BFI302 Risk management and insurance
Individual assignment (Final exam) May-Aug. 2020
Notes:
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Good Luck!
Answer ALL questions
Question 1
Mikas is a manufacturer of childcare safety products, primarily car seats and strollers. The products are sold directly to independent retailers in Europe. The company’s risk manager knows that the company could be sued if a car seat or a stroller is defective, and someone is injured. Because the cost of products liability insurance has increased, the risk manager is considering other techniques to treat the company’s loss exposure.
Name at least three major risk-control techniques that Mikas can apply for reducing the frequency or severity of losses due to potential product defects. Describe specific actions using these techniques that may be helpful in dealing with the company’s products liability exposure. (25 marks)
Several risk control techniques can reduce the frequency or severity of a loss or at the same time. Firstly, Mikas can undertake loss prevention to reduce the frequency of a loss. For instance, Mikas themselves can increase the degree of supervision they have on the machinery that manufacture their products to ensure that the product built and the safety of their products are guaranteed. Subsequently, Mikas could also appoint industry standards professionals to evaluate their products’ manufacturing process to ensure the quality and safety of their products are of the highest priority during production. Subsequently, Mikas could also provide intensive training to its manufacturers to ensure that they sufficiently trained in producing childcare products that have high quality and are non-defective. Mikas could also implement a detailed and structured standard operating procedure at manufacturing factories while ensuring workers comply diligently with those procedures. Therefore, the frequency of getting defective products can be reduced. Mikas should also engage in crash tests to test the durability and reliability of their child car seats during an accident. Mikas could also provide a detailed manual handbook that provides clear guidance on the correct way to install the child car seat, so the losses that arise from incorrect installation of the car seat can be reduced.
Besides, Mikas could also undertake another risk control measure, which is loss reduction, to reduce the severity of a loss. Substantially, Mikas must provide immediate assists to customers that have problems with their childcare products. Compensation must be provided, especially if the defects in the product has injured a person using it. Mikas should also provide immediate claims payment for defected products under warranty so that the losses suffered by the customer can be instantly reduced. A cushion could also be installed in their car seats and strollers to prevent children from suffering from severe injuries if the products fail unexpectedly. For instance, the cushion could be installed at the bottom of the stroller. If the stroller’s structure collapses suddenly, the child will be protected from severe injuries when falling as they are safely cushioned.
On top of that, another risk control technique that Mikas can undertake to reduce the severity and frequency of their losses will be separations, which explains the dividing the assets that are exposed to losses in a way to minimize the damage from a single event. For instance, Mikas could choose to increase the types of childcare products used for different kinds of occasions. For example, car seats are technically only used in cars, and strollers are used in public places such as shopping malls. Perhaps Mikas could increase the range of products provided that will be used in different settings and contexts and thus minimizing the loss exposed to a similar event. Mikas could also offer their childcare products to different geographical regions to reduce the severity of a loss from a single event in a separate geographic area.
Besides, Mikas could also undertake diversification to spread losses to different assets and parties. For instance, Mikas could increase the types of childcare products they provide to spread the loss over a broader range of products. Going into agreements with insurance companies to create a warranty on their products, Mikas could also reduce their obligations on losses as part of the risk will be transferred to insurance companies.
Mikas could also undertake duplication measures, which are illustrated by having more than one copy of essential components if a loss occurs. For instance, Mikas could also install an extra safety belt for child car seats, so that when the car seat fails during an accident, the child will not be immediately be thrown out of the car seat as the extra seat belt safely secures them. Under this measure, Mikas could also provide a spare wheel for their stroller. Just in case one of the stroller wheels fails, the consumer can instantly replace the wheels.
Question 2
- Milan Insurance is a property insurer that entered into a surplus-share reinsurance treaty with Aman Re. Milan has a retention limit of $300,000 on any single building, and up to seven lines of insurance may be ceded to Aman Re. A building valued at $2,200,000 is insured with Milan. Shortly after the policy was issued, a severe windstorm caused an $800,000 loss to the building.
