Term & Universal Life
Chapter 4
Contract Use
Life insurance contracts have the ability to be used in many ways. Obviously, life insurance, both term and permanent, are used to insure an individual’s life, but they may also be used in other formats. Businesses may offer their employees group life insurance where the master contract is held by the employer. Employees receive a certificate of insurability.
Group Insurance Principles
Group insurance can include any type of policy that covers groups of people that have come together for a common purpose. That purpose is often employment, but it can also include fraternities, labor unions, or any type of organized group. It is important to note that the group may not be formed for the sole purpose of buying insurance. Group insurance can include virtually any type of product, but usually we think of group insurance in terms of health coverage. Group life insurance may not be as desired as group health insurance, but it is commonly offered by employers or employing organizations. Since underwriting is performed on the group rather than the individuals within the group, those with health issues will find group life insurance beneficial.
Eligible Groups
Any time an employer sponsors group insurance one eligibility requirement is sure to include employment. Exactly what constitutes a group, however, can be far more encompassing. Precisely what constitutes an eligible group for group insurance purposes is regulated by law since it pertains to specific tax benefits.
Single Employer Groups
When XYZ Company brings in an insurer to underwrite an insurance plan for its employees, XYZ becomes a member of the most popular group: a single employer making group benefits available to its workers. Employers can be sole proprietors, partnerships, or corporations. All sizes of companies can offer group insurance plans to their employees – even if only one employee exists. However, it is medium and large-sized companies that are most likely to do so.
Multiple Employer Trusts (METS)
When the group is comprised of two or more small employers who have come together to purchase a single group plan, they are called multiple employer trusts, or METS. The purpose of smaller employers joining together is one of finance: they generally receive the advantages of a large employer by increasing their size through unity. Some plans have minimum requirements (usually 10 members), so by joining together companies can escape the limitations of their small size.
A separate trust is formed to handle the group business, including collection of premiums and filing claims. Multiple Employer Trusts may be sponsored and administered by insurance companies or non-insurance organizations.
Organized unions are groups of workers who perform the same type of job or work in the same type of field. Federal law requires a trust to be established to collect funds and administer the employee benefits.
The group does not have to be an employer or labor union. Any group of people can form an association or other type of group and purchase insurance on a group basis. Types of eligible groups in this classification must adhere to state laws on group eligibility. The group can be old car collectors, members of a community club, lawyers, or any group of people that come together for a common purpose (other than obtaining group insurance benefits). The group need only have a common relationship that is recognized by law.
When an individual borrows money they may become part of a creditor-debtor group. Creditor-debtor group insurance is offered by the lender to those who borrow money from them. Usually a form of disability or life insurance, its purpose is to protect the creditor if the debtor becomes disabled or dies prior to the debt being paid. Some credit policies are individually issued rather than group issued.
As we know, group insurance is based on a common purpose of membership. In the case of creditor-debtor groups, the common purpose is the lending and borrowing of money from a common institution (a bank, savings-and-loan institution and so forth). Labor groups and other associations may offer this type of protection based on the group association as employers or members of the group. Credit unions offer such protection to their members, for example. Credit card companies also offer creditor-debtor insurance; their common purpose is the credit card itself.
In most types of group insurance, it is the group that is qualified and the insurer can usually be sure that the health or other risk factor involved is well mixed. When a credit card company or other loosely defined group markets creditor-debtor disability or life insurance products, members choose individually whether or not to accept the group coverage. Since those most likely to accept would have a reason for doing so (poor health for example) the possibility of adverse selection is much greater. Adverse selection is the likelihood of high-risk individuals outnumbering healthy members.
A major advantage of group insurance is the ability to avoid individual underwriting. As a result, all members of the group have equal access to the benefits involved. Of course, insurers are still concerned about adverse selection (having primarily high-risk members), but this is much less likely to happen in a mixed group of people coming together for a common purpose other than obtaining insurance. Insurers view the group and underwrite it as a group. The effect of this is balancing of risk. The younger and healthier members will balance out the risks of those who are older and less healthy. Group plans also tend to have a shifting membership. In a company, some employees will stay for many years, while others will stay only a short time. There is a constant shifting of ages, health conditions, and other factors that relate to group underwriting. Group plans require the participation of a high percentage of eligible people to ensure that the plan is not composed primarily of those who are likely to have claims.
Group plans have requirements regarding when employees or other members join the group insurance plan. For employees, it is usually required that they sign up for coverage soon after being employed, usually within the first month. This prevents the employees from only joining the group insurance plan when they know they will need the benefits.
When the group is a MET, underwriting is stricter because the insurers know the group is made up of multiple smaller groups. The MET sponsor, often an insurance company, decides what requirements the smaller groups must meet in order to be accepted for the group insurance plan. If the MET is made up of enough small groups, the underwriting exposure for the insurer ends up being as favorable as that for one large group.
As we know, it is an advantage for the insurer to have a large group since the law of large numbers then lessens their risk. The law of large numbers says that a sufficiently large unit of insureds will balance out the risk of claims. The younger and healthier enrollees will have fewer claims than older or sicker members and yet pay the same approximate premium rate. The larger the numbers involved the easier it is for the insurer to evaluate their potential risk and set the premium accordingly.
Just as large numbers help insurers, it also benefits those that are members of the group. The advantage that most enrollees are most familiar with is price. Another advantage is group acceptance regardless of existing health conditions or other claim risks. Group acceptance means that every person has equal access to insurance protection.
Group underwriting is becoming stricter, however. As the costs of medical care continue to rise, and since it is primarily health insurance that is underwritten for groups, insurers are looking closer than ever before at the people who make up the group.
Even when a business appears to have insured the necessary risks, it is prudent to constantly review the insurance portfolio. Most professionals feel an annual or even semi-annual review is necessary. Probably everyone would like to be able to simply submit an application into a vast marketplace that brings instant results, and to some degree that may be possible. Independent agents will submit proposals through multiple insurers, but that doesn’t guarantee that all risks have been recognized. It is seldom that simple. While there have been online sites for pricing automobile insurance with multiple companies (often through a single broker) business insurance has been slow to follow suit. Part of the reason is the complexity of business insurance. It is unlikely that a business owner shopping online would recognize all of his or her potential risks. Therefore, he or she could overlook some financially devastating possibilities.
Agents and brokers rarely appreciate consumer price shopping but it does actually benefit everyone. When insurance companies must become competitive they tend to put out better products and promote service. In the end, this is a benefit not only to consumers but also to the servicing agents.
It can be time consuming to continually price shop for existing clients, but such service often brings about a loyalty that would not exist otherwise. Loyalty also brings about referrals. In addition, it is generally harder to seek out and obtain new accounts. It is easier to renew and update existing business.
Most consumers, regardless of the type of coverage being considered, want to know one thing: how much money for how much protection? Because consumers feel inadequate they often remain with an unsatisfactory coverage because they have no idea how to compare products. On the other hand, a consumer may change coverage merely because another agent recommends it, without really understanding if the change is beneficial or not.
Agents face a dilemma that may not have a satisfactory answer: the public perceives agents as greedy people who want to make a sale at any cost to the consumer. While there may be some agents that do fit this description the majority are professionals who are educated and strive to deliver products that fit the consumer’s needs. Of course, agents must earn enough commission to support themselves and their families, but seldom is that the first consideration for career agents. Unfortunately, many consumers will never benefit from the professional agent because he or she is so mistrustful of the industry.
