virginia Tech

    J. Tyler Leverty, University of Iowa

    Rebecca A. McQuade, Director of RiskManagement,PACCAR, Inc.

    William H. Rabel, University of Alabama

    Johnny Vestal, Texas Tech This page intentionally left blank 1

    CHAPTER 1

    RISK AND ITS TREATMENT

    “When we take a risk, we are betting on an outcome that

    will result from a decision we have made, though we do not

    know for certain what the outcome will be.”

    Peter L. Bernstein

    Against the Gods: The Remarkable Story of Risk

    Learning Objectives

    After studying this chapter, you should be able to

    ◆ Explain the historical definition of risk.

    ◆ Explain the meaning of loss exposure.

    ◆ Understand the following types of risk:

    Pure risk

    Speculative risk

    Diversifiable risk

    Enterprise risk

    ◆ Identify the major pure risks that are associated with financial insecurity.

    ◆ Show how risk is a burden to society.

    ◆ Explain the major techniques for managing risk. Shannon, age 28, is employed as a bank teller for a commercial bank in Omaha,Nebraska. She is a single parent with two preschool children. Shortly after the

    bank opened on a Saturday morning, two men armed with handguns entered the bank

    and went to Shannon’s window and demanded money. When a bank guard entered

    the premises, one gunman became startled and shot Shannon in the chest. She died

    while being transported to a local hospital.

    Shannon’s tragic and untimely death shows that we live in a risky and dangerous

    world. The news media report daily on similar tragic events that clearly illustrate the

    widespread presence of risk in our society. Examples abound—a tornado destroys a

    small town; a gunman enters a classroom at a local college and kills seven students;

    a drunk driver kills four people in a van on a crowded expressway; a river overflows,and thousands of acres of farm crops are lost. In addition, people experience personal

    tragedies and financial setbacks that cause great economic insecurity—the unexpected

    death of a family head; catastrophic medical bills that bankrupt the family; or the

    loss of a good paying job during a business recession.

    In this chapter, we discuss the nature and treatment of risk in our society. Topics

    discussed include the meaning of risk, the major types of risk that threaten our financial

    security, the burden of risk on the economy, and the basic methods for managing risk.

    DEFINITIONS OF RISK

    There is no single definition of risk. Economists,behavioral scientists, risk theorists, statisticians,and actuaries each have their own concept of risk.

    However, risk historically has been defined in terms

    of uncertainty. Based on this concept, risk is defined

    as uncertainty concerning the occurrence of a loss .

    For example, the risk of being killed in an auto acci-

    dent is present because uncertainty is present. The

    risk of lung cancer for smokers is present because

    uncertainty is present. The risk of flunking a college

    course is present because uncertainty is present.

    Employees in the insurance industry often use the

    term risk in a different manner to identify the prop-

    erty or life that is being considered for insurance. For

    example, in the insurance industry, it is common to

    hear statements such as “that driver is a poor risk,”

    or “that building is an unacceptable risk.”

    Finally, in the economics and finance literature,authors often make a distinction between risk

    and uncertainty. The term “risk” is often used in

    situations where the probability of possible out-

    comes can be estimated with some accuracy, while

    “uncertainty” is used in situations where such

    probabilities cannot be estimated.

    1 As such, many

    authors have developed their own concept of

    risk, and numerous definitions of risk exist in the

    professional literature.

    2

    Because the term risk is ambiguous and has dif-

    ferent meanings, many authors and corporate risk

    managers use the term “loss exposure” to identify

    potential losses. A loss exposure is any situation or

    circumstance in which a loss is possible, regardless

    of whether a loss occurs. Examples of loss exposures

    include manufacturing plants that may be damaged

    by an earthquake or flood, defective products that

    may result in lawsuits against the manufacturer,2 CHANCE OF LOSS 3

    the proportion of homes that will burn. The law

    of large numbers is discussed in greater detail

    in? Chapter 2 .

    Subjective Risk

    Subjective risk is defined as uncertainty based on a

    person’s mental condition or state of mind . For exam-

    ple, assume that a driver with several convictions for

    drunk driving is drinking heavily in a neighborhood

    bar and foolishly attempts to drive home. The driver

    may be uncertain whether he will arrive home safely

    without being arrested by the police for drunk driv-

    ing. This mental uncertainty is called subjective risk.

