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Insurance law is largely based on the law of contracts. However we don't call it an insurance contract...what do we call it? What are the essential terms of this insurance arrangement? In other words why do people get insurance? What do we call the consideration given by the insured party in exchange for insurance? What is an insurable interest? When does one need to establish an insurable interest in a life insurance policy? In a property insurrance policy? What is an incontestability clause? What is a coinsurance clause? What is the difference between Whole life insurance and Term life insurance? What is a cash surrender value?

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Sixta Kovacek
Sixta KovacekLv2
1 Apr 2019

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True or False

____1. Pure risks are those that, when they occur, create a loss.

____2. Insurance is a contract of indemnity, which means that a person is entitled to compensation only to the extent that an actual financial loss has been suffered.

____3. The principle of insurable interest states that a person is entitled to compensation only to the extent that financial loss has been suffered.

____4. When a person or firm is exposed to risk and decides to bear all or part of the financial burden if a loss occurs, this is known as risk retention or risk assumption.

____5. Exposures that are high in frequency yet low in potential severity are best handled by insurance.

____6. Financial planners recognize two fundamental needs for the monies generated by a life insurance policy: replacing income and preserving assets.

____7. Life insurance death proceeds are taxable as income to the recipient.

____8. The capital retention approach determines the amount of life insurance needed by first determining what level of annual income the insured wishes to provide for the family.

____9. Term life, because it is temporary pure death protection, tends to be quite expensive in the early years of the policy.

____10. Unlike whole life in which premiums increase with age, term life policies are based on a level premium throughout the duration of the payment period.

Short Story
Insurance

Let’s now look at Berkshire’s various businesses, starting with our most important sector, insurance. The property/casualty (“P/C”) branch of that industry has been the engine that has propelled our growth since 1967, the year we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, National Indemnity is the largest property/casualty company in the world as measured by net worth.

One reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume.

We recently wrote a huge policy that increased float to more than $100 billion. Beyond that one-time boost, float at GEICO and several of our specialized operations is almost certain to grow at a good clip. National Indemnity’s reinsurance division, however, is party to a number of large run-off contracts whose float is certain to drift downward.

We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. This structure is by design and is a key component in the unequaled financial strength of our insurance companies. It will never be compromised.

If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.

Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses.

Question:
Describe what Buffett means by “float” and “underwriting profit” in his overview of Berkshire’s insurance business.

Mary and Harry Reser, 57 and 62, are looking ahead to retirement early next year. They are thinking about heading south to a cheaper and warmer state but haven't made a firm decision. Harry is the sole breadwinner and earns $64,543, plus an additional $8,169 from investments.

The Reser's two main concerns are longevity and taxes. "We want to take income from investments with the least amount of tax liability and make the money we have accrued last as long as we do," notes Harry. He also noted a concern about taking money out of tax-deferred plans in the correct manner to avoid IRS penalties.

The Reser's can be considered "millionaires next door," with an impressive net worth of $1,065,951. They have absolutely no debt and the following assets: $32,000 in a 2% bank passbook account, $347,365 in telephone stock; $224,901 in Harry's 401(k); $31,000 in an annuity; $202,685 in mutual funds; $23,000 in whole life insurance; their $190,000 home; and $15,000 of personal property.

No information was provided as to the type of mutual funds or the 401(k)'s asset allocation (i.e., the percentage of the account in different types of assets like stocks and bonds). Harry contributes 15% of his salary to the 401(k) and appears to have been doing this for many years. Neither spouse has an individual retirement account (IRA), however.

The Resers estimate that their monthly expenses total $1,500. The are concerned about the future cost of health care and note that, in retirement, "the biggest expense not in our current budget will be medical insurance." Currently, Harry shares part of the cost of health coverage with his employer but this coverage will end after he retires. His employer also provides short-term disability coverage and matches his 401(k) contribution up to the first 8% of pay.

The Reser's car and home have $500,000 and $300,000 of liability coverage, respectively. They do not own an umbrella liability policy. The Resers are thinking of tapping their $23,000 of life insurance cash value. "We do not feel that we need life insurance any longer," says Harry, "and will most likely cash them in."

Taxes were mentioned several times as a major concern. The Reser's taxable income is $50,543. If their adjusted gross income in retirement exceeds $44,000, 85% of their Social Security benefits will be taxed. Tax on Social Security is figured on what is known as "preliminary adjusted gross income." This figure includes all earnings, pensions, dividends and interest from investments, including tax-free municipal bonds, and half of a person's Social Security benefit.

The Resers do not have wills. They have no children and it is unclear who their heirs are.

1. Discuss the strengths and weaknesses of the Rese family's financial situation.

Their strength is their net worth of $1,065,951, their job contribute 8% of their 401k, they invest for the future and they have no debt.

Their weakness is that they can be penalize by the IRS, they have no kids so there’s no will and they have no future health insurance.

2. Comments about Reser family's cash flow.

4. Calculate the savings required to reach Reser family’s financial goals.

5. Recommend 3 to 5 action steps to improve Rese family's financial.

6. Recommended financial products such as bank accounts, insurance policies, and mutual funds for Rese’s family.

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