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G1 Insurance Essentials

This lesson will serve as a brief introduction to basic insurance terms and concepts. These terms and

concepts will help to lay a solid foundation upon which the remaining course lessons will build on.

A. THE VERY BASICS

1. WHAT IS INSURANCE?

Defining and describing insurance within the confines of a few brief paragraphs can prove to be very

challenging, especially when taking into account all the various types of insurance available to consumers

today. Even so, for this lesson, we can simplify this task by reducing our discussion to only two types of

insurance—life and health insurance.

Let’s start by first considering the importance of life and health insurance in our society today. Both

types of insurance play a vital role in the financial well-being of individuals and business owners.

a. Life Insurance

It would be difficult to imagine our lives without the many benefits that life and health insurance provide.

Life insurance death proceeds can be used to pay final expenses—funeral costs, medical bills, taxes,

unpaid debts and much more. Countless numbers of families have been spared financial disaster after

receiving a cash gift in the form of life insurance death proceeds from mom’s or dad’s policy. While

it hurts to see them go, it is even sadder to watch a family grieve for their lost one and also struggle

financially.

With a business, life insurance death proceeds can provide one or more business partners with the

needed amount of cash to buy-out a deceased business owner’s interest.

Whether life insurance is purchased to fill a personal or business need, there is one common element

that applies: death levels the playing field for us all, regardless of age, income, address, or social status.

b. Health Insurance

Health insurance can also provide additional financial protection for most people, and greater access to

health care services.

Different from life insurance is the probable number of claims filed. With life insurance, there will be only

one claim filed—when the insured dies. With health insurance, there may be numerous claims filed over

an extended period of time.

G1 - Insurance Essentials

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Health insurance companies usually offer the option to purchase an individual or family policy through a

licensed and appointed agent. However, most people throughout this country acquire health insurance

coverage through an employer group.

Now that we’ve established a practical understanding of the importance of life and health insurance,

and its role in society, let’s discuss how insurance may be defined and understood in the technical sense.

c. Definition

There are a number of definitions of insurance that may help a person to form an idea of what

insurance is and what it does. Most definitions—regardless of simplicity or complexity—share certain

elements that are common to all. The words “transfer,” “indemnify,” or “loss,” among others seems to be

universal in forming an accurate definition of insurance.

Insurance is a method—or social device—for spreading the risk of loss among many people, thereby

reducing the impact of any single loss. Merriam-Webster defines insurance as, “coverage by contract

whereby one-party undertakes to indemnify or guarantee another against loss by a specified contingency

or peril.”1 With either definition, the individual or business that purchases an insurance policy has at that

point transferred the risk of loss to an insurance company.

Keep in mind that insurance doesn’t prevent losses; rather, it spreads the risk of loss among a large

group of people thus lessening the financial impact to any one person or business if a loss occurs.

2. RISK MANAGEMENT KEY TERMS

a. Risk

The terms “risk” and “loss” can sometimes become confused. From a purely financial perspective, loss

can be defined as “the state of having less of something than before because some of it has gone.”2 In

other words, a reduction in the value of something has occurred. The “something” could be a person’s

life, health, income, or other assets.

Risk, on the other hand, can be defined as the possibility or uncertainty of a loss occurring. A loss could

happen, but it may not. There is an element of uncertainty or doubt that must exist if something is to

be considered a risk.

For example, while driving an automobile, an auto accident could occur. Alternatively, if a person walks

across a freshly mopped floor, he or she might slip and fall, causing injury to them. It’s uncertain if either

of these incidents occurs—but the possibility does exist.

Risk can also be used to describe the insured or the exposure that the insurance covers. For example,

“Joe’s Construction Company is the risk covered under the policy,” or “Joe’s Construction Company is

covered for a liability risk.”