It would be wonderful if all our clients were informed on insurance products. While a few companies do have a person in charge of such things, most do not. Therefore, the agent must expect to spend enough time to fully explain all aspects of the proposed insurance. There is no doubt that it is easier to sell a product when no other agent is also offering a counter-proposal, but whether there is a competitive situation or not it is important that the buyer understand what they are purchasing. When the buyer is misinformed or does not understand the results can cause a backlash on the agent as well as the insuring company.
An agent cannot expect their clients to blindly stay with them year after year. Unlike individual policyholders, businesses are more likely to shop the marketplace on an annual basis. This means regardless of any work you may have previously performed, they are willing to change agents if prices or benefits seem better elsewhere. Agents working the business insurance market must continually offer prices and benefits that are competitive. Therefore, agents in this marketplace must continually price companies and products and be willing to change loyalties when necessary.
Part of an agent’s job is providing insurance quotes. This is one of the major steps in acquiring new business and keeping old business on the books. Most agents provide a new quote each year to existing clients. The new quote compares their current company with others the agent represents. “Captive” agents may not be able to do this since they represent a single company. In that case, their yearly quotes will be more of an annual review of the existing coverage.
Although there are variances, providing a quote tends to follow these steps:
Many agents initially mail the annual quote to their clients and then follow it up with a telephone call. Some agents may present the quote in person, especially if the agent feels a change in companies is necessary due to price changes or benefits available. Unlike the policies written on individuals, where constant replacement may be frowned on by regulating authorities, business insurance often changes from year to year. Such change is considered to be a normal business routine.
The quoting process is not as difficult as it may at first appear. The Buyer’s Guide to Business Insurance[1] lists seven steps to the quote process rather than the three we have listed. Their view is from the consumer’s standpoint and assumes that the agent is not operating in the client’s best interest. While this can certainly be true in some cases, career agents have learned that the client’s best interest is also their own. It is usually easier to keep a current client than find a new one. Therefore, career agents try very hard to work in a way that will retain current business.
An effective agent will keep informal contact with all their clients. This might be something as simple as a timely birthday card, a quarterly newsletter, or occasional telephone calls. Business insurance is purchased as a means of avoiding loss. Therefore, it is very important that the agent act in the best interest of the business by offering coverage for potential losses. A quarterly newsletter can be an effective way of introducing ideas in business insurance. A business could be severely affected if the agent is negligent. A substantial loss could actually shut down a business. Of course, the business owner has some responsibility in maintaining adequate insurance, but if he or she is relying on the knowledge and professionalism of their agent, the blame may be legally placed on that agent in court. Therefore, besides the fact that commissions are lost when adequate insurance is not recommended, it is also a means of avoiding lawsuits.
Every agent that is not captive to a specific company owes it to their clients to shop the marketplace for products. Although the time spent can be considerable it is usually worth it. As an agent gathers quotes for one account, much of the information will carry over to other accounts as well so the time is well spent.
Nearly every business is advised to shop the marketplace. If the current agent does not offer this service, they are likely to find one that does. If an agent has not shopped the marketplace for a particular account for several years, the loss of that client is likely. This is especially true if their premium rate has continually climbed. Business owners typically notice any expense that rises year after year. If their agent has not adequately explained the price increase there is no doubt that the client will be exploring other options.
Agents do not always have sufficient policy options available to them for some types of accounts. Unfortunately, some types of business insurance are difficult to obtain at reasonable rates, especially for small companies with few employees. Even when the agent wants to provide benefits at an affordable rate, they may not be able to. When insurers withdraw from a specific field of coverage it typically means a hardening insurance market. Just like investments, some types of insurance experience both a soft market and a hard market. When markets become hard (rising costs to insure with a lowering profit margin) companies will opt out, canceling existing policies and refusing new business. Agents must search the marketplace for available coverage, sometimes with unsatisfactory results.
When the existing agent is unable to secure the coverage at desired rates it is likely the business will seek out other agents in the hope of obtaining the coverage they want at a price they are willing to pay. Of course, the business may not be successful, but it does open up the opportunity for another agent to pick up the client.
It is common for a business to use the services of multiple agents or agencies. This is not only common; it is sensible. Agents tend to have areas of expertise, but seldom do they know everything about various types of coverage. Agents who learn to work together, often through the same agency, are able to bring together the knowledge of multiple agents to the benefit of their clients. While we would like to be able to “do it all” this is not realistic. Experienced agents realize both their strengths and weaknesses. Knowing this is an asset since it allows agents to combine their efforts with other agents whose strengths and weaknesses compliment each other. When agents look at their job from the perspective of the client, it can only benefit both sides.
It is important to know those that participate in the legal arrangements we call insurance policies.
The organizations that issue the policies are called insurers. They must be formed to administer insurance plans. They might be corporations, partnerships, or syndicates of individual underwriters. The ability to insure effectively depends upon a large number of people who are acquired by insurers, often through sales representatives called agents. This group of people may be referred to as the field force. The agents may be either employees or independent contractors. Often insurers hire management people to provide any needed training and supervising they feel necessary, but this is not always the case. Many insurers offer very little training or supervision. In this case, agents are responsible for acquiring any training or extra knowledge that might be necessary to appropriately represent the company’s products.
Before a policy may be sold, someone must agree to pay for it. The NAIC defines ‘insured’ as parties covered by an insurance policy. There may be more than one insured person listed on the same policy. In business insurance this usually applies to the company itself, either the entity or the group named as the insured. Individuals buying personal policies are more likely to have more than one insured person named on the same policy application. A company may, however, have more than one type of risk or perhaps multiple locations covered by the same contract. The term ‘insured’ is not always used, depending on the situation. For example, another term that may apply is policyowner, which may also be the insured individual or may by someone other than the insured. Another term that may apply is certificate owner, which is the same as policy owner but usually applies when it is a group contract. The term that applies, whatever that term may be, will be defined in the policy.
Since insurers deal in promises a legal document is required. That legal document is the insurance contract or insurance policy. These contracts define the promises made by the insurer to the insured. They define the exact circumstances under which the insurer will pay and the amount that will be paid. Lawyers must prepare the contracts so there is necessary legalese involved. Since lawyers do not always agree, even though one set of lawyers may write the contract, it is not unusual for another lawyer or group of lawyers to contest the meaning. One might believe that the insurance company would be the determining factor since their lawyers wrote the contract, but that is not necessarily the case. Since it involves a contract, the courts must often decide how payment is due under the contract (policy). Even if the intent of the original policy is misstated in the contract, the word of the contract prevails (or how the courts decide the contract reads).
There is an industry joke: How many lawyers does it take to write an insurance policy?
Answer: 3; one to write the policy, one to dispute it, and a third to decide who is right.
Of course, developing a policy is not just the job of an attorney. It also involves analysis of a specific risk and the number of people or companies that risk involves. There are technical and economic considerations in this process. Rates and restrictions must be applied in a way that would make the insured risk profitable for the company and applicable to enough people or companies to make the issuance of such a policy worthwhile. These decisions are made by underwriting specialists who take their job very seriously. An error can cause the insurer severe financial problems. Some of the specialists involved might include engineers, statisticians, physicians, meteorologists, and economists.
The success of an insurance policy depends upon the equitable distribution of cost among those participating in the risks, which are the insureds. Underwriters classify and rate each loss exposure to maintain a semblance of equity among the policyholders. For example, a business that manufactures brooms and wants to insure against burglary will be charged a rate comparable to other similar manufacturers. Premium costs will vary based on the probability of the burglary occurrence (location of the business is often a major factor) and the probable severity (what does he have that would be expensive to replace and likely to be stolen?).
