5 Basic Principles of Insurance. 2 Different Forms of Insurance.

Taking risks is one of the principal characteristics of enterprises. This concept is most valid for insurance companies whose main purpose is to assume risks that other economic entities do not wish to bear and whose principal factor of production is equalization of risks by forming a suitable portfolio of insured risks over time. These two characteristics make an insurance company a prototype risk bearer that other economic entities might use to learn the essentials of risk taking and use the information to their advantage.

It is worth noting that all insurance companies are large institutional investors. Premiums for all lines of insurance are usually necessarily paid in advance. For that reason it is desirable for insurance companies to invest premium funds until they are required to pay claims. However, investment is not the core business of insurance. Moreover, since safety is an important target, insurance companies are not comparable to other investors.

5 Basic Principles of Insurance

1. Distribution of Risk

Insurance is a financial agreement that redistributes the costs of unexpected loss. The insurer (insurance company) concludes contracts (risk transfers) with a large number of parties (insureds) and operates on the basis of the mathematical law of large numbers. This core technique aims at reducing variation, thus making expenses for compensation more calculable. Since insurance plays an important role in society, it operates under special laws that regulate access to the market, reporting, supervising and facilitating the business, for example, by allowing the building of reserves as other economic entities are allowed to do.

Insurance involves both pure and speculative risks. Pure risks present only a possibility of loss. The converse speculative risk may produce a gain or loss. The objection commonly raised against this distinction is that it has no definite zero point, that is, whether a result is considered a gain or loss may depend on a given situation. Thaler and Johnson (1990) found that gaining first and losing later during a visit to a casino is different from experiencing losses from the beginning of a gaming session, and both situations utilize different decision patterns.

Tversky and Kahneman (1981) elaborated a theoretical basis for this behavior and called it framing. For example, whether a glass is half full or half empty is a matter of view (frame). The prospect theory is built around the related concept of reference points that serve as a basis for the reasoning of a decision maker.

The insurance situation, however, is different . In the most basic case, both alternatives (paying a premium and bearing uncertain loss) are framed as negative deviations from a reference point. In other words, the analysis of insurance by distinguishing pure from speculative risks makes sense since there is general agreement on the position of the reference point.

2. Principles of Pricing

Risk transfer impacts insurance premiums. A premium consists of specific elements: (1) a net risk premium calculated on the basis of individual loss exposure, (2) a security loading to absorb variance, (3) a loading to cover costs that are not directly risk-related, (4) a profit margin, and (5) taxes.

3. Fair Premiums

An insurance premium is actuarially fair if based on individual expected loss. A premium calculated on this principle has advantages for insured and insurer, but it is not always feasible to develop actuarially fair premiums. The result may be over- or under-pricing relative to individual risk and the insurance pool may become less predictable (and consequentially more expensive if higher security loadings and reserves become necessary). Poor risk allocation (adverse selection) may even ruin insurance companies.

To explain the importance of an actuarially fair premium, the following example is widely used. Consider a market with two insurance companies and a large number of insurance buyers. Company A charges premiums based on individual expected loss. Company B charges an average premium based on collective expected loss. Let us assume that at the beginning, policyholders are randomly and evenly distributed between the two companies. At the end of each period, contracts must be renewed. Insurance buyers thinking that they pay more than their individually fair premium will switch to Company A. Since all A’s insurance contracts are calculated on the basis of individual loss exposure (the company’s portfolio is called structurally neutral), A is not negatively affected by the switch. Company B is affected because its remaining policyholders have relatively high loss expectations, forcing B to raise premiums to the new average. This procedure repeats itself at the end of each period. Ultimately Company B will leave the market or go bankrupt.

Taking the individual expected loss as a starting point for premium calculation has the additional merit that it can induce risk-reducing or risk-avoiding behavior on the part of the buyer. In fact, as a starting point of risk management, insurance companies rewarded the implementation of risk reduction or risk avoidance measures of policyholders by reducing premiums. It is obvious that such incentives work best when pricing is a matter of individual expected risk.