1 Merriam-Webster, “Insurance.” Accessed April 17, 2013. http://www.merriam-webster.com/dictionary/insurance

2 “Definition of Loss” Macmillan Dictionary and Thesaurus: Free English Dictionary Online, section goes here, accessed April 17, 2013,

http://www.macmillandictionary.com/us/dictionary/american/loss#loss_16

http://www.merriam-webster.com/dictionary/insurance

http://www.macmillandictionary.com/us/dictionary/american/loss#loss_16





There are many types of risks; however, in this course, we will focus on two types of financial risk that are

relevant to insurance: speculative and pure risk.

(1) Speculative Risk

Speculative risk offers the chance of loss as well as the opportunity for gain. Gambling and investing in

the stock market are often used as examples of speculative risks. With both, you have a choice to risk

something for a possible gain.

For example, Joe enjoys playing cards a few times each week. While playing, he bets a small sum of

money on each hand in exchange for a chance of winning a larger sum of money. Joe may win or lose

depending on his poker skills and the cards he is dealt. Playing this game is a win or lose situation—a

speculative risk.

Keep in mind that speculative risks are not insurable. When was the last time anyone heard of an

insurance company offering poker coverage?

(2) Pure Risk

A pure risk only offers the possibility of loss. There is no opportunity for gain or profit.

An example of a pure risk would be a fire loss to a person’s home. Insurance would pay enough to

restore the home back to the way it was before the loss—and no more. If the insured owned a 2,000

square foot home before the fire, that is what the insurance company will pay to replace. There is no real

gain or profit for the insured.

Keep in mind that pure risks are the only types of risk accepted by insurance companies.

b. Exposure

Exposure means almost the same as risk. An exposure can be defined as a condition or situation

that presents the possibility of a loss. For example, Joe takes a part-time job as a window washer for

Skyscraper, Inc. Some of the office buildings where he works are 10 stories and higher. Joe is “exposing”

himself to the possibility of a long fall.

c. Hazard

A hazard is a condition or source that increases the chance of a peril occurring. It could also increase the

severity of a peril. Hazards will typically be present before a peril occurs.





Three common types of hazards are:

(1) Physical Hazard

A physical hazard is the physical source that causes or increases the chance of a loss. Common physical

hazards include slippery floors, icy road conditions, and faulty structural defects.

(2) Moral Hazard

Moral hazards occur as the result of an individual’s decision to do something wrong or to be less

conscious of their actions because they know their insurance coverage will bear the cost of the loss.

For example, since Jane has full insurance coverage on her car, she is not concerned about locking her

car when it is unoccupied. Her way of thinking is that if her car is stolen, her insurance company will

cover the loss. Therefore, Jane is less cautious at the possible expense of her insurance company. The

negative consequence of her behavior increases the chance of vehicle theft considerably.

If Jane were unable to purchase full coverage auto insurance, she may think and act differently about

locking her car.

Another type of moral hazard occurs when an insured fakes an accident, or acts neglectfully with the

intent to collect on an insurance claim.

(3) Morale Hazard

A person’s careless or reckless actions and attitudes may be a hazard if a loss occurs resulting from them.

Examples:

• Using a cell phone while driving;

• Failing to wear a seat-belt while driving or riding in an automobile;

• Regularly eating pastries after being diagnosed with diabetes.

d. Perils

A peril is the cause of a loss. Perils are generally listed in an insurance policy as covered perils, meaning

that any peril not specifically listed in the insurance policy is not covered. With auto insurance, for

example, if collision is not listed with a limit of insurance on the policy, then collision is not included in

the coverage. With homeowners or commercial property policies, if flood is not specifically listed as a

covered peril, then flood is not included in the coverage.

Below are five examples of common perils.

Fire: A house burns to the ground—fire is the peril.

Accidents: A person runs a red light and hits another car — the collision is the peril.

Explosions: A gas stove explodes in a home — the explosion is the peril.





Flood: A river rises above the flood level and floods a home — the flood is the peril.

Death: A person dies from heart disease — death is the peril.

e. Loss

Financial loss occurs when the subject of insurance (person or property) suffers damage or destruction

by perils insured against under an insurance policy. Losses can be total or partial and are stated as a

dollar amount.