    The impact of subjective risk varies depending

    on the individual. Two persons in the same situa-

    tion can have a different perception of risk, and their

    behavior may be altered accordingly. If an individual

    experiences great mental uncertainty concerning the

    occurrence of a loss, that person’s behavior may

    be affected. High subjective risk often results in

    conservative and prudent behavior, while low subjec-

    tive risk may result in less conservative behavior. For

    example, assume that a motorist previously arrested

    for drunk driving is aware that he has consumed too

    much alcohol. The driver may then compensate for

    the mental uncertainty by getting someone else to

    drive the car home or by taking a cab. Another driver

    in the same situation may perceive the risk of being

    arrested as slight. This second driver may drive in a

    more careless and reckless manner; a low subjective

    risk results in less conservative driving behavior.

    CHANCE OF LOSS

    Chance of loss is closely related to the concept of

    risk. Chance of loss is defined as the probability that

    an event will occur . Like risk, “probability” has both

    objective and subjective aspects.

    Objective Probability

    Objective probability refers to the long-run relative

    frequency of an event based on the assumptions of an

    infinite number of observations and of no change in

    the underlying conditions . Objective probabilities can

    be determined in two ways. First, they can be deter-

    mined by deductive reasoning. These probabilities

    possible theft of company property because of

    inadequate security, and potential injury to employ-

    ees because of unsafe working conditions.

    Finally, when the definition of risk includes the

    concept of uncertainty, some authors make a careful

    distinction between objective risk and subjective risk.

    Objective Risk

    Objective risk (also called degree of risk) is defined

    as the relative variation of actual loss from expected

    loss . For example, assume that a property insurer

    has 10,000 houses insured over a long period and,on average, 1 percent, or 100 houses, burn each year.

    However, it would be rare for exactly 100 houses to

    burn each year. In some years, as few as 90 houses

    may burn; in other years, as many as 110 houses may

    burn. Thus, there is a variation of 10 houses from the

    expected number of 100, or a variation of 10 percent.

    This relative variation of actual loss from expected

    loss is known as objective risk.

    Objective risk declines as the number of expo-

    sures increases. More specifically, objective risk

    varies inversely with the square root of the number

    of cases under observation . In our previous example,10,000 houses were insured, and objective risk was

    10100, or 10 percent. Now assume that 1 million

    houses are insured. The expected number of houses

    that will burn is now 10,000, but the variation of

    actual loss from expected loss is only 100. Objective

    risk is now 10010,000, or 1 percent. Thus, as the

    square root of the number of houses increased from

    100 in the first example to 1000 in the second exam-

    ple (10 times), objective risk declined to one-tenth of

    its former level.

    Objective risk can be statistically calculated by

    some measure of dispersion, such as the standard

    deviation or the coefficient of variation. Because

    objective risk can be measured, it is an extremely

    useful concept for an insurer or a corporate risk

    manager. As the number of exposures increases, an

    insurer can predict its future loss experience more

    accurately because it can rely on the law of large

    numbers. The law of large numbers states that as

    the number of exposure units increases, the more

    closely the actual loss experience will approach

    the expected loss experience. For example, as the

    number of homes under observation increases,the greater is the degree of accuracy in p redicting 4 CHAPTER 1 RISK AND ITS TREATMENT

    of loss may be identical for two different groups, but

    objective risk may be quite different. For example,assume that a property insurer has 10,000 homes

    insured in Los Angeles and 10,000 homes insured in

    Philadelphia and that the chance of a fire in each city

    is 1 percent. Thus, on average, 100 homes should burn

    annually in each city. However, if the annual variation

    in losses ranges from 75 to 125 in Philadelphia, but

    only from 90 to 110 in Los Angeles, objective risk is

    greater in Philadelphia even though the chance of loss

    in both cities is the same.

    PERIL AND HAZARD

    The terms peril and hazard should not be confused

    with the concept of risk discussed earlier.

    Peril

    Peril is defined as the cause of loss . If your house burns

    because of a fire, the peril, or cause of loss, is the fire.