To avoid adverse selection, it is necessary to have a large number of policyholders that want to insure against the same risk. Even so, the insurer may not be able to insure all that wish to be insured against the loss. Following the principles of insurance requires skill in the selection of applicants. Underwriters must refuse some because the likelihood of loss is too high. In some high-risk geographical areas it can be very difficult to obtain insurance at all. The incidence of burglary is just too high for insurers to want to issue policies. Or, the underwriters might choose to issue a limited amount of policies in a given area to limit the amount of risk they assume. Highly concentrated exposures run counter to sound underwriting principles. Additionally, underwriters may refuse an applicant due to the physical nature of the property or the moral character of its owner. In some industries this would be viewed as unethical, but in the insurance industry it is the premise on which underwriting is based. They are legally allowed to discriminate when issuing insurance policies.
Insurers are financial institutions; they collect, accumulate, and distribute funds. The nature of insurance requires that they be expert handlers of money. Some liability claims, for example, take years to settle. Insurance companies must invest large sums of money to ensure that when claims are settled, there are sufficient funds to pay claims. As a financial institution, insurers have a significant effect on our economy.
The courts have determined that insurance affects the public interest. Much of the insurance regulation in our country has to do with protecting the public. In fact, public regulation affects nearly all aspects of the insurance industry. In nearly all cases, legislation has to do with financial aspects of the industry and how that affects the consumer. Anytime incompetence or dishonesty is involved in an insurance transaction, it affects the consumer in some way.
The concept of a business having a “public interest” is not new. It originated in 1676 with the British jurist Lord Chief Justice Matthew Hale. It took an additional 200 years, however, for the U.S. Supreme Court to establish first that a business was affected with the public interest and then apply due process. In this case, the Court affirmed the state’s right to regulate when a public interest existed. Under the Court’s ruling, when people (a business) operate in a manner that involves the public, that grants the public an interest in the operation of the property or business. Therefore, the people or business must submit to control by the public for the common good. Such control was held to be a legislative question rather than a judicial one, which would have involved due process. Therefore, the courts cannot substitute their judgment for the legislature on a regulatory policy under the guise of due process.
How does an individual know if their business has a public interest? According to the Court, there is a public interest when the action or product affects the community at large. Obviously, insurance products do affect the community. The Court says a public interest extends to any industry that needs to be controlled for the good of the public. Since insurance products affect those insured financially, regulation of the industry was certain to happen.
Insurance is regulated from the beginning of the process to the end. The formation of insurers, a company’s liquidation, policy provisions, rates, expense limitations, valuation of assets and liabilities, how funds are invested, and agent licensing are all regulated by either the federal or state governments. Regulation is sometimes more intense for some forms of insurance than it is for others. For example, anything to do with the senior marketplace tends to receive greater focus because it is perceived that the elderly are more vulnerable. Regulation will vary from state to state and each agent must know their own state’s requirements. This is not optional. When an agent receives their license they are, from that point on, legally required to know and fully understand their state’s laws and follow them appropriately. As the saying goes “Ignorance of the law is no excuse.”
Key Person Insurance
A business operation often has one or several people who are vital to the smooth operation of the company. In some cases, loss of a key person could actually cripple the company temporarily.
Good insurance planning is necessary in all business functions, but loss of key personnel may be critical to the company. The objective of business life and health insurance is either to maintain a business as a going concern or to retain the values of the business interest for the benefit of the estate following the death (or even disability) of the owner, stockholders, or other key people. Insurance is often used to protect the surviving members of the business where the loss or disability of a partner, stockholder or key employee could:
· Adversely affect who controls the company,
· Dissolve the business entirely, or
· Adversely affect the company’s value.
In a closely held business, numerous relationships exist that must be considered. The deceased’s family must be financially protected, the business must be able to continue to operate (assuming others wish to do so), and there must be sufficient funds to operate effectively. The death or disability of the owner in an individual proprietorship, or one of the owners in a partnership or a small corporation, or of a key employee calls for major financial adjustments, some of which will require up to a year or two to fully complete. Without adequate funds the disabled person, the deceased owner’s estate, the position of survivors, or a combination of these, may be adversely affected. Certainly careful planning is required, which may require the skills of a business attorney. It is necessary to have legal agreements to ensure that those most able to control and run the company are able to continue doing so without interference from family or other associates that may desire control. It is unlikely that this could be accomplished without the use of insurance.
Buy-and-Sell Agreements
A Buy-and-Sell Agreement (also known as a Buy-Sell Agreement or a Purchase-and-Sale Agreement) is a legal document used to protect the interest of a deceased or disabled member, while also protecting the interest of surviving or healthy members. It is a contract that provides a positive market for the interest of the deceased or disabled person and a guarantee to survivors of its purchase at a reasonable price with the funds available for payment within a reasonable length of time. It is a form of “business continuation” contract.
The exact details of buy-and-sell agreements will vary based on the needs of the parties involved. It will also vary based upon the type of company or business organization involved. The names of all parties will appear in the agreement and the purpose of it will be detailed in legal terms. The buy-and-sell agreement may specify the purchase price in dollars or it may simply state a specific formula to be used to arrive at a purchase price. For example, in the case of real estate a fair purchase price today may not be fair in twenty years. Therefore a formula would be stated, such as an official appraisal price by a specified type of appraiser. All parties must legally commit to the plan for the purchase of the interest of the deceased or disabled associate. The method of financing does not have to be through a life or disability policy, but that is a common way of doing so. When insurance is used, the method of financing by use of life or disability income insurance is set forth and provision is made for changing the amounts of insurance, when necessary.
It is important to note that there are usually provisions for changing the amounts of insurance in buy-and-sell agreements. This would especially be necessary for a change of position within the company. For example, a disability amount of $2,000 per month may be adequate when the contract was designed but ten years later it would be inadequate based on the person’s contributions to the business. Therefore, it would be necessary to upgrade the policy to the monthly amount contributed by the owner or employee.
Beneficiary arrangements determine whether the proceeds are to be payable to a trustee who will carry out the transfer or payable directly to the person who, under the agreement, must acquire the business interest of the deceased. A disability income policy is most likely to be payable directly to the person who was disabled while a life insurance policy may be payable to the heirs, to the company, or to the person who will be buying the deceased’s interests. There are many details involved in such a transaction, such as debts and the rights of termination, withdrawal, or amendment. The agreement has important benefits for estate tax purposes if it is properly executed. It will set the taxable values of the business interests for the estate, which may prevent delays in probate. Life and health insurance policies are filed with the agreement. Details are given as to the disposition of the insurance on the life of the surviving associates, as are the rights and privileges under the policies used during the lifetime of the insured. The ownership of the contracts may be by the business firm, by the individual partners, or by a trust, depending on the particular business needs or situation.
It cannot be stressed enough that a well drawn up buy-and-sell agreement is worth whatever the attorney may charge. A poorly drawn document is a waste no matter how little was charged. The carefully drawn agreement, implemented with life insurance, precludes misunderstanding and provides that the interest of a deceased or disabled associate will be purchased at a fair price. Life and health insurance can be used to make this financially possible at the time of need.
The Key Person Principle
The principles underlying key person life and health insurance for one or more individuals of particular value to the company are primarily the same, regardless of its legal form. The objective of key person insurance is to insure the loss of services caused by the death or disability of a vital employee and to provide resources with which to secure a successor in a competitive market. The insurable value may be determined by estimating the portion of the profits for which the key person is responsible, the cost of replacing and retraining an individual to step into the shoes of the key person, or the investment that might be lost by the firm. The life and health insurance purchased to cover these costs may be payable to, and be paid by, the organization that would be affected by the loss. The premiums are not typically deductible, but at the death of the key person the proceeds paid to the organization are not taxed as income either.
