FUNDAMENTALS OF RISK AND INSURANCE pdf

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FUNDAMENTALS OF
RISK AND INSURANCE
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FUNDAMENTALS OF
RISK AND INSURANCE
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TENTH EDITION
EMMETT J. VAUGHAN
THERESE M. VAUGHAN
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ABOUT THE AUTHORS
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Emmett J. Vaughan was a Professor of Insurance
at the University of Iowa for over 40 years, where he
held the Partington Professorship in Insurance until
his death in 2004. Professor Vaughan earned his un-
dergraduate degree in economics from Creighton
University and his M.A. and Ph.D. in economics
and insurance from the University of Nebraska. He
was an enthusiastic teacher, prolific scholar, and
beloved by his students. He inspired hundreds of

students to choose careers in insurance.
Ther ese M. Vaughan is the Robb B. Kelley Distin-
guished Professor of Insurance and Actuarial Sci-
ence at Drake University. Prior to joining Drake,
she served as Iowa Insurance Commissioner for
over 10 years and as President of the National
Association of Insurance Commissioners. Vaughan
earned her undergraduate degree in economics
and insurance from the University of Iowa and her
Ph.D. in insurance from the Univer sity of Pennsyl-
vania.
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PREFACE
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This tenth edition of Fundamentals of Risk and
Insurance marks the 36th anniversary of the first edi-
tion, published in 1972. Over the years, the book
has undergone major change as the field of risk
management and insurance has changed. Emmett
J. Vaughan, an author in the first and all subsequent
editions, guided the revisions over the years to main-
tain the text’s primar y focus—that of a consumer-
oriented text. He was passionate about the field of
risk and insurance, and his passion was reflected in
the book through the decades. Professor Vaughan
saw risk and insurance implications everywhere,
from personal life events to the changing world
around him to the fairy tales he read to his chil-

dren (with commentary). His enthusiasm for the
field was infectious and influenced many students
to pursue careers in risk and insurance. I was fortu-
nate to have him as a teacher, advisor, role model,
and father.
Professor Vaughan died in October 2004, just as
we were beginning to discuss the tenth edition of
the book. This text had been a proud accomplish-
ment of his for over 30 years, and it is with some
apprehension that I have completed this revision
without his guidance. At its heart, of course, this is
his book. While I have updated it to reflect recent
developments and tried (mostly without success)
to shorten it in parts, the bulk of the text reflects his
thoughts over his forty-plus year career. I hope that I
have been able to capture some of the enthusiasm
with which he approached the field.
At the time the first edition was published, the
field of insurance was quite different from what it
is today. Many of the current forms of insurance
coverage did not exist; the world seemed a simpler
place. Medicare was not yet ten years old, and had
no Parts C and D. Richard Nixon was president of
the United States. Automobile no-fault was an ex-
periment that had been adopted by a single state
(Massachusetts), and only three states had compul-
sory automobile insurance (New York, North Car-
olina, and Massachusetts). The 1943 Standard Fire
Policy was the standard form of coverage for most
commercial entities, and the Family Auto Policy was

the standard for personal automobile insurance.
Universal life insurance was not yet on the drawing
board and endowment policies were a staple for
the life insurance agent. There was no such thing
as long-term care insurance, no individual retire-
ment accounts, and ERISA was not yet a gleam in a
Congressperson’s eye. The Social Security tax base
was $9000 and the Medicare Part B premium was
$5.60.
Although the book has changed over the years,
its purpose, organization, and approach remain es-
sentially the same. The original goal was to create a
consumer-oriented text, and this orientation is con-
tinued in the present edition. The first edition of this
book was written in response to a perceived need
for an insurance textbook that addressed the prin-
ciples of risk management without abandoning the
discussion of insurance. The reception to the book
over the past three and a half decades has been grat-
ifying. At least a part of the book’s success is due to
the fascinating subject matter with which it deals.
Experience shows that insurance can be an excit-
ing subject. This comes as no surprise to those of us
who find this field an exciting one. It is satisfying,
however, to find that our excitement can be shared
by our students.
SCOPE OF THE SUBJECT
As the titleindicates, Fundamentals of Risk and Insur-
ance is about risk and about insurance. Its objective
is to summarize the pervasive nature of pure risk on

the individual and on society, and to illustrate the
way in which insurance can be used to deal with
the problems posed by such risk. It is a book on
ix
x PREFACE
insurance theory as well as on how students can
use insurance personally.
The main emphasis is on the insurance product
and the use of insurance within the risk manage-
ment framework. The traditional fields of life insur-
ance, health insurance, property and liability insur-
ance, and social insurance are treated in terms of
their relationship to the wide range of insurance
risks to which the individual and the business firm
are exposed.
The text is designed for use in a college-level sur-
vey of the area of risk and insurance. As an introduc-
tion to the subject, it is intended for students who
have had little or no prior education in insurance.
It may serve as the basis for more advanced texts
for those students who intend to specialize in the
field of insurance, and at the same time it consti-
tutes a compendium of what an informed citizen
and consumer should know about the subject.
WHY STUDY INSURANCE?
The reasons for studying insurance are varied. For
some, the study is undertaken in preparation for a
career in the field. Others study to improve their
knowledge of the subject in order to become more
knowledgeable consumers. The average individual

