The Insurance Transaction
After reading this article you will be able to do the following:
-Explain the role of applications and binders in insurance transactions
-Explain how the federal Fair Credit Reporting Act and the principle of adverse selection affect the underwriting process
-Describe the different methods used to rate insurance policies
-Explain how misrepresentation, fraud, concealment, warranties, and waiver and estoppel may affect an in-force contract
-Define material fact, certificate of insurance, and representation
-Describe the rights and responsibilities of insureds and insurance companies when an insurance policy is canceled or nonrenewed
Before an insurance policy can be issued, the prospective insured must apply to the insurance company.
The agent and the applicant fill out an application form that is then forwarded to the insurance company.
The application is the insured’s offer. (Remember that an offer is one of the necessary elements of a contract.)
The application contains underwriting information to help the company decide whether it should accept or reject the prospects offer to become an insured.
The application also contains rating information that will help the insurance company decide how much the insured will be charged if the policy is issued.
Because the application represents the company’s primary source of information about the risk to be insured, it is vitally important that the agent fill out the application completely and accurately.
The agent must make sure to ask the prospect every question on the application form, faithfully recording answers and questioning information that seems vague or inaccurate to provide as clear a picture of the risk as possible.
Failure to do so can be expensive for the company, the prospect, and the agent
After the agent has completed the application, he may have the authority to issue a binder for insurance.
This is an oral or written statement made by the agent that the insured has immediate protection that is valid for a specified time.
If it is an oral statement, it must be backed up in writing as soon as possible.
A binder can also be issued by the insurance company.
This is often done to let the insured know that there is coverage but that the actual policy will be issued in a few days.
A binder does not guarantee that a policy will be issued; it only guarantees temporary coverage.
The insurance company has access to additional information that is not readily available to an agent.
This information might convince the company to refuse to issue the policy, even though the agent has already issued a binder.
In this case, coverage under the binder may be canceled by a formal cancellation or rejection notice.
However, if no formal cancellation is made, coverage remains in effect until the binder expires.
If the policy is issued, coverage under the binder ceases as of the effective date of the policy.
Suppose John gets an oral statement from his agent on July 6 that he is “bound” effective that date for 90 days.
The insurance company reviews the application and decides not to issue the policy. However, it does not send John a formal notice of cancellation.
On July 21, John has a loss that would have been covered under the policy. Because the agent issued a binder, John will have coverage for this loss.
3- UNDERWRITING THE POLICY
When the application comes to the insurance company, underwriters review it for its acceptability to the company. In addition to the application, underwriters may turn to other sources of information to help them evaluate the risk. These include:
■government bureaus, such as the Bureau of Motor Vehicles;
■insurance industry bureaus, such as the Automated Property Loss Underwriting System;
■financial information services, such as Standard & Poor’s;
■previous insurers; and
■the company’s own claim files.
1. Fair Credit Reporting Act
When an application is submitted to an insurance company, a consumer reporting agency is often hired to obtain information about the applicant.
Reports that have traditionally been called credit reports are actually consumer reports.
In addition to a consumer’s credit standing, the reports explore personal character, reputation, habits, and lifestyle.
Public reaction to the misuse of personal information led to the enactment of the federal Fair Credit Reporting Act.
This act protects consumers by requiring that the consumer be notified in certain situations and by establishing provisions for the removal of outdated and incorrect information.
One of the purposes of the act is toensure that credit reporting agencies exercise their responsibilities with fairness, impartiality, and a respect for the consumer’s right to privacy.
The act applies to the preparation and use of two types of reports: regular consumer reports and investigative consumer reports.
The two contain similar types of information, but the investigative report gathers data through personal interviews with friends, neighbors, and associates of the consumer.
Under the act, reporting agencies may furnish reports only for specific purposes, which are spelled out in the law. A report may be provided to someone who intends to use the information for insurance underwriting purposes or in connection with employment, credit transactions, or other types of personal business transactions.
Consumer reporting agencies are specifically prevented from putting information in their reports about:
■bankruptcies over 10 years old;
■suits and judgments over seven years old or in which the statute of limitations has expired, whichever period is longer;
■paid tax liens or accounts placed for collection or charged to profit that are over seven years old;
■arrests, indictments, or conviction of crime reports; and
■any other adverse information that took place seven years before the report.
These restrictions are not applicable when the consumer credit report is used in connection with a credit transaction of $150,000 or more, a life insurance policy of $150,000 or more, or when it concerns employment of an individual earning $75,000 or more.
Before or shortly after an investigative report (but not a regular report) is ordered, the consumer must be informed in writing that the report may be made and that additional information about the nature and scope of the report is available upon written request.