Insurable Interest for Life Insurance
Even though the life insurance contract is not one of indemnity, it still requires that there be an insurable interest between the policyowner, and the person insured. An insurable interest is only required at the time of purchase, not at the time of death. Therefore, it is possible to maintain the policy even after the key person is no longer “key” to the company’s smooth operation.
The doctrine of insurable interest is broader in the field of life insurance than in any other field of insurance. Some state statutes apply and court cases vary considerably. Generally speaking, however, so far as a person’s own life is concerned, there is no monetary limit. In other words, if people are purchasing life insurance on themselves they may purchase whatever amount they desire. Since suicide is excluded in policies for a specified time period, the policy would not pay if the insured killed him or herself in the early policy years. As a result, it is not necessary to limit the monetary amounts of the policy. Additionally, the courts have held that every person has an insurable interest in his or her own life for any dollar amount.
To establish insurable interest in other relationships there must be pecuniary (financial) interest in the continuance of the life of the insured. In some cases, this interest is obvious. For example, the financial interest between a husband and wife is presumed since they both contribute to the relationship. Actual pecuniary loss resulting from the death of an insured, as well as the expectation of future contributions to the business must be established in key person insurance.
A substantial amount of life insurance is written insuring the life of a partner in a business entity since a partner is obviously a contributing member of the company. Typically the proceeds, should the person die, are paid to the company but they may also go to surviving partners if it would mean a financial loss to them personally. Some key person policies are set up to enable the surviving partners the ability to buy out the interest of the deceased from their family members or beneficiaries.
For example:
Tyrone and Aaron have established an insurance agency together. Each of them contributes by making business decisions, but also by the policies they write. When they formed the company, they decided that half of the commissions on each policy written would be given to the agency to further future growth through advertising, office help, and general overhead (rent, utilities, insurance, and so forth). Although this was a general agreement between them, there is no written requirement. Therefore, if one or the other of them died, their beneficiaries would inherit the full commission renewals that are generated. Therefore, unless the remaining partner can manage sufficiently on their own, it may be wise to purchase key person insurance on each of them for the benefit of the other.
Some employees are considered key to the continuance of the company. In the case of employees, insurable interest is dependent upon the value of the employee to the business. Any employee who could be easily replaced would not be considered insurable as a key person to the company. However, employees who occupy key positions, such as company president, executive officers, or department heads may be difficult to replace. This might especially be true of employees with specific company knowledge that would not generally be held by a new employee no matter how well educated the new person may be. If there is any doubt regarding an insurable interest, it is possible for the employee to purchase the policy rather than the employer. The employee would designate the company as the beneficiary and the employer would pay the premiums on the life insurance policy.
An employee who merely quits would not qualify the company for benefits under the life insurance policy. Only the death of the insured would trigger benefit payment.
Many small corporations are “closely held.” What is a closely held corporation? A closely held corporation is one where all company stock is held by only a few people. Typically, the stockholders have common ground, such as blood relationships or bonds similar to partnerships. In fact, a closely held corporation is often called an “incorporated partnership.” Where stock is closely held the lives of primary stockholders may be insured, with the proceeds to be used to buy the stock of the deceased stockholder. This enables the deceased stockholder’s family to have immediate access to cash and it enables the company to continue without worry of interference of those who may not have the best interest of the company at heart. When life insurance proceeds are designated to purchase the rights of the deceased, there is usually some legal agreement also in place to ensure that the beneficiaries do, in fact, sell the interest to the company.
There may be non-monetary losses if an important company person dies. If non-monetary interests may be established, this is usually sufficient in place of a financial interest (although typically both a monetary and a non-monetary interest exist). Non-monetary interest usually relates to a reasonable expectation of future financial benefits.
Health Insurance on Key Employees and Owners
Companies often overlook key person health insurance. This is unfortunate since an individual is much more likely to be disabled than die. A disability is just as disrupting to the business as a death since the person is then unable to perform his or her duties. In fact, it may be twice as costly to the company since the person is (1) unable to perform his or her duties, and (2) the company must hire someone to take their place. The objective of key person insurance is to insure the loss of services, not the loss of life. Therefore, it makes no difference whether the loss is due to death or disability. While we often consider disability as payment to the disabled person, in this case it may be payment to the company as well as payment to the employee that has become disabled. It could even be payment only to the company, not to the employee.
For Example:
Jose performs all the software programming for ABC Company. Jose is the only employee with the experience and technical training to provide the type of services ABC Company requires. ABC Company purchases both death and disability insurance on Jose with the business listed as the beneficiary on both policies. If Jose wishes to protect his family as well, he must purchase insurance on his own. ABC Company is only purchasing coverage to protect the business organization from the loss of his services.
In our example, ABC Company was protecting the company from the loss of Jose’s services. The company was not attempting to protect Jose’s family from his loss of income. As we have stated, the objective of key person insurance is to prevent financial loss to the company resulting from the loss of employee services due to death or disability. It is not necessarily designed to protect the family of the employee. Furthermore, it provides the resources necessary to secure a successor in a competitive market. Even if ABC Company can hire a successor to Jose, the company would still have to train him or her. During the time that the individual is being trained, he or she may not be able to properly perform the duties, which may also cause a loss of income to the company. The income provided to ABC Company from the key person insurance will replace their lost revenues.
When purchasing this type of coverage, the business must determine what their potential losses will add up to. The insurable value may be determined by estimating the portion of the profits for which the key person is responsible, the cost of replacing and retraining the key person, or the training and experience investment lost by the business entity (or all of the above). The life and health insurance purchased to cover these costs is often payable to, with premiums paid by, the organization itself. Disability premiums, like life insurance premiums, are not typically tax deductible. Also like the life insurance premiums, income realized from the disability policy would not be taxed to the company as income.
Like life insurance key person insurance, when a company is purchasing disability on key personnel, there cannot be any doubt that the individual is vital to the organization. While some, like the company president, would be obvious others may be less so. For example a top salesperson with many personal clients would be vital to the company. If this individual were disabled, it could be very difficult to transfer his or her clients over to another salesperson; it might even prove impossible. The clients might end up changing over to another company entirely. Therefore, the potential financial loss to the company could be severe.
The types of people that are considered key to an organization will, of course, depend upon the business type. The agent who markets disability insurance must be aware of the many types of people that make up a company. Key employees can include such diverse positions as officers, stockholders in small closely held corporations, engineers, chemists, researchers, positions of management, or any other person that financially affects the company and who is not easily replaced. In some cases, a key employee may not be immediately recognized. For example, consider an auto sales company that has a recognizable advertising person. If the individual that consumers frequently see on television advertisements suddenly dies, will that affect future sales?
While key person insurance traditionally is purchased for the safety of the company, it can also be used to attract and keep key personnel. Due to income taxation, an increase in salary may be less attractive than a plan that would provide a continuation of salary for a number of years following death or disability. Often a combination of coverages is provided: indemnity to the organization for the loss of the employee’s services as well as salary continuation for the employee’s dependents. Agents who market key person insurance will find a field ready for their expertise, especially if he or she is experienced in the full use of such policies. If the agent is also able to market group policies for life and health benefits, then he or she becomes a valuable member of the company’s professionals, taking a position along with their attorney and accountant.
The Small Company’s Exposure
It is easy to recognize the financial exposure large companies face when they lose key personnel. Unfortunately, this financial exposure is not always recognized in small companies. Reduced revenues are just as devastating (perhaps more so) is small organizations. As an insurance agent, the key person is certainly you. For the insurance agent, if he or she is no longer able to market and sell insurance policies who will replace his or her income? This is the case in all small one or two-man companies. Reduced revenues and increased medical expenses often come together when a disability happens. If no one is bringing in continued policy sales, how will the insurance agent’s family cope with his or her death or disability?