(i) How much of the loss will Milan pay? (6 marks)
Therefore, Milan has to pay a total loss of $109,090.91.
(ii) How much of the loss will Aman Re pay? (4 marks)
Therefore, Aman Re has to pay a total loss of $690,909.09.
(iii) What is the maximum amount of insurance that Delta can write on a single building under the reinsurance agreement? Explain your answer. (4 marks)
The amount of one line of insurance is equal to the retention limit.
Since up to 7 lines of insurances can be written, the maximum amount of insurance that Aman Re can write on a single building under the reinsurance agreement:
$300,000 + (7 x $300,000) = $2,400,000
- What is the meaning of reinsurance? (4 marks)
Reinsurance is an agreement between two insurers. The primary insurer, which is named the ceding company, transfers part or all of its potential risk of losses to the second insurer, which is the reinsurance company. Usually, the ceding company would go into the reinsurance agreement when they think they are financially incapable of insuring all the potential losses alone. Therefore they will transfer part of these risks to the reinsurance company. The maximum amount of damages that the ceding company will assume in the reinsurance agreement is illustrated as the retention limit. The amount of risks that are transferred to the reinsurer is called the cession. Besides, retrocession may occur in a reinsurance agreement where the reinsurer transfer parts or all of the losses of that is ceded by the ceding company to another reinsurer and is usually practiced to reduce the magnitude of large scale and catastrophic losses.
- Briefly explain the reasons for reinsurance. (4 marks)
Firstly, reinsurance may be used to increase the capacity of underwriting. By entering into a reinsurance agreement, the ceding company can cede more than one lines of insurance to the reinsurer, where generally increases the total amount of insurance they can write without assuming all the risks and losses, as compared if they did not enter into the agreement, where they could not write as many lines as they had to assume all the damages. Ultimately, the ceding company can underwrite more insurance in general, which could increase its profit and diversification if performed adequately. Besides, insurers go into reinsurance agreements to protect themselves against catastrophic losses. By going into complex reinsurance agreements involving more than one reinsurer, the risk is adequately spread across many reinsurers. Subsequently, insurers may go into reinsurance agreements to get valuable advice, especially on underwriting lines of insurances they are not familiar with. By entering into an agreement with the reinsurer, the insurer can exchange their professional advice and expertise on their subsequent insurance line. Insurers can substantially reduce the cost needed for market research on an unfamiliar range of insurance. Lastly, reinsurance could significantly reduce the insurer’s unearned premium reserve, which is the unearned gross premiums from outstanding policies that have reached their maturities.
- Explain the meaning of “securitization of risk.” (3 marks)
Securitization of risk illustrates the transferring of a risk that is insurable into the capital market. It is a process that demonstrates the pooling of few financial assets and subsequently creating marketable security. Types of financial securities created through the means of securitization of risks are futures contracts or catastrophic bonds. Catastrophic bonds are a type of bond that permits the skipping or decrease interest payments in the event of a catastrophic loss.
[Total: 25 Marks]
Question 3
Sonja, age 25, recently purchased a $100,000 ordinary life insurance policy on her life. The waiver-of-premium rider and guaranteed purchase option are attached to the policy. For each of the following situations, indicate the extent of the insurer’s obligation, if any, to Sonja or to Sonja’s beneficiary. Identify the appropriate policy provision or rider that applies in each case. Treat each event separately.
(a) Sonja fails to pay the second annual premium due on January 1. She dies 15 days later. (2 Marks)
Sonya will still be paid the claims for her death, as the grace period, which permits late payments to a maximum of 31 days, is not exceeded, as she only delayed her payment for 15 days. Therefore, she can still claim on her death.
(b) Sonja commits suicide 3 years after the policy was purchased. (2 Marks)
Sonja can still claim on her death according to the suicide clause. Suicide clause states that an insured can only claim a refund on their paid premium, but not the full claim if the insured commits suicide within 2 years after purchasing the policy. Since its already 3 years, Sonja will be paid full claims on her death.
