Distinguishing Characteristics of Insurance Policies: Practice Questions and Solutions

This section of the study guide is intended to provide practice problems and solutions to accompany the pages of Foundations of Risk Management and Insurance, cited below. Students are encouraged to read these pages before attempting the problems. This study guide is entirely an independent effort by Mr. Stolyarov and is not affiliated with any organization(s) to whose textbooks it refers, nor does it represent such organization(s).

Some of the questions here ask for short written answers based on the reading. This is meant to give the student practice in answering questions of the format that will appear on Exam 5. Students are encouraged to type their own answers first and then to compare these answers with the solutions given here. Please note that the solutions provided here are not necessarily the only possible ones.

Source:

Nyce, C.M. Foundations of Risk Management and Insurance (Second Edition). 2006. American Institute for Chartered Property Casualty Underwriters. Chapter 10, pp. 10.3-10.14.

Original Problems and Solutions from The Actuary's Free Study Guide

Problem S5-27-1. Nyce 2006, p. 10.4, lists the following seven typical distinguishing characteristics of insurance policies:
1. Indemnity;

2. Utmost good faith;

3. Fortuitous losses;

4. Contract of adhesion;

5. Exchange of unequal amounts;

6. Conditional;

7. Nontransferable.

In each of the following seven situations, one of these conditions is absent. Identify the absent condition in each situation.

(a) Insurance Company Z offers a policy whereby the insured is entitled to full compensation for a loss, without any duties on the part of the insured that would need to be met before compensation is made.
(b) Vercingetorix, an insurance consumer, sells his automobile insurance policy to Bob.
(c) When filling out his insurance application, Montezuma Smith-Jones deliberately writes his name as "John Doe" and provides a false Social Security Number.
(d) Mr. Y pays insurance premiums every six months. If no loss occurs during these six months, he is refunded the full premium payment, with interest. If a loss does occur, the insurance company will pay the loss amount, but Mr. Y must later pay back the loss amount, with interest, to the insurance company.
(e) Ms. Ϊ wants to purchase insurance against the possibility that she would commit suicide.
(f) An insurance company issues a policy that will always pay the insured $5000 for every loss, irrespective of the magnitude of the loss.
(g) Pi Insurance Company and its insured, Mr. Π, have finally concluded year-long negotiations to arrive at an insurance policy whose terms have been drafted and extensively revised by both parties.

Solution S5-27-1.

Situation (a) lacks the conditional aspect,since no duties are required of the insured in order for the insured to receive compensation.

Situation (b) lacks the nontransferable aspect, since an insured is selling his policy to another individual.

Situation (c) lacks the utmost good faith aspect, since Montezuma Smith-Jones is deliberately misrepresenting his information.

Situation (d) lacks the exchange of unequal amounts aspect. The parties appear not to be engaged in insurance, but rather swapping amounts of money which, when time value of money is taken into account, are equivalent.

Situation (e) lacks the fortuitous loss aspect, since Ms. Ϊ has control of whether she will commit suicide.

Situation (f) lacks the indemnity aspect, since most insureds will not suffer a loss of exactly $5000.

Situation (g) lacks the contract of adhesion aspect, since both parties contribute extensively to the drafting of the policy.

Problem S5-27-2. Which of the following statements about the principle of indemnity are true? More than one statement may be correct.

(a) All insurance policies strictly follow the principle of indemnity.
(b) Under a valued policy, the insurer agrees to pay a preset monetary amount for a total loss, irrespective of the market value of the insured item at the time of loss.
(c) The existence of a deductible is not consistent with the strict principle of indemnity.
(d) Where the principle of indemnity is concerned, it is permissible to disregard the insured's nonfinancial costs of loss - such as lost time and inconvenience.
(e) Multiple insurance sources of recovery are never justified, as they lead to insureds being indemnified multiple times for the same loss.
(f) The collateral source rule prohibits reducing damages to a victim who is also entitled to recover money from an insurance policy.

Solution S5-27-2. This question is based on the discussion in Nyce 2006, pp. 10.5-10.6. The following answers are correct:
(b) Under a valued policy, the insurer agrees to pay a preset monetary amount for a total loss, irrespective of the market value of the insured item at the time of loss.
(c) The existence of a deductible is not consistent with the strict principle of indemnity.
(f) The collateral source rule prohibits reducing damages to a victim who is also entitled to recover money from an insurance policy.

Choice (a) is not correct; some policies, such as valued policies, will often depart from the strict principle of indemnity and will simply pay a present amount. Likewise, policies with deductibles or limits will not compensate the insured for the full loss amount.