Property Loss Example: The insurance adjuster determined that Joe had a covered partial loss in the

amount of $34,000 after an accidental fire damaged his home.

Accident & Health Insurance Example: The insurance company paid the hospital $12,000 for services

rendered to Joe for injuries he sustained during the house fire.

Liability Insurance Example: The insurance company paid Joe’s neighbor, Tom, $25,000 for injuries he

sustained from the fire while at Joe’s house.

Life Insurance Example: Unfortunately, Joe’s 78-year old live-in mother passed away from smoke

inhalation caused by the fire.

f. Direct and Indirect Loss

Some property insurance policies cover only “direct” losses while others cover only “indirect” losses.

Some policies cover both.

(1) Direct Loss

This is a direct physical loss to the property from an insured peril such as fire, wind, or lightning. For

auto insurance, the direct loss may result from an auto collision involving an insured auto.

(2) Indirect Loss

An indirect (or consequential) loss is the result of a direct loss. There can be no indirect loss without a

direct loss occurring first.

For example, Joe’s home has extensive fire damage and is deemed unsafe to occupy Joe must find

somewhere else to live while repairs are being made to his home. His insurance company will pay for a

temporary home for Joe up to the policy limits.

In this situation, the damage caused from the fire to Joe’s home is the direct loss, while the need for

temporary housing is the indirect loss.

f. Principle of Indemnity

Associate the word “restore” with indemnity as it relates to a covered loss. The principle of indemnity

states that the insurance company will restore you to the same financial position you were in before

the loss occurred—no better, no worse. To indemnify means to secure against loss and make whole

after a loss occurs. However, you should not be compensated by the insurance company in an amount





exceeding your economic loss. There should be no gain from your loss—only restoration and not a

profit.

Without this principle, the fundamental purpose of insurance could be challenged by persons purposely

causing losses to profit from insurance.

Indemnity = No Gain in the Claim

h. Predetermined Limits

Life insurance is a good example of predetermined limits. The insurance company knows exactly what

they will pay when the insured dies. If the insured purchases a death benefit of $100,000, the company

knows the amount they will ultimately pay to the insured’s beneficiary. This knowledge allows the

insurer to charge adequate premiums to pay claims and cover company expenses.

Conversely, with health insurance, the insurance company has no idea what the future loss amount will

be on an individual insured.

3. METHODS OF HANDLING RISK

Individuals, businesses, and governments are exposed to innumerable types of risk each day. These risks

may be financial, physical, political, or another category of loss uncertainty.

Many risks are small in nature and do not present a substantial financial impact to us; however, losses

resulting from auto accidents, serious health conditions, or loss of life can have a financially devastating

effect on our lives.

The primary goal of risk management is to minimize or mitigate risks of all types. To that end, a variety

of methods or techniques can be employed to help manage risk.

Typically, risk is mitigated or managed using one or more the following risk management techniques.

a. Avoidance

To avoid a risk, simply do not perform an activity that has any risk. You can completely avoid the risk of

being in an automobile accident, for example, by never getting into an automobile.

Another example is that you can avoid losing value in your retirement portfolio by investing in FDIC

insured certificates of deposit (CD). You are avoiding the riskier investments.

b. Retention

Risk retention is choosing to be financially responsible for all or part of a risk. It’s on you if a loss occurs.

A common example of retaining risk is the use of deductibles or co-insurance in insurance policies. The

insured will retain or self-insure an amount equal to the deductible or coinsurance.

Another example of risk retention is when a person chooses to self-insure rather than purchase insurance.

The insured then retains all the risk.





c. Sharing

Sharing occurs when risk is distributed among several people who have invested a certain amount of

money. Losses are allocated to each person based on a simple formula:

Individual investment ÷ total investment = proportional share of loss

To further illustrate, let’s assume that five investors purchased a large commercial building at a bargain

price of $1,000,000.