The initial written notice must be sent to the consumer no later than three days after the report is ordered.
Many insurers provide prenotification by stating on the insurance application that an investigative report may be ordered.
If a consumer requests the additional information about the nature of the report, the disclosure must be made within five days.
Postnotification of an adverse outcome is required for both regular and investigative reports. If insurance is rejected, reduced, or written at a higher premium because of the information in the report, the consumer must be notified and provided with the name and address of the reporting agency.
The consumer has the right to obtain the substance of the information in the report (but not the actual report) and to be informed of the identity of anyone who received reports within the previous six months.
If the consumer challenges any information, the reporting agency is required to reinvestigate and to change the report if necessary.
If inaccurate information was given to any individuals or organizations within the previous six months, the consumer’s side of the story must be provided to those parties.
Both reporting agencies and users of reports are subject to civil and criminal penalties for failure to comply with the provisions of the act.
For negligent noncompliance, the consumer may recover any actual damages from the guilty party, although such damages may be difficult to prove.
For willful noncompliance, criminal penalties of up to two years in prison, a fine, or both may be imposed.
Anyone who knowingly and willfully obtains consumer information from a reporting agency under false pretenses as well as officers or employees of reporting agencies who knowingly and willfully provide consumer information to anyone not authorized to receive it can be subject to criminal charges.
2. Adverse Selection
Underwriters are responsible for protecting the insurer against adverse selection.
Adverse selection is the tendency for people with a greater-than-average exposure to loss to purchase insurance.
For example, certain parts of the country are very prone to earthquakes, so people in those areas are likely to want earthquake insurance to protect their property against loss.
On the other hand, people who live in areas that are not prone to earthquakes would have no need for such coverage.
An insurance company that wrote a large amount of insurance in earthquake-prone areas would be subject to adverse selection.
This means the company may experience large financial losses and decreased profitability.
3. Basic Types of Construction
For property risks, a building’s construction type is considered when underwriting and rating a policy.
The construction of the building is determined by the types of materials used in the building and roof of the insured structure.
Construction materials are also found in the building’s interior finish and insulation.
Other construction factors that an underwriter considers include the number of fire divisions in the building, the adequacy of electrical circuits for the occupancy, the number of stories, the building’s age, and the type of heating system.
Most underwriters recognize six construction classifications or types:
Class 1—Frame:■ Frame structures have outside support walls, roof, and floors constructed of wood or other combustible materials. The exterior walls may be covered with stucco or brick veneer, and the interior walls are typically lath and plaster.
Class 2—Joisted Masonry: ■Joisted masonry structures have outside support walls made of noncombustible masonry materials (such as concrete, brick, hollow concrete block, stone, or tile) and a roof and floor made of combustible materials (such as wood).
Class 3—Noncombustible:■ A noncombustible structure is one whose exterior walls, floors, and roof are constructed of and supported by non-combustible materials such as metal, asbestos, or gypsum.
Class 4—Masonry Noncombustible:■ Structures in this construction class have exterior walls constructed of masonry materials and a roof and floor made of metal or other non-combustible materials.
Class 5—Modified Fire Resistive: ■Buildings that are modified fire resistive have exterior walls, floors and roof constructed of masonry or fire resistive material with a fire resistance rating of 2 hours or less.
Class 6—Fire Resistive: ■These structures are constructed of masonry or fire resistive material with a fire resistance rating of 2 hours or more.
4- RATING THE POLICY
1. Judgment and Manual Rating
If the insurance company agrees to issue a policy, a premium must be determined. There are three basic ways in which a premium can be computed:
The oldest form of determining rates is called judgment rating.
The premium is determined by considering the individual risk. No books or tables are used; premiums are established through careful judgment.
The second and most common method of premium determination is called manual or class rating.
The company’s rates for a particular state or area are obtained by consulting a manual, which is usually stored on a computer.
Rates are arranged by various categories or classes.
The agent or underwriter classifies the risk according to defined criteria and then looks up the appropriate rate.
The printed rate, which is a rate per unit of insurance, is then multiplied by the number of units of insurance being purchased to calculate the premium.
The formula looks like this:
Rate per unit × number of units = premium.
So, an insured who purchases $60,000 of insurance at a rate of $2 per $1,000 would pay a premium of $120 (2 × 60 = 120).
2. Merit Rating
Another means for determining premiums is merit rating.
Typically, merit rating starts with class or manual rates, which are then modified to reflect the unique characteristics of the risk that are not reflected in the manual rate.