    If your car is damaged in a collision with another car,collision is the peril, or cause of loss. Common per-

    ils that cause loss to property include fire, lightning,windstorm, hail, tornado, earthquake, flood, burglary,and theft.

    Hazard

    A hazard is a condition that creates or increases the

    frequency or severity of loss . There are four major

    types of hazards:

    ■ Physical hazard

    ■ Moral hazard

    ■ Attitudinal hazard (morale hazard)

    ■ Legal hazard

    Physical Hazard A physical hazard is a physical

    con dition that increases the frequency or severity of

    loss . Examples of physical hazards include icy roads

    that increase the chance of an auto accident, defec-

    tive wiring in a building that increases the chance of

    fire, and a defective lock on a door that increases the

    chance of theft.

    Moral Hazard Moral hazard is dishonesty or

    character defects in an individual that increase the

    frequency or severity of loss . Examples of moral

    are called a priori probabilities . For example, the

    probability of getting a head from the toss of a

    perfectly balanced coin is 12 because there are two

    sides, and only one is a head. Likewise, the probabil-

    ity of rolling a 6 with a single die is 16, since there

    are six sides and only one side has six dots.

    Second, objective probabilities can be determined

    by inductive reasoning rather than by deduction. For

    example, the probability that a person age 21 will die

    before age 26 cannot be logically deduced. However,by a careful analysis of past mortality experience, life

    insurers can estimate the probability of death and sell

    a five-year term life insurance policy issued at age 21.

    Subjective Probability

    Subjective probability is the individual’s personal

    estimate of the chance of loss . Subjective probabil-

    ity need not coincide with objective probability. For

    example, people who buy a lottery ticket on their

    birthday may believe it is their lucky day and overes-

    timate the small chance of winning. A wide variety of

    factors can influence subjective probability, including

    a person’s age, gender, intelligence, education, and

    the use of alcohol or drugs.

    In addition, a person’s estimate of a loss may differ

    from objective probability because there may be ambi-

    guity in the way in which the probability is perceived.

    For example, assume that a slot machine in a casino

    requires a display of three lemons to win. The person

    playing the machine may perceive the probability of

    winning to be quite high. But if there are 10 symbols

    on each reel and only one is a lemon, the objective

    probability of hitting the jackpot with three lemons

    is quite small. Assuming that each reel spins indepen-

    dently of the others, the probability that all three will

    simultaneously show a lemon is the product of their

    individual probabilities (110 × 110 × 110 = 11000).

    This knowledge is advantageous to casino owners,who know that most gamblers are not trained stat-

    isticians and are therefore likely to overestimate the

    objective probabilities of winning.

    Chance of Loss Versus Objective Risk

    Chance of loss can be distinguished from objective

    risk. Chance of loss is the probability that an event that

    causes a loss will occur. Objective risk is the relative

    variation of actual loss from expected loss. The chance CLASSIFICATION OF RISK 5

    CLASSIFICATION OF RISK

    Risk can be classified into several distinct classes.

    They include the following:

    ■ Pure and speculative risk

    ■ Diversifiable risk and nondiversifiable risk

    ■ Enterprise risk

    Pure Risk and Speculative Risk

    Pure risk is defined as a situation in which there are

    only the possibilities of loss or no loss . The only possi-

    ble outcomes are adverse (loss) and neutral (no loss).

    Examples of pure risks include premature death,job-related accidents, catastrophic medical expenses,and damage to property from fire, lightning, flood,or earthquake.

    Speculative risk is defined as a situation in which

    either profit or loss is possible . For example, if you

    purchase 100 shares of common stock, you would

    profit if the price of the stock increases but would

    lose if the price declines. Other examples of specula-

    tive risks include betting on a horse race, investing

    in real estate, and going into business for yourself.

    In these situations, both profit and loss are possible.

    It is important to distinguish between pure and

    speculative risks for three reasons. First, private

    insurers generally concentrate on insuring certain

    pure risks. With certain exceptions, private insurers

    generally do not insure speculative risks. However,there are exceptions. Some insurers will insure insti-

    tutional portfolio investments and municipal bonds

    against loss. Also, enterprise risk management (dis-

    cussed later) is another exception where certain

    speculative risks can be insured.

    Second, the law of large numbers can be applied

    more easily to pure risks than to speculative risks.