will spend a significant percentage of his or her dis-
posable income on insurance over a lifetime, and
one of the logical reasons for studying insurance is
to learn how it can be used in personal financial
planning. Still others study insurance as a part of
the discipline of risk management, the managerial
function that aims at preserving the operating effec-
tiveness of the organization.
Although each of these reasons is adequate jus-
tification for the study of insurance, whether that
study should be considered essential for business
students depends on the approach and the specifics
of what is studied. Some have argued that the study
of insurance per se is a narrow specialty, yet the
broader discipline of risk management—of which
insurance buying is only a part—is clearly a func-
tion that all future managers should understand.
A proper understanding of the methods of deal-
ing with exposures to loss is essential for organi-
zational leaders. Although insurance is only one of
the techniques that can be used to deal with pure
risks, risk management decisions presuppose a thor-
ough understanding of the nature and functions of
insurance.
We believe that insurance and risk management
is a subject that needs to be taught in colleges and
universities. Far from being the narrow specialty it
is sometimes characterized as, the study of insur-
ance has a breadth that few disciplines equal. As
you progress through the book, you will encounter

applications from economics, statistics, finance, ac-
counting, law, decision theory, and ethics.
Because the study of risk management and insur-
ance draws on these different disciplines, it is some-
times considered a subset of one of them. Thus, in
many colleges and universities, insurance and risk
management are a part of the finance curriculum,
reflecting the financial nature of the risk manage-
ment function. In other schools, it is considered a
part of economics, while in still others it is located in
another department. This organizational ambiguity
reflects the confusion concerning what the study of
risk management and insurance entails.
In fact, risk management and insurance is a sep-
arate and distinct discipline, which draws on and
integrates the knowledge from a variety of other
business fields. In a micro sense, it is a discipline
in which a variety of methodologies are brought to
bear on a significant problem.
Viewed from a macro perspective, the study of
insurance addresses a variety of important issues
facing society today: the high cost of medical care,
crime, the tort system, pollution and the environ-
ment, climate change, and the broad subject of
ethics. Indeed, it is not an exaggeration to say that
the debates in the insurance arena address ques-
tions of what kind of society we will have and who
will pay for what. Debates over the cost of insurance
and the way in which insurance prices should
be determined have intensified over the past two

decades. Increasingly, the debates over insurance
availability and affordability have come to center
stage as the challenges of the cost of automobile
insurance, access to health care, responsibility for
pollution, damage from hurricanes, product liabil-
ity, and medical malpractice have become crises. As
consumers, we are all affected by the way in which
insurance operates.
Finally, the study of risk management and insur-
ance is a fertile field for considering the subject of
PREFACE xi
ethics in business and in society. Indeed, the ubiqui-
tous presence of ethical problems in the field of in-
surance transactions raises an important question:
is ethics something to be studied and learned, or is
it something innate in the individual?
ORGANIZATION OF THE BOOK
This book is divided into three major sections. The
first section examines the concept of risk, the na-
ture of the insurance device, and the principles
of risk management. This section also provides an
overview of the insurance industry and the manner
in which it operates.
The second section examines the traditional
fields of life and health insurance as solutions to the
risks connected with the loss of income. The Social
Security system, workers compensation, and other
social insurance coverages are discussed in this sec-
tion to permit students to integrate the coverage un-
der these programs in planning income protection.

The final section deals with the risks associated
with the ownership of proper ty and legal liability.
The coverages applicable to the individual or family
are treated in chapters that are separate from those
designed for the business firm, permitting those in-
structors who prefer to concentrate on insurance for
the individual to give only slight treatment to com-
mercial coverages.
The book is designed to fit a one-semester or two-
quarter course, but it may be adapted to longer
and shorter sequences. We have composed what we
consider to be a logical sequence of subject matter,
but the book can be used flexibly. Sections Two and
Three in particular may be taken in different order.
CHANGES IN THE TENTH EDITION
The thirty-six years that have passed since the pub-
lication of the first edition of Fundamentals of
Risk and Insurance have been marked by signif-
icant change in the field of insurance. The sec-
ond through ninth editions are a chronology of that
change.
The insurance industr y and its environment con-
tinue to change, and the authors have attempted
to capture the flavor of that change in each revi-
sion. Changes in the legal environment, revisions in
policy forms, the introduction of new types of in-
surance, and a myriad of new problems continue
to make insurance an exciting field of study but a
challenge to the authors of textbooks.
This edition has been updated to reflect new

policy forms, recent laws affecting pensions and
Medicare, the 2001 CSO mortality table, the emerg-
ing field of enterprise risk management, issues aris-
ing from Hurricane Katrina, and alternative risk
transfer vehicles, such as catastrophe bonds. Where
possible, I have eliminated extensive discussion of
old topics. Unfortunately, the text continues to be
lengthy, reflecting the breadth of the subject matter
with which it deals.
One significant change with this edition is the
introduction of a new website for individuals us-
ing the text. In prior editions, sample policy forms
were included as an appendix to the book (from the
first through sixth editions), as a separate bound
volume (the seventh and eighth edition), or on a
CD-ROM that came with the book (the ninth edi-
tion). With this edition, sample policy forms will be
posted to the website, allowing more forms to be
provided (www.wiley.com/college/vaughan). In ad-
dition, Chapter 34, Insurance in the Future, which
deals with current events and trends, will be pub-
lished on a the website.
ACKNOWLEDGMENTS
Many people have provided support and encour-
agement as I have worked on this revision. First, of
course, are the members of my family, including my
husband, children, mother, and siblings. I am par-
ticularly grateful for their patience. Thanks also to
EmilyRosenberger,who maintainedourhousehold,
took messages, and handled administrative details