Another possibility to induce risk avoidance or reduction and reduce premiums is to cut off loss distribution at its lower end by agreeing upon deductibles. In practice, that means insureds pay their smaller losses. This technique again requires calculation of premiums on the basis of individual expected risk.

On the other hand, a complete transfer of risk from insured to insurance company is widely suspected to generate additional risk, usually referred to as “moral risk” that implies that a policyholder has a higher expected risk when he carries insurance against it. Although little empirical evidence indicates this interrelation, insurance companies try to counter such effect by including deductibles in their insurance agreements. It should be noted that this concept also applies to reinsurance contracts concluded between reinsurers and primary insurers, where (unlike other insurance contracts) both parties are highly knowledgeable about risk and risk transfer.

4. Security Loading

Security loading is intended to provide for the variations of losses inevitable in every portfolio. It can be shown (Karten, 1991) that without security loading, an insurance company will go bankrupt. The reason for this lies in so-called long tail risks that have very small probabilities and very high loss potentials. Security loadings can be replaced by reserves. A new insurance company would require higher security loadings than an insurance company that already has sufficient reserves.

5. Forms of Insurance

Different forms of insurance are often developed because full insurance (complete transfer of risk to insurer) is unfeasible. One reason is that complete transfer may result in unintended consequences. Another is that premiums for full transfers are often prohibitively high. Therefore, the parties try to find a more suitable solution. Different forms of insurance vary the amounts of risk transfer and risk premium as a solution to the problem.

Full insurance—As noted, full insurance means a complete transfer of a risk to an insurer. A contract can include deductibles that limit the insurer’s liability for low and moderate size risks. The result of deductibles, of course, is not a complete risk transfer.

Limited transfer of risk—By setting a maximum sum insured, risk transfer is modified at its upper limit, that is, for large, improbable risks. Basically, the two common forms are used. The first is agreement on a specific sum of money for indemnification. No matter how large a loss actually is, the insurance company will pay only the specific sum in compensation. Settlement of damages is easy and therefore economical, resulting in a reduction in premium. The second type of contract compares an incurred loss to the sum insured and indemnification is calculated proportionally.

The author of the aboved writing:  Maximillian Edelbacher

5 Basic Principles of Insurance. 2 Different Forms of Insurance.

KEY REQUIREMENT OF INSURABLE INTEREST. Understand this key principles and rules in Life Insurance Law. Your Legal Guide of Life Insurance.

Understand the following key principles and rules in Life Insurance Law. Your Legal Guide of Life Insurance.

REQUIREMENT OF INSURABLE INTEREST

“Insurable interest” is a key principle in life insurance law. It is the requirement imposed by law (and by insurers) to prevent a “gaming” or “wagering” by one party on the life of another through insurance. Simply put, to insure the life of an individual, the applicant must have an insurable interest, i.e., a greater concern in the insured’s living than dying. Courts (and insurers) look for “a reasonable ground … to expect some benefit or advantage from the continuance of the [insured].” Stated in another manner, the public has an interest in preventing the contract of insurance where the applicant has no interest in the continuation of the insured’s life other than the prospect of profiting from the insured’s early demise.

It is almost universally accepted that a person has an unquestionable insurable interest in his or her own life. “The mere fact that a man of his own motion insures his life for the benefit of either himself or of another is sufficient evidence of good faith to validate the contract.” So, most applicant-insureds will face no insurable interest issue in obtaining life insurance. Nor will their naming of someone other than their estates as beneficiary usually pose a problem since it is generally assumed that the insured will not name as beneficiary someone who wished him harm or who would wager on his life. (Of course, if the policy was obtained expressly for the purpose of wagering or if the policy was really purchased by and soon after issue assigned to the third party
beneficiary, the courts will declare such a contract void. Public policy will not allow one to accomplish by fraudulent indirection what one clearly is prohibited from doing directly.)