    The law of large numbers is important because it

    enables insurers to predict future loss experience. In

    contrast, it is generally more difficult to apply the law

    of large numbers to speculative risks to predict future

    loss experience. An exception is the speculative risk

    of gambling, where casino operators can apply the

    law of large numbers in a most efficient manner.

    Finally, society may benefit from a speculative

    risk even though a loss occurs, but it is harmed if a

    pure risk is present and a loss occurs. For example,a firm may develop new technology for producing

    inexpensive computers. As a result, some competitors

    hazard in insurance include faking an accident to

    collect from an insurer, submitting a fraudulent

    claim, inflating the amount of a claim, and inten-

    tionally burning unsold merchandise that is insured.

    Murdering the insured to collect the life insur-

    ance proceeds is another important example of

    moral?h azard.

    Moral hazard is present in all forms of

    insurance, and it is difficult to control. Dishonest

    individuals often rationalize their actions on the

    grounds that “the insurer has plenty of money.”

    This view is incorrect because the insurer can pay

    claims only by collecting premiums from other

    insureds. Because of moral hazard, insurance

    premiums are higher for everyone.

    Insurers attempt to control moral hazard by the

    careful underwriting of applicants for insurance and

    by various policy provisions, such as deductibles,waiting periods, exclusions, and riders. These provi-

    sions are examined in Chapter 10 .

    Attitudinal Hazard (Morale Hazard) Attitudinal

    hazard is carelessness or indifference to a loss, which

    increases the frequency or severity of a loss. Examples

    of attitudinal hazard include leaving car?keys in an

    unlocked car, which increases the chance of theft;

    leaving a door unlocked, which allows a burglar to

    enter; and changing lanes suddenly on a congested

    expressway without signaling, which increases the

    chance of an accident. Careless acts like these increase

    the frequency and severity of loss.

    The term morale hazard has the same meaning

    as attitudinal hazard. Morale hazard is a term that

    appeared in earlier editions of this text to describe

    someone who is careless or indifferent to a loss.

    However, the term attitudinal hazard is more widely

    used today and is less confusing to students and more

    descriptive of the concept being discussed.

    Legal hazard Legal hazard refers to characteris tics

    of the legal system or regulatory environment that

    increase the frequency or severity of losses . Examples

    include adverse jury verdicts or large damage awards

    in liability lawsuits; statutes that require insurers to

    include coverage for certain benefits in health insur-

    ance plans, such as coverage for alcoholism; and

    regulatory action by state insurance departments

    that prevents insurers from withdrawing from a state

    because of poor underwriting results. 6 CHAPTER 1 RISK AND ITS TREATMENT

    the federal flood insurance program makes property

    insurance available to individuals and business firms

    in flood zones.

    Enterprise Risk

    Enterprise risk is a term that encompasses all major

    risks faced by a business firm. Such risks include pure

    risk, speculative risk, strategic risk, operational risk,and financial risk. We have already explained the

    meaning of pure and speculative risk. Strategic risk

    refers to uncertainty regarding the firm’s financial

    goals and objectives; for example, if a firm enters a

    new line of business, the line may be unprofitable.

    Operational risk results from the firm’s business

    operations. For example, a bank that offers online

    banking services may incur losses if “hackers” break

    into the bank’s computer.

    Enterprise risk also includes financial risk, which

    is becoming more important in a commercial risk

    management program. Financial risk refers to the

    uncertainty of loss because of adverse changes in

    commodity prices, interest rates, foreign exchange

    rates, and the value of money. For example, a food

    company that agrees to deliver cereal at a fixed

    price to a supermarket chain in six months may lose

    money if grain prices rise. A bank with a large port-

    folio of Treasury bonds may incur losses if interest

    rates rise. Likewise, an American corporation doing

    business in Japan may lose money when Japanese yen

    are exchanged for American dollars.

    Enterprise risk is becoming more important in

    commercial risk management, which is a process

    that organizations use to identify and treat major

    and minor risks. In the evolution of commercial risk

    management, some risk managers are now consider-

    ing all types of risk in one program. Enterprise risk

    management combines into a single unified treat-

    ment program all major risks faced by the firm.