while I was preoccupied.
As a book progresses through successive editions,
the number of persons to whom an author is in-
debted increases geometrically, since the efforts of
so many people become a part of the work. Over
the years, my father recognized many people for
their efforts, and I continue that appreciation. Our
teachers, reviewers, and users have helped shape
our thoughts and the book. Although much has
changed over the years, colleagues and students
xii PREFACE
who provided comments on earlier editions con-
tinue to influence it. As a result, there are many to
whom special thanks are due. They include our for-
mer colleague and my teacher, Professor Michael
Murray, who shared his insights with us over the
years and whose influence has been significant.
They also include my colleague, Professor Robert
Cooper, who has generously provided his support
and guidance over the years. The reviewers of the
first nine editions, whose contributions to those edi-
tions helped to shape this one as well, were Tom
Auippa, Richard C. Allgood, Garth H. Allen, Albert L.
Auxier, W. Oscar Cooper, Robert W. Cooper, Richard
Corbett, Darlene Dicco, Bill Feldhaus, Roger A.
Formisano, John W. Hanye, Kenneth J. Krepas,
E. J. Leverett, Aaron Lieberman, Jim Milanese,
Joseph R. Morrin, Robert J. Myers, John J. O’Connell,
Mike Thorne, S. Travis Pritchett, Dede Paul, Gary K.
Stone, and Robert Witt.

As in previous editions, I want to give special
thanks to Mandell S. Winter, Jr. and to Michael
Snowdon of the College for Financial Planning, for
their assistance in reviewing several editions. Their
suggestions and insights helped to clarify many con-
cepts and to avoid errors that would otherwise have
marred the book. Mr. Winter’s contributions to the
seventh and eighth editions and Mr. Snowden’s as-
sistance in the ninth editions went far beyond those
of a reviewer.
I also offer special thanks to a number of my
father’s former graduate teachings assistants, who
taught the basic insurance course at the Univer-
sity of Iowa and offered many suggestions over the
years. They are Lois Anderson, Phillip Brooks, Robb
Fick, Tim Hamann, Terry Leap, Lacy McNeill, Joseph
Panici, Mark Power, Lori Rider, Roger Stech, Ellen
Steele, Mike Steele, Patrick Steele, Art Cox, Robert
Carney, and Changsu Ouh. Their suggestions con-
tributed significantly to theearlier editions, andtheir
influence carries through to this edition.
Thank you also to the folks at John Wiley and
Sons, who were so helpful in completing this revi-
sion. Barbara Ligour i did an outstanding and thor-
ough job of copyediting, reading the text with a
critical eye and making several suggestions that im-
proved the end result. Shelley Creager and Sarah
Vernon provided invaluable assistance, responding
quickly to numerous requests for information and
other help.

Finally, thank you to all of the students we have
had over the years. Their many comments and in-
telligent questions contributed to the design of the
book and to the examples and illustrations used.
Thank you also to all of the users of the first nine
editions who took time to wr ite with their sugges-
tions and comments.
I would be grateful to receive advice from the
teachers who will use this book, particularly con-
cerning any errors that should be corrected and
any materials should be added or omitted when it
is again revised. To the students who will be com-
pelled to read it, I extend the hope that the material
will seem asexciting andinteresting as it hasseemed
to both of its authors.
Therese M. Vaughan
Des Moines, Iowa
September 2007
■
BRIEF CONTENTS
■
Chapter 1 The Problem of Risk 1
Chapter 2 Introduction to Risk
Management 12
Chapter 3 The Insurance Device 34
Chapter 4 Risk Management
Applications 55
Chapter 5 The Private Insurance
Industry 73
Chapter 6 Regulation of the Insurance

Industry 98
Chapter 7 Functions of Insurers 130
Chapter 8 Financial Aspects of Insurer
Operations 146
Chapter 9 The Legal Framework 165
Chapter 10 Managing Personal
Risks 184
Chapter 11 Social Insurance
Programs 209
Chapter 12 Introduction to Life
Insurance 231
Chapter 13 The Actuarial Basis of
Life Insurance 248
Chapter 14 The Life Insurance
Contract—General Provisions 261
Chapter 15 The Life Insurance
Contract—Other Provisions 273
Chapter 16 Special Life Insurance
Forms 289
Chapter 17 Buying Life Insurance 299
Chapter 18 Annuities and Pension
Benefits 318
Chapter 19 Managing the Retirement
Risk 345
Chapter 20 Health Insurance: Disability
Income Insurance 360
Chapter 21 Health Insurance: Coverage
for Medical Expenses 378
Chapter 22 Health Insurance for
the Elderly 403