Each of the investors contributed the following amounts of money:

Investor Amount Risk Share

Investor 1 - $100,000 10%

Investor 2 - $425,000 42.50%

Investor 3 - $150,000 15%

Investor 4 - $162,500 16.25%

Investor 5 - $162,500 16.25%

A person’s share of the risk is proportional to the percentage their investment represented of the total

amount invested by all persons.

d. Reduction

Since risk cannot be completely avoided, the possibility or severity of a loss can be reduced by using risk

control techniques.

For example, while home fires are not always preventable, the chance or severity of a fire can be greatly

reduced by installing a fire suppression system.

Another example is reducing the chance of death by quitting a dangerous hobby such as skydiving.

e. Transfer

Buying insurance is the most common method used to transfer risk. The policyholder pays a premium

amount much smaller than the value of the insured item or person. In return, the insurance company

accepts the financial responsibility for covered losses under the policy.

Another risk transfer method used in certain circumstances is a hold-harmless agreement. This is an

agreement or contract in which one party agrees to hold the other party free from the responsibility for

any liability or damage that might arise out of the transaction involved.

For example, if a business owner contracts a janitorial service to provide cleaning services to the company

office building, the owner may require the service to sign a hold-harmless agreement indemnifying

(securing against loss) the company if the service negligently causes a dangerous condition that injures

a visitor. The business owner has transferred that risk to the janitorial service.





4. ELEMENTS OF INSURABLE RISKS

While insurance is the most common method to handle risk, not every risk can be insured. Insurers will

only insure pure risks, which offer the possibility of loss with no possibility for gain. No one should profit

from insurance.

To be insurable, the risk must:

a. Be a Predictable Loss

An insurer must be capable of statistically predicting the possibility of the loss. As mentioned earlier,

insurers require a large number of homogeneous (similar) risks to accurately calculate the frequency

and the severity of losses, and to set their premiums accordingly. Insurers are able to measure risk and

accurately predict losses based on the law of large numbers.

b. Be a Chance Occurrence

The risk of loss must be outside the insured’s control. The loss must be unexpected, accidental, or

uncertain. Insurance cannot be provided for losses that are certain to occur.

For example, the risk of loss due to an automobile accident may be unexpected; however, the risk of car

tires wearing out eventually is not an unexpected loss, and therefore not insurable. Tires are expected

to wear out eventually.

c. Not be Catastrophic

Insurers will typically not insure risks that will expose them to losses that may occur to a large number

of insureds at the same time. These causes of loss are not predictable; therefore, they are not normally

insurable.

Examples of catastrophic perils not insurable would include war, nuclear hazards, and hurricanes.

Remember, insurers must have a predictable dollar limit to the losses they insure. Some insurers will

cover certain catastrophic losses for a very high premium; however, most high risk insurance is bought

through the excess and surplus lines market which we will discuss later in this lesson.

d. Be Measurable and Definitive

An insurable risk is a loss that has a definite monetary value. The insurer must be able to measure or

value a potential loss. Insurers will not simply insure a risk with an unknown value. Insurers must know

the value or the limit they will have to pay if a loss occurs.

For example, the amount of life insurance a person should own can be determined by their human life

value (the person’s lost wages after death).

With home and auto coverage, the insurer must know the economic value of the property to be insured.





e. Cause a Financial Hardship

The loss must cause a financial or economic hardship to the insured. Losses that are too small to cause a

financial hardship are not considered insurable.

For instance, if Jane accidentally leaves a romance novel in her hotel room that she was reading while on

vacation in Hawaii, she would not be able to claim this loss under her Homeowners insurance. The loss

of the romance novel would not cause Jane a financial hardship; therefore, it would not be insurable.

f. Be Affordable

The premiums for the coverage must be affordable to the insured. If the risk was so high that the insurer

had to charge an extraordinarily large premium to provide coverage, then the coverage would not be

affordable for the insured.

5. ADVERSE SELECTION

One of the functions of the underwriting department is to protect the insurer from adverse selection.