    As explained earlier, these risks include pure risk,speculative risk, strategic risk, operational risk, and

    financial risk. By packaging major risks into a single

    program, the firm can offset one risk against another.

    As a result, overall risk can be reduced. As long as

    all risks are not perfectly correlated, the combination

    of risks can reduce the firm’s overall risk. In particu-

    lar, if some risks are negatively correlated, overall

    risk can be significantly reduced. Chapter 4 discusses

    enterprise risk management in greater detail.

    may be forced into bankruptcy. Despite the bank-

    ruptcy, society benefits because the computers are

    produced at a lower cost. However, society normally

    does not benefit when a loss from a pure risk occurs,such as a flood or earthquake that devastates an area.

    Diversifiable Risk and Nondiversifiable Risk

    Diversifiable risk is a risk that affects only individuals

    or small groups and not the entire economy. It is a

    risk that can be reduced or eliminated by diversifica-

    tion. For example, a diversified portfolio of stocks,bonds, and certificates of deposit (CDs) is less risky

    than a portfolio that is 100 percent invested in stocks.

    Losses on one type of investment, say stocks, may

    be offset by gains from bonds and CDs. Likewise,there is less risk to a property and liability insurer if

    different lines of insurance are underwritten rather

    than only one line. Losses on one line can be offset

    by profits on other lines. Because diversifiable risk

    affects only specific individuals or small groups, it

    is also called nonsystematic risk or particular risk.

    Examples include car thefts, robberies, and dwelling

    fires. Only individuals and business firms that experi-

    ence such losses are affected, not the entire economy.

    In contrast, nondiversifiable risk is a risk that

    affects the entire economy or large numbers of persons

    or groups within the economy. It is a risk that cannot

    be eliminated or reduced by diversification. Examples

    include rapid inflation, cyclical unemployment,war, hurricanes, floods, and earthquakes because

    large numbers of individuals or groups are affected.

    Because nondiversifiable risk affects the entire econ-

    omy or large numbers of persons in the economy, it is

    also called systematic risk or fundamental risk.

    The distinction between a diversifiable and

    nondiversifiable (fundamental) risk is important

    because government assistance may be necessary to

    insure nondiversifiable risks. Social insurance and

    government insurance programs, as well as govern-

    ment guarantees or subsidies, may be necessary to

    insure certain nondiversifiable risks in the United

    States. For example, the risks of widespread unem-

    ployment and flood are difficult to insure privately

    because the characteristics of an ideal insurable risk

    (discussed in Chapter 2 ) are not easily met. As a

    result, state unemployment compensation programs

    are necessary to provide weekly income to workers

    who become involuntarily unemployed. Likewise, MAJOR PERSONAL RISKS AND COMMERCIAL RISKS 7

    There are at least four costs that result from the

    premature death of a family head. First, the human

    life value of the family head is lost forever. The human

    life value is defined as the present value of the family’s

    share of the deceased breadwinner’s future earnings .

    This loss can be substantial; the actual or potential

    human life value of most college graduates can easily

    exceed 500,000. Second, additional expenses may

    be incurred because of funeral expenses, uninsured

    medical bills, probate and estate settlement costs, and

    estate and inheritance taxes for larger estates. Third,because of insufficient income, some families may

    have trouble making ends meet or covering expenses.

    Finally, certain noneconomic costs are also incurred,including emotional grief, loss of a role model, and

    counseling and guidance for the children.

    Insufficient Income During Retirement The major risk

    associated with retirement is insufficient income. The

    majority of workers in the United States retire before

    age 65. When they retire, they lose their earned income.

    Unless they have sufficient financial assets on which

    to draw, or have access to other sources of retirement

    income, such as Social Security or a private pension, a

    401(k) plan, or an individual retirement account (IRA),they will be exposed to considerable economic insecurity.

    The majority of workers experience a substantial

    reduction in their money incomes when they retire,which can result in a reduced standard of living. For

    example, according to the 2012 Current Population

    Survey, estimated median money income for all

    households in the United States was 50,054 in 2011.

    In contrast, the estimated median income for house-

    holds with a householder aged 65 and older was only

    33,118 in 2010, or 34 percent less.

    4 This amount

    generally is insufficient for retired workers who have

    substantial additional ......