Chapter 23 Employee Benefits and
Other Business Uses of Life and
Health Insurance 426
Chapter 24 The Homeowners
Policy—General Provisions 446
Chapter 25 The Homeowners
Policy Forms 464
Chapter 26 Other Personal Forms of
Property Insurance 479
Chapter 27 Negligence and Legal
Liability 497
Chapter 28 General Liability Insurance
for the Individual 512
Chapter 29 The Automobile and its
Legal Environment 531
Chapter 30 The Personal Auto
Policy 550
Chapter 31 Commercial Property
Insurance 574
Chapter 32 Commercial Liability
Insurance 605
Chapter 33 Surety Bonds and Trade
Credit Insurance 633
Chapter 34 Insurance in the Future
online
xiii
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CONTENTS
■

SECTION ONE RISK, INSURANCE,
AND RISK MANAGEMENT
Chapter 1 The Problem of Risk 1
The Concept of Risk 1
Current Definitions of Risk 2
Our Definition of Risk 2
Uncertainty and Its Relationship
to Risk 3
The Degree of Risk 4
Risk Distinguished from Peril and
Hazard 5
Classifications of Risk 5
The Burden of Risk 8
The Growing Number and Variety of Pure
Risk 8
Increasing Severity of Losses 9
Managing Risk 10
Chapter 2 Introduction to Risk
Management 12
The History of Modern Risk Management 13
Enterprise Risk Management 15
Risk Management Defined 16
Risk Management Tools 17
Risk Control 18
Risk Financing 19
Risk Management as a Business Function 20
Risk Management’s Contribution to the
Organization 21
The Risk Manager’s Job 22
Misconceptions about Risk Management 23

Universal Applicability 23
Anti-Insurance Bias? 23
Risk Management and the Individual 24
The Risk Management Process 24
Determination of Objectives 24
Identifying Risk Exposures 26
Evaluating Risks 28
Consideration of Alternatives and Selection
of the Risk Treatment Device 30
Implementation of the Decision 30
Evaluation and Review 30
Chapter 3 The Insurance Device 34
The Nature and Functions of Insurance 34
Risk Sharing and Risk Transfer 34
Insurance Defined from the Viewpoint of
the Individual 35
Risk Reduction Through Pooling 35
Insurance Defined from the Viewpoint of
Society 41
Insurance: Transfer or Pooling? 41
Insurance and Gambling 42
The Economic Contribution of Insurance 42
Elements of an Insurable Risk 42
Randomness 43
Economic Feasibility 44
Self-Insurance 44
The Fields of Insurance 45
Private (Voluntary) Insurance 45
Social Insurance 48
Public Guarantee Insurance Programs 51

Similarities in the Various Fields of
Insurance 53
Chapter 4 Risk Management
Applications 55
Risk Management Decisions 55
Utility Theory and Risk Management
Decisions 56
Decision Theory and Risk Management
Decisions 56
The Rules of Risk Management 58
xv
xvi CONTENTS
Risk Characteristics as Determinants of
the Tool 60
The Special Case of Risk Reduction 60
Buying Insurance 61
Common Errors in Buying Insurance 61
Need for a Plan 61
Other Considerations in the Choice
Between Insurance and Retention 63
Selecting the Agent and the Company 64
Alternatives to Commercial Insurance 67
Self-Insurance 67
Captive Insurance Companies 69
Risk Retention Act of 1986 70
Chapter 5 The Private Insurance
Industry 73
A Brief History of Private Insurance 74
Insurance in Antiquity 74
Origins of the Modern Insurance

Business 74
Insurance in the United States 75
Classification of Private Insurers 76
Classification by Type of Product 76
Classification by Place of Incorporation and
Licensing 77
Insurers Classification by Legal Form of
Ownership 77
Marketing Systems 83
The Agent 83
Life Insurance Distribution System 84
Property and Liability Distribution
Systems 84
Insurance Marketing and the World Wide
Web 85
Corporate Combinations 85
Nuclear Energy Pools 86
Other Voluntary Syndicates 86
Banks and Insurance 86
Cooperation in the Insurance Industry 87
Rating Organizations 88
Distressed and Residual-Risk Pools 88
Educational Organizations 90
Insurance Trade Associations 90
Competition in the Insurance Industry 90
Price Competition 91
Quality Competition 92
Is the Insurance Industry Really
Competitive? 92
Chapter 6 Regulation of the Insurance

Industry 98
The Why of Government Regulation of
Insurance 98
The Why of Regulation Generally 98
Approaches to Government Control of
Business 99
Rationale for Regulation of the Insurance
Industry 101
Goals of Insurance Regulation 102
A Brief History of Insurance
Regulation 102
Regulation Today 105
The Current Regulatory Structure 105
National Association of Insurance
Commissioners 105
Areas Regulated 105
Solvency Regulation 106
Market Regulation 109
Regulation of Rates 111
Risk-Retention Groups 114
State versus Federal Regulation 115
Pressure for Repeal of the
McCarran-Ferguson Act 115
Arguments Favoring Federal
Regulation 115
Arguments Favoring State
Regulation 116
Consequences of the Repeal of the
McCarran-Ferguson Act 117
Repeal of the McCarran-Ferguson Act as a

