■ FUNDAMENTALS OF RISK AND INSURANCE ■ ■ FUNDAMENTALS OF RISK AND INSURANCE ■ TENTH EDITION EMMETT J. VAUGHAN John Wiley & Sons, Inc. Vice President/Publisher Don Fowley Associate Publisher Judith Joseph Associate Editor Brian Kamins Senior Production Editor Valerie A. Vargas Executive Marketing Manager Amy Scholz Creative Director Harry Nolan Senior Designer Kevin Murphy Production Management Services Aptara, Corp.
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To order books or for customer service please, call 1-800-CALL WILEY (225-5945). ISBN-13 978-0-470-08753-4 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 To Dad This page intentionally left blank ■ ABOUT THE AUTHORS ■ Emmett J. Vaughan was a Professor of Insurance Therese M. Vaughan is the Robb B.
Kelley Distin- at the University of Iowa for over 40 years, where he guished Professor of Insurance and Actuarial Sci- held the Partington Professorship in Insurance until ence at Drake University. Prior to joining Drake, his death in 2004. Professor Vaughan earned his un- she served as Iowa Insurance Commissioner for dergraduate degree in economics from Creighton over 10 years and as President of the National University and his M. in economics Association of Insurance Commissioners.
Vaughan and insurance from the University of Nebraska. He earned her undergraduate degree in economics was an enthusiastic teacher, prolific scholar, and and insurance from the University of Iowa and her beloved by his students. He inspired hundreds of Ph. in insurance from the University of Pennsyl- students to choose careers in insurance.
vii This page intentionally left blank ■ PREFACE ■ This tenth edition of Fundamentals of Risk and sory automobile insurance (New York, North Car- Insurance marks the 36th anniversary of the first edi- olina, and Massachusetts). The 1943 Standard Fire tion, published in 1972. Over the years, the book Policy was the standard form of coverage for most has undergone major change as the field of risk commercial entities, and the Family Auto Policy was management and insurance has changed. Emmett the standard for personal automobile insurance.
Vaughan, an author in the first and all subsequent Universal life insurance was not yet on the drawing editions, guided the revisions over the years to main- board and endowment policies were a staple for tain the text’s primary focus—that of a consumer- the life insurance agent. There was no such thing oriented text. He was passionate about the field of as long-term care insurance, no individual retire- risk and insurance, and his passion was reflected in ment accounts, and ERISA was not yet a gleam in a the book through the decades. Professor Vaughan Congressperson’s eye.
The Social Security tax base saw risk and insurance implications everywhere, was $9000 and the Medicare Part B premium was from personal life events to the changing world $5. around him to the fairy tales he read to his chil- Although the book has changed over the years, dren (with commentary). His enthusiasm for the its purpose, organization, and approach remain es- field was infectious and influenced many students sentially the same. The original goal was to create a to pursue careers in risk and insurance.
I was fortu- consumer-oriented text, and this orientation is con- nate to have him as a teacher, advisor, role model, tinued in the present edition. The first edition of this and father. book was written in response to a perceived need Professor Vaughan died in October 2004, just as for an insurance textbook that addressed the prin- we were beginning to discuss the tenth edition of ciples of risk management without abandoning the the book. This text had been a proud accomplish- discussion of insurance.
The reception to the book ment of his for over 30 years, and it is with some over the past three and a half decades has been grat- apprehension that I have completed this revision ifying. At least a part of the book’s success is due to without his guidance. At its heart, of course, this is the fascinating subject matter with which it deals. While I have updated it to reflect recent Experience shows that insurance can be an excit- developments and tried (mostly without success) ing subject.
This comes as no surprise to those of us to shorten it in parts, the bulk of the text reflects his who find this field an exciting one. It is satisfying, thoughts over his forty-plus year career. I hope that I however, to find that our excitement can be shared have been able to capture some of the enthusiasm by our students. with which he approached the field.
At the time the first edition was published, the field of insurance was quite different from what it SCOPE OF THE SUBJECT is today. Many of the current forms of insurance coverage did not exist; the world seemed a simpler As the title indicates, Fundamentals of Risk and Insur- place. Medicare was not yet ten years old, and had ance is about risk and about insurance. Its objective no Parts C and D.