Choice (d) is not correct; some insurance policies do take into account such aspects of a loss as time and inconvenience lost - although many do not do so. Fully indemnifying the insured might mean compensating for some of these aspects of loss.

Choice (e) is not correct. Sometimes, as when the insured has paid an actuarially fair premium for overlapping coverage on two insurance policies, the insured might be entitled to recover twice for the same loss.

Problem S5-27-3. Give an example of how each of the following parties to an insurance contract might violate the principle of utmost good faith:
(a) An insured, if no loss occurred;

(b) An insured, if a loss occurred;

(c) An insurer, if a loss occurred.

Solution S5-27-3.

Numerous examples are possible. The following are all mentioned in Nyce 2006, p. 10.7.

(a) An insured could violate utmost good faith by filing a claim on an accident or loss that did not take place.

(b) An insured could violate utmost good faith by intentionally overstating the amount of damage resulting from an accident or loss and attempting to collect reimbursement for the inflated amount.

(c) An insurer could violate utmost good faith by failing to promptly investigate claims and/or pay legitimate claims.

Problem S5-27-4. Which of the following statements about fortuitous and non-fortuitous losses are true? More than one answer may be correct.

(a) All fortuitous losses can be covered by insurance policies.
(b) Some non-fortuitous losses are covered by certain insurance policies.
(c) If Mr. Φ might vandalize his car but does not know when he will do so, then the occurrence would be a fortuitous loss.
(d) If Mr. Φ might accidentally slip and fall on a banana peel and injure himself, but does not know when he will do so, then the occurrence would be a fortuitous loss.
(e) If an anvil will fall out of the sky on Mr. Φ's house, and Mr. Φ knows exactly when this will happen, then the occurrence would be a fortuitous loss.
(f) "Claims-made" liability insurance policies often provide coverage for some non-fortuitous losses.

Solution S5-27-4. This question is based on the discussion in Nyce 2006, pp. 10.7-10.8. The following answers are correct:

(b) Some non-fortuitous losses are covered by certain insurance policies.

(d) If Mr. Φ might accidentally slip and fall on a banana peel and injure himself, but does not know when he will do so, then the occurrence would be a fortuitous loss.

(f) "Claims-made" liability insurance policies often provide coverage for some non-fortuitous losses.

Choice (a) is incorrect. Some fortuitous losses, such as inherent vice of an object (i.e. that object's tendency to perish on its own accord) or wear and tear, are typically not covered by insurance policies.

A fortuitous loss is a loss that an insured can neither intentionally inflict nor perfectly predict the timing of. Thus, (c) and (e) are not fortuitous losses. For (c), the vandalism would be an intentional act on the part of Mr. Φ, and for (e), Mr. Φ knows exactly when the loss will occur.

Problem S5-27-5. Which of the following statements about contracts of adhesion are true? More than one answer may be correct.

(a) Contracts of adhesion may contain ambiguities that are acceptable to both parties.
(b) With a contract of adhesion, the contract is always construed in favor of the party that drafted it.
(c) Most insurance policies involve little to no negotiation.
(d) An unsophisticated insured is more likely to have any policy ambiguity interpreted in its favor than a sophisticated insured.
(e) The size of the insured organization has no effect on whether that organization is considered a sophisticated insured. One educated private individual who has a typical personal lines insurance policy may be a more sophisticated insured than a corporation staffed by incompetents.
(f) Manuscript policies are not contracts of adhesion.
(g) The reasonable expectations doctrine might imply that a policyholder who has not been notified of changes in his renewal policy may reasonably assume that the renewal policy is offered on the same terms as the expiring policy.

Solution S5-27-5. This question is based on the discussion in Nyce 2006, pp. 10.9-10.10. The following answers are correct:

(a) Contracts of adhesion may contain ambiguities that are acceptable to both parties.
(c) Most insurance policies involve little to no negotiation.
(d) An unsophisticated insured is more likely to have any policy ambiguity interpreted in its favor than a sophisticated insured.
(f) Manuscript policies are not contracts of adhesion.
(g) The reasonable expectations doctrine might imply that a policyholder who has not been notified of changes in his renewal policy may reasonably assume that the renewal policy is offered on the same terms as the expiring policy.

Choice (b) is not correct. A contract of adhesion is construed against the party that drafted it.

Choice (e) is not correct. The size of an insured organization is one of the factors considered in determining whether it is a "sophisticated insured." Although an educated individual policyholder may indeed know more about insurance than the decision-makers of some corporations, the former will rarely, if ever, be considered a sophisticated insured for the purposes of determining how a contract of adhesion, such as a typical personal lines insurance policy, will be construed.

See other sections of The Actuary's Free Study Guide for Exam 5.