States-Rights Issue 117
The NAIC’s Efforts to Modernize State
Insurance Regulation 118
State versus Federal Regulation and Public
Choice 119
Appendix: The Availability/Affordability
Debate 120
The Essence of the Debate 120
Existing Subsidies in the Insurance
Market 120
Income Redistribution Effects of Subsidies
in Insurance 124
Causes of Availability Problems 125
CONTENTS xvii
Causes of Affordability Problems 125
Availability and Affordability and Public
Choice 127
Chapter 7 Functions of Insurers 130
Functions of Insurers 130
Ratemaking 130
Some Basic Concepts 131
Types of Rates 132
Production 135
Underwriting 135
The Agent’s Role in Underwriting 136
Underwriting Policy 136
Process of Underwriting 136
Postselection Underwriting 138
Credit Scoring 138
Loss Adjustment 139

Adjusters 139
Courses of Action in Claim
Settlement 140
Adjustment Process 140
Difficulties in Loss Settlement 141
The Investment Function 141
Miscellaneous Functions 142
Legal 142
Accounting 142
Engineering 142
Appendix: Retrospective Rating
Plans 143
The Retrospective Formula 143
Chapter 8 Financial Aspects of Insurer
Operations 146
Statutory Accounting Requirements 146
Differences Between Statutory Accounting
and GAAP 147
Terminology 148
Property and Liability Insurers 148
Concept of Earned Premiums 149
Incurred Losses 149
Expenses Incurred 150
Summary of Operations 150
Life Insurance Companies 152
Life Insurer Assets 152
Life Insurer Liabilities 152
Life Insurers’ Policyholders’ Surplus 153
Life Insurer Summary of Operations 153
Surplus Drain in Life Insurance 154

Reinsurance 155
Nature of Reinsurance 155
Type of Reinsurance Treaties 155
Reinsurance in Property and Liability
Insurance 155
Reinsurance in Life Insurance 156
Functions of Reinsurance 156
Risk-Financing Alternatives to
Reinsurance 157
Taxation of Insurance Companies 161
State Premium Tax 161
Federal Income Taxes 161
Chapter 9 The Legal Framework 165
Insurance and the Law of Contracts 165
General Requirements of an Enforceable
Contract 166
Void and Voidable 168
Special Legal Characteristics of Insurance
Contracts 169
Insurance Is a Contract of Indemnity 169
Insurance Is a Personal Contract 174
Insurance Is a Unilateral Contract 175
Insurance Is a Conditional Contract 175
Insurance Is a Contract of Adhesion 175
Insurance Is an Aleatory Contract 176
Insurance Is a Contract of Utmost Good
Faith 176
The Insurance Contract as a Contract 180
Policy Construction 181
SECTION TWO LIFE AND

HEALTH INSURANCE
Chapter 10 Managing Personal
Risks 184
Objectives in Managing Personal Risks 185
Other Steps in Managing Personal Risks 186
Managing Risks Associated with Premature
Death 186
Identifying Risks Associated with
Premature Death 186
Measuring Risks Associated with
Premature Death 186
xviii CONTENTS
The Estate Liquidity Need 195
Estate Planning 197
Trusts 200
The Risks Associated with Superannuation 201
The Risk of Outliving the Retirement
Accumulation 202
Estimating the Accumulation Need 202
The Risks Associated with Disability 203
Needs Analysis for the Disability
Risk 203
Resources Available to Meet the Disability
Risk 204
Addressing Unmet Disability Income
Needs 204
Evaluating the Medical Expense Exposure 205
Managing the Risk of Unemployment 205
State Unemployment Insurance
Programs 205

Retention and Risk Reduction 206
Chapter 11 Social Insurance
Programs 209
Old-Age, Survivors’, Disability, and Health
Insurance 210
Eligibility and Qualification
Requirements 210
Financing 211
Amount of Benefits 212
Classes of Benefits 212
Summary of Qualification
Requirements 214
Loss of Benefits—the OASDHI
Program 215
Soundness of the Program 218
Workers Compensation 223
Historical Background 223
Rationale of Workers Compensation
Laws 224
Principles of Workers Compensation 224
An Overview of State Workers
Compensation Laws 226
Chapter 12 Introduction to Life
Insurance 231
Some Unique Characteristics of Life Insurance 231
Life Insurance Is Not a Contract of
Indemnity 232
Types of Life Insurance Contracts 232
Reasons for Difference in Term and Cash
Value Insurance 233

The Level Premium Concept 234
Tax Treatment of Life Insurance 235
Code Definition of Life Insurance 236
Current Life Insurance Products 237
Term Insurance 237
Whole-Life Insurance 238
Universal Life Insurance 239
Variable Life Insurance 240
Adjustable Life Insurance 241
Endowment Life Insurance 241
Participating and Nonparticipating Life
Insurance 241
General Classifications of Life Insurance 242
Individual Life Insurance 242
Group Life Insurance 242
Credit Life Insurance 244
Total Life Insurance in Force in the United
States 244
Other Types of Life Insurance 245
Chapter 13 The Actuarial Basis of
Life Insurance 248
Life Insurance Premium Computation 248
Mortality 249
Interest 249
The Net Single Premium 252
The Net Level Premium 254
Reserves on Life Insurance Policies 255
Benefit-Certain and Benefit-Uncertain
Contracts 257
Chapter 14 The Life Insurance