The idea of adverse selection is that poor risks are more likely to buy insurance than average risks.

For example, if I am diagnosed with cancer today, I would be happy to go out and buy a cancer policy.

If my doctor tells me that I will die from the cancer within 6 months, I would also want to purchase

additional life insurance. In these cases, the insurance company would not sell a policy to me for obvious

reasons. If I am healthy, then I may tend to delay purchasing insurance or shop less often.

6. THE LAW OF LARGE NUMBERS

Insurance companies would not be in business for long if they did not have a reliable way to predict

future losses. This is where the law of large numbers plays an important role.

Insurance companies use actuaries to analyze the financial costs of risk and uncertainty. Actuaries use

mathematics, statistics, and financial theory to determine the risk of an event occurring to a specific

demographic. Companies must know this information before they can set insurance premiums. These

predictions contribute to the rates that insurers use to develop premiums for insurance coverage.

Actuaries start out with a large number of homogeneous (similar) risks. As the size of the group increases,

predictions become more accurate. In other words, the larger the group used to obtain the statistics, the

more accurate the statistics.

While it would be impossible to predict who would have a loss, it is possible to predict the approximate

number of total losses of a particular group. For example, insurers cannot accurately predict when Joe

will die. However, the law of large numbers allows insurers to predict the average age for Joe’s current

age group and class. With property and casualty insurance, the company has no idea which houses will

burn this year. However, the company knows approximately how many house fires will occur during the

year.


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For life insurance, these statistics help insurers develop mortality tables that are used to predict

mortality rates (average deaths among individuals in a particular class at different ages). The mortality

rates help insurers derive the premiums they charge for life insurance.

For health insurance, these statistics help insurers develop morbidity tables that are used to develop

morbidity rates (the incidence of a particular disease or disorder in a population, usually expressed as

cases per 100,000 or $1 million in one). The morbidity rates help insurers derive the premiums they

charge for certain types of health insurance.

7. REINSURANCE

Reinsurance is insurance that is purchased by an insurance company from another insurance company

(called a reinsurer) to help offset risk. Essentially, a reinsurer is an insurance company’s insurance

company.

Reinsurance program design will vary among insurance companies, but the primary purpose for

implementing a program is somewhat universal. In a nutshell, reinsurance is used by insurance

companies to protect themselves against catastrophic losses.

Reinsurance programs are usually designed to include several reinsurers which allow the insurance

company to expand its total retention limit (the dollar amount the insurance company would be

responsible for in case of a large claim).

The insurance company transferring the risk to the reinsurer is called the ceding company; the

reinsurance company assuming the risk is the reinsurer.

Facultative reinsurance is negotiated separately for each insurance contract that is insured. The

reinsurer retains the right to accept or reject each risk, so there must be an offer and acceptance on

each reinsurance contract.

Treaty reinsurance covers all the insurance policies coming within the scope of the reinsurance

agreement. Under this type of agreement, individual insurance contracts are not negotiated separately

as done under a facultative agreement. As long as the insurance contracts meet the criteria set forth on

the treaty reinsurance agreement, each contract is automatically accepted.


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B. INSURERS

1. TYPES OF INSURERS

The insurance industry is a huge financial industry with over one-thousand insurance companies

operating in the United States today. Insurance companies are categorized according to how they are

organized and operated.

a. Stock Companies

A stock insurer is owned by a group of stockholders who are not necessarily policyholders. Shareholders

or stockholders purchase shares of an insurance company’s stock. By owning company stock, the

stockholders are allowed to participate in company earnings. Similar to most other publicly traded

companies, the stockholders provide the capital necessary to establish and operate the insurance

company.

If the company makes a profit, then the stockholders benefit with increased stock price values and

dividends (not the same as mutual company surplus dividends). In return, the shareholder may be

required to pay taxes on stock price increases and dividends because it represents a return on their

investment.

