Structure of an Insurance Policy
Policies are designed with the following objectives:
- Providing coverage that is attractive in the marketplace
- Limiting risks to those that can be actuarially quantified
- Spreading risks over a large pool of policy holders
- Rating (pricing) policies based on quantifiable risk factors
- Controlling the cost of claims management and settlement
The underwriters are responsible for approving plan design and monitoring new policies to ensure that policies stay within the carrier’s guidelines. Requests for policies with higher inherent risk are either declined or rated into a higher pricing category.
Underwriting Factors for the Primary Types of Policies
Property insurance
- Location of the property
- Condition of the building
- Crime statistics in the area
- Type of construction
- Safety features available
Liability insurance
- Types of exposure being insured
- Track record of industry
- Claims experience of the specific business
- Presence of risk management techniques (or quality control measures)
Auto insurance
- Type/cost of automobile
- Age and marital status of drivers
- Number of miles typically driven each day
- Length of time at residence
- Demographics of area
Health and life insurance
- Age
- Sex
- Occupation
- Personal health history
- Family health history
- Legislated requirements in the state
Pricing Factors
In addition to overall risk, prices vary according to the amount of risk the policy holder is willing to share. There are two ways that this risk sharing occurs:
- Deductible
- Co-insurance
Insurance to cover first dollar exposure is generally not a good investment. You end up paying an insurance company to administer claims that could be more effectively handled internally. In order to cover a $300 claim, the business would likely pay more than $300 in premiums. The reason is that the carrier would expect to incur such losses, would build them into the pricing and add on a margin for administration and profit. The business can benefit in policy years when claims are low by covering small claims out of cash flow. That’s the logic behind “Deductibles”. Generally, a business should opt for the highest deductible that would not disrupt its normal cash flow.
Co-insurance refers to the percentage sharing of the risk between the insurance company and the insured. It is best understood when explained separately for health insurance and property insurance policies.
A Health Insurance policy with might have 20% co-insurance, a $1,000 deductible and a $3,000 claim. The policy holder would pay the first $1,000 as a deductible. The next $2,000 would be shared 80/20, so that the insurance company would pay $1,600. Co-insurance plans also have what’s known as a stop-loss provision, so the amount you have to pay out-of-pocket is capped.
The situation is more complex with a Property Insurance policy. If you insure your business for less than the value of your property less the co-insurance amount, your insurance company imposes a “co-insurance penalty” once a claim is filed. The co-insurance penalty is based on the amount by which your coverage amount falls short of the total value of the property less the co-insurance percentage. Suppose, for example, you own property that you believe to be worth $220,000 and your policy specifies a co-insurance of 20%. Therefore, you purchase insurance with a coverage amount of $176,000. Suppose you were wrong about the value and the actual value is $250,000. A fire causes $100,000 of damage. You should have purchased coverage at 80% of $250,000, or $200,000. You purchased coverage of $176,000 – 88% of the needed level. Therefore the insurance company will pay only 88% of the claim. Your reimbursement is for $88,000 – leaving you out of pocket for $12,000. Underinsurance can be very expensive, so spend enough planning time to adequately assess the value of your property.
Reading a Policy
It is important that every business understand its coverage. If the business owner has never read his policy, it would be a good idea to take some time and gain an understanding. Policies are written in four sections:
- Declarations page
- Insurance agreement
- Conditions of the policy
- Exclusions
The declarations page names the policyholder, describes the risks being insured, states the nature of the coverage and specifies the maximum amount that the insurer will pay in the event of a loss.
The insurance agreement provides detailed explanations of the relationship between the business and the insurance company. It describes the responsibilities of each and likely explains the procedures to be followed in the event of a loss.
The conditions of the policy provide details on the risks covered – listing specific insured property and risks – and enumerates the required actions of both parties in the event of a loss.
The exclusions list specific events and types of property that are not covered under the policy.
Policies will often be amended with an Endorsement, which will expand the coverage in some way, often by listing specific property to be handled in a particular way or listing additional risks to be insured. The Endorsements are a fifth section of the policy.