Contract—General Provisions 261
Inception of the Life Insurance Contract 262
General Provisions of Life Insurance Contracts 262
Entire Contract Clause 262
Ownership Clause 263
Beneficiary Clause 263
Incontestable Clause 264
Misstatement of Age Clause 265
Grace Period 265
Reinstatement 265
CONTENTS xix
Suicide Clause 266
Aviation Exclusions 266
War Clause 267
Settlement Options 267
Interest Option 267
Installments for a Fixed Period 267
Installments of a Fixed Amount 268
Life Income Options 268
Taxation of Policy Proceeds under Various
Settlement Options 269
Chapter 15 The Life Insurance
Contract—Other Provisions 273
Nonforfeiture Values 273
Cash Option 274
Paid-Up Reduced Amount 275
Extended Term Insurance 275
Policy Loan Provisions 276
Automatic Premium Loan 276
Dividend Provisions 277

Important Optional Provisions 279
Disability Waiver of Premium
Provision 279
Accidental Death Benefit 280
Guaranteed Insurability Option 281
Common Disaster Clause 282
Spendthrift Clause 283
Rights of Creditors to Life Insurance
Proceeds 283
Cost-of-Living Riders 283
Universal Life Policy Provisions 284
Premium and Cost of Insurance
Provision 284
Changes in the Amount of Insurance 284
Death Benefit Provision 284
Universal Life Insurance with Secondary
Guarantees 286
Index Universal Life Insurance 286
Chapter 16 Special Life Insurance
Forms 289
Specialized Life Contracts 289
Mortgage Redemption Policy 290
Joint Mortgage Protection Policy 290
Survivorship Whole Life 290
Family Income Policy 291
Family Income Rider 291
Family Protection Policy 292
Return-of-Premium and
Return-of-Cash-Value Policy 292
Modified Whole Life 293

Graded-Premium Whole Life 293
Single-Premium Life 294
Juvenile Insurance 294
Indeterminate Premium Policies 295
Low-Load and No-Load Life
Insurance 296
Advantages and Disadvantages of Special
Forms 297
Chapter 17 Buying Life Insurance 299
Decisions in Buying Life Insurance 299
Buy Term and Invest the Difference? 300
Life Insurance as an Investment 302
Choosing the Company 303
Comparing Differences in Cost 305
The NAIC Life Insurance Illustrations
Model Regulation 308
NAIC Model Replacement
Regulation 309
Investment-Owned Life Insurance 310
Industry Reform Initiatives 311
Shopping for Universal and Variable
Life 311
Some Additional Tax Considerations 313
Section 1035 Exchanges
(“Rollovers”) 313
Life Insurance and Divorce
Agreements 314
Chapter 18 Annuities and Pension
Benefits 318
Annuities 318

Classification of Annuities 320
Income Tax Treatment of Annuities 321
Annuities and the Federal Estate
Tax 322
Specialized Annuities 323
Annuities as Investments for
Retirement 326
Regulation of Annuity Sales 327
xx CONTENTS
Qualified Retirement Plans 328
A General Overview of Qualified
Plans 328
Basic Types of Qualified Plans 329
Significance of the Nature of the
Employer’s Promise 330
Other Types of Qualified Plans 331
Other Requirements for Qualified
Retirement Plans 334
Other Benefits 336
Required Joint-and-Survivor Option 337
Period-Certain Payments 337
Distribution Requirements 337
Taxation of Distributions 338
Individual Retirement Accounts 339
Traditional IRAs 340
The Roth IRA 342
A Concluding Note 343
Chapter 19 Managing the Retirement
Risk 345
An Overview of the Retirement Risk 345

Causes of the Retirement Risk 346
Two Risks Associated with
Retirement 346
Retirement Risk Alternatives 346
An Overview of the Retirement Planning
Process 346
Countering the Urgency Deficit 349
Constructing a Retirement Plan 349
Estimating Retirement Needs 350
Planning the Accumulation 353
Managing the Distribution 354
Chapter 20 Health Insurance: Disability
Income Insurance 360
General Nature of Disability Income
Insurance 361
Types of Insurers 361
Methods of Marketing 361
Need for Disability Income
Insurance 361
Short-Term versus Long-Term Disability
Coverage 362
Disability Income Underwriting and
Pricing 363
Disability Income Contracts 364
Perils Covered 364
Elimination Periods 364
Limitations on Amount of Coverage 365
Definitions of Disability Income
Policies 365
Exclusions in Disability Income

Contracts 367
Payments for Other Than Total
Disability 367
Optional Benefit Provisions 369
Individual Health Insurance Policy
Provisions 370
Individual Health Insurance Continuance
Provisions 370
Uniform Provisions 371
Optional Uniform Provisions 372
Programming and Buying Disability Income
Insurance 373
Determining Disability Income Coverage
Needs 373
Evaluating Existing Sources of
Protection 374
Taxation of Disability Income 375
Cost of Disability Income Insurance 375
Chapter 21 Health Insurance: Coverage
for Medical Expenses 378
Background on the Current Health Insurance
Market 379
Historical Development of Health
Insurance in the United States 379
The Health Insurance Market 382
The Private Sector 382
The Public Sector 383
Deficiencies in the System and Prior Reform
Efforts 385
Previous Attacks on the Access