Experience rating is a form of merit rating that modifies the manual premium on the basis of the insured’s loss experience (i.e., the dollars paid out in claims vs. the premium received) over some period, generally the three years proceeding the current policy year.
When past loss experience is poorer than the average loss experience expected for this class of insured, the insured will pay more than the manual premium.
When the insured’s past loss experience is better than average, the insured will pay less than the manual premium.
Other types of merit rating include retrospective rating, which bases the insured’s premium on losses incurred during the policy period, and schedule rating, which applies a system of debits or credits to reflect characteristics of a particular insured.
5- CERTIFICATE OF INS URANCE
After a policy has been issued, an insured may need a certificate of insurance as proof that the policy has been written.
A certificate of insurance, which contains a general summary of the policy’s coverage, is frequently required in loan transactions and other legal matters.
6- MISREPRESENT ATION, CONCEALMENT , AND FRAUD
Once an applicant’s offer has been accepted and the policy has been rated, issued, and countersigned, the contract may only be canceled by the insurance company under very specific circumstances. State laws, as well as the policy itself, spell out these circumstances.
Since the insurance contract is a contract of utmost good faith, it is expected that the insured and the insurance company will be fair and honest in their dealings with each other. However, the insurance company can void the contract on the basis of misrepresentation, concealment, or fraud by the insured.
Misrepresentation is a written or verbal misstatement of a material fact involved in the contract on which the insurer relies. Misrepresentation will void the policy only if it concerns a material fact.
A material fact is a fact that would cause an insurer to decline a risk, charge a different premium, or change the provisions of the policy that was issued.
Concealment is similar to misrepresentation except that it involves withholding, rather than misstating, a material fact.
Fraud is a deliberate misrepresentation that causes harm. An act of fraud contains four elements.
■Someone deliberately lies.
■The intent of the lie is for someone else to rely on that lie.
■ Another person relies on that lie.
■The other person suffers harm as a result of relying on that lie.
Fraud differs from misrepresentation in that misrepresentation may be intentional or unintentional.
Fraud is always intentional and involves an all-out effort by one party to deceive and cheat the other.
7- REPRESENTATIONS AND WARRANTIES
Most of the statements contained in the insured’s application for insurance are representations—statements that the applicant believes are true. Under the law, a representation is not considered a matter to which the parties contract, so a policy cannot be voided on the basis of a representation.
Sometimes, however, specific agreements are made between the insured and insurer that certain conditions will be met.
For example, they might require that while a business is closed, a security guard will be on duty at all times.
These agreements, called warranties, become a part of the policy and can void the policy if they are breached, whether the breach was intentional or unintentional.
8- WAIVE R AND EST OPPEL
The legal definition of waiver is the intentional relinquishment of a known right. Sometimes an insurer or its representative knowingly overlooks a condition or exclusion that would normally have been grounds for denying coverage, increasing the premium, reducing the benefits provided in the policy, or some other material change in the policy.
When the insurer or its representative relinquishes the insurer’s right of denial or refusal, the act becomes a waiver.
Though any policy provision may be waived, the requirement of an insurable interest may not be waived, nor may facts be waived.
If an insurance company representative intentionally or unintentionally creates the impression that a certain fact exists when it does not, and an innocent party relies on that impression and is damaged as a result, the insurance company will be estopped (prevented) from denying this fact.
For example, if an agent states or indicates by his actions that a particular loss is covered, the insurance company will be estopped from denying that coverage.
9- CANCELLATION AND NONRENE WAL
Most insurance policies are issued with a definite effective date and expiration date. The policy period or term—the time between the effective date and the expiration date—may be six months, one year, or even three years.
But at times, the insured or the insurance company may want to cancel the insurance before the policy expires.
The insured may cancel the policy by writing a letter to the insurance company or by surrendering the policy to the company.
The insurance company returns any unearned premium; that is, any premium not yet “used up” during the policy period.
These premiums may be returned on a short rate basis.
This means that when the insured cancels before the expiration date, the company not only keeps the premium for insurance already provided but also keeps an allowance for expenses, such as issuing the policy.
The insurance company does not have the same freedom to cancel that the insured does. Each state has rules governing the circumstances under which a policy may be canceled by the company.
Most states do not permit arbitrary cancellation but restrict this right to such situations as nonpayment of premium.
When the company does cancel, various state laws and policy provisions require that the insured be notified of the cancellation in writing within a specified number of days before the effective date of cancellation.
When the insurance company cancels the policy, unearned premium is returned to the insured on a pro rata basis.
This means the company retains only the earned premium and is not permitted to keep an extra amount for expenses.
Occasionally, a policy is canceled by either the insured or the insurance company on its effective date. This is called flat cancellation