Every state has either statutory law or case law on insurable interest and all require that either the beneficiary or applicant hold such interest at the inception of the contract. Most states do not require that either the beneficiary or assignee of a policy have an insurable interest. The majority of states hold that there is nothing conclusively illegal about an assignment to one who holds no insurable interest—even where the insured is paid value for the assignment. But some states do require that the assignee have an insurable interest—even though some of the same states allow the insured to name a beneficiary who does not have an insurable interest.

Because each state is free to create its own laws on insurable interest and because different state courts have come to different conclusions on the issue, it is impossible to develop rules that apply without question in every state. Most state laws do not question the insured’s insurable interest in his own life nor the interest of close relatives related by blood or law and bonded through natural love and affection with the insured. With respect to others, statutes favor persons who stand to profit by the insured’s continued life, suffer economic loss at the insured’s death, and who have more to gain by the insured’s continued life than death.

Generally, the following rules regarding insurable interest apply:
1) Blood relatives –
 A parent usually is deemed to have an insurable interest in his or her child’s life.
 A child usually is deemed to have an insurable interest in his or her parent’s life. (But once the child becomes a financially independent adult, it is not certain that all courts would hold that the blood relationship alone would be sufficient to meet insurable interest tests).
 A grandchild usually is deemed to have an insurable interest in the life of a grandparent.
 A grandparent usually is deemed to have an insurable interest in the life of a grandchild.
 Siblings usually are deemed to have an insurable interest in the life or lives of brothers and sisters.
 Other relatives, such as an aunt, uncle, niece, nephew, or cousin, generally are not deemed to have an insurable interest merely by virtue of their blood relationship (but may have an insurable interest arising out of a business or financial transaction or out of financial dependency on the insured).

2) Marriage –
 Spouses have an insurable interest on each other’s lives.
 A few courts have held that a person engaged to another has an insurable interest in the other’s life.
 Other individuals related to the insured by marriage are usually deemed not to have an insurable interest based solely on a marriage relationship (but may have an insurable interest based on financial dependency). In-laws, for example, or step-sons or daughters, or foster children have no per se insurable interest based on family relationships but can obtain insurable interest because of dependency.

3) Business –
 A person (or business or financial enterprise) that would suffer a financial loss at the insured’s death will usually be deemed to have an insurable interest (assuming that the amount of coverage bears a reasonable relationship to the loss that would be suffered at the death of the insured). This means an employer can insure an employee, an employee can insure an employer, a partner can insure a partner, and a partnership can insure its partners, a surety can insure the life of his principal, and a member of a commercial enterprise can insure an individual if that person’s death would adversely affect the financial stability or profits of the enterprise. (Although a business generally has an insurable interest in the lives of officers, directors, and
managers, or others on whose continued life or lives the business’ success may depend upon, a corporation may not have insurable interest in the life of a shareholder who has no working or other financial relationship with the business. The point is that it is not the mere legal relationship that creates the insurable interest, but rather the “existence of circumstances which arise out of or by reason of” the entity.)
 Where business associates have insured each other to fund a purchase of the business interest at the insured’s death or the business itself has insured an owner to fund a purchase of that person’s interest at death, usually there will be an insurable interest.
 Creditors have been allowed to purchase policies on debtors as long as the relationship between the amount of insurance and the debt were proportionate. But at the point where the transaction was more of a wager than an effort to secure a debt (decided on a case by case basis), the policy is void as lacking insurable interest. So the closer the insurance amount is to the debt owed, the more likely insurable interest will not be an issue. (However, once the policy has been issued to a creditor, the creditor typically is allowed to keep the entire amount of the proceeds even if the amount exceeds the debt.)

Most states require that insurable interest be present only at the time when the life insurance contract is entered into (i.e., at the inception of the policy) and need not be present at the insured’s death. Therefore, a wife who is married at the time the insurance is purchased on her husband’s life but divorced from him at his death is not barred from collecting. Likewise, if a corporation purchases insurance on the life of a key employee, by definition there is an insurable interest at that time. If the employee later leaves the firm, the corporation can still collect the proceeds of the policy on his life.