Loss of the Small Business Owner
Even when a company has additional employees besides the owner, it is likely that it is the owner that keeps the business going. Owners often supply not only business capital (such as commissions through the sale of policies) but also their time and talents. Even if another agent could be hired by the owner’s family to continue marketing policies, it is unlikely that he or she would do so with the continuation of the company as their primary concern. Therefore, it may be impossible to actually replace the owner and primary salesperson of the company. The family may be forced to sell or close the company as a result.
Over 90 percent of the business units in the United States are sole proprietorships. The sole proprietorship makes no legal distinction between the personal and business estate. The debts of the business are the debts of the estate. The sole proprietor’s estate does not pass to the heirs until all creditors (business and personal) have been paid. If the insurance agent or his customer has not incorporated, remaining a sole proprietorship, there may be far more problems than the proprietor ever anticipated upon his or her death.
The sole proprietor’s death or disability places several decisions on the doorstep of his or her family:
1. Should the business be sold?
2. Can the business be sold? There are some types that do not readily find a buyer since the company would not be profitable once the owner has died or become disabled.
3. Can the agent’s family continue the business without his or her expertise or salesmanship?
4. Is it possible to hire individuals with the ability to carry the business forward?
5. Are there other family members both able and willing to step forward and carry on?
The primary decision is simple: liquidate the business, continue the business, or sell the business. Once that decision has been reached, other decisions will then follow, but nothing can be considered until the first question is answered. In many proprietorship companies the owner is the reason the business exists. Without him or her, the company cannot continue. Even if someone can be hired, it means an extra expense for the company since income must now be generated not only for the owner or the owner’s family, but also for the people they are now forced to hire. Revenues are likely to decline because the company’s recognition came from the owner who is now unavailable to current clients. There will be a quantity of clients that move to other companies as a result.
Sole proprietorships should plan ahead if possible by having a buy-and-sell agreement in place. Of course, this is not always possible since a ready buyer may not be available without the availability of the owner being present (since he or she is the reason the company succeeds). However, if the company could continue without the present owner, a buy-and-sell agreement may prevent some of the problems that would otherwise exist for the owner’s family. It is often a key employee that would be interested in buying the business. An insurance policy put in place would supply the funds allowing the key employee to acquire the business should the owner die or become disabled.
Of course, sole proprietorships are not the only small companies that suffer when the owner or primary owner dies. The same is true for closely held corporations and partnerships.
The legal relationship between partners is a personal one, and includes husbands and wives. While we would like to believe that all marriages are made in heaven, statistics tell us otherwise. When a married couple enters into a legal business and then experiences a divorce the business is likely to suffer financially. Few couples are able to separate personal and business relationships. A previously drawn contract specifying business relationships and ownership can be a valuable tool. When a married couple constitutes the partnership the actual business may be ran by only one of the two members. Therefore, only one may be a key employee, but both retain all legal rights and debts of the company.
Each partner is fully responsible for the business acts and debts of all other partners. If the business partners are not husband and wife, the divorce of one partner can affect the assets of the company adversely since they may be drawn into the divorce.
If one partner withdraws from the firm, the partnership is terminated. It must then be either liquidated or reorganized, with the withdrawing partner receiving compensation in some way. If the partner’s disability causes the withdrawal the firm’s resources will be severely strained. This might especially be true if the partner was a key employee. Although financial resources are strained, the partners may want to continue the disabled partner’s income at the same level. If a partner is permanently disabled, the firm may find it advantageous to buy that partner’s interest so that he or she can be replaced. The partnership is not legally compelled to liquidate or reorganize. This will be a choice of the remaining partners.
Of course, a partnership may be terminated due to death. In that event, the law requires that the partnership be either terminated or reorganized. The issues involved between liquidation and reorganization are similar regardless of whether the choice comes from disability or death of one of the partners. If liquidation is chosen, the assets of the business may be sold and the net proceeds divided proportionally among the surviving partners and the heirs of the deceased partner. Seldom is liquidation a satisfactory solution. Liquidation nearly always results in loss. Additionally, the surviving partners are out of a job. Selling the business rather than liquidating it may keep the company intact, but it will not necessarily add income to the surviving partners or the deceased’s partner’s family. Each company has a specified worth, usually based on assets. However, it may provide continuing jobs for the surviving partners, which may prove to be an advantage for them. Additionally, a company sold as a continuing business is not likely to result in a loss since all debts will be sold with the company.
When a company is sold rather than liquidated, four options are usually available to the remaining partners and the heirs:
1. The heirs of the deceased’s interest may become partners in the new partnership.
2. The heirs may sell the deceased partner’s interest to an outside party.
3. The heirs may buy the surviving partners’ interests.
4. The surviving partners may buy the deceased partner’s interest from his or her heirs.
If the heirs want to become partners in the new partnership or if the heirs decide to sell the deceased partner’s interest to an outside party then the law typically requires the consent of the surviving partners. In most cases, it is felt that the most satisfactory solution is for the remaining partners to buy out the interest of the deceased or disabled partner. This prevents either liquidation or sale of the company, allows for the remaining partners continued employment, and the business can continue to prosper under continued management. If no insurance is in place for this specific purpose, two problems may prevent purchasing the deceased or disabled partner’s share:
· Price agreement, and
· Financing the purchase.
Heirs may not have a realistic picture of the worth of their inherited interest. When two or more partners exist without having specified a mutually binding buy-and-sell agreement, disagreement on the value of the partnership can continue for years. Eventually such disagreements can cause the business to fail. When buy-and-sell agreements are reached while all partners are healthy and in equal bargaining positions, such time-consuming squabbles can be eliminated. Even if the heirs feel the agreement does not provide them with as much money as they feel to be fair, the agreement is legally binding. It allows the surviving partners to organize a new partnership and continue the business.
In closely held corporations (where stock is owned by only a few people) it is important to remember how a corporation functions: usually each stock represents one vote. Therefore, a person holding 50 percent of the stock also holds 50 percent of the votes on any issue brought forth. A minority owner, usually an employee, will have little power unless his or her combined stock ownership equals at least 51 percent of the total stock issued. Where multiple employees own stock, they may be able to combine forces to exercise control, assuming all the employees can organize well enough (and agree on primary issues) to take control. Again, their combined strength would have to equal at least 51 percent of the voting stock or equal more votes than the largest shareholder. Not all stock may have voting rights. Some companies issue stock without voting rights, but normally each stock is accompanied by the right to vote.
Being incorporated does not eliminate all the problems of a disabled or deceased stockholder. It will still be necessary to determine the best course of action if death or disability occurs. If the disability is permanent, either the other stockholders or the corporation itself, if legally permitted, will have to buy out the disabled member. If there are funds available for this purpose, it should be a smooth transition. A corporation that has a risk manager is likely to have an insurance policy in place for such a situation. Unfortunately, many small corporations do not assign anyone to act as risk manager. If no agent has suggested that such a policy be purchased, there may not be one in place.
When a shareholder dies, the corporation’s existence is not affected. Where the law protects partnerships from unwanted partners, the corporation does not have the same legal protection. The heirs of the stock can sell them to anyone they choose or they can exercise their rights of stock ownership at meetings. When just two people own all stock equally, the company can experience severe problems as each stockholder (each having 50 percent voting rights) stall all decisions affecting the business. There have been cases where the divorce of two equal owners/stockholders caused the company to fail because each party confused their divorce issues with the operation of a successful business.