Problem 388
Efforts to Reduce Costs 390
The Insurance Product 391
Traditional Forms of Medical Expense
Coverage 391
HMO Contracts 393
Exclusions under Health Insurance
Policies 393
Coordination of Benefit 394
CONTENTS xxi
Other Medical Expense Coverages 394
Limited Health Insurance
Policies 394
Dental Expense Insurance 394
Limited Policies—Prescription
Drugs 395
Buying Health Insurance 395
First-Dollar Coverages 396
Taxes and Health Care Costs 396
The Future of Health Insurance 396
The Failure of Past Efforts 396
The Attack on Managed Care 396
Consumer-Driven Health
Care 397
Proposals for National Health
Insurance 398
Recent Developments 399
The Future 400
Chapter 22 Health Insurance for
the Elderly 403

Medicare 404
Original Medicare 404
Traditional Program Medicare Supplement
Policies 409
Part C—Medicare Advantage 411
Part D—Prescription Drug
Coverage 413
The Future of Medicare 415
Long-Term Care Insurance 416
Nature of the Long-Term Care
Exposure 416
Inadequacy of Medicare for Long-Term
Care Needs 416
Development of LTC Insurance 417
Coverage of LTC Policies 418
Cost of LTC Insurance 420
The Life Insurance Accelerated Benefits
Alternative to LTC 421
Long-Term Care and Annuities 421
Viatication 421
Medicaid Planning 422
Statutory Restrictions 422
Spousal Impoverishment Provisions 422
Estate Recovery 423
Long-Term Care Partnership
Programs 423
Chapter 23 Employee Benefits and
Other Business Uses of Life and
Health Insurance 426
Employee Benefits Generally 427

Group Life and Health Insurance as Employee
Benefits 428
Group Term Life Insurance 428
Group Ordinary Life Insurance 428
Group Paid-Up Life Insurance 429
Group Universal Life 429
Survivor Income Benefit Insurance 429
Retired Lives Reserve 429
Funding Issues 429
Funding through a 501(c)(9) Trust 430
Pensions 431
Legislation Affecting Pension Plans 431
Qualification Requirements 433
Funding Pensions 434
Trusts and Insurance Companies 436
ERISA Pension Plan Termination
Insurance 438
Accounting for Defined Benefit Plans 439
Decline in Defined Benefit Plans 440
Cafeteria Employee Benefit Plans 440
Some Specialized Uses of Life Insurance in
Business 441
Business Continuation Insurance 441
Key-Person Insurance 442
Split-Dollar Plan 442
Deferred Compensation 443
Corporate-Owned Life Insurance 443
Summary 444
SECTION THREE PROPERTY AND
LIABILITY INSURANCE

Chapter 24 The Homeowners
Policy—General Provisions 446
The Homeowners Policy Program 446
Historical Development 446
General Nature of the Homeowners
Program 447
Homeowners Section I Coverage 447
Section I Coverages: An Overview 447
Perils Insured 448
xxii CONTENTS
Dwelling and Other Structures
Coverage 450
Personal Property Coverage 451
Loss of Use Coverage 455
Additional Coverages 455
Homeowners Deductibles 458
Other Provisions 458
Section I Conditions 458
General Conditions Applicable to Sections
I and II 460
Chapter 25 The Homeowners
Policy Forms 464
Differences Among Homeowners Forms 464
Homeowners 2 Broad Form 464
Homeowners 3 Special Form 465
Homeowners 4 Contents Broad
Form 471
Homeowners 5 Comprehensive
Form 471
Homeowners 6 Condominium

Unit–Owners Form 472
Homeowners 8 Modified Coverage
Form 474
Homeowners Section I Optional Coverages 474
Optional Perils 474
Other Endorsements 475
Chapter 26 Other Personal Forms of
Property Insurance 479
Monoline Fire Dwelling Program 480
Current Dwelling Program 480
Eligibility 480
Coverages under the Dwelling
Program 481
Endorsements to the Dwelling Program
Forms 481
Mobilehome Program 482
Eligibility 482
Coverage of the Mobilehome 483
Flood Insurance 483
General Nature of the Program 483
The Flood Insurance Policy 485
Inland Marine Coverage for the
Individual 487
Personal Inland Marine Floaters 488
Scheduled Personal Property
Endorsement 488
Insurance on Watercraft 490
Buying Property Insurance for the Individual 492
Pricing and Cost Considerations 492
Choosing the Form 492

Tailoring the Coverage under the
Homeowners Policy 493
Flood Insurance 493
Title Insurance 494
Torrens System 494
Chapter 27 Negligence and Legal
Liability 497
Criminal and Tortious Behavior 498
Negligence and Legal Liability 498
There Must Be Negligence 498
There Must Be Actual Damage or
Loss 501
Negligence Must Be the Proximate Cause
of the Damage 502
Defenses to Negligence 505
Possible Changes in the Tort System 508
Summary 509
Chapter 28 General Liability Insurance
for the Individual 512
Liability Insurance in General 512
Types of Liability Insurance 513
Comprehensive Personal Liability Coverage 513
General Nature of the Coverage 514
Personal Liability Coverage 514
Medical Payments to Others 521
Additional Coverages 522
Section II Conditions 524
Cost of Personal Liability Insurance 525
Optional Personal Liability Endorsements
525