Even if the insurable interest tests are met by a third party applicant, state law will void the contract if the insured is not informed and the insured’s consent is not obtained. Even a spouse cannot lawfully purchase a policy on the other spouse’s life in most states without that person’s knowledge and consent. However, there is a practical exception to this general rule: a parent can, without the child’s consent, purchase relatively small amounts of life insurance on the life of a minor child since the child does not have the legal capacity to consent and so such consent would be meaningless.

Passing of the contestable period will not bar an insurer from asserting a lack of insurable interest since the strength and validity of the incontestable clause is predicated on the existence of a valid contract. Absent insurable interest, there never was a valid contract.

An insurer has a legal duty to use reasonable care in ascertaining the existence of insurable interest and in assuring that the insured did in fact consent to the coverage. If the insurer does not use reasonable care in both duties, it may be liable for the harm that occurs to the insured and/or beneficiaries. For this (and sound underwriting economic) reason(s), insurance companies are often more stringent than state law requires.

KEY REQUIREMENT OF INSURABLE INTEREST. Understand this key principles and rules in Life Insurance Law. Your Legal Guide of Life Insurance.

Fundamentals of Annuities Planning. Wealth Management, Pensions, Annuities & Retirement Planning Guide. Your Learning Resource Centre.

Annuities


WHAT IS IT?
Annuities are the only investment vehicles that can guarantee investors that they will not outlive their income, and they do this in a tax-favored manner. In addition, annuities are available with a host of features to meet a wide variety of investor needs. The income taxation of annuities is governed by IRC Section 72.

Technically, annuities are contracts providing for the systematic liquidation of principal and interest in the form of a series of payments over time.[1.] However, this really refers to the “payout” phase of an annuity; in point of fact, annuities can (and often do) have an accumulation phase that also lasts for a substantial period of time.

An annuity is established when the investor makes a cash payment to an insurance company, which invests the money – this may be a single large cash payment or a series of periodic payments over time. The money remains invested with the insurance company and is periodically credited with some growth factor – this is the accumulation phase of the annuity. In return for making a deposit into an annuity, the insurance company ultimately agrees to pay the owner (or owners) a specified amount (the annuity payments) periodically, beginning on a specified date – this is the payout phase of the annuity.

If the specified date for payouts to begin is within one year of the date the contract is established (i.e., a single cash payment is made and the insurance company begins a systematic liquidation of the payment back to the owner within one year), the annuity is called an “immediate annuity”. If, alternatively, the specified date for payouts to begin is at least one year later, the annuity is called a “deferred annuity” (because deposits are made now, but the payout is deferred). An immediate annuity only has a payout phase; a deferred annuity has both an accumulation and a payout phase.

If the payout phase of the annuity is a life annuity, the company promises that payouts will continue for as long as the annuitant (or annuitants) live; the income stream can never be outlived (NOTE: although often the same, technically the owner of the annuity does not necessarily need to also be the annuitant; occasionally these are different individuals). If the payout phase is a fixed period annuity (also called a term-certain annuity), the company promises to pay stipulated amounts for a fixed or guaranteed period of time independent of the survival of the annuitant. An annuity payout can also utilize a combination of the life and fixed period options, such as “for the greater of 10 years or the life of the annuitant(s).

In addition to differentiating between immediate and deferred annuities, and fixed and term-certain payouts, annuities are also categorized as to whether they are fixed or variable (be careful not to confuse a “fixed annuity” with a “fixed period payout”). Classification as a fixed or variable annuity refers to the underlying investments during the accumulation phase of the annuity; a fixed annuity is invested in the general fixed account of the insurance company, while a variable annuity is invested in separately managed sub-accounts (that function similarly to mutual funds) selected by the annuity owner. Variable annuities often have additional features to help manage the risk of their underlying investments, such as guaranteed death benefits or newer “living benefits” that provide company-guaranteed payments for owners or beneficiaries even if (or especially if) they would be higher than actual investment performance would provide for.

Newer annuities may also offer a variable option during the payout phase (whether for a fixed or term-certain period). A “variable annuitization” has payments that may fluctuate up or down depending upon the performance of the underlying sub-account investments; a “fixed annuitization” has payments that remain the same through the payout phase (or occasionally increase by some set rate to keep pace with inflation; however, this rate is pre-determined and contractual, is still invested in the insurance company’s general account, and is thus still considered a “fixed payout”).