Stock companies normally issue nonparticipating (nonpar) policies. When the insured signs up for

a non-par whole life policy, he or she will know what the premium, cash surrender values, and death

benefit will be for the life of the contract. Future company earnings will have no effect on the policy

after issue.

b. Mutual Companies

Mutual insurance companies have no stockholders. Instead, the policyholders own the company.

Mutual companies usually sell participating (par) policies that pay policy dividends to the policyowner

when declared by the company. Dividends are company profit that the insurer divides among the

policyholders. Since the policyholders own the company, any excess profit belongs to them. However,

the annual decision to pay dividends rests with the company’s board of trustees.

Note that participating policies generally have somewhat higher premiums than nonparticipating

policies due to an allowance for future dividends.

c. Fraternal Benefit Societies

Fraternal societies have memberships based on religious, national, or ethnic affiliations. They are well

known for their social, charitable, and benevolent activities.

Fraternal companies primarily sell life insurance. Before you can purchase life insurance from a fraternal,

you must become a member of the fraternal organization. The membership application is normally

completed along with the application for insurance.


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To a certain extent, a fraternal company is regulated differently than a stock or mutual company.

A fraternal company is operated for the benefit of its members; therefore, there are no

stockholders to answer to, or policyholders to share dividends with. Organizationally, fraternal

companies more closely resemble mutual companies in their operations.

d. Lloyd’s Associations

Lloyd’s is the world’s best known, but probably least understood insurance brand. This is because

Lloyd’s is not an insurance company but rather a society of members, both corporate and individual,

who underwrite in syndicates. Combined, the syndicates at Lloyd’s form one of the world’s largest

commercial insurers and reinsurers. Capital is provided by investment institutions, specialist investors,

international insurance companies, and individuals.

Lloyd’s are better described as a market where individuals and groups gather to exchange insurance,

similar to how stock exchanges provide a place to buy, sell and trade stocks. Lloyd’s provides a meeting

facility and administrative services to its members.

e. Self-Insurers

Some companies and individuals choose to self-insure. Part or all the risk of loss is borne without the

benefit of insurance coverage to fall back on if a loss occurs. Many large companies are self-insured

because they have the resources to withstand losses and their claims experience demonstrates that it is

cheaper to be self-insured than to pay for insurance coverage.

f. Surplus Lines

If the risk is very large or unusual in nature, the typical admitted insurance company may not be

unwilling to consider it. These types of high-risk specialty products are not available in the regular

market place. Coverage can often be written through non-admitted insurers called excess or surplus

lines companies. These companies are not authorized to write regular insurance business in the state;

however, most states will allow licensed excess or surplus lines agents to place insurance through these

companies when coverage cannot be acquired through the regular insurance market.

For certain special risks, the surplus or excess lines market is the only option to obtain coverage.


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2. PRIVATE AND GOVERNMENT INSURERS

The federal government along with the states provides social insurance programs to cover risks that

private insurers cannot or will not insure. These programs are primarily funded through taxes and serve

national and state public interest.

Examples of government insurance programs include Social Security, Medicare, Medicaid, and state

worker’s compensation programs. Servicemembers Group Life Insurance (SGLI) and Tricare are

insurance programs available to the military and their families.

Other coverages include the National Flood Insurance Program (NFIP) to help provide flood insurance

for catastrophic flood losses, the Federal Crop Insurance Corporation (FCIC), and the Federal Deposit

Insurance Corporation (FDIC) that insures bank deposits.

With the wide variety of insurance coverage types, the U.S. government may be the largest insurer in

the world today.

Government-sponsored social insurance programs have all the following characteristics:

• All aspects of the program, including benefits, funding, and eligibility requirements, are prescribed

by law.

• The program does not provide benefits through an insurance contract or policy. Often, a trust fund

is utilized to provide explicit accountability of benefit payments and income.

• The program is funded by taxes or premiums paid by (or on behalf) of participants. Some programs

are subsidized using government contributions or other sources.

• Program participation is compulsory for a defined population; however, program contribution levels

subsidized to the extent that the vast majority of eligible individuals choose to participate3.