When the originator and employees own a stock company, the death of the originator can lead to problems if the heirs do not have the same business sense as their deceased family member. We have seen many failed businesses after the creator of the company died leaving it in the hands of an unqualified person. If the remaining stockholders, often employees, do not have the capital to buy out the family member or do not have a buy-sell agreement setting a fair price, they may find their company slowly dying as inexperienced heirs attempt to run the company their way. Employees realize that the corporation profits are primarily the result of their efforts. When the heirs come forth to claim salaries that have not been earned or attempt to expand in ways that adversely affect the bottom line, the remaining stockholders (employees) will resent those with the majority of the stock (thus voting rights). Obviously, an investment that leads to fighting among stockholders, personal recriminations, and perhaps even legal action is not conducive to a profitable business.
Planning Ahead for Death or Disability
Everyone will die some day but most of us expect that to happen when we are elderly, not during our working career. Most people now purchase life insurance to protect their families but many do not purchase life insurance to protect their business organizations, whether that happens to be a partnership or a corporation or a sole proprietorship. If no risk manager has been assigned or if the owner of the company is not aware of the risks involved with his or her death or disability, this aspect of a company may go unprotected. Agents can play a vital role by pointing out the need to protect business rights and business income.
Disability is statistically more likely than death, yet disability remains the most unprotected risk in our lives. Probably few insurance agents have protected their family by insuring their ability to work. If agents do not consider protection for themselves and their own families, it is unlikely that they are offering this risk protection to their clients. It remains one of the great untapped markets.
Insuring Entities
There are various types of insurers. Each type provides a service. It is the job of the agent and buyer to determine if one type better suits the client’s needs than another.
Insurance may be divided into several types. The broadest division is between private insurers and government. Government insurance will not be handled by private agents.
At one time the private insurance industry was separated into three branches in the United States:
Most states allowed companies to write coverage only in one of these three branches. It was not a sensible system in the view of many. For example, automobile was split between fire insurers for physical damage and casualty insurers for liability. It seemed impractical to need two insurers to secure both types of coverage. Either type of insurer could write collision coverage.
It was not until the 1940s and early 1950s that legislation was passed allowing for full multiple line underwriting for fire and casualty insurers. By 1955, when Ohio finally adopted the changes (being the last state to do so) an insurer could write both fire and casualty insurance in every state. It is important to note that not all states extend multiple line underwriting to life insurance. The majority of states still consider life to be a separate line.
Before multiple-line underwriting was allowed, homeowners and business owners had to have separate policies for fire insurance and liability insurance. Additionally, a separate policy was needed for theft insurance as well as many other types of coverage. This was not only inconvenient; it was also usually more costly for the insured. Multiple-line underwriting made it possible for insurance companies to design policy forms that cover the major property and liability exposures under one contract.
With multiple line underwriting private insurance was reduced from three to two major branches:
Either life insurers or property-liability insurers may write health insurance. Most often we consider health insurance as part of life coverage, but that is not necessarily the case.
Life companies write three types of coverage: life insurance, annuities, and health insurance. As we know, life insurance is designed to insure the premature death of another or provide business protection when a major participant dies. Life insurance provides money for the named survivors or heirs of the insured. It may also be purchased as a means of covering the expenses leading up to death and burial costs.
Annuities are the opposite of life insurance. Where life policies pay when a specified person dies, annuities are designed to provide income prior to death. In effect, an annuity is a means of liquidating the estate by paying income for a specified time period or for the lifetime of the annuitant. Not all annuities are liquidated prior to death; statistically, the majority of annuities are not. Despite this fact, they were designed to do so. Annuities are used for many purposes. They have become a very popular means of saving for retirement and other life goals. In fact, many state lotteries use annuities to pay the winners.
Health insurance provides money to cover in full or part the costs of health care. Depending upon the policy, the individual receives reimbursement for the costs of doctor visits, hospitalization, prescription drugs, outpatient treatments, surgery, and many other items relating to illness and injury of the insured.
There are five types of coverage written by property and liability insurers:
Physical damage or loss coverage protects the insured against loss of or damage to owned property. This would include such things as direct loss from fire, windstorm, and theft. Loss of income and extra expense coverage provides protection for insureds from income loss and extra expenses incurred due to damage to their property or the property of others. Liability coverage protects the insured against third-party claims for bodily injury or property damage caused by negligence or imposed by statute or contract. This would include such things as automobile liability, workers’ compensation, and contractual liability insurance. Health insurance written by property-liability insurers is the same as that written by life insurers. Surety (often referred to as suretyship) allows parties to offer a financial guarantee of their honesty or their performance under a contract or agreement. Fidelity, construction, and bail bonds are examples of surety coverage.
Government Insurance
Either the state or federal government may write government insurance. Additionally, it may be either voluntary or compulsory, depending upon the insurance being discussed.
Voluntary means that an individual has the choice of participation. The federal government writes crop insurance, military personnel life insurance, bank-deposit insurance, savings-and-loan insurance, securities investor protection insurance, crime insurance, mortgage and property improvement loan insurance, Medicare insurance, insurance against foreign expropriation, and backup programs written in cooperation with private insurers for coverage against perils of flood and riot in qualified areas, and for writing of surety bonds for small minority contractors. In all cases, since it is voluntary, no one is required to participate in these policies. Several states also offer varying types of voluntary coverage. Again, since they are voluntary, no one is required to participate, although some types of bank loans would not be possible without proof of insurance (so, in that respect, they may be thought of as compulsory).
Compulsory means that participation is required. Compulsory government insurance is required of the masses and we usually call this type “social insurance.” It may be written by either the federal or state governments. The best-known government insurance program is Social Security, which provides income in retirement, following a qualified disability, and for qualified survivors of deceased covered workers.
Periodically, America looks at national health insurance. While it has never been approved, if it were to be, that would be a form of compulsory government insurance and would probably be jointly underwritten by both the federal and state governments.
Some states underwrite workers’ compensation insurance while others use private insurers. Several states operate monopolistic state funds for workers’ compensation, so no private insurance is allowed. The states typically make these plans compulsory. Workers’ compensation is required in most states, even when private insurers are allowed to compete for the business, in some cases with the state itself.
Some states have made automobile liability insurance compulsory. This does not mean that the state provides such insurance; merely that drivers are required to purchase the coverage in order to legally drive their vehicle.
Along with stock insurers, mutual companies also assume liabilities in their corporate capacity. Unlike stock insurers, which are operated for the sole benefit of their stockholders, mutual companies are controlled by their policyholders. However, just as many stockholders do not actively participate, neither do policyholders. Therefore, the so-called “control” may be more theoretical than real.
There was originally much doubt as to whether or not a mutual company could survive. It was thought that policyholders were less likely to successfully operate a corporation. In fact, mutual companies have enjoyed a great deal of success, although that success may be more of a tribute to the company managers than to their policyholders. Few purchasers of insurance are interested in running the insurance company. They are more interested in the premium rate, the claims history, and the benefits they will receive. Few care what type of organization the insurer is.
Most mutual insurers write insurance under the “assessment plan.” Assessment mutuals usually confine their business to specific types of property in limited areas and do not compete in the broad marketplace. Many mutual companies do not employ insurance agents, writing business instead directly out of the home office for the benefit of local residents.
Non-assessable mutuals operate similar to stock companies. They utilize agencies or direct writing systems. This type of mutual company is growing in numbers. Under most state laws a mutual insurer may issue non-assessable policies provided it has a surplus over all liabilities equal to the capital and surplus required of stock insurers writing the same class of business. Even though there are fewer non-assessable mutuals than there are assessment mutuals, the non-assessable write the majority of business.