Annuities purchased from an insurance company are called “commercial annuities” while those purchased from a person or entity that is not in the business of selling annuities are called “private annuities.

Annuities grow tax-deferred during the accumulation phase, although withdrawals during this phase are taxed on a LIFO (last in, first out) basis – meaning that withdrawals during the accumulation phase are considered to be withdrawals of growth first (fully taxable) and principal second.[3.] Payouts during the annuitization phase are split; a portion of each payment is considered principal and a portion is deemed interest/growth. The proportion of each is determined at the annuity’s beginning payment date and is based upon the already-accumulated growth, an assumed internal growth factor for the payout period, and the expected length of the payout period. All amounts distributed that are considered interest/growth are taxed as ordinary income, regardless of the phase or timing of the withdrawal. In addition, certain withdrawals before the age of 59 1/2 may be subject to an additional 10% tax penalty.

Although annuities have tax-deferral features that can be quite advantageous, the primary reason annuities should be purchased are for their risk management features. Annuities can provide a variety of guarantees, whether protecting against interest rate risk, reinvestment risk, market volatility risk, or the risk of living too long and outliving one’s assets. Annuities are first and foremost a risk management tool.


ADVANTAGES
1. The guarantees of safety, interest rates, and particularly lifelong income (if selected) give the purchaser peace of mind and psychological security.
2. An annuity protects and builds a person’s cash reserve. The insurer guarantees principal and interest (in the case of a fixed annuity; a variable annuity is subject to the performance of the underlying selected sub-accounts), and the promise (if purchased) that the annuity can never be outlived. This makes the annuity particularly attractive to those who have retired and desire, or require, fixed monthly income and lifetime guarantees.
3. An annuity allows a client to invest in the market while moderating risk. The insurer may provide guarantees of death proceeds or a certain annuitization amount (if purchased) within a variable annuity, thus providing guarantees that would otherwise be unavailable to a client that purchased the underlying investments directly. This makes a variable annuity particularly attractive to those who have retired or are nearing retirement and need (or want) to hold risky investments while trying to moderate risk.
4. A client can “time” the receipt of income and shift it into lower bracket years. This ability to decide when to be taxed allows the annuitant to compound the advantage of deferral.
5. Because the interest on an annuity is tax-deferred, an annuity paying the same rate of interest (after expenses) as a taxable investment will result in a higher effective yield.
6. Because of the risk-management factors available, especially in variable annuities, a client may be able to take on greater risk in the underlying investment options (e.g., equities, smaller-capitalization equities, high-yield bonds, etc.) while still maintaining a reasonable overall risk exposure due to the underlying guarantees.
7. Adjusted Gross Income (AGI) may be reduced in years where the annuity is held with no withdrawals (thanks to the tax-deferral features of the accumulation phase). In addition, lower taxable income may be recognized during the payout phase, due to the partial recovery of basis associated with each payment. A reduced AGI can bring tax savings, as many other income tax rules are calculated based upon AGI and generally a lower AGI results in lower taxation (and vice versa). A reduced AGI can create tax savings by lowering the amount of Social Security includable in income, reducing the floor threshold for deduction of medical expenses (7.5% of AGI) or miscellaneous itemized deductions (2% of AGI), and avoiding the threshold for phase-out of exemptions and itemized deductions.