According to an article4 published by the Center on Budget and Policy Priorities, nearly 50 percent of

2010 federal expenditures went to Social Security and the major health insurance programs—Medicare,

Medicaid, and Children’s Health Insurance Program (CHIP). That equates to over $1.4 trillion for these

three programs.

3 Social Insurance .., http://www.actuarialstandardsboard.org/pdf/asops/asop032_062.pdf (accessed May 16, 2013).

4 Where Do Our Federal Tax Dollars Go .., http://www.cbpp.org/cms/index.cfm?fa=view&id=1258 (accessed May 16, 2013).

http://www.actuarialstandardsboard.org/pdf/asops/asop032_062.pdf

http://www.cbpp.org/cms/index.cfm?fa=view&id=1258


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3. AUTHORIZED AND UNAUTHORIZED INSURERS

Before an insurer can transact business in a specific state, they must apply for a Certificate of Authority

from the Insurance Commissioner and meet the capital and surplus requirements required by that state.

Insurers who meet these financial requirements and are approved to transact business in the state

are considered authorized or admitted into the state as a legal insurer. Insurers who have not been

approved to do business in a state are considered unauthorized or non-admitted insurers.

Note that once a Certificate of Authority is issued, it belongs to the state rather than to the insurer

Those insurers who have not been approved to do business in the state are considered unauthorized

or non-admitted companies.

4. DOMICILE

Domestic, foreign, and alien companies must always be licensed in each state in which they transact

business. State designation for insurers is the state of incorporation.

These are types of state designations:

a. Domestic Insurers

These are companies that are incorporated in the same state in which they conduct business.

b. Foreign Insurers

These are companies that are incorporated in a state other than where they are conducting business.

c. Alien Insurers

These are companies that are incorporated in a country other than where they are conducting business.


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5. FINANCIAL STATUS (INDEPENDENT RATING SERVICE)

One of the most important things you can do when choosing an insurance company is to select one

that’s financially sound. To help you in your decision, there are independent organizations that rate the

financial stability of insurance companies. These companies assign ratings based on an insurer’s financial

soundness and credit. Both insurance producers and consumers have a right to see this information

before accepting appointments, placing coverage, or applying for a policy.

Five of the most well-known rating services are Standard & Poor’s, the A.M. Best Company, Duff & Phelps,

Weiss Research and Moody’s Investors Services.

Rating Services Key Points:

• Not all services rate all insurance companies.

• Each service uses different criteria for rating and evaluating the financial strength of insurance

companies.

• Each service assigns a letter grade from A to F with varying degrees.

b. Standard & Poor’s

Highest financial-strength ratings are AAA (extremely strong) and AA (very strong). Standard & Poor’s

also designates certain companies as Security Circle insurers. These companies must rank in the top

four categories for financial strength, submit to a comprehensive initial review, and undergo ongoing

monitoring.

c. A.M. Best

Unlike the other services, A.M. Best rates only insurance companies, and it rates the entire market. Top

financial-strength ratings fall in the categories of superior (A++, A+) and excellent (A, A-).

d. Duff & Phelps

This agency specializes in rating small-to-medium size insurers. Companies with a high claims-paying

ability get marks of AAA, AA+, AA, and AA-. Along with its ratings, Duff & Phelps’ Solvency Seal identifies

companies that have been in operation five years or longer, and show a strong long- and short-term

capacity to pay claims.

e. Weiss Research

Weiss Ratings is the nation’s independent provider of bank, credit union and insurance company financial

strength ratings and sovereign debt ratings. Weiss top financial-strength ratings fall in the category of

excellent, A+, A, A-.

f. Moody’s Investors Services

Moody’s Investors Service is a leading provider of credit ratings, research, and risk analysis. Moody’s

issues Aaa, Aa, and A to companies with minimal to low credit risk.