Assessment mutuals are most active in the fire insurance field and operate principally in one of two ways:
Under assessments, insurance may be furnished on the deposit of a cash premium. There is also an agreement that in case losses and expenses exceed income, the balance is to be collected through the assessments levied on the members (the insureds). The maximum assessment liability for both assessment and non-assessment mutuals for members is usually fixed by the laws of each individual state or by the charter and bylaws of the insurer. State law dominates, if different than the charters and bylaws.
So, who sets up mutual insurers? In theory, nearly anyone can. From a practical standpoint, it tends to be organized by a group with a similar goal. Often this is done by farmers or by property owners in towns and small cities in order to secure insurance at the lowest possible cost. How does one begin such an undertaking? Usually arranging insurance for the original founding members starts the business. After officers have been elected and the organization legally perfected, the business is entrusted to the care of an elected secretary. Since this is a new, startup business the officers (including the secretary) may have other jobs that support them financially. In fact, the officers may even be volunteers, working for the insurance business without pay. This keeps expenses down. Limitation on the risks and amounts to be accepted is usually left to the discretion of the board of directors or an executive committee.
Depending upon who is speaking, the fact that mutuals operate in restricted districts is either an advantage or a disadvantage. It all depends upon one’s viewpoint. Due to their local nature, mutual insurers eliminate much of the moral hazard normally associated with insurance. When a company is small and owned by the policyholders there is likely to be a conscious effort to minimize risks that would possibly end up in a claim (costing the company money). Members know each other. This makes it easier to avoid over-insuring. It also makes fraudulent claims very difficult to achieve. Since the company is small and local, policyholders tend to have a higher moral code when dealing with their neighbors and business associates. It is much easier to feel a large, distant insurance company has lots of money to give in questionable claims.
There is a downside to this. Writing insurance on a restricted number of risks also constitutes an element of danger since it loses sight of the unrelenting application of the law of averages. Writes the author of Property and Liability Insurance: “So long as the loss record of the locality is sufficiently low and uniform, a small mutual may prosper, but on the advent of several losses at about the same time, there may be trouble. The system of assessments providing for such contingencies, while fine in theory, might sometimes fail because of the difficulty or impossibility of collecting the assessments.”[2] Such insurers are not always required by state or other regulating authorities to maintain surplus funds. Even so, there is an obvious tendency shown to keep a sizable ratio of surplus to coverage. In addition, history has shown the companies tend to use scientific valuation of liabilities, which helps to keep mutuals in business. Many of these companies have done far more right than their counterparts that issue stocks. In fact, the oldest insurance company in the United States, the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, established in 1752, is a mutual fire insurer.
While laws vary, some states discourage mutuals from operating in large cities. There may even be laws forbidding it. States do so because they recognize the necessity for the mutual insurers to protect their insured members against catastrophic losses. Operating in large cities may have the tendency to increase the likelihood of catastrophic losses since buildings are side-by-side and face additional types of threat. Some states merely limit the mutuals’ activity to insuring the less hazardous risks of dwellings, farm buildings, and stores within given districts. In nearly every state, the amount of insurance written must be backed by specifically stated amounts of cash premium (often 25 percent).
When a mutual company manages to spread over one or more states, it is referred to as a state mutual company. A mutual insurer this big has more risk. It no longer is made up of neighbors and friends who know each other. When this advantage disappears so does much of the protection from fraud and misrepresentation. The moral hazard increases. The company may also now have to rely upon agents for soliciting business. The selections of risk is now removed from the home office and placed on the judgment of their agents (who may or may not have the company’s best interest in mind).
For the consumer’s protection, a number of states have passed laws with special reference to the organization and operation of such mutual insurers. The number of applications for insurance that must be in hand before the company is considered “viable” is usually much larger for state mutuals than it is for local mutual insurers. The class of business that may be accepted by state mutuals is carefully limited in certain states, whereas in others a limit is placed on the amount of insurance that may be written on any one type of risk. State mutual companies find that the services they are allowed to render as a whole are limited.
Mutual insurers may operate similarly to a stock company if they wish to. If they choose to, they will charge an advance-premium intended to be sufficient to enable them to meet all of their disbursements for losses and expenses while accumulating a surplus. If the mutual insurer happens to earn a profit, the directors of the mutual insurer may announce a dividend, which is paid to all their policyholders. Again, the policyholders are the owners. On the other hand, if the insurer suffers a loss and has not qualified to issue non-assessable policies, the policyholders could be assessed, usually an additional premium. This would not usually happen, however, since the surplus would be used to offset the loss. The right to assess another premium is an element of strength, though. It means that the company is not limited to using the surplus, since it has the right to assess an extra premium from its members. Mutuals can shift to the non-assessable plan when they have accumulated sufficient surplus to qualify under the applicable state laws.
Many mutual insurers only issue non-assessable policies. Under these policies, the policyowners cannot be asked to pay anything in addition to their initial premiums if adverse experience happens. These companies usually follow the business methods of stock companies and maintain large surpluses to cover claims. Their premiums are typically higher because they operate like a stock company would. Although non-assessable mutuals are numerically smaller, they write more business than do the assessment mutuals.
It is common for mutual companies to convert to stock insurers. Between 1930 and 1995 approximately 70 mutual property-liability insurers did so. While there are many varying reasons for doing so, some of the reasons include:
There is no doubt that it is more difficult for a small or even middle-sized company to operate amid the giants of the industry.
Reciprocal exchange or inter-insurer (also called inter-insurance) associations is a type of cooperative insurance. All policyholders insure each other. Therefore, each policyholder cooperatively insures the next. Each policyholder is also an insurer, as contracts are exchanged on a reciprocal basis.
It must be noted that the reciprocal exchange is not a mutual insurer in the legal sense. That’s because the individual policyholders assume their liability as individuals, not as a responsibility of the group as a whole. Reciprocals are not incorporated either, as a mutual company typically is. Rather reciprocals are formed under separate laws as associations.
The funds held by a reciprocal are the sum total of individual credits held for the account of individual subscribers. These subscribers are required over a period of years to accumulate reserves representing a multiple ranging from two to five annual premiums before underwriting earnings, if any, are returned in cash. A separate account is maintained for each subscriber. Out of this is paid only his individual share of each loss and expense. Beyond that, the reciprocal usually can levy an assessment up to a multiple of premiums paid, such as ten times, but the liability of each subscriber is definitely limited. Reciprocal insurance is quite distinctly an American development.[3]
In its pure form, reciprocals are still operating in the United States. In fact, there are only around fifty to fifty-five reciprocals in operation. Most of these are small companies. The larger ones include the Farmer’s Insurance Group based in Los Angeles, the Automobile Club of Southern California, and the United Insurance Services Automobile Association based in San Antonio, Texas. Each company writes more than $500 million of private passenger auto liability premium annually. Farmer’s Insurance Group, a multiple-line company, writes total premium in excess of $8 billion.
The majority of business is written by reciprocals that are not performing in the pure form. These companies deviate in a number of ways. The companies are mutual in the sense that all the other members insure each policyholder. The members are represented by an attorney-in-fact who has been given the power to manage the affairs of the organization subject only to such restrictions as may be stated within the terms of the powers of attorney or the organization. The liability of each insured is fixed.
Like all things, reciprocals can be either good or bad, depending upon the situation. Opponents of this type of organization point out:
Those that favor reciprocals state the following advantages:
The bulk of reciprocal insurance is written by inter-insurance associations whose characteristics have been modified to some extent. The modifications often include the lack of separate accounts that are maintained for the members. There may be no pro-ration of expenses or losses by the insured. Additionally, no individual may have any claim to any portion of surplus funds. Surplus funds become the property of the organization. Most of the reciprocal companies issue non-assessable policies. Those that do not issue non-assessable policies typically limit maximum possible assessments to no more than one annual premium.