(c) At Sonja’s death, the life insurer discovers that Sonja deliberately lied about her age. Instead of being 25 years old, as she indicated, she was actually 26 years old at the time the policy was purchased. (2 Marks)
Under the misstatement of age clause, even though Sonja has deliberately lied about her age, she will not be voided of her policy. Instead, she will be paid a total amount of claims that sum up to the total premium amount paid according to her actual age, 26 years old, and not 25 years old. Therefore, she will receive a considerably lesser sum than she would have expected.
(d) Two years after the policy was purchased, Sonja is told that she has leukemia. She is uninsurable but would like to obtain additional life insurance. (2 Marks)
Sonja can obtain additional life insurance. Her insurance policy has the guaranteed purchase options attached, which entitles her to the right to purchase additional life insurance on top of her current policy without the need for insurability evidence, in a specific time period in the future.
(e) Sonja is seriously injured in an auto accident. After 6 months, she is still unable to return to work. She has no income from her job, and the insurance premium payments are financially burdensome. (3 Marks)
Since Sonja’s has the waiver-of premium rider attached to her policy, she can exercise the waiver-of-premium provision that allows her to waive all her premium payments moving forward if she is completely disabled, as reflected with her current state where she could not go to work at all. Once the provision is intact, the premium payments made in the six-month processing period will be refunded. When the provision is in force, all benefits of the policy, such as dividends and death benefits, will remain intact.
(f) Sonja has a mentally disabled son. She wants to make certain that her son will have a continuous income after her death. (2 Marks)
Under her insurance policy, she has to entitle her son as her primary beneficiary. By doing so, her son will be the first to receive all the death claims from Sonja’s death.
Sonja could also add a term insurance rider to increase the benefits that she could get at her death. Therefore, her son can have substantially more income after her death.
(g) Sonja lets her policy lapse. After 4 years, she wants to reinstate the policy. Her health is fine. Point out to Sonja how she can reinstate her life insurance. (3 Marks)
To reinstate her life insurance, there are three steps that Sonja has to fulfill. Firstly, Sonja has to settle the payment for all insurance premiums and interests outstanding on the previous policy. She must also compensate for the unpaid payment on any loans on the previous policy that she wishes to reinstate. Thirdly, Sonja will need to present the evidence of insurability to the insurance company. By fully performing these three objectives, Sonja can, therefore, reinstate her insurance.
(h) Sonja wants to retire and does not wish to pay the premiums on her policy. Indicate the various options that are available to her. (5 Marks)
One of the options that Sonja can undertake will be to surrender the insurance policy to exchange for cash values completely. However, she will not be under the coverage of the policy in the future anymore. Subsequently, Sonja could also surrender the policy on a nonforfeiture basis, which means that she could get back a certain amount of the total premium paid, cash value, or reduced benefits. Thirdly, she could also pass on the existing insurance policy to a new owner. For instance, she could pass to her children if they don’t have an existing policy.
(i) Ten years after the policy was purchased, Sonja is fired from her job. She is unemployed and is in desperate need of cash. (2 Marks)
There were two choices that Sonja can undertake. The first option is to seek out a loan for her policy to sustain her payment for policies under the loan provision. Secondly, she could surrender the policy to get the cash values and other fringe benefits to help her maintain her expenditures.
(j) When Sonja applied for life insurance, she concealed the fact that she had high blood pressure. She dies 5 years later. (2 Marks)
Under the incontestability clause, the insurer will be prohibited from voiding a policy if it is intact for more than two years. Therefore, two years will be the maximum period for an insurer to ascertain an insured’s insurability. Since it has been five years since Sonja has purchased the policy and the insurer has not found out that she has high blood pressure within that period, the insurer will still be obliged to pay for Sonja’s death claims.