DISADVANTAGES
1. Receipt of a lump sum (either at retirement, or to a beneficiary at death) could result in a significant tax burden because income averaging is not available (however, this can be moderated if the proceeds are annuitized).
2. The cash flow stream of a fixed payout may not keep pace with inflation, particularly for longer-term payout phases such as a life annuitization.
3. A 10% penalty tax is generally imposed on withdrawals of accumulated interest during the accumulation phase prior to age 59 1/2 or disability (this may also apply to the annuitization phase if the annuity was not an immediate annuity and certain short payout terms are selected).[6.]
4. With a few limited exceptions, if an annuity contract is held by a corporation or other entity that is not a natural person, the contract is not treated as an annuity contract for federal income tax purposes. This means that income on the contract for any taxable year is treated as current taxable ordinary income to the owner of the contract regardless of whether or not withdrawals are made.
5. If the client is forced to liquidate the investment in the early years of an annuity, management and maintenance fees and sales costs could prove expensive. Total management fees and mortality charges can run from 1% to 2 1/2% of the value of the contract (occasionally as high as 3% in the case of variable annuities with a number of underlying guarantees). There may be a “back end” surrender charge if the contract is terminated within the first few years to compensate the insurer for the sales charges that are not typically levied “up front.”
6. Investment earnings are taxed at the owner’s ordinary income tax rate when the owner receives payments, regardless of the source or nature of the return. Consequently, investment earnings attributable to long-term capital appreciation (typically in variable annuities) do not enjoy the more favorable long-term capital-gain tax rate that would otherwise generally apply. This has become even more disadvantageous with the reduction of the maximum long-term capital-gain rate to 15% (or even 5% for lower-income taxpayers). Furthermore, investment earnings attributable to dividends on stocks that would qualify for the 15% maximum tax rate if the stocks were held outside an annuity will also be taxed at the owner’s ordinary income tax rate (although these dividends will not be taxed until withdrawal). Consequently, variable annuities where the annuity owner is inclined to invest in equities are much less attractive than previously.


WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?
There are five typical fees or charges that are usually incurred when purchasing annuities, particularly variable annuities. These include:
1. Investment Management Fees – These fees run from a low of about 0.25% to a high of about 1%.
2. Administration Expense and Mortality Risk Charge – This charge ranges from a low of about 0.5% to a high of about 1.3%. However, additional riders and features can increase this cost to as high as 2.0%.
3. Annual Maintenance Charge – This charge typically ranges from $25 to $100. However, it is often waived once total investments exceed a specified amount, such as $25,000.
4. Charge per Fund Exchange – This charge generally ranges from $0 to $10, but most funds will permit a limited number of charge-free exchanges per year. In addition, automatic rebalancing programs usually do not count towards this limit.
5. Maximum Surrender Charge – Surrender charges vary by company and policy and generally phase-out over a number of years. If the charge is lower, the phase-out range tends to be longer. For example, typical charges and phase-out periods are 5% of premium decreasing to 0% over 10 years or 8% of premium decreasing to 0% over 7 years.

Items 1 through 4 in the above list must be explicitly stated in the prospectus for a variable annuity. In a fixed annuity, these costs are generally incorporated into the management of the insurance company’s general account and are simply netted out of the return credited to annuity-holders. Thus, when comparing fixed annuities, cost comparisons (although other non-cost aspects are also analyzed) are generally restricted to an evaluation of the comparable crediting rates of the general account and the surrender charges.


HOW DO I SELECT THE BEST OF ITS TYPE?
1. Compare, on a spreadsheet, the costs and features of selected annuities. Consider all of the five costs discussed above as well as how much can be withdrawn from the contract each year without fee. Be certain to fully read through the full details of costs/ charges, guarantees, riders, and special features in the prospectus of a variable annuity.
2. Compare the total outlay with the total annual annuity payment in the case of fixed annuities. Be certain to incorporate the time value of money if the payment schedules are different.
3. In an analysis of variable annuities, evaluate the total return for the variable annuity sub-accounts over multiple time periods (Lipper Analytical Services, Inc., and Morningstar, Inc., both have information to help assess this).
4. Compare the relative financial strength of the companies through services such as A.M. Best. Insist on a credit rating of A+ (or at the very least, thoroughly discuss with the prospective buyer the risks involved in purchasing from a company with a lesser rating).



For more Information:
Pensions, Annuities & Retirement
Pension and Retirement Plans. How to Retire Happy. Variable Income Annuities, Pension System, Endowments

Fundamentals of Annuities Planning. Wealth Management, Pensions, Annuities & Retirement Planning Guide. Your Learning Resource Centre.