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6. MARKETING (DISTRIBUTION) SYSTEMS

Insurance is sold by many companies through an assortment of different distribution systems. The

majority of consumers buy insurance through an insurance producer who represents an insurance

company.

Insurance producers may either be an agent who represents a specific company or a broker who

represents many different insurance companies.

a. Captive (Exclusive) Agency System

Captive agencies are similar to branch offices of stock and mutual insurance companies that represent

one particular insurer in a specific geographical area.

Captive agencies recruit insurance producers who are trained and supervised by a company employee

or a General Agent.

Depending on the insurance company, General Agents may act exclusively as a manager or as a manager

and insurance producer combined.

(1) Producer Category

A captive or exclusive producer is an agent who represents one insurance company and sells only that

company’s insurance products. The captive producer represents the insurance company, not the insured.

Producers who are new to the insurance business are usually paid first year commissions (FYC) of

approximately 50% on the annual life premium, plus a training allowance for the first two or three years.

They also usually receive renewal commissions of approximately of 10%.

b. Independent Agency System

The independent agency system is a spin-off of the property and casualty insurance industry. Producers

are not affiliated with a particular insurer; therefore, they are independent producers who represent

various insurers.


Independent producers usually work for themselves or for a General Agent (GA) or Managing General

Agent (MGA). The producer represents the insured rather than the insurer. Producers may represent as

many insurers as they desire, and are paid commissions on the business they write.

The independent producer owns the policy expirations that allow the producer to place an insured’s

business with another insurer at renewal time, if it is in the insured’s best interest.

c. Managing General Agent System (MGA)

A personal producing general agency system recruits, hires, trains, and supervises other producers

through a contractual agreement with an insurer. However, any producers hired by an MGA are

employees or independent contractors of the MGA and not the insurance company.


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The MGA’s primary responsibilities are twofold:

• To sell insurance

• To build and supervise a sales force of producers in which the MGA receives an override commission.

MGA’s are usually responsible for the overhead of maintaining their offices and administrative staff.


Generally, producers hired by an MGA will sell only products through contractual arrangements with

insurers the MGA represents; however, there are many different types of agreements or arrangements

permitted under the MGA system.

d. Brokers

Brokers are independent producers who sell insurance through many different insurance companies.

A producer acting as a broker represents the insured in selecting the best coverage available from the

various companies they represent. Brokers do not have binding authority.

e. Direct Response

Certain insurance marketing is conducted through direct selling methods in the mass media. This type

of marketing is referred to as Direct-Response Marketing.

This method uses advertisements in newspapers, magazines, television, and other mass media sources

to market policies directly to consumers. The policies offered usually have low premiums and low

benefits.


Direct response systems do not normally use agents for the sale of insurance. Instead, insurance is

sold through mass media advertising, typically with the customer responding by calling an advertised

telephone number that links the customer directly to the insurance company, or by mailing a direct

response card or application provided by the insurance company.

f. Direct Writing Companies

Direct writing companies sell their policies through company employees who are compensated by salary

or a combination of salary plus commission. The representatives do not own the policy expirations, so

they do not have the choice of moving a policy to another company when the policy renews. Therefore,

the insurer owns the business written.


Generally, producers are salaried employees of the direct writing company.

g. Internet Insurance Sales Systems

This is a relatively new insurance distribution system, offering many different lines of insurance coverage.

Insurance can be purchased online directly from the insurance company or agent.


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Many property & casualty and life & health insurers have websites available, either for direct purchase

or to locate an agent.

h. Franchise Marketing Systems

Franchise marketing provides insurance coverage to groups of employees that are too small to meet

the requirements of a group policy. Individual policies are issued with premiums payable by payroll

deduction. Each policy will vary as to the amount of coverage issued and premium amounts. Individual

underwriting is required; therefore, no group underwriting or premium rate reduction is given.

i. Non-Insurance Marketing Systems

This system markets insurance products through financial institutions that issue credit cards. The

purchase of the insurance product can be deducted from the credit cards or banking accounts held by

the financial institutions marketing the insurance product.

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