When the characteristics of a reciprocal change so too do the avenues of marketing. Some write automobile, life, and other lines in addition to fire insurance. This significantly changes the description of the marketing company.
Underwriting is a major element in the insurance business. Whether it is for a life insurance policy, a fire policy, or a long-term care policy, the underwriting often determines how the company continues and whether or not they show a profit.
Stock and mutual insurers might organize into underwriting groups for the purpose of insuring special classes of property along with their normal insurance business. Although there can be many reasons why they do so, it is often to insure a unique or especially hazardous type of risk. It may also be done when there is a heavy concentration of values involved, or specialized services are required.
Some types of risks require the use of syndicates, who handle the insurance of aviation and marine risks, cotton and oil properties, and other similar risks. Syndicates are distinguished by the management of the group, which makes all underwriting decisions within the framework established by the board, independent of individual member-insurer influence. The participants accept their share of all the lines that are written by the group office.
Some mutual companies were organized with a special purpose in mind. Typically these organizations limit their insurance protection to a specific type of business, such as lumber, logging, grain or milling, or drug manufacturers. At one time these were known as class mutuals. They wrote insurance only for a specified occupation or class in which they had specialized knowledge. Often the objective was lower premiums or certain forms of coverage. Today these specialized companies are known as factory mutuals and they now tend to write much broader coverage.
Factory mutuals began in 1835 and emphasized loss prevention through a cooperative effort of the policyholder and the company. The factory mutuals supplied inspection services and engineering advice, backed up by a comprehensive research program.
Today’s factory mutuals have broadened the type of risk they cover to include commercial property, public and educational institutions, and large-scale housing units. To be eligible a property must be of substantial construction, properly designed to minimize hazards pertaining to its class, equipped with automatic sprinklers (where applicable), and with high-grade management.
The factory mutual system consists of three mutual companies, one wholly owned stock insurance subsidiary, and the Factory Mutual Engineering Corporation. The Factory Mutual Engineering Corporation provides inspection, adjustment, appraisal, and plan service for all the companies. Working closely with the Factory Mutual Research Corporation, it carries on basic research into the physics and chemistry of combustion and heat transfer, and the Factory Mutual Test Center, located near Providence, Rhode Island, makes it possible to duplicate industrial and storage hazards in full-scale tests. Recently prevention has been given special consideration through personnel training. This training begins with a commitment to property protection and reduced loss by top management, with training flowing down through the levels of company employees.
Factory mutuals require their insured members to pay a large deposit premium, which is several times the yearly cost. At the end of the policy period, deductions are made for substantial loss operation services, other expenses and actual losses paid, and the balance is returned to the insured. There are no agents for the company; contracts are written using special representatives. These representatives are stationed at branch offices throughout the United States and Canada. They are almost entirely graduate engineers, with loss prevention being one of their basic functions and part of their responsibilities. The insurers do usually accept, on a brokerage basis, business from independent agents. A negotiated commission is paid in such cases.
Factory mutual companies are characterized by their large deposit premiums, insurance for large and high-grade industrial and institutional properties, and an emphasis on loss prevention. Factory mutual forms provide coverage (at a single rate) for fire, windstorm, explosion, sprinkler leakage, riot, civil commotion, malicious mischief, sonic boom, vehicle and aircraft damage, radioactive contamination, and volcanic eruption and molten material. Boiler and Machinery Insurance, in the same amount as the other property insurance, are also underwritten by Factory Mutuals.
Every agent would like to think he or she is superior in his or her profession. When it comes to business insurance only those with specialized knowledge or training should be recommending products.
Many major errors are made by agents who mean no harm. These individuals are not intending to cause their client any financial loss, but that can happen when the agent is not as experienced or educated as he or she should be in the products they are recommending. Some areas of insurance are now mandating suitability training in products in an attempt to correct this problem. Insurers market in a variety of ways, but most of them use agents, especially when it comes to business insurance. Each state has thousands of licensed agents and brokers representing hundreds of commercial insurance companies.
Although there is a distinct difference between an agent and a broker most consumers think they are synonymous and interchangeable. The only direct writers are those companies that do not use agents at all, but rather sell directly through the mail or through association programs. However, captive agents and independent agents are the two groups most likely to be involved in marketing business insurance. Captive agents sometimes represent themselves as direct writers, but this is not technically true since an agent is involved.
We have sometimes heard that an independent agent is more likely to be able to assist the consumer when claims are disputed, since they represent the client rather than the insurer. In reality it is unlikely that any agent, captive or independent, has much clout to move a claim forward. It is true that an independent agent can still write business with other companies if he or she is having a dispute with one of the insurers they have licensed with. However, it is unlikely that any one agent has enough business with the insurer to truly make any difference in a claim dispute. Most disputed claims go to arbitration or litigation whether the agent agrees or disagrees with the insurer’s stance on claim payment.
Captive agents are likely to have a contract that mandates their alliance to the company rather than the client. Even so, claims that are disputed will not be settled by the agent, captive or otherwise. The state statutes will determine some, but most will be settled between the policyholder and insurer, independent of the agent.
For the policyholder, the bigger issue should be the stability of the writing agency (second, of course, to the stability of the insurer chosen). While the insurer might assign a replacement agency if the agency closes, most policyholders want to know whom they are dealing with.
One determining factor might be the size of the agency, although that does not necessarily guarantee financial stability. Some businesses may want to select a specific agent they feel secure with whether that happens to be a one-man or one-woman operation or a large agency they are employed by.
A necessary consideration is the availability of products for the type of business being insured. The size of the business being insured can determine the type of insurance product needed. It is necessary, therefore, to know the size of the business prior to setting up a meeting between owner and agent. This is true not only for the business owner but for the agent as well. There is no point in wasting each other’s time if the agent is unable to deliver what the business wants to buy.
National insurance brokerages are the largest of the independent agencies. These brokerages usually have multiple offices and are located in the majority of the states. They may even have affiliations overseas.
Next in size is the medium to large-size independent agencies. While there may be some variances, these agencies usually write a significant amount of commercial business. The large-size agencies place business with fifty or more insurance companies and is fully automated. Sometimes they have special arrangements with insurers that benefit the business owner. This might include such things as the ability to bind the coverage or the ability to commit the insurer to insure the risk. Larger companies tend to be fully computerized tying directly to systems in some insurers.
From our point of view one of the most important factors is the expertise of the agent. As we said, too many agents attempt to advise in areas they are not qualified for. The Buyer’s Guide to Business Insurance by Don Bury and Larry Heischman states: “The insurance industry has tried to encourage its members to involve themselves in continuing education programs to show a commitment to the industry and to professionalism.” Unfortunately state mandated education has not necessarily yielded educated agents. It has been our experience that those who wish to be educated will be with or without state mandates. Those who are not interested in broadening their knowledge will not do so, even when legally required to.
Some agents pursue special designations in insurance. Some are harder to achieve than others, but all of them demonstrate an interest on the part of the agent in higher education. Since the difficulty in achieving these designations varies we do not wish to make any comment on which one is best. It is our view that any additional education is worthwhile, though some are certainly better than others.
“Parts” pertain to the sections of education that must be completed in order to obtain the specified professional designation. Agents may obtain additional information from the groups that offer this education. There may be additional designations besides those listed here. Each will require some amount of education.
End of Chapter 4