[Total : 25 Marks]
Question 4
(a) Briefly explain the basic characteristics of the following types of managed care plans:
(i) Health maintenance organizations (HMOs) (7 marks)
Health maintenance organizations are a coordinated healthcare system that focuses on providing medical services that are both extensive and comprehensive to their members. The members of a health maintenance organization are charged on a prepaid basis. Typically, agreements and negotiations are formed between health maintenance organizations, medical centers, and physicians to provide medical services for their members. Substantially, health maintenance organizations put a heavy focus on cost optimization and effectiveness. Therefore, their cost structure is very clear-cut and optimized, where the two types of costs incurred by HMOs towards their partnering medical centers are such as capitation fees, modified fee for service. Capitation fees are fixed and are paid yearly for each member to the medical service provider regardless of how often they use their service. On the other hand, modified fees for service are a payment structure commonly used for the payment for physicians, derived from a negotiated fee structure. Moreover, there are a few types of health maintenance organizations, where each is unique on its own, namely the network model, group model, staff model, and individual practice association. Besides, members of health maintenance organizations are not allowed to seek medical help from providers outside of the network.
(ii) Preferred provider organizations (PPOs) (7 marks)
Preferred provider organization is a type of managed care plan that entitle their
members towards specific medical services that are offered at a discounted
price. Like health maintenance organizations, this plan involves an agreement or contract with an external healthcare service provider. Just like the name, this plan has an agreement with certain preferred healthcare providers, that entitle members to a higher deductible if they use their services. However, members are allowed to seek medical services from other providers rather than the ones that are preferred, but this may entitle them to lower deductibles and co-payments for their services. The fee structure of preferred provider organizations is on a fee-for-service basis. This means the fees are unbundled and charged separately according to different services, which is substantially distinctive from health maintenance organizations. Therefore, the provider only receives payments for their services that the members have used, unlike healthcare maintenance organizations that provide annual payment to providers regardless of frequency of usage, each having their advantage. When the actual payment is more than the negotiated fees, the provider will be liable for the excess fees. Besides, most preferred provider organizations do not have a gatekeeper physician, a healthcare professional who has the first encounter with the patient. Therefore, this explains the flexibility that this managed care plan offers to their members, as most probably, they can choose the physician to their preference.
(iii) Point-of-service (POS) plans (7 marks)
Point-of-service (POS) plans are structured in a somewhat similar manner as a health maintenance organization. Still, the main difference is that the members of a point-of-service plan can seek medical help from healthcare providers outside of the organization’s network. On this aspect, the members of the point-of-service plan are entitled to higher flexibility than members of health maintenance organizations. On the other hand, the members will only have to pay a small fee or nothing when they seek services from providers within the network. Naturally, they will have to pay more when they use facilities from healthcare providers outside the network. Therefore, they are somewhat similar to a preferred provider organization in this aspect. However, the point-of-service plan still has a rather niche market share in the current insurance market. Health maintenance organizations and preferred provider organizations remain the top favorites in the market. It is believed that this could be due to the fact that point-of-service plans are not marketed as aggressively as the other two. The general premium price of point of service plans falls in between the premium price of health maintenance plans and preferred providers plans. Health maintenance plans are the least expensive overall and preferred provider plan being the most expensive overall. Point of sales plans could also be complicated and complex at times, which may reduce their desirability towards the public if not projected thoroughly and clearly.
(b) What is the purpose of stop-loss insurance that is used with self-insured group medical expense plans? (4 marks)
Stop-loss insurance is illustrated when a commercial insurer will pay for any claims by employees who have exceeded a specific claims limit. Therefore, the self-insured medical expense plan will not be obliged to pay for any claims that have exceeded the predetermined threshold. Stop-loss insurance is typically used to protect employers that self-insure their employees but do not want to assume all of the claims. Besides, stop-loss insurance is particularly useful in safeguarding employers that self-insure from any unpredictable and catastrophic losses, which may significantly increase the claims by their employees, that the employer may not be financially capable in fully compensating, and failing to do so may result in serious financial setbacks towards the firm. Therefore, the employer seeks insurance from an external commercial insurer that determines the maximum claims the self-insurance plan will be responsible, limiting the losses assumed by the employer to a certain degree. Stop-loss insurances are either purchased individually or purchased on top of an existing insurance plan. Ultimately, stop-loss insurance allows the self-insurer to protect themselves, while at the same time not forgoing the best possible coverage for their employees.
[Total : 25 Marks]
END OF QUESTION PAPER