Professional Liability Insurance 526
Malpractice Insurance 526
Errors and Omissions Insurance 527
Umbrella Liability Policy 527
Exclusions under the Umbrella Liability
Policy 528
Cost of the Umbrella 528
CONTENTS xxiii
Chapter 29 The Automobile and its
Legal Environment 531
A Brief Overview of Automobile Coverages 532
Automobile Liability Insurance 532
Medical Payments Coverage 532
Physical Damage Coverage 532
Uninsured Motorists Coverage 532
Legal Liability and the Automobile 532
Vicarious Liability and the
Automobile 533
Guest Hazard Statutes 533
Automobile Liability Insurance and the
Law 534
Insurance for High-Risk Drivers 536
The Automobile Insurance Problem and Changes in
the Tort System 538
Criticisms of the Traditional System 538
The No-Fault Concept 539
Cost of Automobile Insurance 543
The Basic Automobile Insurance Rating
System 543
Evolution of Automobile Rating

Systems 545
The Shifting View of Auto Insurance 547
Chapter 30 The Personal Auto
Policy 550
General Nature of the Personal Auto
Policy 550
Eligibility 551
Policy Format 552
Liability Coverage 552
Liability Insuring Agreement 552
Liability Exclusions 554
Other Liability Coverage Provisions 556
Medical Payments Coverage 557
Medical Payments Insurance
Agreement 557
Medical Payments Exclusions 558
Limitations Applicable to Medical Payment
Recoveries 558
Uninsured Motorist Coverage 558
Uninsured Motorist Insuring
Agreement 558
Underinsured Motorist Coverage 560
Physical Damage Coverage 560
Physical Damage Insuring
Agreement 560
Physical Damage Exclusions 562
Other Physical Damage Provisions 563
Policy Conditions 564
Part E—Duties after an Accident or
Loss 564

Part F—General Provisions 565
Endorsements to the PAP 566
Extended Non-Owned Coverage 566
Named Non-Owner Policy 567
Miscellaneous Type Vehicle
Endorsement 567
Buying Automobile Insurance 569
Liability Coverage 570
Medical Payments Coverage 570
Physical Damage Coverage 571
Uninsured Motorist Coverage 571
Cost Differences among
Companies 571
Summary 572
Chapter 31 Commercial Property
Insurance 574
Commercial Property Coverage 575
Commercial Property Direct Loss Coverages 576
Commercial Property Coverage
Policies 576
Building and Personal Property Coverage
Form 576
Blanket Insurance 583
Reporting Form Coverage 583
Builder’s Risk Coverage Form 584
Condominium Association Coverage
Form 584
Condominium Commercial Unit-Owner’s
Coverage Form 584
Standard Property Policy 584

Plate Glass Insurance 584
Commercial Property Coverage for Indirect
Loss 585
Business Interruption Insurance 585
Extra Expense Insurance 585
Contingent Business Interruption and Extra
Expenses 586
Leasehold Interest Insurance 587
Rain Insurance 587
xxiv CONTENTS
Boiler and Machinery Insurance 587
The ISO Breakdown Protection Coverage
Form 588
Direct Damage Equipment
Coverages 588
Indirect Loss Boiler and Machinery
Coverages 589
Deductibles 590
Suspension 590
Transportation Coverages 590
Ocean Marine Insurance 590
Inland Marine Insurance 592
The National Flood Insurance Program 595
The General Property Form Flood
Insurance Policy 596
Nonresidential Condominiums 596
Insurance Against Dishonesty 596
Dishonesty Insurance Coverage
Triggers 596
The ISO Crime Insurance

Program 597
Employee Crime Coverages 597
Nonemployee Crime Coverages 599
Package Policies for Business Firms 601
Commercial Package Policy 601
Businessowners Policy 601
Summary 602
Chapter 32 Commercial Liability
Insurance 605
Employers Liability and Workers
Compensation 606
Workers Compensation Policy 606
General Liability Insurance 608
General Liability Exposures 609
Commercial General Liability
Coverage 610
Occurrence-First-Reported
Coverage 617
Other Portfolio Liability Coverages 618
Miscellaneous General Liability
Coverages 618
Commercial Automobile Insurance 620
Business Auto Coverage Form 620
Garage Coverage Form 623
Trucking 623
Insurance for Bailees 626
Bailee Liability 626
Bailee Liability Coverages 627
Aviation Insurance 627
Excess Liability and Umbrella Liability

Coverage 628
Excess Liability Distinguished from
Umbrella Liability Contracts 628
Umbrella Liability Policies 629
Chapter 33 Surety Bonds and Trade
Credit Insurance 633
Surety Bonds 634
Suretyship Distinguished from
Insurance 634
Contract Bonds 635
Judicial Bonds 635
License and Permit Bonds 637
Public Official Bonds 637
Miscellaneous Bonds 638
Trade Credit Insurance 638
Specific-Account versus Whole-Turnover
Coverage 639
Proportional versus Excess-of-Loss
Coverage 639
Credit Insurance in Securitization of
Accounts Receivable 640
Collection Service 640
Credit Enhancement Insurance 640
Municipal Bond Guarantee
Insurance 641
Municipal Lease Insurance 641
Commercial Paper Insurance 641
Industrial Development Bond
Insurance 641
Money Market Fund Insurance 641

Chapter 34 Insurance in the
Future
This chapter can be found on the web at
www.wiley.com/college/vaughan
Health and Retirement Security
The Social Security System
Medicare
Health Insurance
Retirement Security