Richard Nixon was president of is to summarize the pervasive nature of pure risk on the United States. Automobile no-fault was an ex- the individual and on society, and to illustrate the periment that had been adopted by a single state way in which insurance can be used to deal with (Massachusetts), and only three states had compul- the problems posed by such risk. It is a book on ix x PREFACE insurance theory as well as on how students can risks, risk management decisions presuppose a thor- use insurance personally. ough understanding of the nature and functions of The main emphasis is on the insurance product insurance.
and the use of insurance within the risk manage- We believe that insurance and risk management ment framework. The traditional fields of life insur- is a subject that needs to be taught in colleges and ance, health insurance, property and liability insur- universities. Far from being the narrow specialty it ance, and social insurance are treated in terms of is sometimes characterized as, the study of insur- their relationship to the wide range of insurance ance has a breadth that few disciplines equal. As risks to which the individual and the business firm you progress through the book, you will encounter are exposed.
applications from economics, statistics, finance, ac- The text is designed for use in a college-level sur- counting, law, decision theory, and ethics. vey of the area of risk and insurance. As an introduc- Because the study of risk management and insur- tion to the subject, it is intended for students who ance draws on these different disciplines, it is some- have had little or no prior education in insurance. times considered a subset of one of them.
Thus, in It may serve as the basis for more advanced texts many colleges and universities, insurance and risk for those students who intend to specialize in the management are a part of the finance curriculum, field of insurance, and at the same time it consti- reflecting the financial nature of the risk manage- tutes a compendium of what an informed citizen ment function. In other schools, it is considered a and consumer should know about the subject. part of economics, while in still others it is located in another department. This organizational ambiguity reflects the confusion concerning what the study of WHY STUDY INSURANCE? risk management and insurance entails.
In fact, risk management and insurance is a sep- The reasons for studying insurance are varied. For arate and distinct discipline, which draws on and some, the study is undertaken in preparation for a integrates the knowledge from a variety of other career in the field. Others study to improve their business fields. In a micro sense, it is a discipline knowledge of the subject in order to become more in which a variety of methodologies are brought to knowledgeable consumers.
The average individual bear on a significant problem. will spend a significant percentage of his or her dis- Viewed from a macro perspective, the study of posable income on insurance over a lifetime, and insurance addresses a variety of important issues one of the logical reasons for studying insurance is facing society today: the high cost of medical care, to learn how it can be used in personal financial crime, the tort system, pollution and the environ- planning. Still others study insurance as a part of ment, climate change, and the broad subject of the discipline of risk management, the managerial ethics. Indeed, it is not an exaggeration to say that function that aims at preserving the operating effec- the debates in the insurance arena address ques- tiveness of the organization.
tions of what kind of society we will have and who Although each of these reasons is adequate jus- will pay for what. Debates over the cost of insurance tification for the study of insurance, whether that and the way in which insurance prices should study should be considered essential for business be determined have intensified over the past two students depends on the approach and the specifics decades. Increasingly, the debates over insurance of what is studied. Some have argued that the study availability and affordability have come to center of insurance per se is a narrow specialty, yet the stage as the challenges of the cost of automobile broader discipline of risk management—of which insurance, access to health care, responsibility for insurance buying is only a part—is clearly a func- pollution, damage from hurricanes, product liabil- tion that all future managers should understand.
ity, and medical malpractice have become crises. As A proper understanding of the methods of deal- consumers, we are all affected by the way in which ing with exposures to loss is essential for organi- insurance operates. Although insurance is only one of Finally, the study of risk management and insur- the techniques that can be used to deal with pure ance is a fertile field for considering the subject of PREFACE xi ethics in business and in society. Indeed, the ubiqui- sion.
Changes in the legal environment, revisions in tous presence of ethical problems in the field of in- policy forms, the introduction of new types of in- surance transactions raises an important question: surance, and a myriad of new problems continue is ethics something to be studied and learned, or is to make insurance an exciting field of study but a it something innate in the individual? challenge to the authors of textbooks. This edition has been updated to reflect new policy forms, recent laws affecting pensions and ORGANIZATION OF THE BOOK Medicare, the 2001 CSO mortality table, the emerg- ing field of enterprise risk management, issues aris- This book is divided into three major sections. The ing from Hurricane Katrina, and alternative risk first section examines the concept of risk, the na- transfer vehicles, such as catastrophe bonds.